Governance and sustainability

The need for good governance

Good sustainability governance is particularly critical at a time of increased scrutiny from both regulators and investors and a demand for wider sustainability-related measures to be considered as a key component of evaluating a firm’s performance. Without a robust governance structure, a firm will find it very challenging to implement its sustainability strategy across its business, manage reporting processes or strengthen its relations with external stakeholders.

Governance in sustainability reforms

In terms of governance requirements, there are already a number of international standards that touch on the topic and these are being translated into domestic rules. In Europe, governance forms a key component of both the Sustainable Finance Disclosure Regulation and the Corporate Sustainability Due Diligence Directive. In the UK, existing governance requirements are being utilised in the financial services sector ahead of reforms in the sustainability space and more widely the UK Government is consulting on a disclosure framework which also has an emphasis on governance. 

In this briefing note we try to bring together the different governance requirements in the ESG space. First, we take a look at some simple steps that a firm may take to update their governance arrangements in light of their sustainability commitments. Second, we summarise the governance requirements set out in key international, EU and UK standards.

Like any other change project

In one sense sustainability is an issue similar to many others that firms have faced. For example, with any project designed to implement new rules and requirements it should be clear which roles at a firm are responsible for driving change and ensuring that the entire organisation is aligned to the firm’s priorities and commitments. This includes on environmental and social matters, such as climate transition, biodiversity etc.

The board is ultimately responsible for the firm’s business strategy, with its role being to provide oversight and open, constructive and robust challenge in respect of the delivery of the strategy. For the board to function effectively and be equipped for long term success, members need to have the right skills, knowledge and expertise. Given that sustainability issues may require specialist knowledge, a board may include a member with the necessary technical knowledge or gain access to that expertise either internally or externally to support decision making on these issues. 

Whilst the tone from the top is important, the tone from the middle is also as important to ensure that the message from the top is cascading down to employees in their everyday work environment. Perhaps this is even more important in the sustainability space to ensure that day-to-day decision-making reflects the firm’s sustainability commitments.

With any change, a firm needs to ask itself whether it needs to update its decision-making processes and also whether its management information systems need refreshing. There may also be a need to set up new systems and controls to ensure adherence to new policies and conditions, as well as an audit trail to measure performance against plans.

TCFD

The Task Force on Climate-Related Financial Disclosures (TCFD) has a governance pillar which emphasises the importance of board and management focus on climate-related issues. When gauging the effectiveness of a firm’s climate response, the TCFD notes that investors and other stakeholders need to understand the role an organization’s board plays in overseeing climate-related issues as well as management’s role in assessing and managing those issues. Such information supports evaluations of whether climate-related issues receive appropriate board and management attention. 

In describing the board’s oversight of climate-related issues, organizations should consider including a discussion of the following:

• Processes and frequency by which the board and/or board committees (e.g., audit, risk, or other committees) are informed about climate-related issues.
• Whether the board and/or board committees consider climate-related issues when reviewing and guiding strategy, major plans of action, risk management policies, annual budgets, and business plans as well as setting the organization’s performance objectives, monitoring implementation and performance, and overseeing major capital expenditures, acquisitions, and divestitures.
• How the board monitors and oversees progress against goals and targets for addressing climate-related issues.

In describing management’s role related to the assessment and management of climate-related issues, organisations should consider including the following information:

• Whether the organization has assigned climate-related responsibilities to management-level positions or committees and, if so, whether such management positions or committees report to the board or a committee of the board and whether those responsibilities include assessing and/or managing climate-related issues.
• A description of the associated organizational structure(s).
• Processes by which management is informed about climate-related issues.
• How management (through specific positions and/or management committees) monitors climate-related issues. 

ISSB

On 26 June 2023, the International Sustainability Standards Board (ISSB) published its inaugural standards. The standards are designed to be a global baseline for sustainability reporting and ensure that companies provide sustainability-related information alongside financial statements – in the same reporting package. These inaugural standards (IFRS S1 and IFRS S2), which fully incorporate the TCFD’s recommendations, comprise general sustainability-related disclosure requirements and climate-related disclosure requirements.

IFRS S1 ‘General Requirements for Disclosure of Sustainability-related Financial Information’ is effective for annual reporting periods beginning on or after 1 January 2024 with earlier application permitted as long as IFRS S2 ‘Climate-related Disclosures’ is applied. The objective of IFRS S1 is to require an entity to disclose information about its sustainability-related risks and opportunities that is useful to users of general purpose financial reports in making decisions relating to providing resources to the entity. In particular, an entity is required to provide disclosures about the:

• Governance processes, controls and procedures the entity uses to monitor, manage and oversee sustainability-related risks and opportunities.
• Entity’s strategy for managing sustainability-related risks and opportunities.
• Processes the entity uses to identify, assess, prioritise and monitor sustainability-related risks and opportunities.
• Entity’s performance in relation to sustainability-related risks and opportunities, including progress towards any targets the entity has set or is required to meet by law or regulation.

SFDR

The primary objective of the Sustainable Finance Disclosure Regulation (SFDR) is to lay down harmonised rules for transparent communication of sustainability-related information at entity-level and product-level. It also provides for a classification of financial products based on their non-financial features. The SFDR defines three categories of financial products: Article 9 products (with a defined sustainable investment objective), Article 8 products (promoting environmental or social characteristics), and Article 6 products (mainstream products that do not have any specific ESG characteristics or sustainable objective but may integrate sustainability risks). 

Article 8 products promote, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices. The SFDR does not set out minimum requirements that qualify the concept of good governance. Financial market participants need to carry out their own assessment for each investment and disclose their underlying assumptions. A number of firms have created a good governance policy which sets out how they evaluate and monitor potential and current investments for good governance.

Corporate Sustainability Due Diligence Directive

Firm’s operating in the EU will also be keeping an eye on the proposed Directive on Corporate Sustainability Due Diligence (CSDD) as it makes its way through the trilogue process. The proposed CSDD serves a number of purposes. First, the CSDD should improve corporate governance practices to better integrate risk management and mitigation processes of human rights and environmental risks and impacts, including those risks that stem from value chains, into corporate strategies. Second, the CSDD is aimed at increasing corporate accountability for adverse impacts and ensuring coherence for companies with regard to obligations under existing and proposed EU legislation as well as policies on responsible business conduct. Third, the CSDD should improve access to remedies for persons affected by adverse human rights and environmental impacts of corporate behaviour.

ECB report

On 21 April 2023, the ECB published a report containing the results of its third review of the disclosure of climate-related and environmental (C&E) risks among significant institutions (SIs) and a selected number of less significant institutions (LSIs). The review was conducted by the ECB and Member State competent authorities and covered 103 SIs and 28 LSIs. In addition, the disclosures of 12 global systematically important banks established outside the EU were benchmarked against the disclosures of the EU banks within the scope of the assessment. The report describes the main findings of the review for all these institutions.

In terms of governance, the report noted that notwithstanding an ever-improving picture in the context of internal governance as regards climate-related risks, there was still progress to be made towards more detailed disclosures providing more precise information regarding the interface between the respective committees, the flow of information among the three lines of defence, the bottom-up and top-down provision of information, the frequency of reporting and the transversal nature of climate-related risks as embedded in the risk management spectrum of the institutions.

The report also set out observed practices which may be useful to firms generally. For example:

• Climate-related risk reporting is sent to the management board and the risk committee of the supervisory board on a regular basis, while meetings are held every two months so that the highest decision-makers are regularly informed about relevant sustainability issues. The chair of the management board is in regular contact with the chief sustainability officer (at least once a month) and receives information on various sustainability issues. In addition, current developments in the area of ESG are discussed at every meeting of the supervisory board.
• Climate-related risk topics can be followed up in different ways, including via a dedicated body, a forum and/or a dedicated sub-committee, several institutions also include detailed information on the following elements: composition and frequency of meetings, processes to report information to the management bodies and the overall involvement of the management bodies in the management of this risk. The various approaches should not be seen as mutually exclusive. Several institutions have adopted a combination of methodologies
• Banks assigned (and subsequently disclosed) responsibilities for climate risk to the three lines of defence for the primary risk domains (market risk, credit risk, underwriting risk and liquidity risk). In particular, banks described how these departments implement an appropriate risk management framework consisting of the identification, measurement, management and reporting of climate risk in accordance with the risk appetite statement established by the board. One institution has started providing this information in visual form through a high-level description of roles in relation to C&E risks across the three lines of defence, including any other department and/or function supporting their work.

UK’s Transition Plan Taskforce

In 2022 the UK launched the Transition Plan Taskforce (TPT) to support the UK Government’s commitment to make the UK the world’s first net zero financial centre. In February 2023, the TPT’s consultation on a disclosure framework for credible transition plans closed. The framework builds on the recommendations and guidance of the Glasgow Financial Alliance for Net Zero (GFANZ). Both the GFANZ and the TPT recognise that a credible strategy to deliver on net zero commitments will require fundamental changes to governance, culture, people strategies and incentives.

The governance aspect of the TPT disclosure framework emphasises:

• Board oversight and reporting: arrangements for board-level governance of the transition plan, including its processes for board-level review and approval of the transition plan, and for the oversight of monitoring and reporting of progress against the entity’s stated objectives and priorities.
• Roles, responsibility and accountability: senior management roles and responsibilities for the execution of the transition plan, as well as the entity’s wider control, review and accountability mechanisms.
• Culture: the steps that the entity has put in place to build a culture aligned with the strategic ambition in its transition plan, including through leadership and training programmes, HR policies and procedures and wider workforce engagement.
• Incentives and remuneration: arrangements to align remuneration and incentive structures with the stated objectives and priorities in its transition plan.
• Skills, competencies and training: skills, competencies and knowledge across the organisation to effectively design, develop and deliver the transition plan.

PRA and FCA requirements

UK financial services firms have to adhere to a number of rules regarding governance that have been put in place by the regulators – the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA). 

For instance, the PRA sets expectations, for dual regulated firms, in Supervisory Statement 5/16 that an effective board needs to include individuals with a mix of skills and experience that are up to date and cover the major business areas in order to make informed decisions and provide effective oversight of the risks. This may include having members of the board with a background or expertise in sustainability-related matters or facilitating access to that expertise either internally or externally to support decision making on these issues.

The Financial Reporting Council’s Corporate Governance Code requires that the board should establish the company’s purpose, values and strategy, and satisfy itself that these and its culture are aligned. The PRA, in Supervisory Statement SS5/16, expects that ‘the board should articulate and maintain a culture of risk awareness and ethical behaviour for the entire organisation to follow in pursuit of its business goals’.

In addition, in Supervisory Statement 3/19 the PRA sets the expectation that firms should allocate responsibility for identifying and managing financial risks from climate change to an appropriate existing senior manager within the firm’s organisational structure. Furthermore, this activity should be included in that senior manager’s statement of responsibilities.

For UK financial services firms regulated by the FCA only (solo regulated forms), the FCA does not prescribe responsibilities for senior managers for the delivery of climate- or other sustainability-related objectives. The regulator believes that responsibility for these objectives could extend across various roles in the organisation, and it is up to firms to consider who is responsible and accountable. 

The remuneration codes that the regulators have introduced promote effective risk management. A firm’s remuneration policy should be aligned with its purpose, long-term strategy and values. Under the MIFIDPRU Remuneration Code (SYSC 19G), this should also include consideration of ESG risk factors and the firm’s culture and values. Guidance in the FCA’s MIFIDPRU Remuneration Code provides a non-exhaustive list of examples that MIFIDPRU investment firms may wish to consider when assessing individual performance. This list includes achieving targets relating to ESG factors and diversity and inclusion. 

In terms of a firm maintaining appropriate oversight of its products and services, the FCA’s product governance sourcebook refers to ‘the systems and controls firms have in place to design, approve, market and manage products throughout the products’ lifecycle to ensure they meet legal and regulatory requirements’. The FCA expects all firms making sustainability-related claims about their products or services to maintain appropriate governance arrangements to deliver the product in line with these. It also expects firms to have appropriate arrangements in place to ensure those claims reflect the sustainability profile of the product. Where firms have specific governing bodies in place in relation to their products the FCA expects those governing bodies to have appropriate oversight of and accountability for the delivery of the product.

In line with the UK Government’s commitment to introduce mandatory TCFD-aligned disclosure requirements across the economy by 2025, the FCA has introduced climate-related disclosure rules for listed issuers (Policy Statements 20/17 and 21/23) as well as regulated firms (asset managers and FCA-regulated asset owners) (Policy Statement 21/24).

The UK Government’s Roadmap to Sustainable Investing set the expectation for Sustainability Disclosure Requirements (SDR) to be introduced across the UK economy, building from the economy wide TCFD implementation by extending the UK framework to other sustainability topics beyond climate change. It signalled that the ISSB’s standards will ‘form a core component of the SDR framework, and the backbone of its corporate reporting element’. The FCA is committed to consulting on implementation of the ISSB’s standards.

FCA consultation on SDR

In October 2022, the FCA issued Consultation Paper 22/20: Sustainability Disclosure Requirements (SDR) and investment labels (CP22/20). In CP22/20 the FCA proposes to introduce a sustainable investment product label and sets out restrictions on how certain sustainability-related terms – such as ‘ESG’, ‘green’ or ‘sustainable’ – can be used in product names and marketing for products which don’t qualify for the sustainable investment labels. 

In order for products to qualify for the sustainable investment label the FCA proposes that they must meet certain overarching principles and a number of cross-cutting requirements. In terms of the overarching principles these include that a firm must ensure that appropriate resourcing, governance and organisational arrangements are in place to support delivery in line with the product’s sustainability objective. 

The cross-cutting requirements for this principle are:

• A firm must apply and maintain the following resources as appropriate for supporting and achieving the product’s sustainability objective and the delivery of its investment policy and strategy: 
  • investment professionals with appropriate skills and experience
  • technological inputs and research
  • data and analytical tools
  • where appropriate, oversight by any governing body in relation to the product; and 
  • other resources as appropriate
• A firm must carry out due diligence on any data, research and analytical resources it relies upon (including when third-party ESG data service providers are used), ensuring that any gaps and shortcomings identified are documented and appropriately mitigated.
• A firm must maintain the arrangements and resources it has in place to oversee the sustainability research, data and analytical tools that it uses and ensure that these remain fit for purpose in supporting the product’s sustainability objective on an ongoing basis.
• A firm must maintain governance and organisational arrangements that appropriately support and incentivise the high-quality delivery of its investment policy and strategy in line with the product’s sustainability objective.
  
   

CP22/20 closed for comments in January this year and the Policy Statement containing final rules is expected in Q3 2023.

Conclusion

A firm’s governance structure forms the foundation of its environmental and social programs and the framework on which policies addressing these issues are built – the international standards and those being implemented in the EU and UK recognise this.

New requirements are being implemented in both the EU and the UK and firms need to be ready for these. For those firms that are already advanced in their governance of environmental and social matters this will provide a good opportunity to review what has already been done and revise processes and procedures where necessary also taking on board any other useful guidance like the ECB report mentioned above. Given how quickly developments are moving in the ESG space, governance plans need to be fluid and not set in stone.   

For those firms that have been slow in updating their governance requirements and dealing with environmental and social issues generally, the new requirements will present a perfect opportunity to get their house in order and manage any greenwashing risk particularly given that nowadays firms must not only stand behind any ESG badge they give themselves but also provide evidence that will satisfy a regulator or even a court.