Environmental, social and governance (ESG) issues are flying high on the boardroom agenda. The pandemic has, for many, crystalised the need to align business activities to a wider societal purpose and in service of existential challenges such as climate change. Greater political, customer and investor awareness of ESG has led to a profusion of corporate communication and product strategies. This is especially true in financial services, a sector that acts as a conduit for the global economy and holds significant gatekeeping power as a consequence. While governance requirements have been bolstered since the 2008-9 financial crisis, ESG remains a nascent field with few recognised standards.

Now, regulators are catching up. Financial institutions (FIs) operating in the UK will be required to comply with a deluge of new regulation around ESG, as early as the first half of 2022. The requirements are part of two main policy frameworks: the UK Government’s recently-released Sustainable Finance Roadmap, and the European Union’s Sustainable Finance Disclosure Regulation (SFDR). Some rules have been announced in detail. Others remain in development, but are likely to come into force next year.

  • SFDR “Double Materiality” disclosures: An ambitious sustainability policy package, the first phase of the SFDR will come into force in June 2022 and applies to any UK FI operating in the EU or transacting with EU-based clients. It will require firms to disclose to the market its impacts in two initial areas of a Sustainable Finance Taxonomy: climate change mitigation and adaptation. Four further areas will follow, with water use and protection, and the transition to a circular economy the next up. The EU’s approach is built on the Double Materiality principle; it considers both the risks and opportunities of a given sustainability area for the reporting firm, and the impacts of the company on that area. Compliance with the Taxonomy will be used to determine access to sustainable finance, a rapidly growing pool of capital the UN estimates to be worth at least $3.2 trillion. The exact disclosure requirements remain vague – clarification of expectations and data parameters is much needed. In the interim, FIs must understand the kind of data they will need to collect from their borrowers, depositors, and asset operators, and what access they currently have to it.
  • Further climate change risk and opportunity detail: The first requirement of the UK’s green finance framework is reporting on the framework of the Task Force on Climate Related Financial Disclosures (TCFD). The TCFD rules are simpler than those under the EU’s SFDR, as they are based on Single Materiality. A firm must, therefore, only disclose the risks and opportunities posed to it by climate change, rather than the details of its own impact. Asset managers and owners – including pension schemes – will have to report on TCFD in 2022, and government is seeking approval to require the largest financial services firms to do the same. All companies will need to report on the framework by 2025. While the TCFD is less arduous in some ways than the EU SFDR, it mandates a level of specificity not currently met by many firms’ sustainability reports.
  • Getting to grips with greenwashing: The Financial Conduct Authority (FCA) will be regulating ESG-marketed financial products to prevent greenwashing, the practice of labelling non-ESG compliant products otherwise. TCFD disclosures will be required for financial products in 2022, but consultations will begin on more detailed consumer-facing disclosures. As with other FCA rules, non-compliant institutions risk being sanctioned and fined. Many FS firms may be confident in their ESG product development and marketing processes, however, even institutions perceived to lead in this space are struggling with accusations of dubious practices. German asset manager DWS is under investigation for greenwashing, and investors have claimed HSBC misled them over its plans to become carbon neutral while continuing to finance coal in some countries. What is under the bonnet of ESG investments may surprise investors and CEOs alike. If the regulatory pipeline is not incentive enough for leaders to manage risk in this space, the rising tide of litigation across the Atlantic should be.
  • Diving into the detail of ESG data: The FCA is also considering regulations on ESG data providers. This area is dominated by some of the largest market data companies, including Bloomberg, S&P, and Refinitiv. There is very little standardisation of ESG data and disclosures, with companies reporting differently on a wide array of conflicting metrics. FCA rules will seek to limit the range of ESG metrics and set standards for quality, to help investors make informed capital allocation choices. The IFRS’s new International Sustainability Standards Board (ISSB) will also seek to standardise reporting practices and data sources for ESG, which the UK Government has pledged to adopt. Reporting entities should, thus, be hyper-aware of where they are getting their data – choosing the most flexible metrics may ease implementation now, but it will create challenges going forward.
  • UK-specific disclosures extending to societal impacts: Lastly, the UK will implement its own Sustainable Disclosure Requirement (SDR) and Taxonomy around 2023. Similar to the EU’s Taxonomy, the SDR will require firms to report on their impacts in several key sustainability areas, beginning with the environment and gradually expanding to social metrics. These will likely be much harder to quantify and present higher risk to FIs than environmental impacts; there are accepted methodologies for measuring carbon emissions, but far fewer approaches to accurately quantifying labour conditions or community impacts.

The rules above focus on disclosure of financial firms’ activities, rather than regulation of the activities themselves. However, this should not disincentivise leaders from ensuring their organisations are prepared. The lack of clarity and specificity is exactly what will make implementing these regulations challenging – institutions risk running aground from rapidly evolving rules in an already ambiguous space. Leaders must ensure their compliance and reporting functions are agile, and that robust processes are in place to collect this data from the business and from clients as requirements evolve. Not only will FIs likely face fines if they fail to properly disclose their ESG impacts, but they will also risk major reputational damage and investor pressures that could impact their bottom line.