Even after the 26th United Nations Climate Change Conference of the Parties (COP26) came to a close last November, the ESG landscape still remains unclear.
Environmental, Social and Governance and sustainable finance currently are like the Wild West. That’s because corporate ESG data continues to be uneven and incomplete, and consistency is often lacking across companies, sectors and borders. Many companies are disclosing some types of environmental risks but not others, and there remains a disconnect between investors’ needs for relevant ESG data and what companies are disclosing.
A new report from the International Organization of Securities Commissions (IOSCO), a global group of regulators, shows that there is currently a lack of clarity and standards for ESG metrics, a lack of transparency about the methodologies in ratings, and uneven coverage of sectors and geographies. While climate change is seen as a priority ESG issue for institutional investors, less than half of organizations currently track their portfolio emissions or address physical and transitional metrics toward a lower-carbon economy. This may entail extensive policy, legal, technology and market changes to address mitigation and adaptation requirements related to climate change.
The question is: How soon will this change? Just one year ago, a European Central Bank report, which addressed how the European banking sector manages climate and environmental risks, found that most banks do not have concrete plans to start preparing for climate change.
Changing ESG Landscapes
In 2022, however, there are many important new regulations and standards in development to bring clarity to this picture. Here is a taste of some of the upcoming ESG regulations and standards around sustainable finance we’ll see in 2022.
First, the recently published 2021 status report from the Task Force on Climate-Related Financial Disclosures explained how its disclosure recommendations have become the global standard that guide private sector disclosures, informing new laws and regulations and governing bodies, including the European Union, the United Kingdom, Switzerland and New Zealand. These countries are incorporating the recommendations into official disclosure requirements. Some countries, including Canada, have moved to mandatory disclosures on climate-related risks and opportunities.
The EU has been leading the way on many updates and leading disclosure and regulatory changes, which, in turn, affects global ESG requirements. The EU is aiming to commit the financial sector to act as a catalyst for the transformation of the real economy.
In the past, not many investors had contact with their portfolio companies, but as regulatory pressure increases, ESG information has become an integrated part of decision-making and communication between the financial sector and the economy. These regulatory requirements also affect financial institutions and organizations outside of the European Union if companies provide financial products in the EU or have economic relations with European financial service providers. The idea behind this is to create an economically efficient and sustainable financial system that provides more capital for sustainable investments, and this is how investors are influencing sustainability throughout the economy.
Companies are facing several sustainability-related challenges, including:
- Managing more diversified ESG data
- Creating business value through nonfinancial aspects
- Making sure that C-level management understands ESG matters
- Integrating sustainability/ESG reporting into financial reporting and corporate risk management
The game-changer will be the end-to-end integration of financial and nonfinancial reporting as financial and other types of organizations need to relate their ESG and sustainability data to financial metrics. The goal is to harmonize what organizations communicate to investors and what is operationally implemented throughout the organization.
To get a sense of what’s to come, here are some facts on upcoming regulations you should know:
EU Corporate Sustainability Reporting Directive (effective Jan. 1, 2022):
This is a new directive for all nonfinancial reporting that every company listed on an EU-regulated market must follow (with the exception of microenterprises). Any EU directive needs to be translated by member states into national regulations (e.g., in Germany in CSR-RUG CSR-Richtlinie-Umsetzungsgesetzes (CSR-RUG)).
The Corporate Sustainability Reporting directive includes all companies active on the capital market as well as all noncapital market-oriented if they meet two of the following three criteria:
- Total assets of more than 20 million euros ($22.6 million)
- Net sales of more than 40 million euros ($45.2 million)
- More than 250 employees
Companies must publish information on sustainability goals, the role of the executive board and supervisory board, the most material adverse effects of the company and on intangible resources that have not yet been recognized in balance sheets. For ESG purposes, companies should also report on:
- Environmental protection
- Social responsibility and dealing with employees
- Anti-corruption and bribery
- Diversity on corporate boards
Besides these material topics, companies are required to report on:
- Double Materiality: This means the reporting on the risks businesses face from external sources such as climate-related risks (Impact on Enterprise Value), plus the risks for the planet or people resulting from the business and its operations (Impact on Society and Environment)
- Other forward-looking information: This includes sustainability targets and their current progress
- Information on intangible assets: This includes things like the parameters of environmental and/or sustainability performance.
- Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomy Regulation: More on these below.
EU TAXONOMY (Effective Jan. 1, 2022, but fully integrated on Jan. 1, 2024):
The EU has developed a legislated “taxonomy” (classification) of sustainable activities of businesses across sectors. The idea is that companies must classify what portion of their turnover is generated from sustainable business areas. Companies thus need to provide a classification of their sustainable business activities and disclose these.
This is required for all sectors; there is technical and sector-specific guidance available. The EU taxonomy covers activities that contribute up to 80% of European greenhouse gases: electricity, transport, forestry, building, information and communication technologies, and manufacturing. Agricultural activities are currently in development.
The taxonomy aims to classify if the company’s activities:
- Contribute substantially to at least one of the environmental objectives.
- “Do no significant harm” to any other environmental objective.
- Be carried out in compliance with minimum social and governance safeguards.
- Comply with technical screening criteria to be adopted under the regulation
The Taxonomy Regulation defines sustainable economic activities as those providing a substantial contribution to one of six environmental objectives:
- Climate change mitigation
- Climate change adaptation
- The sustainable use and protection of water and marine resources
- The transition to a circular economy
- Pollution prevention and control
- The protection and restoration of biodiversity and ecosystems
At the same time, substantial contribution to any of those objectives must not contribute any significant harm to any other objectives. The EU Taxonomy Regulation will be an essential reference in several other forthcoming sustainable finance regulations in the EU, such as those addressing disclosures or the EU green bond standard.
Sustainable Finance Disclosure Regulation SFDR (Effective Jan. 1, 2022):
As a key part of the EU’s sustainable development policy agenda, the SFDR is intended to increase transparency on sustainability among financial institutions and market participants. The regulation aims to standardize sustainability performance for financial institutions reporting around entity level and product level. Keep in mind that financial institutions need to report not only on the sectors they invest in but also in the actual companies they invest in. The disclosure requirements are considered at the level of the entity and of the product. The SFDR mainly applies to financial institutions (banks, insurers, asset managers and investment firms) operating within the EU. Non-EU entities will be affected indirectly through EU subsidiaries, market participation in the EU or via market pressure.
The SFDR aims to bring regulation of financial market participants and financial advisers on:
- Transparency in relation to sustainability risks
- Consideration of adverse sustainability impacts in their investment processes
- The provision of sustainability-related information with respect to financial products
Financial market participants and financial advisers need to disclose information on their corporate website:
- Sustainability risk policy: The integration of sustainability risks into the investment decision-making process
- Principal Adverse Sustainability Impact: The adverse effects on sustainability of the investment decision/advice
- Consistent alignment of the remuneration policies with the sustainability objectives
This applies to portfolio management and investment advice services, insurance-based investment products, pension products as well as alternative Investment Fund and UCITS products (Undertakings for Collective Investments in Transferable Securities).
Further, financial market participants and financial advisers are required to disclose product information related to sustainability for both ESG-related products and non-ESG products. The regulation requires entities to classify the products or advice they offer into one of the three following categories:
- Mainstream products
- Products promoting environmental or social characteristics
- Products with sustainable investment objectives.
Product-level disclosure requirements affect pre-contractual disclosure (client information, brochure, etc), product website disclosure, and periodic product reports..
These new rules apply to European financial services organisations from 2022. From 2023 they will cover all EU-listed companies and non-listed companies employing 250+ people.
Net Zero Standard Financial Sector
Besides the new Net Zero Standard recently developed and published by the Science-based target initiative, the organisation is currently developing a standard around net zero announcements by the financial sector.
Currently, there is a draft paper for public consultation around the standard’s methodology, including discussions around:
- Which net-zero metrics are suitable for financial institutions?
- Coverage of all activities
- Levels of ambition
- Role of carbon credits
International Sustainability Standards Board (ISSB)
Further, the newly founded International Sustainability Standards Board (ISSB) develops a comprehensive global baseline of high-quality investor-focused sustainability disclosure standards to meet investors’ information needs.
The initiative consolidates the Climate Disclosure Standards Board (CDSB an initiative of CDP) and the Value Reporting Foundation (VRF, which was created in June 2021 from the merger of the Integrated Reporting Framework and the SASB Standards) by June 2022.
The goal is to lay the technical groundwork for global sustainability standards for financial markets, fulfilling urgent demand for streamlining and formalizing corporate sustainability disclosures.
Ready to learn more?
Contact Sphera to learn more about the upcoming regulations and how to implement them into your overall ESG reporting efforts.