ESG and Financial Regulation Our top six predictions for the future

It's no secret that while COP26 has shone a light on the pressing need for action, there has also been some backlash amongst executive ranks against ESG. Former senior managers from multiple asset managers have decried ESG as, amongst other things, "a deadly distraction" and "harmful posturing". As the dust from COP26 begins to settle, the finance industry is about to take a leap of faith as new ESG regulations enter into force, their impact somewhat unknown, often doubted.

However, with a flurry of policy announcements from HM Treasury and the FCA in the past few weeks – one of the greatest certainties is that change is afoot. We are starting to see some signs, particularly with the release of the UK's Greening Finance roadmap (the "Roadmap"), that there is government direction on the fundamental issues.

In this briefing, we do a slight bit of crystal ball gazing and set out our view on what we consider the future trends and issues in ESG will look like in the UK, along with some predictions of things to come.

1. ESG data and related expectations - an expansion of the regulatory perimeter and expectations

With the Roadmap suggesting that ESG data providers will likely be brought into scope of the FCA remit, we expect to see an increasing focus of regulators on the accuracy and reliability of ESG data but also much higher expectations on regulated firms with regards to their use of data. In the near future, we expect firms to be required to have properly trained and experienced staff in order to interpret and challenge sustainability data appropriately.

This view is corroborated by the FCA's "Dear Chair" letter to authorised funds, which made clear that authorised funds are expected to have sufficient resources to pursue their stated sustainability objectives. As such, we expect the FCA to start asking questions of all regulated firms as to whether they possess the right staff, technology, research, data and analytical tools to meet their sustainability related goals, objectives and regulatory requirements.

We expect to see increased regulatory focus on financial institutions' resources and staff in this area, with the expectation that climate- / data- specialists form a key part of financial institutions at an operational and strategic level, to the extent they are not already.

2. Transition to Net Zero - a new area of regulatory focus and intervention

Hidden away in the depths of the Roadmap publication was a statement that the government expects transition plans to become the norm across the economy and, to that end, certain firms will be required to publish Net Zero transition plans, which consider the UK's Net Zero by 2050 target, on a "comply-or-explain" basis. The Roadmap – and subsequent UK Government announcement on 3 November during COP26 - states that regulators will incorporate standards for such plans into regulation as they develop.

It is difficult to understate the significance on this announcement. Currently, ESG regulation is very much focussed on disclosure - financial institutions can fund all the fossil-fuels and carbon-intensive industries they like provided that they disclose what they are doing. By requiring financial institutions to publish Net Zero transition plans, the UK is taking a far more interventionist approach and effectively requiring financial institutions to put ESG considerations at the core of their business strategy. Importantly investors and other stakeholders are likely to hold such firms to account in terms of their performance compared to their transition plan.

The Roadmap indicated that standards and mandatory rules will be introduced as consensus builds over what "good" looks like in the context of transition plans. Will these standards and rules tie firms in to setting net zero targets? The Government says no. (But the real questions should be will investors?).

Although firms will only be required to "consider" the UK's Net Zero target at this stage, it seems likely that expectations in this regard will shift over time and that regulators expectations may be more onerous. Similarly, institutions may face pressure to ensure that their transition plans are suitably aligned with the Paris Agreement goals.

In terms of the future, the Net Zero transition plan requirement could easily become the regulatory "hook" the FCA needs in order to take enforcement action against firms it perceives to not be taking ESG seriously. Particularly where performance as measured against the plan is not sufficiently closely aligned.

3. ESG policies - it's time to grow up

The last 24 months or so has seen a proliferation of financial products claiming to "be ESG". However, when you dig under the surface, it is not always clear that these claims are backed up by substance. Funds may market themselves as sustainable or ESG on the basis of a negative screening to exclude things like armaments manufacturers, tobacco producers and/or coal producing companies - but may still possess extensive holdings in companies in sectors such as oil and gas, without any clear Stewardship policy or other means of aligning these holdings with their stated sustainable characteristics.

This is not to say that these investment processes are necessarily problematic. The issue comes about when there is a discrepancy between the expectation of investors (particularly retail investors) when they see the term "ESG" or "sustainable" promoted in relation to a financial product and the reality of the investment process followed by that product. This issue has not been helped by SFDR - where it appears that the European Commission itself cannot seem to land on a clear definition of what amounts to an Article 6 versus Article 8 financial product.

The FCA's proposed plan to create a five-tier sustainability badge system is clearly designed to try and deal with some of the issues thrown up by the implementation of SFDR. Of those five tiers, three are labelled as "sustainable": Transitioning, Aligned and Impact. Each of these tiers will have minimum criteria which products will be required to meet in order to qualify, meaning funds will need to exhibit specific sustainability characteristics and be able to evidence these in order to market themselves as "sustainable" under the UK regime. In contrast, there is little guidance under SFDR as to what constitutes an Article 8 fund beyond "exhibiting environmental or social characteristics", leaving a grey area which has been interpreted, in some cases, loosely.

We expect the UK's announcements to lead to a movement away from the "quick-fix" approach of incorporating a light-touch negative screening process on to a fund in order to achieve Article 8 status, to more considered and robust approaches to ESG. We expect to see more asset managers and asset owners with a focus on investment approaches which incorporate screening, ESG integration and active stewardship in order to achieve the "sustainable" badges under the UK regime.

4. Oil isn't the enemy - increased promotion and regulation of stewardship

Part of the backlash against ESG has been the idea that for all a financial institution may promote its ESG credentials, it is difficult to exhibit the real-world impact of many ESG strategies. After all, if you do not invest in an unsustainable business, that does not stop someone else investing.

One of the most interesting takeaways from the FCA's keynote discussion at the FCA's Sustainability Techsprint was the notion that it would be a poor policy outcome to simply drive the ownership of fossil-fuel assets into private hands. Instead, what the FCA want is investment in change and in companies pushing others to transition to Net Zero. The idea here is that it is far more productive to own fossil-fuel assets and use your voting rights and influence a drive to an efficient Net Zero transition than it is to divest and let that asset fall into private hands, which are unregulated and beyond the FCA's reach.

As such, it is unsurprising to see a renewed focus on stewardship in the Roadmap - a marked step change from the EU regulatory approach, where it is not featured heavily at all. The UK's focus on stewardship in the Roadmap is a sign that the UK intends to push this to the forefront of ESG investing, by encouraging asset managers and asset owners to sign-up to the Stewardship Code and hinting at future standards and targets against which firms' stewardship approaches could be measured.

We expect to see regulation in the future which promotes responsible Stewardship, possibly through new disclosures or metrics specific to this area, but also by the imposition of Net Zero transition plan requirements, which will force firms to promote sustainable Stewardship practices in order to meet their own targets to achieve net zero emissions.

5. Trust and technology - the problem and the solution to the supervision of sustainability claims

• Last month we attended the FCA's Sustainability Techsprint - a four-day challenge where teams from different industries collaborate to develop solution proposals for use cases designed by the FCA. This year, the focus was on issues relating to sustainability, with some example use cases set out below:
• How can technology enable regulators to verify that ESG disclosures by both listed companies and regulated financial services firms are accurate and complete?
• How can technology be better deployed by regulators to generate insights from ESG disclosures and other unstructured data sources to understand how regulated firms and listed issuers are approaching the transition to a more sustainable future, and to help determine any further regulatory intervention that is required?

How can technology help regulators determine the key areas and data points to consider as part of their methodology for designing a robust, reliable and accurate sustainable investment label, so that consumers can better understand their choices and compare the ESG characteristics of different financial products/providers?

What we found interesting about the use cases this year was that the focus was very much on solutions to help the regulator - rather than solutions to help industry - with a clear focus on how to verify sustainability data's accuracy and reliability. In our experience, different ESG data providers can provide wildly different ESG ratings for the same company. Similarly, many clients have emphasised that it can be difficult to know which ESG data provider to choose for which business line or product. In our view, this highlights a prescient problem for the regulator: the vast influx of data from regulated firms, which needs to be verified and then utilised effectively. This will likely be dealt with by an expansion of the FCA's staff, but also by the increasing adoption of RegTech solutions.

One of the proposed solutions at the Techsprint was to use satellite imaging and blockchain technology to create a reliable and trustworthy mechanism to verify carbon offsetting claims - the idea being that if a company chooses to offset emissions through afforestation, this can be verified easily via satellite imaging, with the blockchain allowing this information to be passed along the value chain with its source remaining clear and reliability intact.

With "tools" and "trust" listed as two of the five key themes in the FCA's sustainable finance strategy, we expect to see the FCA investing heavily in technology solutions as a means of supervising firms in relation to ESG. We predict that new technology solutions will be promoted and trialled in the near future.

6. Remuneration and corporate culture - old classics

Finally, we have yet to see any concrete proposals in this area, but it is difficult to imagine such vast changes in the way that financial institutions operate without reform to remuneration structures and corporate culture.

In our view, the most likely way these changes will manifest themselves is through reforms to link remuneration to firms' Net Zero transition plans. It is not too outlandish to imagine a world where performance-related pay is linked to the achievement of Net Zero transition plan targets - both at the executive level and below. Certainly this was the rationale behind the disclosure requirement under the EU SFDR to set out how remuneration structures within firms were aligned with consideration of sustainability risks.

Clearly, as we saw from the 2008 financial crisis, remuneration can drive culture. If you reward people for achieving sustainability linked goals, the culture becomes more sustainability-oriented - or so the logic goes. However, we expect the regulators to begin focussing on culture in a wider sense. In its sustainable finance strategy, the FCA states that one of its core principles is "influence beyond rulemaking" and that it will "set expectations through [its] supervisory processes and channels for less formal influence and engagement". We might expect to see regulators setting "soft" expectations as to what steps firms should be taking to educate their staff about the impacts of their investment decisions on the climate and society, for example.

Therefore, we predict that regulators will start engaging more with firms as to what measures they are taking to embed sustainability in their corporate culture, as well as potentially a reform to remuneration rules in the medium-term.

Author: Henry Glasford