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.

Regulators are well and truly in `back to work' mode after the holiday season and are pressing ahead with their ESG and sustainability agendas. With elections expected in 2024 in both the EU and the UK, there is uncertainty around which in-progress regulatory initiatives will make the cut. Potential casualties include the UK Green Taxonomy, consultation on which was expected in Autumn 2023 but is still outstanding, and the EU's Corporate Sustainability Due Diligence Directive (CSDDD), which has been provisionally agreed but may be subject to further political wrangling as the proposal goes through the final stages of the EU legislative process.

Regulators and supervisors have made several announcements regarding their 2024 priorities. The FSB's 2024 workplan will see a continuing focus on coordinating international work through its roadmap for addressing climate-related financial risks. The ECB has ramped up its climate and nature-related workplan for 2024 and 2025 and has also produced a report on the risks of decarbonisation misalignment in Euro area banks' financing activities. The EBA is consulting on guidelines to manage ESG risks and conducting a survey on the methodologies used by banks classify their ESG risks. Meanwhile, ESMA has put forward an approach to dynamic climate risk modelling, considered the financial impact of greenwashing activities, and reviewed whether certain impact funds fulfil their promises to investors. The PRA's January supervisory priority letters for UK Deposit Takers, International Banks and Insurers reaffirmed its expectation that firms will make further progress this year in measuring, managing and mitigating climate-related financial risks.

A delay to the timeline for adopting sector-specific standards under the Corporate Sustainability Reporting Directive (CSRD) has now been confirmed. Linked to the CSRD, EFRAG has signed a co-operation agreement with the Taskforce on Nature-related Financial Disclosures (TNFD), sending a clear message that nature-related reporting cannot be ignored. Responsibility for monitoring ISSB and TCFD-aligned reporting has now passed to the IFRS Foundation, and the ISSB is expected to confirm its next areas of focus in H2. A voluntary ‘green’ label for retail loans and mortgages has been proposed in the EU, together with draft guidelines on the supervision of sustainability disclosures. In the UK, HM Treasury (HMT) has extended the mandate for the Transition Plan Taskforce (TPT), with sector-specific guidance due in March. 

The FCA has published initial clarifications on its incoming Sustainability Disclosure Requirements (SDR) for financial services firms. Although it had deemed the EEA to be equivalent under its Overseas Funds Regime, the UK government plans to consult on extending the SDR to cover EEA funds in the regime. Meanwhile, the EU continues to consider proposed amendments to the more detailed requirements under the Sustainable Finance Disclosure Regulation (SFDR).

The revised UK Corporate Governance Code has now been issued. Although most of the ESG-related provisions originally proposed have been dropped, the code still reflects the responsibilities of boards around sustainability reporting and focusing on outcomes for shareholders. 

Turning to markets initiatives, the FCA welcomed the establishment of a code of conduct for ESG data and ratings providers and HMT has announced a review into how companies can continue to access the capital they need to decarbonise and deliver the UK's net zero ambitions. Provisional political agreement has also been reached on a proposal to regulate ESG ratings firms operating in the EU. While the details have not yet been published, the regime will include authorisation requirements and proportionality for smaller firms, as well as principles to avoid conflicts of interest — notably ESG rating providers will still not be able to provide credit ratings, consulting and audit activities from the same legal entity.

For more information on these and other updates, read on.

• Climate and environment-related financial risks 
• Reporting and disclosures 
• Markets 
• Other regulatory and standard-setter updates 

FSB 2024 workplan continues focus on climate change

Through its 2024 workplan, the Financial Stability Board (FSB) will continue to coordinate international work through its roadmap for addressing climate-related financial risks. Work this year will include analysis of the relevance of transition plans for financial stability and, as mandated by the G20, a stocktake of regulatory and supervisory initiatives related to the identification and assessment of nature-related financial risks. It will also deliver a further progress report on achieving consistent climate-related financial disclosures.

ECB climate- and nature-related work plan for 2024 and 2025

The European Central Bank (ECB) will expand its work on climate change and nature in 2024 and 2025, undertaking new activities in the following focus areas:

• The impact and risks of the transition to a green economy, especially the associated transition costs and investment needs;
• The increasing physical impact of climate change, and how measures to adapt to a hotter world affect the economy; and
• The risks stemming from nature loss and degradation, how they interact with climate-related risks and how they could affect the ECB's work through their impact on the economy and financial system.

Existing workstreams will also be broadened — including work on macroeconomic and financial stability, stress testing and scenarios, climate-related data, and banking supervision. Firms should expect increased supervisory engagement in these areas.

ECB report on risk from misalignment of banks' financing with EU climate objectives

The ECB has published a report on the risks of decarbonisation misalignment in Euro area banks' financing activities. It found substantial misalignment which, it notes, increases banks' transition risks. 90% of significant institutions were misaligned, with 70% subject to increased reputational and litigation risks.

Banks, irrespective of whether they were included in the ECB's report sample, should review their transition risk assessments and consider how their portfolios align with decarbonisation pathways. When measuring alignment, banks should select a pathway that is science-based and reputable, has a temperature target that is consistent with stated policy objectives, and is geographically relevant to their portfolio.

EBA consultation on guidelines to manage ESG risks

The EBA is consulting on draft guidelines on the minimum standards and reference methodology for the identification, measurement, management and monitoring of ESG risks. The guidelines would apply to EBA firms in scope of the Capital Requirements Directive (CRD) and be applied by national competent authorities.

The EBA expects firms to consider the role of ESG risks as potential drivers of all traditional categories of financial risks, including credit, market, operational, reputational, liquidity, business model and concentration risks. They should embed ESG risks within their regular risk management systems and processes, ensuring consistency with their overall business and risk strategies. Firms should develop a robust approach to managing and mitigating ESG risks over the short, medium and long term, including a time horizon of at least 10 years. They should also develop CRD-based prudential transition plans to monitor and address the financial risks arising from the transition.

The deadline to respond to the consultation is 18 April. The EBA intends to finalise the guidelines by end-2024, and they will apply from the same date as CRD6.

EBA survey on classification methodologies for exposures to ESG risks

The EBA has launched an industry survey to collect qualitative data from credit institutions on their methodologies for classifying exposures to ESG risks. The EBA will use the data to consider the feasibility of introducing a standardised methodology to identify and quantify exposures to ESG risks. The survey is not mandatory, but firms are strongly encouraged to participate. The deadline for submissions is 29 March.

ESMA reports on its approach to dynamic climate risk modelling, the financial impacts of greenwashing, and impact funds

ESMA has published three papers:

1. Offering an approach to dynamic climate risk modelling — ESMA explores identification of scenarios, modelling price shocks to underlying assets, assumptions used in climate modelling and the illustrative results of its example modelling exercise.
2. Considering the financial impact of greenwashing controversies — ESMA notes that financial risks can stem from the materialisation of reputational risk or legal risks. It found that greenwashing controversies had not yet had a clear, systematic negative financial impact on firms, suggesting that investors and markets did not pay close attention to them. However, with a common definition for greenwashing now in place, and growing levels of public scrutiny of sustainability-related claims investor and market reactions may change going forward. It would therefore be prudent for firms to review their existing and planned sustainability claims to ensure that they are consistent with the profile of the entity, product or service being offered.
3. Reviewing whether funds that state they contribute to the UN Sustainable Development Goals (SDGs) fulfil their promises to investors — ESMA proposes an approach for identifying SDG funds and uses data to assess the extent to which their holdings align with their claims. The report shows that the SDG funds identified by ESMA do not significantly differ from non-SDG counterparts or ESG peers regarding their alignment with the UN SDGs. This raises questions as to whether the funds are fulfilling their promises to investors. 

While the papers do not contain any mandatory actions, they will be of interest to firms in considering their own business practices and the extent to which they align with ESMA's findings.

ESRB report on macroprudential frameworks for managing climate risk

The European Systematic Risk Board (ESRB) has published a report considering three potential frameworks for relating climate risks to financial stability:

• Addressing risk surveillance: this would track climate-related financial stability risks and their interplay with financial risk, including how risks may compound over time.
• Macroprudential policy: this proposes a macroprudential strategy for climate change, drawing on existing instruments and applying them to climate-related risks.
• Broader risks to nature: this takes a first look at nature-related risk, including a preliminary quantitative exploration of exposure.

As the report is aimed at prudential policy makers in the EU, there is no action for firms yet, though they should note that these frameworks may be adopted by prudential supervisors.

EFRAG and TNFD co-operation agreement to advance nature-related reporting

At the end of December 2023 EFRAG and TNFD signed a co-operation agreement highlighting the importance of nature-related issues in corporate sustainability reporting. For more information, see the article above.

Extension of Transition Plan Taskforce mandate

HMT has extended the mandate of the UK Transition Plan Taskforce (TPT) to July 2024, with the option of extending further to October 2024. The extension will allow the TPT to release its final outputs and to support the work of the Transition Finance Market Review (TFMR) (for more on TFMR, see below).

The final financial services-related output expected from the TPT is:

• Deep dive sector guidance for asset owners, asset managers, and banks.
• Notes on adaptation, nature, the just transition, emerging markets and developing economies.
• A forward pathway on transition plans with considerations for the maintenance of a strong ecosystem around transition plans.

Clarifications on the FCA's Sustainability Disclosure Requirements

At the beginning of February, the FCA launched a new webpage for firms, setting out some initial clarifications and responses to commonly asked questions. While aspects of the page recap information that was already known, there are some useful clarifications on trickier aspects of the regime — for example on the scope of the naming and marketing rules, the status of fund of funds, and on the `robust evidence-based standard' used for labels. The FCA will continue to update the page as it receives further queries.

The UK's Overseas Funds Regime

The UK government has announced that it has deemed countries in the EEA (including EU) to be equivalent under the UK's Overseas Funds Regime (OFR). This important step means that EEA UCITS will be able to use a streamlined mechanism to market to UK retail customers, and ends uncertainty on how EEA funds would access the UK post-Brexit. Notably, the government plans to consult on extending the FCA's SDR regime to funds in the OFR (these are currently out of scope of the SDR). It notes that it would ensure there is adequate time for industry to adapt to any future requirements.

Amendments to the EU Sustainable Finance Disclosure Regulation

As noted in the last ESG Regulatory Essentials publication, in December 2023 the ESAs proposed amendments to the European Commission on the SFDR Regulatory Technical Standards (RTS). These amendments were scrutinised by the European Parliament's ECON Committee in January 2024. It is not yet clear whether the Commission will adopt the RTS as proposed by the ESAs (initially expected to be within three months of their publication), or whether their adoption could be delayed. A significant delay could lead to these revisions to the RTS being caught up in Commission's wider review of the SFDR (see a summary here).

FCA establishes industry-led working group for financial advisors

The FCA has set up an industry-led working group for financial advisors to support them in providing competitive and suitable advice to consumers regarding sustainability information. The establishment of the group follows publication of the FCA's SDR, which introduced new retail-facing product labels and disclosures for fund managers but did not address the role of financial advisers. The working group may play a role in ensuring that labelled and non-labelled products are appropriately marketed.

A report on how financial advisors can be supported in delivering good practice is due in the second half of 2024.

European Parliament agrees delays to sector-specific CSRD reporting

The European Parliament has voted in favour of a proposal to delay the adoption of sector-specific sustainability reporting standards under the Corporate Sustainability Reporting Directive (CSRD) by two years until June 2026. The sector-specific standards are still in development.

The proposal also delays the adoption of general sustainability reporting standards for non-EU parent companies until 2026. A separate set of sustainability standards for non-EU parents is under development and will apply for financial year 2028 with first reporting in 2029. The first set of 12 general sustainability standards became applicable from 1 January, with first reporting from 2025 for EU in-scope entities.

EBA proposes a voluntary `green' label for retail loans and mortgages

The EBA has proposed the development of a voluntary label for 'green' retail loans and mortgages. It suggests that the EU Taxonomy would not provide the only 'green' criteria, with other market and industry standards recognised in the label. It is also considering how the Mortgage Credit Directive could be leveraged to build in capacity for 'green' mortgages.

To build out the green retail loan market, the EBA is proposing that the European Commission develop a definition and label for green loans that could be applied on a voluntary basis. It suggests that the criteria for applying the label should leverage existing market practice and industry standards, meaning that the EU Taxonomy would not be the sole source of 'green' criteria. This differs to the approach taken by other existing sustainability-linked labelling frameworks, such as the EU Green Bond Standard.

ESMA consults on draft guidelines for supervision of corporate sustainability information

ESMA is consulting until 15 March on guidelines for the enforcement of sustainability information. The guidelines would standardise the supervision of listed companies' sustainability information, as reported under the Corporate Sustainability Reporting Directive (CSRD), the European Sustainability Reporting Standards (ESRS) and Article 8 of the Taxonomy Regulation.

The overall objective of supervision is to ensure the consistency of information disclosed across EU member states, leading to greater transparency across the single market and a reduced risk of regulatory arbitrage. The supervision work performed will be different to assurance: no opinion, positive or negative, will be issued and information should already have been subject to suitable review. The supervisor/enforcer will only determine whether infringements of the CSRD have occurred.

Launch of industry code of conduct for ESG data and ratings providers

In 2022, HMT and the FCA convened an industry-based group to develop a voluntary code of conduct for ESG data and ratings providers. The International Capital Market Association (ICMA) has published a final version of the code which was welcomed by the FCA.

The code is consistent with other existing regulatory initiatives, and promotes six principles regarding:

• Good governance
• Securing quality systems and controls
• Conflicts of interest
• Transparency
• Confidentiality systems and controls
• Engagement systems and controls

Once an ESG ratings or data provider signs up to the code, they will have six months or twelve months respectively to embed the above principles across their organisation.

HMT initiation of Transition Finance Market Review

A new UK government review panel has been convened to investigate how companies in the UK and abroad can be supported to continue to access the capital they need to decarbonise and deliver the UK's net zero ambitions. The Transition Finance Market Review (TFMR) will consider how transition-focused finance can be scaled and raised with integrity, as well as how to position the UK's economy as a global hub for transition-enabling capital. The review will report back in July.

TPR general corporate governance code laid in Parliament

The Pensions Regulator's (TPR's) new general code was laid in Parliament, delivering one set of clear, consistent expectations for pension scheme governance and administration. The new code brings together ten existing codes of practice:

• Reporting breaches of the law
• Early leavers
• Late payment of contributions (occupational pension schemes)
• Late payment of contributions (personal pension schemes)
• Trustee knowledge and understanding
• Member nominated trustees/member-nominated directors putting arrangements in place
• Internal controls
• Dispute resolution reasonable periods
• DC code
• Public service code

This new, collated format should make it easier for governing bodies to understand TPR's expectations. The code is expected to come into force on 27 March.