ESG Regulatory Essentials

A summary of ESG regulatory developments impacting financial services firms

November 2024 — Issue 15

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 last edition of ESG Regulatory Essentials for 2024 rounds up the latest updates and looks ahead to what the FS sector can expect before the end of the year and into 2025.

The UK Chancellor of the Exchequer has just delivered her first Mansion House speech, outlining steps to make the UK `a global leader in sustainable finance' - for more on the government's plans, see the article below.

Across the UK and the EU, focus on the financial risks of climate change has intensified. EIOPA's recommendations for capital charges for assets held in the fossil fuel sector could have significant implications for both insurers and the wider sector. The European Supervisory Authorities (ESAs) have also published the results of their `Fit-for-55' scenario analysis. The PRA has shared thematic feedback on capturing climate risk in banks' expected credit losses and has asked auditors to monitor progress on areas of concern. Meanwhile, the latest macro-financial scenarios from the Network for Greening the Financial System (NGFS) reflect the most recent scientific data and the UK Climate Financial Risk Forum (CFRF) has published a new set of guides on nature, short-term scenarios and adaptation finance.

The Financial Stability Board (FSB) has issued a report on achieving consistent and comparable climate-related disclosures, highlighting areas of further work. The FCA has granted temporary flexibility for fund managers on its SDR naming and marketing rules under certain circumstances and has also provided examples of good and poor practice on SDR pre-contractual disclosures. In the EU, ESMA's fund name guidelines now apply to new funds, and the ESAs have published their latest annual report on SFDR principle adverse impacts disclosures.

Market developments continue. IOSCO and ESMA have both published reports on the functioning of carbon markets, and a new set of integrity principles for voluntary carbon and nature markets was launched by the UK government at COP29, with a consultation to follow. The UK government is also consulting on the merits of a UK Green Taxonomy and has published a consultation response and draft legislation to bring ESG ratings providers into regulation. EU rules for ESG ratings providers are in the final stages of ratification. The Financial Reporting Council (FRC) has proposed revisions to the UK Stewardship Code to reframe expectations around sustainability.

Before the end of 2024, we expect draft guidelines from the EBA on the management of ESG risks under the Capital Requirements Directive mandate and the first of two reports on the prudential treatment of environmental and social exposures under the Capital Requirements Regulation. In the UK, an FCA policy statement on non-financial misconduct, linked to last year's diversity and inclusion proposals, is due imminently. Looking ahead to the new year, there will be consultations in the UK on streamlined sustainability disclosures for economically significant companies and transition plan mandates. The eagerly awaited consultation on updates to PRA SS3/19 (Enhancing banks' and insurers' approaches to managing the financial risks from climate change) is due in Q1 and the UK regulators' policy statement on diversity and inclusion in the financial sector is expected in the first half of the year.

In this issue:

More detail

Regulatory workplans

Joint Committee of the ESAs 2025 workplan

The Joint Committee of the ESAs (the EBA, EIOPA and ESMA) has published its 2025 co-ordinated workplan to ensure consistency of practices. Key areas of focus for 2025 include:

Contributing guidance on sustainability disclosures and principal adverse impacts (PAI) reporting under the Sustainable Finance Disclosure Regulation (SFDR).
Monitoring the practical application of SFDR and developing Q&As or other tools for supervisory convergence.
Starting work on technical standards for ESG rating disclosures.
Developing guidelines for stress testing ESG risks under CRD6 and Solvency II.

Climate and environment-related financial risk

EIOPA recommends capital charges for fossil fuel assets

In its recent report on the prudential treatment of sustainability risks within Solvency II, EIOPA recommended that insurers holding equities and bonds in the fossil fuel sector should face additional capital charges. For more information, see the article above.

`Fit-for-55' climate scenario analysis results

The ESAs have published the results of the `Fit-for-55' climate scenario analysis which was based on three scenarios:

1. A baseline scenario where the `Fit-for-55' package is implemented in macroeconomic and financial conditions that facilitate an orderly green transition

2. An adverse scenario where risks stem from asset price corrections triggered by a sudden reassessment of transition risks (i.e. the `run on brown')

3. A second adverse scenario that combines the above `run on brown' scenario with additional macroeconomic stress factors (e.g. geopolitical risk)

The results show that estimated losses stemming from a `run on brown' scenario have a limited impact on the EU financial system. First and second-round losses in scenario two range from between 6.8% and 11.2%. In scenario three, where the ESAs consider adverse macro-financial conditions, the first and second-round losses then increase to a range of 11% and 25%.

The ESAs conclude that the interaction of adverse macro-financial risks with transition risk could substantially increase firms' losses. However, although these losses are sizeable, they could potentially be mitigated by firms' income and cash holdings.

NGFS updates macro-financial scenarios for climate risk assessment

The Network for Greening the Financial System (NGFS) has published its latest iteration of climate risk scenarios. The updated scenarios include the most recent country-level climate commitments as of March 2024, as well as a new 'damage function' which integrates the latest scientific evidence about the economic impacts of a warming climate. In all scenarios, the impact of physical risk rapidly outweighs the impact of transition efforts. The NGFS notes that limiting the temperature increase to 1.5 degrees in an orderly fashion is within reach but will require substantially more intensive efforts.

Publication of new Climate Financial Risk Forum guides

The Climate Financial Risk Forum (CFRF), a financial services industry forum established jointly by the FCA and the PRA in 2019, has published three new guides on key areas of climate risk: nature-related risk, short-term scenarios and adaptation finance. The CFRF guides are written by industry, for industry, and are intended to help develop effective practice in relation to climate-related risks and opportunities. They do not necessarily reflect the views of regulators and do not constitute regulatory guidance.

The nature handbook is an introduction for financial institutions to help frame nature as a risk, and discusses emerging practices in incorporating nature into financial risk management.
In response to growing interest in, and use of, short-term scenarios, the short-term scenarios guide considers their various use cases for banks, asset managers and insurers.
The guide on mobilising adaptation finance provides industry with guidance in assessing physical risks, and facilitating increased levels of investment into climate adaptation to respond to those risks as an opportunity.

The Climate Resilience Dialogue's conclusions on narrowing the climate protection gap

The Climate Resilience Dialogue has issued a report emphasising the need for collective action to address the climate insurance protection gap and build resilience to climate change. Key factors contributing to this climate protection gap include low risk awareness, limited data availability and affordability of insurance. Actions proposed in the report include:

Raising risk awareness through accessible information campaigns
Conducting risk assessments based on robust data
Implementing adaptation measures and risk-based pricing in insurance
Increasing collaboration between public and private actors (including through public-private partnerships)
Exploring insurance solutions like bundled insurance and parametric insurance

The Climate Resilience Dialogue is a temporary group set up by the European Commission in 2022 to discuss climate insurance protection gaps in Europe and possible solutions to address them. The recommendations made in the report are not mandatory for insurers, supervisors or governments but they mirror previous reports from EIOPA on the insurance protection gap and are aligned with existing supervisory thinking/action in the EU.

ESMA analysis on funds' exposures to physical climate risks

ESMA has published an analysis of funds' portfolio exposures to climate physical risks. It finds that, although their holdings' exposure to physical risk appears limited due to their ability to quickly rebalance portfolios and the short-term nature of their liabilities, some funds may still be exposed. Overall, the most prominent risks for EU funds arise from water-related hazards.

This is a research paper so has no direct policy implications for EU asset managers. However, ESMA notes that it will continue to monitor EU fund exposures to climate physical risks by incorporating some of the indicators discussed in the paper into its regular risk assessments.

PRA Dear CFO letter on climate risk

The PRA has shared thematic feedback with banks on accounting for IFRS 9 expected credit losses (ECL) and climate risk. For more information, see the article above.

Reporting and disclosures

FSB report on globally consistent and comparable climate-related disclosures

The Financial Stability Board (FSB) has published a report on achieving consistent and comparable climate-related disclosures. It concludes that significant progress has been made in setting internationally consistent disclosure standards, and notes that most FSB jurisdictions have regulations or roadmaps in place for such disclosures. However, the FSB also emphasises that further work is needed to help small and medium enterprises (SMEs) and emerging markets with their disclosures.

IOSCO report on transition plans

IOSCO has published its report on transition plans, noting that while a range of frameworks and guidance is currently available, most jurisdictions do not have transition plan-specific regulations. IOSCO finds that market participants are increasingly looking to use transition plans for their decisions on capital allocation, portfolio constructions, risk assessment, pricing, valuation, product design and stewardship activities.

The five most useful components of transition plan disclosures are identified as:

1. Ambition and targets

2. Decarbonisation levers and action plan

3. Governance and oversight

4. Financial resources and human capital

5. Financial implications

The report also highlights future action that IOSCO and its stakeholders can take in the areas of:

Encouraging consistency and comparability through guidance on transition plan disclosures
Promoting assurance of transition plan disclosures
Enhancing legal and regulatory clarity and oversight
Building capacity

ESMA fund name guidelines translated and published

ESMA has translated and published its ESG fund name guidelines in all EU languages. The guidelines applied to new funds from 21 November 2024 and will apply to existing funds from 21 May 2025. The naming guidelines are an interim measure while the EU reforms the SFDR to tighten up the requirements that apply to funds that claim to have ESG characteristics. Fund managers should ramp up their implementation programs to ensure that they are prepared for the deadlines. This means immediately adapting the product manufacturing process for new funds and undertaking a review of all existing funds.

ESAs' latest annual report on SFDR PAI disclosures

The European Supervisory Authorities (ESAs) have published their third annual report to the European Commission on the disclosure of entity- and product-level principal adverse impact (PAI) disclosures under the SFDR. Overall, they find that the accessibility of PAI disclosures and quality of disclosed information have improved compared to the previous year. In this year's report, the ESAs have also included recommendations to National Competent Authorities (NCAs) to increase supervisory convergence and good practice for market participants. The latter should be reviewed in detail by firms.

FCA good and poor practice for SDR pre-contractual disclosures

The FCA has provided examples of good and poor practice for labelled funds and their pre-contractual disclosures under the Sustainability Disclosure Requirements (SDR) regime. Examples of good practice for two Sustainability Focus funds and one Sustainability Improvers fund are provided. No examples are provided for Impact or Mixed Goals funds but the FCA states that much of the illustrative practice should be relevant to all labels.

Examples of good practice include specific sustainability objectives, and clear explanations as to why the standard was chosen and how compliance will be monitored. Poor practice examples include not disclosing manager override for asset selection, and where the disclosed asset selection process does not link to the specified sustainability objective.

Temporary flexibility for firms on SDR naming and marketing rules

The FCA has announced temporary flexibility, in certain narrowly defined circumstances, for fund managers to comply with the SDR naming and marketing rules. The standard deadline is 2 December 2024, but firms meeting the specified conditions will have until 2 April 2025 to comply with the rules. Where firms can comply with the rules without requiring any flexibility, the FCA requires them to do so. It also expects firms to comply with the rules as soon as they can, without waiting until 2 April 2025.

Temporary flexibility is permitted where the fund manager:

Submitted a completed application for approval of amended disclosures in line with ESG 5.3.2R for that fund by 1 October 2024 [ESG 5.3.2R sets out pre-contractual disclosure requirements where firms use a label or restricted terms]; and
Is currently using one or more of the terms `sustainable', `sustainability' or `impact' (or a variation of those terms) in the name of that fund and is intending either to use a label, or to change the name of that fund.

All other aspects of the SDR implementation timeline for UK funds remain unchanged. More broadly, the FCA's final SDR rules for portfolio managers have been delayed until Q2 2025, and a UK government consultation on extending the SDR to EEA funds was due in Q3 2024 but has not yet been published.

Markets

Compromise agreement on EU regulation of ESG rating activities

The compromise agreement on the regulation of ESG ratings activities in the EU has been published, updated by the European Parliament at the October 21-24 session. The agreement aims to ensure that ESG ratings are `independent, comparable where possible, impartial, systematic and of adequate quality'. Once the European Council has given its final approval, the legislative act will be adopted.

IOSCO final report on voluntary carbon markets

IOSCO has published its final report on promoting the integrity and orderly functioning of voluntary carbon markets. It highlights 21 good practices that address five key principles of financial market regulation:

1. Clear and effective regulatory frameworks that provide legal certainty and proportional oversight

2. Enhanced transparency in carbon credit creation, trading and use

3. Strong governance standards, risk management frameworks, and policies to address conflicts of interest within the carbon credit ecosystem

4. Comprehensive market surveillance to detect and prevent fraud, abuse, and disruptive behaviours

5. Open, fair, and accessible trading for all participants, and standardization to boost market liquidity

The report is not a policy statement or regulation, but instead offers guidance for developing and operating voluntary carbon markets.

ESMA market report on EU carbon markets

ESMA's first annual report on EU carbon markets provides updates on prices, volatility, auctions, trading and positions, and finds that there are no significant issues affecting the functioning of the markets.

The 2024 report builds on ESMA's 2022 report on the trading of emission allowances and finds that, overall, there are neither significant issues affecting the functioning of EU carbon markets function nor any new major policy issues. Most of the policy recommendations from the 2022 report have been either fully or partially implemented. As ESMA continues to monitor carbon market developments, it may conduct further policy analysis in future.

UK government principles for the integrity of voluntary carbon and nature markets

On November 15, at COP29, the UK government put forward a set of principles for the integrity of voluntary carbon and nature markets. The six principles have been launched in response to concerns about the quality and integrity of some credits available in the market and how they are used to make claims about environmental impact. To use credits responsibly and appropriately as part of meeting their climate or environment goals, buyers such as businesses or other organisations should:

1. Use credits in addition to ambitious actions within value chains

2. Use high integrity credits

3. Measure and disclose the planned use of credits as part of sustainability reporting

4. Plan ahead (where organisations are making relevant transition plan disclosures)

5. Make accurate green claims using appropriate terminology

6. Co-operate with others to support the growth of high integrity markets

The government will consult in early 2025 on how the principles could be applied through guidance, standards and regulatory oversight.

UK government consults on Green Taxonomy

Following the Chancellor's Mansion House speech (see above), the UK government is consulting on the value case for a UK Green Taxonomy. The primary purpose of the consultation is to establish whether a UK Taxonomy would be additional and complementary to existing policies in meeting the objectives of mitigating greenwashing and channelling capital in support of the government's sustainability objectives. The government has requested market and regulatory use cases as well as feedback on how to maximise the usability of a UK Taxonomy, with particular consideration of key design features and challenges. At this stage, the government is not seeking detailed feedback on specific activity-level standards. The consultation closes on 6 February 2025.

UK government response to consultation on regulating ESG ratings providers

The UK government has published its response to the consultation which closed at the end of June 2023, together with draft legislation to bring ESG ratings providers into regulation. The consultation response sets out the details of the scope of the regulatory regime, including which activities will be captured, and this is presented in a draft Statutory Instrument (SI) to amend the Regulatory Activities Order. The government will finalise the legislation in 2025 and the FCA will then consult on the specific requirements. Technical comments on the draft SI can be submitted until 14 January 2025.

Stewardship

FRC consultation on revising the UK Stewardship Code

Following the launch of the Stewardship Code review in February 2024, and changes announced in July, the Financial Reporting Council (FRC) has launched a public consultation on revising the 2020 Stewardship Code.

The consultation is wide-ranging and proposes some significant changes that aim to balance ongoing support for effective stewardship and high-quality disclosures, whilst removing unnecessary reporting burdens. This is set in the wider context of efforts to bolster UK capital markets. The proposals would broaden the definition of stewardship, streamline and amend the reporting process, restructure the Code's existing Principles with additional guidance, and permit cross-referencing to information disclosed outside of the stewardship report. Principles would also be introduced specifically for proxy advisors and investment consultants for the first time.

Subject to feedback, it is expected that a revised Code would be published in H1 2025 and take effect from January 2026. However, the timeline is to be confirmed and the FRC will provide further information in due course to ensure a smooth transition to the revised Code.