Corporate reporting requirements and rules for financial services are expanding.

Banking and insurance supervisors are refining their expectations regarding climate-related risks, and more jurisdictions are introducing rules for asset owners and managers.

Climate-related risks are also increasingly being factored into the work of central banks and monetary policy, as evidenced by the ECB’s recent announcement.

New Sustainable Finance Strategy

The European Commission’s new sustainable finance strategy is ambitious in both substance and timeline, but some commentators say it does not go far enough. The initiatives include ones previously heralded and new ones, and will impact issuers, banks, insurers, asset managers and credit rating agencies (CRAs). The Annex (PDF 501 KB) provides a useful summary of the initiatives. In outline:

Financing the transition of the real economy

  • Support financing certain economic activities contributing to reducing greenhouse gas emissions.
  • Consider options for a possible extension of the Taxonomy framework to recognise transition efforts – report by end-2021.
  • Include additional sustainable activities in the Taxonomy – agriculture and certain energy sectors in autumn 2021, and further manufacturing and transportation activities and the other four environmental objectives by June 2022.
  • Extend sustainable finance standards and labels – EUGBS (see below), further bond labels by 2022, labels for other financial instruments by 2023, review of climate-related benchmarks by end-2021, new ESG benchmarks (no date), minimum criteria for SFDR Article 8 products (no date), prospectus disclosures for securities during 2022.

A more inclusive sustainable finance framework

  • Empower retail investors and SMEs to access sustainable finance opportunities – work on green mortgages and loans during 2022, strengthen expertise and qualification of financial advisers, tools and advisory services for SMEs.
  • Leverage opportunities that digital technologies offer for sustainable finance – link with European Data Strategy and possible extension of the Taxonomy.
  • Greater protection from climate and environmental risks through increasing insurance coverage – EIOPA to continue with its natural disaster dashboard and work on best practices, a Climate Resilience Dialogue by 2022.
  • Credible social investments – Sustainable corporate Governance initiative in 2021, report on a social taxonomy by end-2021, work with the ESAs on indicators under SFDR by end-2022.
  • Green budgeting and risk-sharing mechanisms.

Improving the financial sector’s resilience and contribution

  • Financial reporting standards that adequately reflect sustainability risks and encourage natural capital accounting.
  • ESG risks systematically and transparently captured by credit ratings and rating outlooks – ESMA to assess implementation of its guidelines on disclosures of ESG ratings by CRAs by Q3 2021 and how CRAs’ methodologies incorporate ESG factors by Q2 2022; legislative action by Q1 2023.
  • Integrate sustainability risks in banks’ risk management systems – new requirements for both banks and supervisors, including internal stress tests and SREP, as part of CRR/CRD review; consideration of energy-efficient mortgage collateral, extended prudential reporting, disclosures by more banks; EBA assessment of a dedicated prudential treatment of sustainable exposures brought forward to 2023.
  • Integrate sustainability risks in insurers’ prudential framework – requirement to conduct climate change analysis for prudential purposes, EIOPA assessment of a dedicated prudential treatment of sustainable exposures by 2023, other possible changes as part of Solvency II review.
  • Monitor and address potential systemic risks, to maintain long-term financial stability and limit systemic risk — a methodological framework and assessment of potential financial risks associated with biodiversity loss and ecosystem degradation by 2022, a report on climate-related risks to financial stability by end-2023, the ECB and ESAs to perform regular stress tests and assessments of resilience.
  • Reinforce science-based target setting, disclosure and monitoring of the financial sector’s commitments – the proposed CSRD (see below), guidance on voluntary pledges.
  • Clarify the fiduciary duties and stewardship rules of investors – EIOPA to assess broadening the concept of long-term best interests, introducing the double materiality concept and clarifying the prudent person rules before the IORPD II review; alongside IORPD II changes, further changes to MiFID II, UCITS, AIFMD and IDD; changes as part of the SRD II review by 2023, guidance on acting in concert.
  • Improve the availability, integrity and transparency of ESG market research and ratings – consultation by Q4 2021, legislative proposal by Q1 2023.
  • Assess supervisory powers to address greenwashing.
  • A robust monitoring framework to measure progress made by the EU financial system – detailed gap analysis by Q1 2023, Member States’ assessments by June 2023, consolidated report by end-2023.
  • Improved cooperation between authorities on monitoring.
  • A Sustainable Finance Research Forum.

Fostering global ambition

  • Promote ambitious cooperation in international forums and in the development of international sustainable finance initiatives and standards.
  • Expand the work of the International Platform on Sustainable Finance to new topics and strengthen its governance – reports on a Common Ground Taxonomy and sustainability-related disclosures in autumn 2021.
  • Support low- and middle-income countries in their transition efforts, with dedicated tools to help scale up their access to sustainable finance.

Corporate reporting expands

IOSCO’s report (PDF 109 KB), which provides input to the new IFRS Sustainability Standards Board (ISSB), says it is imperative that the ISSB establish strong governance, proven independence and rigorous due process. IOSCO reiterates the urgent need to improve the consistency, comparability and reliability of sustainability reporting by corporate issuers, to support investors’ evolving informational needs and the ability of markets to price sustainability-related risks and opportunities and support capital allocation.

The work of the ISSB and IOSCO focuses on climate change and will build on the recommendations of the global Task Force on Climate-related Financial Disclosures (TCFD). Some jurisdictions may adopt domestic reporting requirements in a shorter timeframe and consider wider ESG factors.

The European Commission has taken on board the ESAs’ recommendations on how large financial firms should disclose in their annual reports the proportions of revenue and expenses related to environmentally sustainable activities. The Commission has issued FAQs (PDF 334 KB) on the Level 2 rules, which provide a useful summary of the different KPIs and some clarity on reporting periods. The Commission has also proposed a Corporate Sustainability Reporting Directive (CSRD), which will cover around 49,000 companies and will apply from:

  • January 2023 for all (listed or non-listed) large companies, meeting two or more of three criteria (more than 250 employees, EUR 40 mn turnover or EUR 20 mn total assets).
  • January 2026 for all other listed companies and perhaps also many unlisted companies.

Meanwhile, the UK FCA is proposing to extend to all listed companies (excluding listed investment companies) the requirement to “comply or explain” against the TCFD’s recommendations.

Taxonomies multiply

The Commission’s EU Taxonomy Compass enables users to check which activities are included, to which objectives they substantially contribute, and what criteria they must meet. The Compass is also intended to help integration of the criteria into business databases and other IT systems. As noted above, in the autumn the Commission will issue additional Level 2 rules covering nuclear energy and agriculture. These sections of the rules have proved especially contentious, with strongly held views on opposing sides of the arguments.

The Platform on Sustainable Finance is consulting on extending the Taxonomy to cover “brown” activities and a new social taxonomy. The current Taxonomy covers only things that are definitely “green”, indicating a binary classification. The Platform notes the importance of encouraging non-green activities to transition and suggests two new concepts – “significantly harmful” and “no significant harm”. The aim of a social taxonomy would be to identify economic activities that contribute to advancing social objectives. A follow-up report by the Commission is expected by end-2021. The eventual outcome will be a mandatory social dictionary, which will add further to the corporate reporting requirements mentioned above and company processes and company-level and product disclosures for the buy-side (see below). It will also be the basis for a Social Bond Standard. Meanwhile, there are industry calls for a global approach to reporting on social issues.

In the UK, to minimise the risk of “greenwashing”, the new Green Technical Advisory Group (GTAG) will oversee the government’s delivery of a Green Taxonomy.

Asset managers and owners

The Commission has written to the European Parliament and Council saying that publication of the much-awaited final Level 2 rules under SFDR will be delayed in order to include rules on the additional product disclosures introduced via Articles 6 and 7 of the Taxonomy Regulation. Consequently, the Commission suggests that implementation deadline be delayed by six months to July 2022. However, given the amount of work required to comply with the detailed rules, it is important that firms continue to progress their current projects and timelines.

IOSCO is consulting (PDF 685 KB) on sustainability-related expectations in asset management, with reference to the TCFD recommendations. IOSCO’s report focuses on investor protection issues, existing gaps in skills and expertise, and the risk of fragmentation caused by divergent regulatory approaches. It proposes that securities regulators consider setting regulatory and supervisory expectations for asset managers regarding:

  • Asset manager practices, policies, procedures and disclosure.
  • Product disclosure.
  • Supervision and enforcement.
  • Terminology.
  • Financial and investor education.

The FCA has proposed company- and product-level disclosures for asset and fund managers, life insurers and pension providers that mirror SFDR. However, the disclosures will relate to the TCFD recommendations (not wider ESG factors) and therefore do not require consideration of principle adverse impacts. Also, there will be an exemption for firms with under £5 billion assets under management or administration.

EU Green Bond Standard (EUGBS)

The European Commission has issued a draft EUGBS Regulation, which aims to address concerns about “greenwashing” and protecting market integrity, to ensure that legitimate environmental projects are financed. It will be a voluntary standard available to all issuers, both private and sovereign, and to non-EU as well as EU issuers. The four key requirements under the proposed framework are as previously indicated:

  1. Funds raised by the bond must be allocated fully to projects aligned with the EU Taxonomy.
  2. Full transparency on how bond proceeds are allocated, through detailed reporting requirements.
  3. Checking by an external reviewer to ensure compliance with the Regulation and that funded projects are aligned with the Taxonomy (with specific, limited flexibility for sovereign issuers).
  4. External reviewers must be registered with and supervised by ESMA, to ensure the quality and reliability of their services and reviews (again, with specific, limited flexibility for sovereign issuers).

Risk frameworks and stress testing

IAIS and the UN Sustainable Insurance Forum (SIF) have issued key recommendations for insurance supervisors to strengthen efforts to address climate-related risks. The recommendations relate to the Insurance Core Principles that cover supervisory review and reporting, corporate governance, risk management, investments and disclosures.

A joint ECB/ESRB report shows uneven impacts of climate change for the EU financial sector:

  • Financial stability vulnerabilities are concentrated in certain regions, sectors and firms.
  • Vulnerability to river flooding is widespread across countries, compounded by wildfire, heat and water stress risk in some regions.
  • Transition risk resulting from financial market repricing has cross-sector impact and varies within sectors due to differences in emissions efficiency.
  • Timely and orderly macroeconomic policies can reduce financial stability risks, notably for highest greenhouse-gas emitting sectors.

“These findings underline the crucial and urgent need for climate policies and economic transitions, not only to ensure that the targets of the Paris Agreement are met, but also to limit the long-run disruption to our economies, businesses and livelihoods,” said Christine Lagarde, President of the ECB and ESRB Chair.

The EBA has published results of a voluntary stress test on 29 banks. The findings highlight the urgent need to remedy data gaps if banks are to achieve a meaningful and smooth transition to a low-carbon economy. A first estimate of aggregate green asset ratio (GAR) is 7.9%. The findings also show significant differences in banks’ application of the Taxonomy. Individual results for the banks participating in the 2021 EU-wide stress test, along with a report summarising the results in aggregate terms, will be published at the end of July.

Preliminary findings from the ECB’s first economy-wide, desktop climate stress test, which covers four million companies worldwide and 2,000 banks, looking 30 years ahead, show that in the absence of further climate policies, the costs to companies arising from extreme weather events rise substantially and greatly increase their probability of default. The final results – expected in the summer – will inform the ECB’s supervisory climate stress-test of individual banks in 2022.

Meanwhile, the Bank of England has announced the key elements of its 2021 Climate Biennial Exploratory Scenario for the largest UK banks and insurers:

  • Quantitative analysis to explore vulnerability of current business models to physical and transition risks under three scenarios – early, late and no action – plus a qualitative questionnaire.
  • Focus on credit risk in the banking book, including detailed analysis of risks to large corporate counterparties and, for insurers, on changes in invested assets and insurance liabilities assuming an instantaneous shock.
  • The exercise is intended as a learning exercise for firms and the regulator and will not be used to inform capital-setting.
  • Firm submissions are due by October 2021, with aggregated results expected no later than May 2022.

Changes to supervisory processes

EIOPA has issued three publications that support the Sustainable Finance Strategy and address key issues of climate change-related risk for the insurance sector:

  • A first pilot dashboard, which reveals that only 35% of the total losses caused by extreme weather and climate-related events across Europe are insured.
  • Proposed methodological steps for integrating climate change in the underwriting risk capital charge of the Solvency II standard formula.
  • A report on non-life underwriting and pricing.

The EBA has proposed how ESG factors and risks should be included in the regulatory and supervisory framework for banks and investment firms. A report outlines the impact ESG factors can have on firms’ counterparties or invested assets, affecting financial risks. It illustrates available indicators, metrics and evaluation methods that are needed for effective ESG risk management and identifies remaining gaps and challenges. The EBA recommends that firms incorporate ESG risk-related considerations in their strategies, objectives and governance structures, and manage the risks as drivers of financial risks in their risk appetite and internal capital allocation process.

To enhance the supervisory review and evaluation process (SREP), the EBA suggests extending the time horizon of the supervisory assessment of the resilience of institutions’ business models to at least 10 years. A phased-in approach is proposed, starting with the inclusion of climate-related and environmental factors and risks into the supervisory business model and internal governance analysis, but the EBA encourages firms and supervisors to develop quantification approaches to cover other elements.

The report should be considered in conjunction with disclosures under CRR, the Taxonomy Regulation and SFDR. Final Pillar 3 disclosure requirements on ESG risks, transition risks and physical risks will be published later this year.

Also expected soon

  • Final ESG-related amendments to MiFID II, UCITS, AIFMD, Solvency II and IDD.
  • IOSCO consultation on ESG ratings and data providers.

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