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.

Shortly after publication of the last edition of ESG Regulatory Essentials, KPMG in the UK released its H2 2023 Regulatory Barometer. The Barometer again identified ESG and sustainable finance developments as having the greatest impact on firms across all areas of FS regulation. Regulatory scrutiny around greenwashing, expanding and more demanding disclosure requirements, and intensifying supervisory expectations are all contributing factors and show no signs of easing off.

The European Supervisory Authorities have released their work programmes for 2024. EBA, EIOPA and ESMA will continue to focus on sustainable finance, with work planned on SFDR, climate risk stress testing and greenwashing. The European Commission will also continue to drive the sustainability agenda, but in response to concerns over the reporting burden on firms, it has proposed changes to the adoption timeline for sector-specific sustainability standards.

Significant reporting initiatives have been finalised since the summer break. The Transition Plan Taskforce (TPT) in the UK and the global Taskforce on Nature-related Financial Disclosures (TNFD) both recently released their final frameworks — regulators must now consider how they translate guidance into mandatory reporting requirements. The Sustainable Finance Disclosure Regulation (SFDR) is currently under review, with the European Commission launching a wide-ranging consultation to capture views on the usefulness and compatibility of the current rules. In the UK, the FCA is expected to release its final rules on Sustainability Disclosure Requirements by the end of the year.  

Diversity and inclusion (D&I) in the financial sector is a high priority for UK regulators, with consultations from the PRA and FCA. Both have proposed clear expectations that certain firms would develop D&I strategies and targets, ensure Board oversight of D&I strategies, and make relevant disclosures both externally and via regulatory returns. The proposals will require thoughtful consideration by firms from several angles.  

The PRA’s latest Dear CFO letter on written auditor reporting focused on how the financial risks of climate change are captured. Banks have been given feedback and areas to work on for 2024. Meanwhile, the EBA has assessed how the current prudential framework for banks and investment firms captures environmental and social risks, and has recommended targeted enhancements to Pillar 1 approaches. In the US, the Federal Reserve Board has issued its final inter-agency guidance on how large institutions can manage the financial risks of climate change. 

The European Parliament and Council have both now adopted the European Green Bond (EUGB) Regulation. And the EU’s Carbon Border Adjustment Mechanism (CBAM) has entered the transitional phase of its implementation, with the first reports for key high-carbon imports due by 31 January 2024.

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

• Regulatory priorities
• Reporting and disclosures
• Diversity and inclusion
• Climate and environment-related financial risks
• ESG and markets

ESAs’ joint 2024 work programme focuses on sustainable finance 

The EBA, EIOPA and ESMA have published a joint work programme (PDF 231KB) for 2024, with sustainable finance as a key agenda item. Priorities include:

• Delivery of their third annual report under Article 18 of the SFDR regarding the extent and quality of the voluntary reporting of principal adverse impacts (PAI) of investment decisions on sustainability factors.
• Monitoring of the practical application of the SFDR to determine if Q&As or other tools are needed to promote supervisory convergence.
• Activities on climate risk stress testing, including a one-off system-wide scenario analysis and developing stress testing guidelines for supervisors.
• Continued research into the drivers of greenwashing risk — with a report to the European Commission due by May 2024 with their views on the prevalence of this risk and supervisory responses.

European Commission 2024 work programme

See below for proposals relating to adoption of sector-specific European Sustainability Reporting Standards for ESG disclosures.

Launch of the final TPT disclosure framework

The finalised Disclosure Framework from the TPT was published on 9 October, alongside other guidance. For more detail, see the article above.

European Commission consults on changes to the SFDR

The European Commission has launched a wide-ranging consultation on the SFDR. For more detail, see the article above.

TNFD releases final recommendations and guidance

The final set of TNFD recommendations and guidance were released in September during Climate Week in New York. For more insights, see the link above.

European Commission proposal to delay adoption of sector specific ESRS

The European Commission has committed in its 2024 work programme to reducing the reporting burden on firms by 25%. With this in mind, it has put forward a proposal (PDF 197KB) to delay adoption of the sector-specific set of ESRS (Set 2) under the Corporate Sustainability Reporting Directive to enable firms to focus on implementation of the sector-agnostic set of ESRS (Set 1), due to apply from 1 January 2024. The sector-specific standards have not yet been issued but were expected to be adopted in 2024 — under the proposal, this would now be 30 June 2026. For consistency, the Commission also proposes to postpone the deadline for adoption of the ESRS for non-EU companies meeting certain thresholds from 30 June 2024 to 30 June 2026.

FCA approach to developing ISSB-aligned disclosure requirements

In the 45^th edition of the Primary Market Bulletin, the FCA outlined its approach to developing ISSB-aligned disclosure requirements and supervising TCFD-aligned reporting.

In H1 2024 the FCA plans to consult on updating its existing TCFD-aligned disclosure requirements for listed companies to reference IFRS S1 (general sustainability-related disclosures) and IFRS S2 (climate-related disclosures). Final policy is expected by the end of 2024, with new disclosures intended to be in force for accounting periods beginning on or after 1 January 2025 (first reporting 2026).

The FCA will also consult on an appropriate scope and design for the new disclosure regime. The premium and standard listing categories will potentially be replaced with a single category of equity shares in commercial companies. The consultation will also identify any transitional measures which could smooth implementation.

Into 2024, the FCA will continue with its thematic review of TCFD-aligned disclosures by listed companies, though its approach may evolve as implementation of the ISSB standards gets closer.

TCFD 2023 Status Report

The TCFD has published its sixth and final status report (PDF 17.4MB) under the auspices of the Financial Stability Board (FSB). The Taskforce used AI technology to review publicly available reports for more than 1,350 large companies in specific sectors around the world over a three-year period. It also reviewed TCFD-aligned reports from the top 50 asset managers and top 50 asset owners globally (based on assets under management) and surveyed these firms. The results were encouraging, but the Taskforce believes that more progress is needed to improve transparency on the actual and potential impact of climate change on companies. It is concerned that too few companies are disclosing decision-useful climate-related financial information, particularly regarding impacts on their business, strategies, and financial planning.

Transfer of TCFD monitoring responsibilities to the ISSB from 2024

Following publication of the first two ISSB standards, the FSB has asked the IFRS Foundation to take over the monitoring of companies’ climate-related disclosures from 2024. IFRS S1 and S2 fully incorporate the recommendations of the TCFD — the FSB therefore finds that the ISSB standards mark ‘the culmination of the work of the TCFD’.

PRA and FCA consult on diversity and inclusion requirements

The PRA and FCA (PDF 1.6MB) have published separate consultations on diversity and inclusion requirements for regulated firms. For more detail, see the article above.

PRA thematic feedback on 2022/23 written auditor reporting

The PRA’s September ‘Dear CFO’ letter (PDF 364MB) provided thematic feedback on deposit takers’ written auditor reports for 2022/23 with specific focus on climate risk. The PRA notes that firms have enhanced their governance, data and risk assessments when capturing the impact of climate risk on their balance sheets. Key findings are that:

• It continues to be a challenge for firms to determine the right metrics to identify the loan portfolios and segments that could be most impacted by climate risk.
• Firms are developing tools to quantify the impact of climate risk on expected credit losses but are at varying stages.
• Not all firms documented their plans to develop climate accounting capabilities or put in place management information to oversee delivery.
• Both the availability and quality of data remain a challenge, with firms having different approaches to climate data from internal and external sources.

Areas of focus for firms in 2024 include:

• Improving capabilities to quantify the impact of climate risks on expected credit losses.
• Strengthening governance and financial reporting risk assessments.
• Improving controls to support the use of a higher volume of forward-looking climate-related data in financial reporting.
• Improving capabilities to quantify the impact of climate risks on balance sheets and financial performance.

EBA recommends enhancements to the Pillar 1 framework to capture E and S risks

​​​​​​​The EBA has published a report (PDF 2.4MB) assessing how the current prudential framework for credit institutions and investment firms captures environmental and social risks. The EBA recommends targeted enhancements to accelerate the integration of these risks across Pillar 1, to support the transition towards a more sustainable economy while ensuring that the banking sector remains resilient.

Short-term actions that could be taken over the next three years as part of the implementation of the revised Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD), include:

• Including environmental risks in stress testing programmes under both the internal ratings-based (IRB) and the internal model approaches (IMA);
• Encouraging the inclusion of environmental and social factors as part of external credit assessments by credit rating agencies; and
• Requiring institutions to identify whether environmental and social factors are triggers of operational risk losses.

Firms should also note the longer-term changes to the Pillar 1 framework explored by the EBA, including the possible introduction of environment-related concentration risk metrics.

MEPs approve new ‘Green Bond’ standard

On 5 October, the EU Parliament adopted a new voluntary standard for the use of a ‘European Green Bond’ (EUGB) label. The European Council also adopted the regulation on 23 October, meaning it will enter into force 20 days after publication in the Official Journal of the EU.

The EUGB regulation has been in development since 2021 and lays down uniform standards for issuers who wish to use the EUGB designation in the marketing of bonds that pursue sustainability objectives. It is the first of its kind in the world and proved challenging due to interdependencies with other parts of the EU sustainable finance framework. However, it is an important part of the EU’s strategy to bring all use-of-proceeds financial instruments within the scope of that framework.

Implementation of Carbon Border Adjustment Mechanism (CBAM)

On 1 October, the EU’s Carbon Border Adjustment Mechanism (CBAM) entered the transitional phase to implementation. During this phase the CBAM will apply only to imports of key high-carbon goods, with importers required to report the volume of greenhouse gas (GHG) emissions embedded in their production.

The first reports for key high-carbon imports are due by 31 January 2024. Beginning January 2026, importers must buy and surrender ‘CBAM certificates’ equivalent to the value of the GHG emissions embedded in their imports.

ESMA analysis of ESG factors in EU fund names and documentation

ESMA has published an article that analyses the use of language related to ESG factors in EU fund names and documentation. Using natural language processing (NLP) to analyse funds’ names and disclosures, ESMA found that the share of EU UCITS with ESG words in their name has markedly increased since 2013, and that fund managers tend to prefer using generic language (such as ‘sustainable’) rather than more specific words. The study also found evidence of high and consistent investor appetite for funds with an ESG-related term in their name, relative to funds without any ESG words in their name. Looking ahead, ESMA noted that it will continue to scale up the monitoring and supervision of greenwashing, potentially using NLP-based tools to increase the effectiveness of supervision.