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This article is also to be published by LexisPSL.
In response to the Paris Agreement, governments and intra-governmental organisations launched a number of measures to promote sustainable finance. To date, these have focused on voluntary measures, relying on businesses and investors to self-monitor in this area. As the global move towards a more sustainable economy gathers pace, and the need to respond to the risks presented by climate change becomes more urgent, these measures are beginning to be transposed into legislation and regulation. Whilst many financial institutions have already implemented internal systems for assessing and monitoring the sustainability of their businesses, the introduction of regulatory frameworks focused on sustainable finance should lead to standardisation in this diverse area, requiring financial institutions to assess and report on sustainability issues within their existing governance and risk management structures.
This briefing will outline global and EU initiatives in sustainable finance, as well as the current approach in the UK.
Sustainable finance refers to the integration of environmental, social and governance (ESG) criteria by financial institutions into business or investment decisions1. Its origins lie in climate finance (referred to under the Paris Agreement as finance to fund activities that reduce greenhouse gas emissions or help in adapting to the impact of climate change), although the scope of sustainable finance is broader, and links also to the UN Sustainable Development Goals. In addition to environmental issues, such as reducing environmental impact, minimising waste and reducing greenhouse gas emissions, sustainable finance also includes social factors, such as working conditions, local communities, conflict and human rights, and governance matters, such as executive pay, bribery and corruption, board structure and tax strategy, within financial decision-making.
Investment criteria are often focused on short-term results. To properly assess environmental and social risk factors, which are more apparent only in the long-term, requires the finance sector to develop an investment framework which takes into account long-term risks2. To encourage this shift towards a more resilient, longer-term view, governmental and inter-governmental initiatives are increasing, to encourage financial institutions to include sustainability issues in their governance and risk management functions.
Initiatives have focused on risk disclosure, to provide greater transparency for investors. Financial institutions are encouraged to inform investors of the environmental impact of their investments, and to disclose their method of environmental risk assessments. Existing measures have concentrated on environmental, rather than social or governance-related risk disclosure, but this is likely to broaden, given the new proposals on the horizon. By encouraging financial institutions to implement sustainability risk disclosure initiatives, the aim of regulators has been to increase voluntary climate-friendly investing, reducing the need for legislative intervention in this area. The concern with this approach is that a lack of standardisation in risk assessment and labelling creates a system that is opaque to investors and regulators alike. This places the onus on the investor to satisfy themselves that a particular investment is sustainable and does not allow direct comparison between different investment opportunities. It has also not produced the increased flow of funds to sustainable investments, which is required if countries are to meet their Paris Agreement commitments.
The Financial Stability Board (FSB), an international body established by the G20, responsible for monitoring the global financial system, established the Task Force on Climate-related Financial Disclosure (TCFD), which published its final recommendations for effective disclosure of climate-related risks in June 20173.
The TCFD recommendations are applicable to financial-sector organisations, including banks, insurance companies, asset managers and asset owners. Although only a voluntary framework, the recommendations are drafted to be widely adoptable, to be useful to both investors and lenders. The recommendations include:
The Climate Disclosure Standards Board has outlined certain challenges in implementing such recommendations, including a lack of internal and investor engagement, a lack of education at board level, difficulty adapting to longer-term horizons and outdated risk management and financial modelling tools4. As a result, the extent of implementation varies widely and whilst there has been an increase in regulatory guidance at the national level, the aim of the TCFD is to facilitate an approach driven by the private sector.
The TCFD recommendations are gaining momentum in the private sector, as businesses look for clarity and consistency in this area. For example, the United Nations is providing guidance to the financial sector in transitioning to a green economy. The United Nations Environment Programme Finance Initiative (UNEP FI), together with leading banks, is developing climate-related disclosures in alignment with the TCFD recommendations5. Participating banks include Barclays, BBVA, BNP Paribas, Bradesco, Citi, DNB, Itaú, National Australia Bank, Rabobank, Royal Bank of Canada, Santander, Société Générale, Standard Chartered, TD Bank Group and UBS.
Separately, the Sustainable Banking Network (SBN) is a global initiative comprising a voluntary community of regulatory agencies and banking associations, established to facilitate the collective learning of its members and to provide support in the development of initiatives aimed at promoting sustainable investing. In February 2018, the SBN published its Global Progress Report6, evaluating sustainable finance policies in 34 member countries and suggesting practical indicators and tools which members can apply to their own domestic markets.
Linked to these initiatives are moves to develop sustainable finance focused products, including developing voluntary guidelines to encourage transparency and disclosure, and promote the development of the green products market.
Committed to becoming a global leader in sustainable finance, the European (Commission) established the High-Level Expert Group on Sustainable Finance (HLEG) in 2016, tasked with developing a comprehensive EU strategy on sustainable finance. In January 2018 the HLEG published its final report7, detailing priority recommendations.
These recommendations form the basis of the Commission’s action plan on sustainable finance adopted in March 20188, which has three main objectives
We summarise below some of the actions which the Commission propose
In May 2018 the Commission adopted measures implementing some aspects of its action plan9 which include a proposal for a regulation on the establishment of a unified taxonomy on what can be considered an environmentally sustainable economic activity, and on disclosure obligations relating to sustainable investments and risks. The Commission has also proposed amending the Benchmarks Regulation (2016/1011) to create a new category of low-carbon and positive carbon impact benchmarks. Measures are also proposed in relation to including ESG considerations into the advice that investment firms and distributors offer clients, and to clarify how asset managers, insurance companies, and investment or insurance advisors should integrate sustainability risks.
The Commission’s action plan includes a timetable for all actions that will be rolled out by Q2 201910. In terms of next steps, the proposals will be discussed by the European Parliament and the Council, with a unified EU classification system in place by June 2022 (under the current proposals). With regards to proposals on disclosure, delegated acts will further specify presentation and content of the information. These delegated acts will be adopted between end-2019 and mid-2022.
EU-level regulation in this area is considered necessary due to the divergent attitude of Member States towards environmental issues. As with other measures, the EU hopes to encourage voluntary sustainable investing rather than regulating extensively in this area.
In the UK, these global trends are supported by research published by the Prudential Regulatory Authority (PRA). In its report published in September 2018 on the financial risks facing the UK banking sector as a result of climate change11, the PRA identified two risk factors which manifest as increasing credit, market and operational risk
The PRA’s findings revealed that UK banks, building societies and regulated asset managers have begun transitioning from viewing climate change primarily through the lens of corporate social responsibility policy to viewing it as a financialrisk to their business. 60 per cent of the UK banking sector surveyed had begun considering the most immediate physical risks to their business models and were beginning to factor transition risks into decision making, albeit from a relatively narrow and a short-term perspective of 3-5 years. Only 10 per cent of those surveyed were taking a strategic view, engaging at board level to manage the long-term financial risks and an orderly transition to a low-carbon economy. Based on these findings, the PRA decided to consult on supervisory expectations on how a financial institution’s governance, strategy and risk management frameworks need to incorporate climate-related risks.
The UK is committed to helping drive the transition to a lower-carbon economy and to the delivery of sustainable development goals. As one of the prominent players in this area, the UK government has introduced measures to better integrate sustainable investing concerns into the decision making frameworks of businesses. Measures already adopted include amendments made in 2013 by the Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013 (SI 2013/1970), which require certain companies to disclose ESG matters, including their greenhouse gas emissions, in their directors’ report or, if of strategic importance, in their strategic report.
In June 2018, the House of Commons published its green finance report12 aimed at embedding sustainability in financial decision making. In doing so, businesses and regulators must factor long-term environmental risks into financial decision making. The report recommends the government should do this by
Rather than legislative intervention, the recommendations encourage the cooperation of the government, regulators and the private sector, as does the report produced by the Green Finance Taskforce (GFT), launched in 2017 to help accelerate the growth of green finance in the UK13. The report was published in March 2018 and recommends
In this context, UK regulators are beginning to consult on measures to embed climate risk into the regulatory framework.
Building on the PRA’s September 2018 report (mentioned above), the PRA is now developing supervisory expectations for banks and insurers, t with the purpose of encouraging firms to reflect on their current approach to governance and risk management structures in responding to the financial risks arising from climate change. In October 2018, the PRA published a consultation paper on a draft supervisory statement (SS) on banks’ and insurers’ approaches to managing the financial risks from climate change14. The SS is informed by the PRA’s report noted above and is intended to complement existing policy material. The desired outcome is to encourage firms to strategically manage the financial risks from climate change, by taking account of current and future risks, and actions required to mitigate those risks. The Statement sets out the PRA’s proposed expectations, with views sought by sought by 15 January 2019. Under the SS, firms will be expected to
Firms are now assessing the proposals carefully and considering the changes required to governance and management practices should the Statement be adopted.
The Financial Conduct Authority (FCA) is also looking into these issues. In October 2018, the FCA published a Discussion Paper on the impact of climate change and green finance on financial services15, setting out how the impacts of climate change are relevant to the protection of consumers and market integrity. The FCA also considers the opportunities for financial services, as a result of the transition to a low carbon economy, including the opportunity to grow as a centre for green finance, but notes that there are currently no minimum standards and guiding principles for measuring performance and impact of green finance products. Feedback is sought by January 31, 2019.
The discussion paper also identifies four areas requiring greater regulatory focus:
To help banks overcome the challenges posed by the risks of climate change, the PRA and FCA are working to establish a Climate Financial Risk Forum, aimed at improving data and furthering the development of climate-related scenarios.
The direction of travel is clear: financial institutions and investors will increasingly be required to assess, monitor and disclose the sustainability of their investments. Whilst regulatory intervention in increasing in some markets, voluntary initiatives are being adopted in others. Although measures are likely to represent an increased cost to businesses, they also present an opportunity for the development of new products and services. In the face of climate risk, the market has an opportunity to innovate which, within the appropriate framework, can drive value as well as further climate-related and ESG objectives.
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Banking, being a part of financial service industry, has now been fully opened to foreign investment.