ESG Regulatory Essentials

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

As we head into February, regulators are again pressing ahead with their ESG agendas. Following a flurry of regulatory publications in the run-up to the holiday season, indications so far in 2023 are that regulators are well and truly in `back to work' mode. However, this edition is shorter than the last one as we move to a bi-monthly publication cycle to bring you updates more rapidly.

One of the most significant updates at the end of 2022 was the UK government's announcement on the proposed Green Taxonomy. This finally confirmed publicly that the Taxonomy has been delayed, and that the expected approach will be considered “carefully” — paving the way for changes to both the substance and form. The independent “Skidmore Review”, published in early 2023, maintains pressure on the UK government to fulfil its net-zero ambitions and includes recommendations that will be of interest to businesses across the UK, including financial services firms.

Looking to the EU, the changes that were made in July 2022 to include certain nuclear/gas activities in the EU Taxonomy entered into force on 1 January 2023. Consequential amendments will be made to the Sustainable Finance Disclosure Regulation (SFDR) product-level disclosure templates. The European Securities and Markets Authority (ESMA) also published advice from its Securities and Markets Shareholder Group (SMSG) on how exposures to fossil gas and nuclear energy should be disclosed in precontractual information and periodic reporting. The European Commission has adopted revisions to the templates, but they are still being considered by the Council and Parliament.

Still on disclosures, asset managers should take note of ESMA’s research paper on the proposed EU Ecolabel for retail financial products — while there is no action to take, the paper highlights the challenges in developing a stringent yet feasible labelling framework. Additionally, the three European Supervisory Authorities (ESAs) each published their opinions on the draft European Sustainability Reporting Standards (ESRS), which are due to be adopted in June 2023. At a global level, the ISSB is still deliberating on the detail of its first two standards for sustainability and climate-related disclosures and has announced that they too will be finalised in June this year.

The UN’s COP15 conference in Montreal at the end of 2022 was a significant moment. The Kunming-Montreal Global Biodiversity Framework (GBF) was introduced, with governments signing up to ambitious commitments to preserve and protect biodiversity. For financial services firms, the expectations on reporting and disclosures are particularly relevant.

Climate-related financial risk continues to be a priority for banks and insurers. EIOPA has published two papers: a discussion paper on the prudential treatment of sustainability risks, and another on the transition risk exposure of Institutions for Occupational Retirement Provisions (IORPs). The Basel Committee on Banking Supervision (BCBS) has released FAQs on how climate-related risk should be captured in Pillar 1 calculations, and the European Central Bank (ECB) has published climate-related statistical indicators to help narrow the climate data gap. In the UK, the Climate Financial Risk Forum (CFRF) released cross-sectoral guides following its third session. For the first time the guides cover the transition to net zero, as well as continuing to focus on scenario analysis, disclosures, data and metrics.

Regulatory attention has turned to the role of carbon markets. The European Council and Parliament reached provisional agreement on the Carbon Border Adjustment Mechanism (CBAM), and the European Commission, under the European Green Deal, has proposed a voluntary framework to certify high-quality carbon removals. Additionally, the International Organisation of Securities Commission (IOSCO) has launched two public consultations on the development of Compliance Carbon Markets (CCM) and Voluntary Carbon Markets (VCM).

Looking ahead, the PRA’s annual letters to banks and insurers have noted climate risk as an ongoing supervisory priority, and the International Association of Insurance Supervisors’ (IAIS) 2023 – 2024 Roadmap reinforces its commitment to responding to the emerging and accelerating risks, as well as challenges and opportunities, of climate change.

For more information, read on.

• Net-zero reviews
• Taxonomy developments
• Reporting and disclosures
• Nature and biodiversity
• Climate-related financial risk
• Carbon markets

Skidmore 'Net Zero Review'

Former UK Energy Minister and Chair of the Net Zero Review, Chris Skidmore, published his independent report on how the UK can deliver on its net zero commitments. The review makes 129 recommendations, many of which relate to `backing business' and would, if adopted, affect financial services firms.

The report recommends that the government should:

• Review, by the end of 2023, how HM Treasury (HMT) incentivises investment in decarbonisation, including via the tax system and capital allowances.
• Before Autumn 2023, conduct and publish a review of how the UK should change regulation for emerging net zero technologies.
• Through the HMT and the Department for Business, Energy & Industrial Strategy (BEIS) update to the Green Finance Strategy, set a clear, robust, and ambitious approach to disclosure, standard setting, and scaling up green finance — including how the strategy will meet existing commitments to implement Sustainable Disclosure Requirements across the economy.
• Create a new forum to coordinate across all regulators on the signals they are sending to businesses and investors across sectors about the net zero transition — including the FCA, Ofwat, Ofgem, Environment Agency, Competition and Markets Authority, and the North Sea Transition Authority.
• Protect industries from environmental undercutting by progressing a consultation on carbon leakage measures and speeding up decision-making to enable government to implement effective future carbon leakage mitigations from 2026.
• Provide businesses with clarity and increase the incentives to invest in new, green technologies, and developing a pathway for the UK Emissions Trading Scheme (ETS) Authority until 2040.

The report does not require firms to take any action. However, it was informed by a call for evidence and direct engagement with businesses, organisations, local government, academia and the public, and as such is a helpful barometer of both public and industry opinion on how the UK government should proceed with its net-zero ambitions.

Development of UK Green Taxonomy

A statement from Andrew Griffith, Economic Secretary to the Treasury, clarified that the UK government would not make secondary legislation under the on-shored Taxonomy Regulations in 2022. The Financial Services and Markets Bill (FSMB) currently before Parliament will repeal retained EU law relating to financial services — including the Taxonomy Regulations — effectively removing the obligation to make and adopt the Technical Screening Criteria (TSC) by 1 January 2023. HMT will consider how to use the powers in the FSMB to “restate and modify retained EU law and decide whether to change the UK's approach”. For more information, see the article above.

ISSB final standards expected in June 2023

Speaking on a panel at the World Economic Forum in Davos, the Chair of the IFRS Foundation Erkki Liikanen announced that the International Sustainability Standards Board (ISSB) will release its first two finalised disclosure standards in June 2023.

Originally published in March 2022 for consultation, the standards set out general sustainability-related (draft IFRS S1) and climate-related (draft IFRS S2) disclosures. The final date is later than expected, with the ISSB revealing after its January meeting that the following proposals require further deliberation:

• In both drafts:
  • The objective for disclosing metrics and targets.
  • The requirements for an entity to disclose current and anticipated financial effects of sustainability-related risks and opportunities.
  • The concept of “reasonable and supportable information that is available at the reporting date without undue cost or effort” and whether and how to introduce this concept.
• In draft IFRS S1:
  • The requirements for an entity to disclose its judgements, assumptions and estimates, and the current and anticipated financial effects of sustainability-related risks and opportunities.
  • The requirement to disclose information about sustainability-related opportunities in circumstances when that information may be commercially sensitive.
  • The requirements on connected information.
• In draft IFRS S2:
  • The requirement for an entity to use scenario analysis to assess its climate resilience.
  • The requirements for an entity to disclose its greenhouse gas emissions and a potential reporting relief.
  • The requirement for an entity to disclose its climate-related targets.
    

ESAs provide views on draft European Sustainability Reporting Standards (ESRS)

In January the three ESAs — the EBA, EIOPA and ESMA — provided their opinions on the draft European Sustainability Reporting Standards (ESRS). Published in November 2022, the draft ESRS are currently subject to review by the European Commission, with the three ESAs having been invited to provide their comments.

All three regulators agree that the ESRS are broadly consistent with both international standards and relevant EU directives. However, moving beyond this overall view and delving into the detail, we note that they all seek further clarification from the Commission on technical matters.

The EBA asks for additional guidance on:

• Interoperability with international standards, especially with regard to timings of both the ESRS and the standards from the ISSB.
• The materiality assessment and implementation of value chain concept for firms in financial services.
• Alignment with the EBA’s Pillar 3 requirements.
• Consistency between the ESRS and European directives on accounting and on fraud.

Some of the areas highlighted by ESMA for clarification are:

• The materiality assessment process.
• The definition of ‘corruption’ and its consistency with other EU law definitions.
• A mapping of how ESRS align with ISSB standards and the Global Reporting Initiative (GRI).

Finally, EIOPA’s opinion notes that:

• To avoid fragmentation of sustainability reporting requirements across jurisdictions, firms that report under ESRS should automatically be considered as complying with the IFRS sustainability reporting framework.
• To level the playing field with the banking sector, low-risk undertakings should be allowed to apply simplified standards under the CSRD.

The Commission will consider these opinions and adopt the final ESRS in June 2023.

ESMA research paper on EU Ecolabel for retail funds

EU authorities have been considering creating a version of the EU Ecolabel for EU retail financial products. This would help retail investors make informed investment decisions on the sustainability features of investment products. ESMA has now published research that tests three draft Ecolabel criteria on a sample of 3,000 sustainability-oriented UCITS equity funds with EUR 1 trillion in assets under management.

Using fund portfolio holdings and proxy data, ESMA found that only 0.5 % of the sampled funds would meet both the proposed "minimum portfolio greenness threshold" of 50% and the exclusion requirements:

• Criterion 1 —Portfolio greenness ratio (based on companies' green turnover and capital expenditure as defined in the EU Taxonomy): only 26 funds (less than 1% of the sample) had a portfolio greenness ratio above 50%. Article 9 funds were more likely than Article 8 funds to meet the threshold (0.4% of sampled Article 8 funds and 3.7% of sampled Article 9 funds met the threshold).
• Criteria 2 & 3 — Environmental and social exclusions: only a subset of four types of exclusions were tested against (relating to the use of pesticides, fossil fuels, tobacco, and controversial weapons). Only 48% of the sampled funds would be eligible to meet all four of the tested exclusion criteria. Only 0.5% of the sample would meet the greenness ratio requirement (above) and all four tested exclusion criteria.

To note, this is research and does "not prejudge any policy developments or decisions regarding an EU Ecolabel for financial products". No action needs to be taken by firms. However, it illustrates the policy challenges with the development of an Ecolabel, highlighting the trade-off between the stringency and feasibility of the Ecolabel requirements. Looser requirements could increase the potential volumes of green finance channelled through eligible funds but could damage the credibility of the Ecolabel. The findings therefore highlight the importance of carefully calibrating the Ecolabel criteria to achieve the desired balance between credibility and take-up by product managers.

Kunming-Montreal Global Biodiversity Framework

December 2022 saw the much-awaited UN COP15 Biodiversity Conference in Montreal, where the historic Kunming-Montreal Global Biodiversity Framework (GBF) was agreed. The framework introduced ambitious commitments to preserve and protect biodiversity, with four overarching global goals:

• To maintain, enhance or restore the integrity, connectivity and resilience of all ecosystems by 2050 (including halting human-induced extinction of threatened species and maintaining genetic diversity within the populations of wild and domesticated species).
• To use biodiversity sustainably and to value, maintain and enhance nature's contributions to people, including ecosystem functions and services. 
• To equitably share the monetary and non-monetary benefits from the utilisation of genetic resources.
• To ensure all parties to the agreement have adequate means, including financial, to implement the GBF.

To achieve these goals, the framework has set 23 targets. For those in financial services, the target of most interest will be that around disclosing their risks, dependencies, and impacts on biodiversity — and this is applicable not only to firms' own operations but also to their supply and value chains. Firms can expect stronger requirements from individual jurisdictions by 2030 at the latest.

EIOPA'S prudential treatment of sustainability risks

EIOPA published a discussion paper on the prudential treatment of sustainability risks, proposing that the Solvency II framework is conceptually well placed to capture these risks. The paper explores ways to recognise these risks under existing elements of the Solvency II balance sheet and considers capital implications for both assets with high sustainability risks and non-life insurance liabilities that lack climate adaptation measures. For more details see the article above.

Basel Committee on Banking Supervision issues FAQs on climate-related financial risks

At the end of 2022 the Basel Committee on Banking Supervision (BCBS) published a set of FAQs that have been added to the Basel Framework, covering issues related to climate-related financial risks in Pillar 1 calculations.

Areas where the BCBS issued clarifications are:

• Calculation of risk weighted assets (RWA) for credit risk
• Standardised Credit Risk Assessment (SCRA) approach
• General corporate exposures
• Specialised lending
• Regulatory real estate exposures
• Internal-ratings based (IRB) approach
• Ratings assignment horizon
• Stress tests in the assessment of capital adequacy
• Overall requirements for estimation
• Requirements specific to probability of default (PD) estimation — corporate, sovereign and bank exposures
• Requirements specific to own-loss given default (LGD) estimates — standards for all asset classes
• Calculation of RWA for operational risk
• Calculation of RWA for market risk
• Liquidity coverage ratio (LCR)
  

The above list should not be considered exhaustive, and the BCBS will publish additional FAQs in future, as needed, to facilitate implementation of the existing Basel Framework.

EIOPA results of first IORPs climate stress test

EIOPA published the results of its first climate stress test on Institutions for Occupational Retirement Provisions (IORPs). It assessed IORPs' resilience in a climate change scenario that simulated a sudden, disorderly transition to a green economy. In total, 187 IORPs from 18 EEA countries were included in the stress test, representing (by asset size) 65.3% of the EEA IORP market coverage.

The main finding is that IORPs have a material exposure to transition risks. Their assets saw a material devaluation — by 12.9% — in the stress test. Because the scenario simulated a rise in interest rates, the higher risk-free interest rate led to a devaluation of technical provisions. The net impact on excess assets over liabilities was -2.9%. IORPs were able to maintain strong funding ratios and their balance sheets were not materially weakened. However, EIOPA has warned that this counterbalance may not exist in every exercise, and IORPs should test different scenarios to identify other climate vulnerabilities.

ECB climate-related statistical indicators

The ECB has published new climate-related statistical indicators, and a detailed technical annex, in a bid to narrow the gap around availability and quality of climate-related data. The indicators cover three main areas:

• Sustainable finance indicators: these aim to provide an overview of the issuance and holding of debt instruments with sustainability characteristics by residents in the euro area, offer market transparency and contribute to the design and implementation of ECB monetary policy.
• Carbon emissions indicators: these aim to provide information on the carbon intensity of financial institutions’ securities and loan portfolios and help assess the financial sector’s role in financing the transition to net-zero.
• Physical risk indicators of loan and security portfolios: these aim to assess risks from the impact of climate change-induced natural hazards, such as floods and wildfires, on the performance of loans, bonds and equities.

The ECB classifies the new indicators as either ‘experimental’, meaning they do not comply with all of the quality requirements of official ECB statistics, or ‘analytical’, meaning the data may have significant limitations. They are a work in progress, and although firms may begin using them now, they are warned to do so with caution. The ECB will work with national central banks to improve its methodology and broaden the data sources used in this work.

Climate Financial Risk Forum publishes third round of guides

Launched in 2019 by the PRA and FCA, the Climate Financial Risk Forum (CFRF) comprises representatives from banks, insurers and asset managers, aiming to share best practice and analysis to advance firms' approaches to managing the financial risks of climate change. The CFRF convened its third and most recent session in July 2022, where the transition to net zero was covered for the first time and the forum also continued its existing work on scenario analysis and disclosures and data. The new guides, published in December cover:

• Transition to net zero — mobilising investment into climate solutions 
• Transition to net zero — disclosures: managing legal risks 
• Transition to net zero — carbon budget primer for financial institutions 
• Scenario analysis — physical risk underwriting guide 
• Scenario analysis — scenario analysis guide for banks
• Scenario analysis — scenario analysis in financial firms 
• Scenario analysis — climate litigation risk
• Disclosures, data and metrics — industry frameworks and metrics in relation to green and transition finance

Both the PRA and the FCA caution that, while they convene and facilitate CFRF discussions, the guides themselves are “written by industry, for industry” and represent current good practice, which will continue to evolve.

EU Council and Parliament provisional agreement on Carbon Border Adjustment Mechanism

The European Council and the European Parliament have reached provisional agreement on the Carbon Border Adjustment Mechanism (CBAM). The CBAM targets imports of products in carbon-intensive industries and aims to prevent an increase in greenhouse gas emissions from the offshoring of emissions outside the EU's borders to countries that have less ambitious policies to combat climate change.

CBAM is designed to function in parallel with the EU's Emissions Trading System (EU ETS) to ensure that the same pricing applies to imported goods. It will gradually replace other existing EU mechanisms (in particular, the free allocation of EU ETS allowances) to address the risk of carbon leakage.

The provisional agreement will operate from October 2023 onwards but needs to be confirmed and adopted by ambassadors of the EU Member States and by the European Parliament before it becomes final. Firms should be alert to the transition risk implications that could arise as CBAM affects the credit and market risks of investment and lending portfolios.

European Commission proposal for certification of carbon removals

Under the European Green Deal, and in line with its bid to become the first climate-neutral jurisdiction by 2050, the EU Commission adopted a proposal for a voluntary framework to certify high-quality carbon removals.

The proposed regulation will set out rules for the independent verification of carbon removals, as well as rules to recognise certification schemes that can be used to demonstrate compliance with the EU framework. It will establish four 'QU.A.L.ITY' criteria to ensure the quality and comparability of carbon removals:

• Quantification: carbon removal activities need to be measured accurately and deliver unambiguous benefits for the climate.
• Additionality: carbon removal activities need to go beyond existing practices and what is required by law.
• Long-term storage: certificates are linked to the duration of carbon storage to ensure permanent storage.
• Sustainability: carbon removal activities must preserve or contribute to sustainability objectives such as climate change adaptation, circular economy, water and marine resources, and biodiversity.

The Commission will now develop tailored certification methodologies for the different types of carbon removal activities, supported by an expert group that will meet for the first time in Q1 2023.

IOSCO consultation on the development of sound and well-functioning carbon markets

The International Organisation of Securities Commission (IOSCO) has launched two public consultations on the development of Compliance Carbon Markets (CCM) and Voluntary Carbon Markets (VCM). The two consultations will run concurrently until 10 February 2023, but responses will be submitted separately. The proposals for CCMs include recommendations for the oversight of markets that aim to meet obligations under Article 6 of the Paris Agreement. The recommendations for VCMs include ways in which the resilience of such markets can be ensured and how regulators may be involved in their oversight. For more information, see the article above.