Requiring sustainable finance

Five years ago, this topic received one brief mention in our report. In 2021, it is the issue most discussed by regulators, industry and investors around the world. Plans are underway for the next COP26 meeting in November 2021, against a backdrop of the ongoing pandemic. International policymakers are focused on sustainability risks, especially of climate change, and want more data and more consistent reporting. Meanwhile, investor demand for sustainable investment strategies and products continues to rise.

The search for common global definitions, corporate reporting standards and metrics has gathered pace. The state-of-play on specific financial services regulation remains mixed, with the EU at present in the lead on imposing detailed rules on asset owners and asset managers about their processes, and regarding disclosures to investors and beneficiaries. However, regulators in other jurisdictions are now proposing new requirements, and supervisory scrutiny is increasing.

• A focus on climate change risk
• Investor demands increase and issuers respond
• Search for common reporting standards
• The US re-enters the debate
• EU ESG rules expand in scope and detail
• France imposes additional requirements
• Elsewhere, ESG rules emerge
• Diversity - a social and regulatory issue

The International Monetary Fund's Global Financial Stability Report of April 2020 says "Disasters as a result of climate change are projected to be more frequent and more severe, which could threaten financial stability". The report finds the impact of large physical disasters on equity markets generally to have been modest over the past 50 years, but notes that aggregate equity valuations as of 2019 did not reflect the predicted changes in physical risk under various climate change scenarios, which suggests that investors do not pay enough attention to these risks. The report argues that better disclosures and stress testing for financial firms can help preserve financial stability and should complement policy measures to mitigate and adapt to climate change.

In a letter sent to the G20 finance ministers and central bank governors ahead of their April 2021 meeting, Financial Stability Board (FSB) Chair, Randal Quarles wrote that addressing issues related to climate change "is essential to a sustainable recovery from the COVID event and beyond." The FSB is to report by July 2021 on ways to promote consistent, high-quality climate disclosures based on the recommendations of its Task Force on Climate-Related Financial Disclosures (TCFD), and on the data necessary for the assessment of financial stability risks and related data gaps.

The International Organization of Securities Commissions (IOSCO) has committed (PDF 234 KB) to issue three reports on:

• Disclosures by issuers, by end-June 2021
• Disclosures by asset managers, with attention to "green washing", by end-2021
• ESG (environment, social, governance) ratings and data providers, by end-2021

An increasing number of central banks and regulators around the globe are joining the debate. For example, the Bank Negara Malaysia and Securities Commission Malaysia issued a joint statement entitled "Towards Greening the Financial Sector for 2021". They will build on these initiatives to strengthen the financial industry's capacity in managing climate-related risks and to enhance its role in scaling up green finance. The Central Bank of Mexico is asking companies for climate-related data, and the National Bank of Hungary has issued (PDF 510 KB) a challenging Guideline on Green finance.

In September 2020, the Dubai Financial Services Authority (DFSA) opened a debate on the most suitable ways to prompt the development of sustainable finance in the Dubai International Financial Centre (DIFC), with a view to serving the objectives of Dubai and the UAE while facilitating and energizing the activities of the DIFC financial sector.

In March 2021, Ravi Menon, Managing Director of the Monetary Authority of Singapore (MAS) said that the future of capital is green and there are three powerful forces driving this: growing recognition of climate change as a global priority; advances in approaches to sustainable investing; and changing investor preferences. And in May 2021, Japan released Transition Finance Core Principles. It is expected that activities to transition enterprises from brown to green will be boosted by investors adopting these principles.

Investors - from sovereign wealth funds and large institutional investors, to individuals with modest amounts to invest - are increasingly asking questions of companies and investment funds about their ESG credentials. Two, of many, examples illustrate this trend.

In Australia, a superannuation fund settled out of court with an individual, who said the fund was not taking climate change seriously. The Employees Provident Fund (EPF), Malaysia's largest retirement fund, aims to base all its investments on ESG considerations by 2030, in the belief that a strategy of holding sustainable assets will make it more resilient against future market upheavals. It is understood to be asking brokerage firms to incorporate ESG considerations into their research process alongside traditional financial metrics.

Issuers and fund managers are responding. There are significant increases in the number and size of green funds. The Climate Bonds Initiative - a not-for-profit, investor-focused organization - reports that 2020 was a record year for the green bond market and that issuance could double during 2021. The market is spreading. Many green bonds have been issued in Thailand and the first ever ESG-compliant Sharia debt security (green sukuk) was issued in Saudi Arabia by a large utility company, with more such issuances expected.

Corporate reporting authorities around the globe are at different stages in incorporating into their requirements the TCFD recommendations. The TCFD's October 2020 status report noted that, despite significant sign-up by companies to the recommendations, disclosure of the potential financial impact of climate change on companies' businesses and strategies remains low, that only one in 15 companies reviewed disclosed information on the resilience of their strategy, and that asset manager/asset owner reporting to their clients/beneficiaries is "likely insufficient"

The trustees of the International Financial Reporting Standards (IFRS) Foundation have announced plans to establish a new board for setting sustainability reporting standards. It will focus on information that is material to the decisions of investors and other creditors, initially on climate-related matters, and will build on the TCFD recommendations. The announcement was welcomed around the globe but delivering widely accepted standards will not be an easy task.

One of the many questions to be considered is whether the standards should focus only on financial factors or give equal weight to sustainability risks and financial factors - "double materiality". The EU has enshrined this concept throughout its ESG-related regulation but recognizes that some leeway is needed in jurisdictions where ESG investing is less developed. Other jurisdictions recommend a focus on financial factors, due to the challenges of determining what constitutes a negative environmental or social impact in different jurisdictions.

Another key question is what is meant by ESG factors. The TCFD focuses on climate change. The UN Sustainable Development Goals and the framework of the Sustainability Accounting Standards Board (SASB) - a not-for-profit industry organization - cover all three factors. The EU's Taxonomy is written into law. At present it covers only E but will be extended to cover S, and is increasingly detailed, at over 500 pages and climbing. It is the compulsory dictionary for EU entities for any corporate reporting, company policies, or company or product disclosures. Progress in finalizing the detailed "Level 2" rules for the climate change mitigation and adaptation objectives has been difficult. In addition to industry concerns, member states have differing views on how nuclear power and gas should be classified.

EU asset managers that are listed or "large public interest entities" will be required to include in their company annual reports the proportions of their turnover and expenses that relate to environmentally sustainable activities. The European Securities and Markets Authority (ESMA) recommended (PDF 2.9 MB) to the European Commission that in-scope asset managers should report based on the proportion of assets under management, for both collective investment funds and separately managed accounts. The Commission has proposed a new Corporate Sustainability Reporting Directive, which will cover many more firms and require further disclosures.

Japan's corporate governance code requires premium-listed companies to disclose against the TCFD recommendations, on a "comply or explain" basis. The UK has introduced similar rules (which capture some asset managers) and the government is considering requiring a wider set of companies to publish annual "resilience" statements. It is consulting on whether these could provide a means for companies to provide disclosures consistent with the TCFD's recommendations. Guernsey will adopt the EU Taxonomy and will permit insurers a lower capital hit for green investments, including funds. Hungary, likewise, is reducing capital requirements regarding specific types of green loans and bonds.

US Treasury Secretary, Janet Yellen presided over her first meeting as head of the Financial Stability Oversight Council at end-March 2021. The public portion of the agenda included climate change and its potential impacts on financial stability.

In March 2021, the US Securities and Exchanges Commission (SEC) sought public input on its effort to expand requirements for corporate disclosure of ESG issues and climate risk. The SEC posed questions about data and metrics that cut across industries, the extent to which an industry-specific approach should be used, the existing voluntary climate disclosure, and how a disclosure framework can be flexible enough to keep up with the latest market and scientific developments.

In the same month, the SEC created an enforcement task force on climate and ESG issues, which will develop initiatives to identify ESG-related misconduct. It will look for material gaps or misstatements in issuers' disclosure of climate risks, and will analyze disclosure and compliance issues related to ESG strategies used by investment managers and funds. The SEC also established a web page to help the public keep track of the regulator's ESG-related activity. The site is part of the agency-wide response to soaring demand from investors for information about climate and ESG issues.

The EU Sustainable Finance Disclosure Regulation (SFDR) must be implemented on dates ranging from March 2021 to end-2022 and is one part of a wider package of ESG rules impacting asset managers and asset owners (including investment funds). The SFDR requires companies to disclose whether and how ESG factors are integrated into investment decisions, and by end-2022, whether and how adverse impacts are considered. Each investment strategy or fund must be classified into one of three categories. The company-level and product-specific disclosures must be included in pre-contractual documents, periodic reports and on firms' websites. Also, firms must publicly disclose how their remuneration policies are consistent with the integration of sustainability risks.

Detailed Level 2 rules, including mandatory reporting templates, should have been issued by end-2020 and still await final adoption by the Commission, but the March 2021 deadline was not delayed. Further, ESMA has consulted on rules to underpin the additional requirements for "light green" and "dark green" products under the SFDR, which were introduced via the Taxonomy Regulation. ESMA recognizes that firms face several practical difficulties:

• Lack of data, especially on principal adverse impacts
• Fitting the additional disclosures into products with length-constrained pre-contractual information documents
• For managers of separately managed accounts, balancing the website disclosure requirements with client privacy and data protection rules
• For smaller firms, meeting growing compliance costs, due to lack of economies of scale

The Commission has issued amendments to existing rules under the Markets in Financial Instruments Directive (MiFID II), the UCITS1 Directive and the Alternative Investment Fund Managers Directive (AIFMD). In addition to clarifying implications of the SFDR, firms will need to consider clients' ESG wishes in suitability assessments and incorporate consideration of sustainability risks into their investment risk processes, product governance and conflicts of interest policies.

Firms must consider conflicts that might arise from remuneration or personal transactions of relevant staff, or between funds managed by the same firm, and whether conflicts could give rise to greenwashing, mis-selling or misrepresentation of investment strategies. The new Investment Firms Directive (see chapter 5) also requires asset managers to incorporate ESG risks into their governance arrangements and internal risk frameworks.

The Commission continues to work on an EU Eco-label for investment products, which will set prescriptive minimum green investment thresholds for products, over and above the SFDR fund classifications. The German Ministry of Finance has said it will launch a sustainability traffic light system for retail funds if an EU-wide label is not forthcoming. The aim is to make it easier for savers to invest with environmental and social criteria in mind. The system could be based on audited sustainability reports and SFRD disclosures.

The Commission has consulted on an EU Green Bond Standard (GBS) and whether a similar standard should be developed for social bonds. The GBS would apply to any type of issuer: listed or non-listed, public or private, European or international. EU asset managers and funds will need to review bonds in their portfolios that are currently classified using industry standards.

Luxembourg has already anticipated market trends and investor demand. In September 2020, it launched its Sustainability Bond Framework, which has been designed to comply with the draft EU GBS and incorporates eligibility criteria that are fully in line with the recommendations of the final report of the Commission's Technical Expert Group on the EU Taxonomy. The framework will enable the issuance of green, social or sustainability bonds (i.e. combining green and social aspects). Meanwhile, there are calls for EU regulation to be extended to ESG data and rating providers. To prevent misallocation of investment and greenwashing, and to ensure investor protection, the French and Dutch regulators have called for a framework of internal control processes, transparency of methodologies and management of conflicts of interest.

In July 2020, the French Autorité des Marchés Financiers (AMF) updated its "Doctrine", which aims to help investors understand sustainable funds by requiring consistency between what is said within marketing material and what is done in terms of ESG portfolio management. Non-French funds marketing in France and wishing to make non-financial criteria a key element of their marketing communications must now complete a new form as part of the passport notification file sent to the AMF by their home regulators. The form enables the AMF to see whether the requirements are met and, if they are not, that the disclaimer provided for in the Doctrine has been included in fund marketing materials.

The AMF considers the Doctrine to be complimentary to the SFDR, noting that both are aimed at preventing greenwashing. However, fund managers expressed concerns about the wording differences between the two texts and the need to perform a double analysis in the same timeline, increasing costs. The AMF may reassess the Doctrine depending on the final SFDR Level 2 rules.

In February 2021, the AMF introduced a new sustainable finance certification and added more questions on ESG topics within the general professional examination. The aim is to enable professionals to explain the fundamentals of sustainable finance to their clients when identifying their ESG preferences.

Switzerland is considering whether to apply EU ESG rules to its own firms and funds. To date, the UK Financial Conduct Authority (FCA) has encouraged firms to conform with industry standards issued by the UK Climate Financial Risk Forum, but FCA guiding principles are now expected to be published by end-2021 and a UK "taxonomy" by end-2022 .

In December 2020, the MAS issued environmental risk management guidelines for asset managers in Singapore. The Guidelines aim to enhance the resilience of investment funds (including real estate investment trusts) and the discretionary mandates of asset managers, by setting out sound environmental risk management practices. They cover governance and strategy, research and portfolio construction, portfolio risk management, stewardship and disclosure of environmental risk information.

Firms should have in place a clear allocation of responsibilities for management of environmental risk in accordance with the three lines of defense model. The Board and senior management should maintain effective oversight of the manager's environmental risk management and disclosure, and the integration of environment risk into the manager's investment risk management framework. In assessing environmental risk (on an initial and ongoing basis), firms should consider both transition and physical risks for an individual asset or across a portfolio, refer to international standards and frameworks, and apply risk criteria to identify sectors with higher environmental risk. Firms are expected to exercise sound stewardship to help shape the corporate behavior of investee companies, through engagement, proxy voting and sector collaboration.

Firms should implement the Guidelines in a way that is commensurate with the size and nature of their activities, including investment focus and strategies of their funds/ mandates. The MAS expects managers' approaches to managing and disclosing environmental risk to mature as the methodologies for assessing, monitoring and reporting such risk evolve.

The US Department of Labor (DoL) said (PDF 19.9 MB) in March 2021 that it will not enforce a rule that makes it tougher for "401(k)" retirement plans to invest in ESG funds, by requiring plan fiduciaries to select investments and strategies based solely on how they will affect the plan's financial performance. "We intend to conduct significantly more stakeholder outreach to determine how to craft rules that better recognize the important role that environmental, social, and governance integration can play in the evaluation and management of plan investments, while continuing to uphold fundamental fiduciary obligations," said Ali Khawar, principal deputy assistant secretary at the DoL's Employee Benefits Security Administration.

New laws under consideration would require investment advisers to maintain a sustainable investment policy, inform workers about it and to file it with the regulators. In April 2021, the SEC found (PDF 316 KB) some investment firms that are potentially misleading investors in their statements about their ESG investment processes and adherence to global ESG frameworks. It has also seen cases where portfolio managers were not consistently disclosing their ESG strategies and where their proxy voting on shareholder proposals did not align with the firm's stated stance on socially responsible issues.

In South Africa, diversity has been a legal requirement for many years. For all jurisdictions, the recovery phase of the pandemic is likely to raise additional equality and potential discrimination issues, and some financial regulators are now focusing on this issue.

Official statistics are telling. Financial services were among Europe's worst industries on gender pay gaps in 2018, according to Eurostat, and some asset managers are reporting deteriorating figures. Disclosure of diversity and inclusion (D&I) policies or reporting of pay information is mainly voluntary, but regulation has been introduced in a small and growing number of jurisdictions. There has been some progress within the investment industry on D&I policies. However, collecting data on the protected characteristics of a firm's workforce, including employees' ethnicity, has been one of the most common and difficult challenges faced by firms. Legal, data protection and trust issues can be obstacles to full disclosure.

Regulators are increasingly recognizing that good D&I practices reduce risk for regulated firms by reducing "groupthink". They are calling out pay gaps and lack of diversity among firms' boards and senior management, and prescriptive rules may be introduced if the industry does not make quick progress.

For example, the Japanese Corporate Governance Code now includes a requirement for listed companies to disclose their approach, and set voluntary and measurable targets, for ensuring diversity in the appointment of core human resources, including the appointment of women, non-Japanese and mid-career hires to management positions. They must also disclose their human resource development policies and internal environment improvement policies to ensure diversity, along with the status of their implementation.

Back in 2018, the Central Bank of Ireland (CBI) warned that it would impose gender diversity requirements if improvements were not made. Sharon Donnery, Deputy Governor said gender balance can help ameliorate issues such as "groupthink, insufficient challenge, poorly assessed risk and problems with culture", which, she said, contributed to the 2008 financial crisis. In March 2021, the CBI noted lack of progress in gender diversity at senior levels of regulated firms. This issue will continue to be a priority of the CBI, which will undertake detailed and thematic reviews.

The UK FCA has indicated that it expects to see sufficient diversity in a regulated firm's leadership team. D&I is a central consideration of the FCA in all aspects of conduct, including towards customers. In March 2021, FCA CEO, Nikhil Rathi said that diversity will be crucial in the FCA's consideration of vulnerability, particularly as we recover from a pandemic that has disproportionately affected women and people of color. The FCA will increasingly ask "tough" questions of firms about representation across grades, and whether their culture is open and inclusive and provides a safe space for colleagues at all levels.

The European Commission's five-year Gender Equality Strategy includes the introduction of binding measures on improving the gender balance on corporate boards. Such measures already exist in a few member states. In France, for example, the obligation for boards to have at least 40 percent female members was extended in January 2020 from listed companies to companies with at least 250 employees, and sanctions were strengthened.

To tackle gender and ethnic pay gaps, the Commission has issued a draft directive (PDF 559 KB) on equal pay for equal work, with transparency and enforcement provisions. Guidelines issued under the new Investment Firms Directive (see chapter 4) expect asset managers to apply a gender-neutral remuneration policy to all staff. The European Banking Authority, which is responsible for the guidelines, said that "Any form of discrimination, based on gender or otherwise cannot be tolerated". It defines gender-neutral remuneration policies as being "consistent with the principle of equal pay for male, female and diverse workers for equal work or work of equal value".

Issues of pay inequality, the diversity and wellbeing of staff, career development and training, and links between remuneration and sustainability risks may be challenging for traditional remuneration committees. Firms will need to undertake a fundamental review of the terms of reference, skill sets and composition of their remuneration committees.