We have been working with a number of institutions, helping them to navigate the complexities of requirements around sustainable finance and managing the financial risks posed by climate change. One of the areas where this has been most pronounced, is in relation to branches and subsidiaries of third-country banks, who are required to both consider the requirements in the jurisdiction of their head office, but also the local law regimes in the jurisdictions in which they operate through subsidiaries and branches. We set out below, a summary of some of the key considerations in this context.
How does the UK regulators’ expectations apply to UK branches and UK subsidiaries of third-country firms?
The PRA’s Supervisory Statement (the SS) 3/19 ‘Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change,’ sets out the regulator’s expectations in relation to the way in which banks manage the financial risks from climate change.
Firms are expected to:
- embed the consideration of the financial risks from climate change in their governance arrangements;
- incorporate the financial risks from climate change into existing risk management practice;
- use (long-term) scenario analysis to inform strategy setting, and risk identification and assessment; and
- develop an approach to disclosure on the financial risks from climate change.
In the SS, the regulator identified the fact that several respondents had asked the PRA to clarify whether the SS applies to third-country branches. The PRA confirmed that the SS applies to regulated UK-incorporated entities, and “although it does not specifically apply to branches, those firms are welcome to advance these issues within their firm more broadly and can approach their supervisory contact to discuss the expectations if helpful.”
However, we are aware of UK branches of third-country firms, having received letters from the PRA which indicate an expectation that most firms’ business models will be impacted by climate change to some degree, and therefore that branches as well as subsidiaries should have regard to regulatory expectation in this area and be making changes to address this.
During 2020, the PRA expects firms to identify and assess their exposure to risk from climate change, and embed appropriate governance and risk management processes as well as making progress on their plans for scenario analysis and disclosure. On July 1, 2020, the PRA issued a Dear CEO letter in which it states that firms should have fully embedded their approaches to managing climate-related financial risks by the end of 2021. This means that by the end of 2021, firms should be able to demonstrate that the expectations set out in the SS have been implemented and embedded throughout their organization as fully as possible. In doing this, firms should take a proportionate approach that reflects their exposure to climate-related financial risk and the complexity of its operations.
What are some of the practical challenges for international groups with third country head offices?
Range of requirements and expectations
There is a range of regulatory requirements and expectations globally, and this makes it extremely challenging for firms to ensure they are aligned with the market in all jurisdictions where they operate.
In several jurisdictions, the regulatory regimes in this area are still developing, and firms need to be in a position to respond effectively to changes.
There are also challenges around data.
In the market, there are a number of challenges to greater embedding of sustainable finance considerations that have been identified, including:
- Data, including inconsistent data, conflicting sustainability ratings or indices, data gaps, and inconsistent coverage.
- Costs of technology to aggregate data, produce sustainability reports, benchmark performance, produce profiles, and create new sustainability-based products.
- The complexity of social factors and the lack of a definite, industry-wide definition of what social factors are.
Managing local and head office interactions
Another challenge for international groups is how to manage the dynamic between local branches/subsidiaries and head office to ensure that policies and procedures align with local and global regulatory requirements and expectations.
Sustainable finance is one area where different regulators are advancing their expectations at a slightly different rate – whilst some (for example those in the UK and EU) are already fairly advanced, others are still in the development pipeline stage.
In broad terms:
- UK regulators would expect UK operations to meet UK requirements.
- Where the regime in the UK is less strict than, but substantively aligned with, the approach taken by regulators in the head office jurisdiction, the PRA is unlikely to challenge a firm for adopting the stricter set of requirements across its global business.
- However, where the approach in the head office jurisdiction is less strict or substantively different to that taken by the PRA, then this is likely to be more problematic.
Some firms take a ‘one-way valve’ approach to applying standards across their group. This means that the firm can have strategic policies applied by head office globally, which then flow through the group to all local subsidiaries and branches. At the same time, local branches/subsidiaries might need to impose a second set of obligations on only the local business – these would not flow up to the head office or to the other global operations.
Ensuring that the UK business has the power to raise local issues and adopt a local position that might diverge from that taken centrally by head office, is important, and firms should consider questions such as:
- How do the committee structures operate?
- Who has oversight of the UK business?
- How are issues escalated to the global board?
- How can you ensure issues are raised where you have a third-country head office?
- What about reporting (horizontal and vertical) and MI?
Firms will need to document their decision making so that they could justify, if challenged, why certain decisions were made.
Is there a difference between the approach taken in relation to GSIBs and other financial institutions?
Financial risks from climate change can affect all firms, regardless of size. For instance, smaller firms with particular sector or geographical concentrations could be disproportionately affected by the financial risks from climate change.
Therefore, the PRA is keen to avoid being overly prescriptive in terms of how it expects firms to apply the requirements.
Instead, firms should consider how they best meet regulatory expectations in a way that is appropriate for them and proportionate to the nature, scale, and complexity of their business.
What do senior managers need to think about?
There is also an important element to this from a director/senior individual perspective.
Firms that are subject to the UK’s Senior Managers and Certification Regime (SMCR) will be aware that a cornerstone of the Regime is the requirement on firms to submit appropriate Responsibility Statements. Although climate change is not a prescribed responsibility, the SS reflects the fact that the PRA expects firms to identify and allocate responsibility for identifying and managing financial risks from climate change to an appropriate Senior Manager, and for this to be reflected in the individual’s Responsibility Statement and senior manager forms.
It is up to each firm to decide which senior manager should assume this responsibility – although firms asked for guidance on which individual(s) to appoint as relevant SMF holder(s), and whether they should be first- or second-line of defense, the PRA has, to-date, not wanted to be prescriptive in relation to which individual(s) should be appointed the responsible SMF(s). It is for firms to decide the individual(s) most appropriate in their organization.
How does the issue of sustainable finance fit into the broader shareholder engagement agenda?
Integrating sustainable finance considerations is a key consideration for institutional investors as part of the new Shareholder Rights Directive II (SRD II) in the EU and institutional investors and asset managers are required to:
- develop and publicly disclose a policy on shareholder engagement;
- disclose annually how they have implemented the policy;
- disclose how they have voted in general meetings of companies in which they hold shares; or
- explain why they have not complied with any of the above requirements.
The shareholder engagement policy must include detail of how institutional investors and asset managers:
- integrate shareholder engagement in their investment strategy and how the approach contributes to the creation of sustainable value for end investors, the economy and society;
- monitor companies in which they have invested;
- conduct dialogues with companies in which they have invested;
- exercise voting (and other) rights;
- cooperate with shareholders;
- communicate with stakeholders of companies in which they have invested; and
- manage conflicts of interest (actual and potential).
It’s also worth noting that the sustainability agenda is becoming increasingly important for Independent Governance Committees (IGCs), which currently provide independent oversight of the value for money of workplace personal pensions in accumulation. The FCA has now extended the remit of IGCs to include a new duty for those groups to consider and report on their firm’s policies on sustainability issues, member concerns, and stewardship, for the products that IGCs oversee (https://www.fca.org.uk/publication/policy/ps19-30.pdf)
How might Brexit impact the UK’s approach to sustainable finance?
In the Green Finance Strategy, published in July 2019, the Government committed, in relation to green finance, to at least match the ambition of the three key objectives included in the EU’s Sustainable Finance Action Plan, which are to:
- reorient capital flows towards sustainable investment;
- manage financial risks stemming from climate changes by considering environmental and social goals in financial decision-making; and
- increase transparency in financial products so that citizens can make informed decisions about their investments.
The UK will retain the framework of the EU’s Taxonomy Regulation, including the six environmental objectives, as it will enter into force on July 12, 2020, before the end of the transition period and will form part of retained EU law. However, the disclosure requirements will apply later (January 1, 2022 for climate change mitigation and adaptation; January 1, 2023 for the other objectives) and therefore will not form part of retained EU law. The Government has declined to comment on the extent to which the UK will align with the EU after the implementation period because the delegated legislation containing technical standards has not yet been published by the European Commission, meaning the UK does not “have clarity on the final outcome of the file.”
The EU Sustainable Finance Disclosure Regulation (SFDR) entered into force on December 29, 2019 and therefore forms part of retained EU law as the UK remained an EU Member State. Whilst most provisions of the SFDR are due to come into effect on March 10, 2021, some come into effect on January 1, 2022 (and have been omitted from UK law).
The amendments to the Benchmarks Regulation introducing the EU Climate Transition Benchmark and EU Paris-aligned Benchmarks enter into force on December 10, 2019 and benchmark administrators must comply with the new requirements by April 30, 2020, within the transition period. The amended Benchmarks Regulation will therefore form part of retained EU law and will apply in the UK.
How should businesses think about approaching learning lessons from COVID-19 in the context of sustainable finance?
Wider “lessons learned” reviews can be very valuable exercises to understand how businesses have performed through COVID-19.
Once the COVID-19 pandemic is under control, it is likely that the next major focus of regulators and rule-makers will be sustainability.
Firms would therefore benefit from considering sustainability as part of any future lessons learned reviews – both what has gone well and what could be improved:
- Where issues have arisen, they can give valuable insight into the root causes of these so they can be fixed going forwards.
- Businesses can also satisfy themselves that the issues should not reoccur and investigate whether they caused any detriment that needs remediating.
- Lessons learned can then be fed back throughout the business to improve processes and behaviors.
They can also give confident positive cultural messages to stakeholders and regulators. Some areas we see as particularly relevant in this context include:
- The depth and span the data businesses have, to enable meaningful review and challenge.
- The strength of their climate-related risk assessment and management processes, and how well integrated these are into their traditional risk management processes.
- The range of scenarios they use.
- The sufficiency of their policies.
- Their disclosures and target-setting in relation to their exposures to carbon-related assets.
- The robustness, detail and ambition of their climate change governance and strategies.