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.

This edition of ESG Regulatory Essentials is shorter than usual. 2024 is a year of elections, and both the EU and UK saw a pause in major regulatory announcements as a result in the run-up to the summer break. Significant updates are unlikely until policymakers return from their summer recesses and engage with post-election political priorities. In the UK, the new Labour government has committed to making the UK `the green finance capital of the world' via key initiatives on credible transition plans and aligning UK sustainability disclosure requirements with the ISSB and TPT frameworks. In the EU, policymakers will be challenged to enact a more competitiveness-focused agenda without downplaying climate aspirations. 

In the meantime, global standard-setters have continued to progress their work programmes. Nature-related financial risk continues to be in focus, with the Financial Stability Board (FSB) publishing its stocktake on regulatory initiatives across jurisdictions and the Network for Greening the Financial System (NGFS) developing a conceptual framework. 

The International Association of Insurance Supervisors (IAIS) is consulting on insurers' climate-related public disclosures and the inclusion of climate risks in regulatory reporting. The Pensions Regulator (TPR) conducted a review of pension scheme disclosures, finding that trustees need to do more to comply with their ESG duties. 

Finally, the EU Banking Package (which includes ESG risk-related provisions) and the Corporate Sustainability Due Diligence Directive (CSDDD) have both been published in the Official Journal of the EU (OJEU), completing lengthy negotiation processes. 

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

• Climate and environment-related financial risk 
• Reporting and disclosures
• Greenwashing and corporate responsibility 

NGFS launches conceptual framework for nature-related financial risks  

The NGFS has created a conceptual framework for the actions central banks can take to manage nature-related financial risks. The principles-based framework focuses on three phases:

• Identifying the sources of physical and transition risk — analysing exposures to dependencies on nature, supplementing static analysis with scenario analysis to get a forward-looking view, considering both local and systemic implications of nature dependencies, and considering the climate-nature nexus. 
• Assessing economic risk — translating the above exposures into economic risks, while considering how substitutable the nature dependencies are (i.e. would a business be required to move its operations, are there technological alternatives that can replace the loss of an ecosystem etc). 
• Assessing risk to, from, and within the financial system — central banks should consider how economic risks transmit to traditional financial risk categories, how nature-related risks can be amplified via feedback loops and whether the financial sector is contributing materially to the physical risks to which it is exposed. 

While the framework is aimed at central banks, firms can apply the principles to assess and manage their own nature-related risks.

At the request of G20 Finance Ministers and Central Bank Governors, the FSB has carried out a stocktake of regulatory and supervisory initiatives that address nature-related financial risks. Key observations:

• Financial authorities are at different states of evaluating the relevance of biodiversity loss and other nature-related risks as a financial risk — some authorities have concluded that that there is a material financial risk, while others continue to monitor international work on the issue before making a judgement. Some authorities have decided not to work on the topic at all, either due to data gaps or to focus on their existing climate risk priorities.
• Modelling challenges — where authorities are already analysing nature-related risk, they categorise them into physical and transition risks, as with climate. Firms face large exposures to physical risk via their investments and financing activities, but there are challenges in translating this exposure into a quantifiable measure of financial risk. More work is required to develop a holistic approach that considers the interdependencies between climate and nature.
• Capacity building — there is general recognition that more expertise is needed across supervisors, central banks and within firms to address nature-related risks.

Ongoing work by the TNFD, ISSB and NGFS will contribute to further developing regulators' and firms' understanding of nature-related financial risks. Given the focus on building capacity to understand nature-related risks, firms can likely expect increased regulatory attention on this issue.

The final adopted texts for the Capital Requirements Regulation (CRR3) and Capital Requirements Directive (CRD6), collectively known as the EU Banking Package, were published in the OJEU on 19 June. Both include provisions relating to ESG risk.

CRR3 outlines the tools available to markets and competent authorities `to properly assess the ESG risks that institutions might face', including regulatory reporting, public disclosures, and `establishing a full link between ESG risk drivers and traditional categories of financial risks'. The EBA is mandated to produce two reports, by end 2024 and end 2025, on whether a `dedicated prudential treatment of exposures related to assets or activities substantially associated with environmental or social objectives would be justified.' 

CRD6 provides additional information on ESG risks, such as the instruction for the EBA, EIOPA and ESMA to jointly develop guidelines for common methodologies for stress testing ESG risks. As more ESG risk data and methodologies become available, `competent authorities should increasingly assess the impact of ESG risks in their adequacy assessments of institutions.'

IAIS consults on supervisory guidance for climate-related reporting and disclosures 

The IAIS has published the final paper in its four-part series of climate-related consultations, focusing on climate-related reporting and disclosures. It recommends that:

• Disclosure regimes should ensure that the information presented in insurers' financial statements is connected to the information presented in their climate disclosures, allowing users to understand the impact on business activities. 
• Supervisors should clarify how climate-related exposures are to be disclosed in line with existing requirements under Insurance Core Principle (ICP) 20 on public disclosure of material risks. 
• Material climate-related risks should be fully integrated into supervisory reporting. Supervisors should clarify how these risks will be monitored on an ongoing basis. 
• Supervisors should consider whether Own Risk and Solvency Assessments (ORSAs) are providing them with the information they need to assess climate-related risks and address any gaps. 

The deadline for stakeholder feedback is 30 September 2024.

TPR finds that pension trustees need to do more to comply with ESG duties 

TPR has reviewed pension providers' disclosures to assess their compliance with ESG duties. The review used machine reading to review the disclosures of around 3,500 pension schemes and highlights the fiduciary duty of pension trustees to consider financially material risks and opportunities, including in relation to climate change. It found that: 

• Trustees often failed to demonstrate ownership of their policies or key ESG-related activities. 
• Where trustees delegated activities to managers, the former often failed to demonstrate oversight of ESG activities. 
• For pensions invested in pooled funds, several trustees flagged their limited ability to influence underlying managers on decisions related to ESG. 

TPR has made recommendations for trustees, covering proportionate and appropriate action to mitigate risks, taking ownership of ESG activities, and reviewing fund manager policies on ESG-related issues.

Publication of CSDDD in the Official Journal of the EU

The CSDDD has been published in the OJEU, following adoption in May, completing a lengthy negotiation and political process. Several concessions were necessary to get the deal over the line — for more information, see KPMG's articles here and here.

The CSDDD aims to ensure that companies contribute to sustainable development and the sustainability transition of economies and societies. This will be achieved through the identification and, where necessary, prevention and mitigation of actual or potential adverse human rights and environmental impacts connected with activities across their supply chain. 

For regulated financial undertakings, 'only the upstream but not the downstream part of their chain of activities' will be covered by the Directive. However, this may only be a temporary reprieve. Within two years of the Directive coming into force, and following an impact assessment, the European Commission will put forward further requirements tailored to the provision of financial services and investment activities.

Member States now have two years to transpose the CSDDD into national law, after which there will be a phasing-in period for EU and non-EU companies based on financial and employee thresholds. However, given the potential transformation needed to implement human rights and environmental due diligence across business functions and value chains, companies should start preparing now.

ESMA opinion on the Sustainable Finance Regulatory Framework

ESMA has  set out its recommendations on long-term improvements to the EU's Sustainable Finance Regulatory Framework. The opinion builds on ESMA's report on greenwashing and the ESAs' joint opinion on the review of the SFDR. It is the final deliverable linked to the European Commission's request for input on greenwashing. 

ESMA recommends improvements aligned with the previous reports, including:

• Extending the EU Taxonomy and standardising definitions of 'sustainable investment' across regulations. 
• Baseline minimum disclosure requirements for all financial products.
• A product categorisation system for investors to understand the sustainability features of products. 

It also induces a new recommendation that ESG data products be brought within the regulatory perimeter.

European Commission regulation defining PAI statement requirements for STS transactions 

The European Commission has finalised rules setting out the requirements for Principle Adverse Impact (PAI) statements for simple, transparent and standardised (STS) transactions. The regulation builds on the EU sustainable finance framework underpinned by the SFDR and aims to ensure that investors understand the sustainability features of securitisation instruments. The contents of PAI statements are aligned to other instruments under the SFDR and annexes for the presentation of relevant and required information are included.