ESG Regulatory Essentials

This is a regular publication from KPMG's EMA Financial Services Regulatory Insight Centre, providing a summary of the latest ESG regulatory developments impacting financial services firms in the UK and EU.

Financial regulators have set out their stalls for the year ahead. For all, ESG remains a key priority and focus is expanding to meet new challenges.

January saw the publication of supervisory priorities from the International Association of Insurance Supervisors (IAIS), the European Central Bank (ECB) and the UK's Prudential Regulation Authority (PRA), with clear expectations for firms in their monitoring and management of climate-related financial risks. The European Securities and Markets Authority (ESMA) followed in February with its three-year roadmap for sustainable finance.

Requirements around sustainability disclosures continue to expand with further announcements from the UK's Financial Conduct Authority (FCA) enhancing climate-related disclosures for UK listed companies, asset managers, life insurers and FCA-regulated pension providers.

In the EU, taxonomy-aligned disclosures for the first two environmental objectives, climate change mitigation and adaptation now apply. The European Commission (EC) has presented its long-awaited proposal to expand the scope of the Taxonomy Regulation through a Complementary Climate Delegated Act which sets out conditions for the inclusion of certain nuclear and gas transition-related activities. It may not be a straightforward passage through the European Parliament for this Act, with several countries objecting to the inclusion of nuclear and gas and/or to the lack of public consultation.

The protracted debate on nuclear and gas has delayed other EC initiatives, such as the EU Ecolabel and the final EU Green Bond Standard, but the Platform on Sustainable Finance (PSF) has now issued its final report on a social taxonomy.

The IAIS and European Insurance and Occupation Pensions Authority (EIOPA) are focused on the development of climate change scenarios for insurers. ESMA is consulting on embedding ESG factors into MiFID suitability assessments and has also fed back to the European Council and Parliament on its principal observations on the draft regulation Green Bond Standard (EU GBS).

Scrutiny of ESG ratings providers continues to grow, with ESMA launching a call for evidence, and further consultation expected by the EC later in the year. ESMA is also consulting on the methodology for a climate risk stress test for central counterparties, the first of its kind.

The ECB has launched its 2022 climate stress test for banks and in the UK, the Bank of England's (BoE's) CBES is moving to a second round of submissions, due by end-March 2022.

Banks have also received the European Banking Authority's (EBA's) final draft implementing technical standards for Pillar 3 disclosures of ESG risks.

Looking ahead, the first standards from the newly formed International Sustainability Standards Board are expected soon, along with more detail on the remaining four objectives of the EU Taxonomy and the Taskforce on Nature-Related Financial Disclosures' draft framework.

• European Commission Guide towards fair and inclusive transition to climate neutrality
• European Commission adopts corporate sustainability due diligence proposal
• EU Taxonomy Complementary Climate Delegated Act  - nuclear and gas activities
• PSF – Final Report on Social Taxonomy
  
• FCA - enhanced climate-related disclosures for standard listed issuers, asset managers and owners, and pension funds
  
• ESMA Sustainable Finance Roadmap for 2022 to 2024
• ESMA consults on embedding ESG factors into MiFID II suitability assessments
• ESMA feedback on EU Green Bond Regulation proposal
• ESMA call for evidence on ESG Rating Providers 
• ESMA call for evidence on climate stress testing for CCPs
  
• IAIS roadmap 2022-2023
• EIOPA consultation on climate change materiality assessment and scenarios 
• PRA climate risk priorities 
• ECB 2022-24 climate risk priorities
• ECB climate stress test launch
• BoE climate stress test second round
• EBA Final draft ITS on Pillar 3 ESG disclosures 
• EBA consultation on remuneration and gender pay gap benchmarking exercise

The European Commission has issued its guide for a fair and inclusive transition towards climate neutrality, an integral part of the European Green Deal launched in 2019.

The proposed Council Recommendation sets out specific guidance to help Member States devise and implement policy packages that ensure a fair transition towards climate neutrality, by addressing the relevant employment and social aspects linked to the transition in a comprehensive manner. It encourages Member States to take measure and actions, adapted to their particular circumstances, including:

• Supporting quality employment and facilitate job-to-job transitions
• Supporting equal access to quality education and training
• Supporting fair tax-benefit and social protection systems
• Supporting affordable access to essential services
• Optimising use of public and private funding

European Commission adopts corporate sustainability due diligence proposal

The Corporate Sustainability Due Diligence Directive aims to “foster sustainable and responsible corporate behaviour and to anchor human rights and environmental considerations in companies’ operations and corporate governance”.

Although widely considered to be a watered down version of the original, the proposal introduces a corporate due diligence duty and specific duties for directors. The new rules will apply to large EU limited liability companies in two groups:

• Group 1: companies with 500 or more employees and more than EUR 150 million turnover worldwide
• Group 2: companies with more than 250 employees and more than EUR 40 million turnover worldwide, operating in defined high impact sectors such as textiles, agriculture, extraction of minerals. For this group, the rules will apply two years later than for Group

Third country companies whose EU-generated revenue aligns with Groups 1 and 2 are also captured.

National administrative authorities appointed by Member States will be responsible for supervising the new rules and may impose fines in the case of non-compliance. In addition, victims will be able to take legal action for damages that could have been avoided with appropriate due diligence measures.

The proposal will now go to the European Parliament and the Council for approval. Once adopted, Member States will have two years to transpose the Directive into national law and communicate the relevant texts to the Commission.

EU Taxonomy developments on gas and nuclear activities

Following consultation through 2021, the EU Commission has presented a Taxonomy Complementary Climate Delegated Act on climate change mitigation and adaptation covering certain gas and nuclear activities.

The Complementary Delegated Act sets out clear and strict conditions, under which certain nuclear and gas activities can be added as transitional activities to the activities already covered by the first Delegated Act on climate mitigation and adaptation, which became applicable on 1 January 2022. In summary:

• Both gas and nuclear must contribute to the transition to climate neutrality
• Nuclear must fulfil nuclear and environmental safety requirements
• Gas must contribute to the transition from coal to renewables

The Complementary Delegated Act also introduces specific disclosure requirements for businesses related to their activities in the gas and nuclear energy sectors. To help ensure transparency, the Commission has also amended the Taxonomy Disclosures Delegated Act, so that investors can identify which investment opportunities include gas or nuclear activities and make informed choices.

The Complementary Delegated Act will enter into force and apply as of 1 January 2023. For more, see the European Commission Q&As here and the European Commission factsheet here ( PDF 352 KB).

PSF - Final report on Social Taxonomy

Progress towards a social taxonomy continues, slowly, with the publication (PDF 1.72 MB) of the PSF’s final report on a proposed structure. Three overarching social objectives, decent work (including across the value chain), adequate living standards and well-being for end-users, and inclusive and sustainable communities and societies are complemented by sub-objectives which will be used to focus on the identification and measurement of substantial contributions to health and safety, healthcare, housing, wages, non-discrimination, consumer health, and communities’ livelihoods.

Three types of substantial contribution are proposed:

• The creation of additional social benefits deriving from the inherent benefit of the activity itself — for example the research of pharmaceuticals
• The avoidance and mitigation of negative impacts on workers, consumers or communities — for example paying wages as agreed in collective agreements
• Enabling activities which help other activities meet the above two criteria

As in the environmental taxonomy, activities making a significant contribution to one objective must not do significant harm to any other objective. Socially harmful activities will be identified and excluded.

Taxonomy alignment will be at activity rather than company level when considering substantial contribution and DNSH. However, minimum safeguards will be applied at company level. The approach to evidencing alignment/compliance is still to be developed.

The EC is not bound by any of the recommendations in the report. It will feed into a further EC report on the extension of the taxonomy framework, as required under the Taxonomy Regulation.

Enhanced climate-related disclosures for standard listed issuers

The FCA has extended its climate-related disclosure requirements for premium listed commercial companies to a wider scope of standard listed companies. The new policy will apply (for accounting periods beginning on or after 1 January 2022) to firms which issue standard shares (including equity and those other than equity) and standard listed issuers of global depository receipts which represent equity shares.

More listed companies will now be subject to TCFD-aligned disclosures on a comply or explain basis.

Relevant firms must include a statement in their annual financial report:

• Setting out whether they have made disclosures consistent with TCFD recommendations in their annual financial report
• If some or all disclosures are inconsistent with TCFD recommendations, explaining why and describing the steps being taken to make consistent disclosures in the future. Timeframes for compliance must be disclosed
• If disclosures are not made wholly in the annual report, explaining why and where the disclosures can be found

Enhanced climate-related disclosures for asset managers, life insurers and FCA-regulated pension providers

The FCA has also published a policy statement (PDF 824 KB) mandating annual disclosures at entity and product level for asset managers, including:

• Investment portfolio managers
• UK Undertakings for Collective Investment in Transferable Securities (UCITS) management companies
• Full-scope UK Alternative Investment Fund Managers (AIFMs)

and FCA-regulated pension providers, including:

• Life insurers (including pure reinsurers) in relation to insurance-based investment products and defined contribution (DC) pension products
• Non-insurer FCA-regulated pension providers, including platform firms
• Self-invested Personal Pension (SIPP) operators, to the extent that SIPP operators provide a ready-made selection of investments

At entity-level, an annual TCFD entity report must be published in a prominent place on the main website of the firm's business, disclosing how a firm takes climate-related matters into account when managing or administering investments on behalf of its clients.

At product level, core climate metrics and other information as to the firm's products and portfolios and its alignment with climate-related targets should be disclosed.

The rules are accompanied by guidance to help firms determine whether their disclosures are consistent with TCFD recommendations. A new ESG sourcebook, containing rules and guidance on TCFD-aligned disclosures will be added to the FCA Handbook.

ESMA has issued its Sustainable Finance Roadmap for 2022 to 2024

The roadmap (PDF 331 KB) sets out three key objectives for ESMA's sustainable finance work:

• Tackling greenwashing and promoting transparency
• Building National Competent Authorities' and ESMA's capacities in the sustainable finance field
• Monitoring, assessing and analysing ESG markets and risks

ESMA has identified one cross-activity workstream and seven business activities, and developed an action plan for the next three years which will include:

• Reviewing the supervisory approach to greenwashing
• Reviewing technical standards for SFDR regulation to better define the Principle Adverse Impacts for (i) climate and environment and (ii) social and employee matters, including human rights, and anti-bribery and corruption
• Developing technical standards to support proposed EU Green Bond regulation
• Reviewing the current state of EU ecolabels
• Developing a standardised approach to climate scenario analysis for investment managers - including a one-off stress test to test the resilience of investment funds
• Assisting with the proposal for the creation of an EU ESG benchmarks label
• Co-ordinated supervisory action on sustainability disclosures and ESG factors in suitability assessments
• The building of analytical tools to monitor developments in carbon markets

ESMA consults on embedding ESG factors into MiFID II suitability assessments

The consultation (PDF 527 KB) until 27 April proposes draft guidelines for certain aspects of the MiFID suitability requirements, including:

• Collection of information — firms will need to collect information on clients' sustainability preferences and the extent to which they want to invest in the different types of sustainable products
• Assessment of sustainability preferences — once a firm has identified a range of suitable products for client, it shall identify the product(s) that fulfil the client's sustainability preferences
• Organisational requirements — firms will need to provide staff with appropriate training on sustainability topics and keep appropriate records of clients' sustainability preferences including any updates to these preferences

A final report is expected in Q3 2022.

ESMA feedback on EU Green Bond Regulation proposal

ESMA welcomed the potential of the regulation to help channel investment flows towards more sustainable activities, but noted challenges in three key areas:

• The timing of implementing measures — so-called “level 2” deliverables
• The functioning of third country regimes
• The appropriateness of the resourcing and funding model provided for ESMA's supervision, taking into account the need for external verifiers for third country regimes

ESMA call for evidence on ESG ratings providers

ESMA has launched a call for evidence on Market Characteristics for ESG Rating Providers in the EU. The questionnaire is aimed at ESG ratings agencies, parties using such ratings, and entities subject to ESG ratings.

ESG ratings agencies are not currently in the scope of ESMA's supervision. However, ESMA has begun work to promote good practice amongst ESG ratings agencies, and this call for evidence aims to gather information as to the number, size, business models and product offerings of different ESG rating providers active within the EU.

This information will be used to develop ESMA's approach to the potential supervision of relevant ratings agencies. Stakeholders responses are requested via the questionnaire (PDF 258 KB) by 11 March 2022.

A further, complementary consultation on the use of ESG ratings will be launched soon by the European Commission. This will consider stakeholder views on ESG ratings, the functioning and dynamics of the market, potential issues and also help to evaluate potential costs of intervention at EU level.

ESMA call for evidence on climate stress testing for CCPs

ESMA has launched a call for evidence on its proposed approach to climate stress testing for central counterparties (CCPs). It seeks views, by 21 April on:

• A proposed classification of climate risks relevant to CCPs
• The methodology for building an EU-wide climate risk stress testing framework for CCPs
• How to best calibrate the stress test
• The current status of climate risk assessments by CCPs

The call for evidence aims to (i) map the specific climate-related risks that apply to CCPs, (ii) understand how these risks can be assessed and what limitations need to be acknowledged, (iii) take stock of ongoing efforts by CCPs, and (iv) contribute to market participants’ awareness of the relevance of climate risks to CCPs.

The IAIS has published its roadmap for 2022 to 2023

Amongst its key objectives the IAIS will develop its integration of climate data collection into the global monitoring exercise (GME), led by its Climate Risk Steering Group.

The IAIS's climate risk working group will undertake climate risk scenario analysis, assessing the need for further guidance to be made as to effective supervisory practice and supporting information specific to the insurance sector.

The climate risk working group will also perform a gap analysis of IAIS supervisory material for indicators that changes are requires to ICPs or other frameworks to take account of climate risk.

EIOPA has concluded its consultation on the application guidance on running climate change materiality assessment and using climate change scenarios in the Own Risk and Solvency Assessment (ORSA)

EIOPA notes that only a small minority of undertakings currently assess climate change risk using scenario analysis in the ORSA. Where undertakings perform a quantitative analysis of climate change risk, most assessments take a short-term perspective. EIOPA therefore proposes to develop additional non-binding application guidance.

This should support firms in meeting the requirements of Article 45a of Solvency II under which insurers must identify any material exposure to climate change risks and, where relevant, assess the impact of long-term climate change scenarios on their business.

Final application guidance is expected in June 2022 once feedback has been integrated and the March 2022 pilot exercise is complete.

PRA climate risk priorities

The PRA wrote to UK banks (PDF 380 KB), international banks (PDF 367 KB) and insurers PDF 372 KB) setting out its supervisory priorities for 2022. All PRA-supervised firms are expected to take a forward-looking, strategic, and ambitious approach to managing climate-related financial risks that is proportionate to the scale of the risks and the complexity of their operations.

The PRA notes that progress in embedding the supervisory expectations set out in SS3/19 (PDF 880 KB) has been inconsistent across firms. From 2022, climate-related financial risks will be a core part of the PRA's supervisory approach and will be included in all relevant elements of the supervisory cycle.

As understanding, data, tools, and best practice evolve, firms will be expected to refine their approaches to climate-related risks. The PRA will focus on how firms quantify and incorporate those risks into business strategies, decision-making, and risk-taking and will deploy the full range of supervisory tools where firms' progress is deemed insufficient.

Insurers are encouraged to conduct further research on emerging climate-related risks such as the potential impact of litigation risk on their balance sheets and the impact of physical risks on assets and liabilities. See our article here.

ECB climate risk priorities

The ECB's supervisory priorities for 2022 to 2024, identify banks' exposure to climate-related and environmental risks as a key vulnerability. Banks are expected to proactively incorporate climate-related and environmental risks into their business strategies and governance and risk management frameworks.

Key planned supervisory activities include:

• Bottom-up climate risk stress test and development of best practices on climate stress testing
• Thematic review of banks' strategies and governance and risk management frameworks
• On-site inspection

The ECB has formally launched its 2022 climate stress test (CST)

The exercise fulfils the ECB's obligation under CRD 4 to carry out an annual stress test on supervised entities, and aims to identify vulnerabilities, industry best practices and the challenges faced by banks in managing climate-related financial risk.

The CST will be conducted in the first half of 2022 with banks submitting their templates from March. Supervisors will then engage with banks to provide feedback and ensure fair and consistent outcomes. Aggregate results will be published in July 2022.

The exercise consists of three modules. Banks will be asked to participate in module 1, modules 1 and 2 or all 3 modules, as determined by the ECB.

Module 1 — a questionnaire to assess how banks are building their climate stress test capabilities to be used as a risk management tool. The results of this module will give an overview of banks' progress.

Module 2 — peer to peer benchmark analysis across a set of defined climate risk metrics. The results of this module will provide an indication of how sustainable banks' current business models are, and the extent to which they, individually and as a sector, are exposed to carbon-intensive companies. Metrics will include disclosure of income from carbon-intensive industry sources, and the volume of greenhouse gases financed by banks.

Module 3 — a bottom-up stress test which will consider both physical and transition risks including:

• How extreme weather events would affect banks over a 12 month time horizon
• The vulnerability of banks to a sharp increase in the price of carbon emissions over a three year time horizon
• How banks would respond to transition scenarios over the next 30 years

A degree of proportionality will be permitted in banks' responses to the stress test methodology, and the smallest banks will not be required to determine their own projections. Quality assurance procedures are required for all participants but will also be subject to a proportional approach.

Output from the CST will be integrated into the Supervisory Review and Evaluation Process (SREP) using a qualitative approach. There will be no direct capital impact through Pillar 2 guidance, however it is possible that there could be an indirect impact, via the SREP scores.

In 2022, the ECB will also carry out a thematic review of banks' climate-related and environmental risk management practices — the results of this review will be included in full in the SREP.

BoE climate stress test second round

The BoE has asked all first round CBES participants (banks and insurers) to make further submissions by 31 March. The second round will focus on challenges to participants' business models from climate-related risks, their likely responses and the implications for the provision of financial services.

The EBA has issued final draft implementing technical standards (ITS) on Pillar 3 disclosures on ESG risks.

The final draft (PDF 1.25 MB) ITS follow the March 2021 draft for consultation and will enter into force from 28 June 2022.

The final draft ITS aim to ensure that stakeholders are well-informed about institutions' ESG exposures, risks, and strategies and can make informed decisions and exercise market discipline. They implement the Pillar 3 framework for prudential disclosures on ESG risks, to support banks in disclosing meaningful and comparable information on how ESG-related risks and vulnerabilities, in particular climate change, may exacerbate other risks in their balance sheet.

The framework will allow investors and stakeholders to compare the sustainability performance of institutions and of their financial activities. It will also help banks be more transparent about how they are mitigating risk and how they are supporting their customers and counterparties in adapting to climate change and the transition to a more sustainable economy.

The ITS put forward comparable quantitative and qualitative disclosures and KPIs, including a green asset ratio (GAR) and a banking book taxonomy alignment ratio (BTAR).

They build on TCFD recommendations, the EU Commission's non-binding guidelines on climate reporting, and the published parts of the EU taxonomy.

The current focus is on climate change, but the ITS will be extended at a later stage to broaden the scope of quantitative disclosures to other ESG risks.

Since the consultation stage:

• A number of templates have been simplified based on feedback received
• Concerns as to the confidentiality of information have been addressed in aggregation of disclosed information
• A proposal to extend the templated disclosure for physical risk has been dropped, with the BTAR disclosure remaining in a simplified version
• A proposal for disclosure of trading book taxonomy alignment has been dropped. Further development of this disclosure is expected in future ITS iterations

The EBA is consulting on updates to its guidelines for the remuneration and gender pay gap benchmarking exercise for banks and investment firms

The guidelines were originally published in 2012 and updated in 2014. The EBA notes that the principle of equal pay for equal work or work of equal value and measures to ensure equal opportunities have already been included in the EBA Guidelines on sound remuneration policies and internal governance.

The benchmarking of the gender pay gap will allow competent authorities to monitor the implementation of such measures and their development at different levels of pay. The guidelines aim at ensuring that the benchmarking of the gender pay gap covers a representative sample of institutions. Specific templates for the benchmarking of the gender pay gap have also been introduced.