ESG criteria have become increasingly important for investors and other stakeholder groups alike (read more about ESG here). In light of this, it is imperative for companies to disclose their ESG practices through ESG ratings (read more about ESG ratings here). The disclosure of a company’s ESG practices faces many challenges, one of which is that disclosure is often optional. This leads to inconsistent reporting across an industry. It also means that companies can “mark their own work” as well as pick-and-choose what to report or omit. By disclosing only what “looks good”, companies can easily “greenwash” their practices – an increasingly common act where a company makes an unsubstantiated claim to deceive stakeholders into believing that their products are sustainable have become increasingly important for investors and other stakeholder groups alike (read more about ESG here). In light of this, it is imperative for companies to disclose their ESG practices through ESG ratings (read more about ESG ratings here). The disclosure of a company’s ESG practices faces many challenges, one of which is that disclosure is often optional. This leads to inconsistent reporting across an industry. It also means that companies can “mark their own work” as well as pick-and-choose what to report or omit. By disclosing only what “looks good”, companies can easily “greenwash” their practices – an increasingly common act where a company makes an unsubstantiated claim to deceive stakeholders into believing that their products are sustainable.
ESG Disclosure in the EU
To overcome these challenges, the EU has published a taxonomy in the Official Journal of the European Union in June 2020, defining the duties of, and disclosure by, companies and financial institutions within the EU concerning ESG criteria. The taxonomy also defines the conditions for economic activity that is considered sustainable. Since March 2021 the EU has also started to phase in the Sustainable Finance Disclosure Regulation (SFDR) to introduce standardised ESG reporting.
Sustainable Finance Disclosure Regulation
The SFDR is part of a broader package of legislative tools aimed at encouraging and facilitating sustainable investment as well as combating greenwashing. The SFDR came into force on 19 December 2019 and became applicable from 10 March 2021. The SFDR uses mandatory disclosure templates for financial advisers and financial market participants to disclose certain ESG-related information concerning the services they provide and the marketing of financial products.
Among other things, the SFDR introduces the concept of Principal Adverse Impacts (PAIs). PAIs are the negative effects on sustainability factors that an investment decision or advice might have. Sustainability factors are listed as environmental (e.g. biodiversity), social, and employee matters, as well as matters relating to human rights, anti‐corruption, and anti‐bribery. PAIs can be disclosed on a “comply or explain” basis (for firms with under 500 employees). Obligated firms must disclose the potentially negative consequences an investment decision may have on sustainability factors and how they are mitigating the impacts. The first reporting period for PAI indicators started in June 2021, with the requirement to report starting in June 2022. Moreover, under the SFDR, if a product is categorised as an Article 8 (financial products where the primary objective is not sustainable investment but the promotion, among other things, of environmental or social characteristics) or Article 9 (financial products with sustainable investment as its core objective) product, additional disclosures need to be made. These will eventually be enforced by the Regulatory Technical Standards (expected in January 2022).
According to Anthesis, the SFDR regulation is directed at Financial Market Participants (FMPs), including firms who oversee financial transactions (e.g. fund managers or pension providers) or advise on investment strategy (e.g. banks and investment firms) and their products (e.g. investment and mutual funds, insurance-based investment products and advice, and pensions). FMPs can adhere to their disclosure obligations through three reporting channels:
- Mandatory website disclosures
- Pre-contractual disclosures
- Periodic reporting to investors
ESG Disclosure in the UK
How did Brexit affect ESG disclosure in the UK?
Initially, the Financial Miscellaneous Amendments (EU Exit) Regulations 2020, provided for parts of the SFDR and of the EU Taxonomy Regulation to apply in the UK after departure from the EU. However, the UK government ultimately decided to implement neither. Instead, it has vowed to establish its own domestic green taxonomy (albeit based on the EU’s taxonomy) and ESG disclosure regime. Perhaps in an attempt to move away from EU-centric policies after Brexit, the UK has opted to apply the international disclosure standards set by the Financial Stability Board’s Task Force for Climate-related Financial Disclosures (TCFD).
ESG disclosure in the UK: current legislation
The UK government has pledged to develop a more robust approach to ESG disclosure than the one taken by the EU. While the EU has taken a “comply or explain” policy to disclosure, the UK has opted for mandatory reporting for UK companies and financial institutions. In November 2020, the UK government announced its intention for the UK to become the first country in the world to fully mandate TCFD standards for companies and financial institutions.
TCFD has published a roadmap for implementing mandatory disclosures:
- Pension schemes of over £5 billion, banks, insurance companies and building societies are expected to comply with TCFD recommendations;
- Smaller pension schemes, asset managers and life insurers will be subject to disclosure requirements from 2022;
- Life insurers, FCO-regulated pension providers and other UK-authorised asset managers will be subject to disclosure requirements from 2023;
- All other occupational pensions schemes and UK financial services firms will be subject to mandatory climate-related financial disclosures by 2025;
The UK government will provide an update on progress in the 2022 refresh of the Green Finance Strategy.
Currently, the Financial Conduct Authority (FCA), the Prudential Regulation Authority (PRA), the Department for Work & Pensions (DWP) and the Department for Business, Energy and Industrial Strategy (BEIS) all share some degree of oversight responsibility. The UK has not yet released any information on the content of its green taxonomy, but has established a Green Technical Advisory Group (GTAG), which will oversee the delivery of the green taxonomy in the UK, advise the government on developing the framework, support investors, consumers as well as businesses to make green financial decisions and clamp down on greenwashing.
Challenge or opportunity?
Should the UK deviate too much from the ESG provisions implemented by the EU (whether this is through greater or less strict legislation), there will be challenges for UK businesses trading within the EU. This is because UK divergence from EU systems would create extra reporting requirements for firms – further complicating EU/UK regulatory alignment.
However, a strict approach from the UK could also help set a new global high standard for ESG regulation, which would encourage other countries to introduce stricter green regulation and taxonomies. With COP26 high on its policy agenda, the UK government probably views ESG reporting as an opportunity to support the green economy, and perhaps to seize an opportunity to become a leading centre for green finance in the post-pandemic world. By becoming the first country to mandate the TCFD’s standards the UK will probably attract companies, with the opportunity to boost their ESG credentials under the highest global standards. This should prove extremely beneficial for the UK’s green economy agenda.