Welcome to the latest edition of ESG Regulatory Essentials.
This is a regular publication from KPMG's EMA Financial Services Regulatory Insight Centre, providing a summary of the latest ESG regulatory developments impacting financial services firms in the UK and EU.
As we head towards the summer holidays, regulators and standard-setters in the ESG space show no signs of slowing down.
Since our last issue, sustainability reporting and disclosures have continued to be front and centre and there is more to come. TCFD disclosures are now mandatory for the largest UK-registered companies and financial institutions and the FCA requires issuers to report against specific diversity and ethnicity targets. Consultations on proposed sustainability standards have been launched by the International Sustainability Standards Board (ISSB), the European Financial Reporting Advisory Group (EFRAG) and the US Securities and Exchange Commission, with potential synergies, divergences and interactions provoking significant debate. UK-based firms are preparing for the imminent publication of the FCA’s Sustainability Disclosure Requirements (SDR) and the delayed UK Green Taxonomy.
Support for firms as they develop transition plans is gaining momentum, with HM Treasury (HMT) and the Glasgow Financial Alliance For Net Zero (GFANZ) consulting on draft guidance.
Nature and biodiversity are also sharply in focus - version 2.0 of the Task Force for Nature-related Financial Disclosures’ (TNFD) beta framework is hot off the press, incorporating feedback on the first prototype issued in March.
Approaches to assessing and managing climate and other ESG risks are evolving. The Basel Committee (BCBS) has agreed final principles on managing climate-related risk, the Bank of England (BOE) has published aggregate results for its first combined climate stress test of the largest banks and insurers, the ECB is expected to publish its results in July, and the EBA is seeking feedback on a Discussion Paper on the effective management of climate-related risk. For asset managers, ESMA has issued a supervisory briefing on the integration of sustainability risks and their disclosure.
There has been a raft of other analysis, updates and clarifications too, ranging from the Sustainable Finance Disclosure Regulation (SFDR) and EU Taxonomy Regulation, to sustainable securitisation, the ESG ratings market and the trading of emissions allowances in the EU carbon markets. In short, there is a lot for firms to track, digest and, potentially, implement over the coming months.
For more on all the above, read on.
In this issue:
Reporting and disclosures
The UK Transition Plan Taskforce (TPT) has launched a Call for Evidence (PDF 1.21 MB) that aims to identify the vital elements and key principles that should inform all transition plans. This will result in a model framework that can apply across all sectors, ensuring a shared and consistent understanding for firms of what is needed. The framework will inform UK regulations for certain financial sector firms and listed companies to publish climate transition plans. The consultation period closes on 13 July.
GFANZ releases guidance on transition plans
The Glasgow Financial Alliance for Net Zero (GFANZ) is consulting until 27 July on its draft Net-zero Transition Plan (NZTP) framework for the financial sector. GFANZ has also published a set of connected tools, frameworks and other resources for firms to support their transition to net zero.
FCA introduces new Listing Rules for diversity and inclusion
The FCA has introduced new requirements (PDF 644 KB) for Diversity and Inclusion (D&I) on company boards and executive committees. It is the first time such targets have been set by the regulator and the new rules represent a significant step in expanding regulatory policy around D&I. New Listing Rules require issuers to include a statement in their annual financial report setting out on a "comply-or-explain" basis whether they have met specific board diversity targets:
- At least 40% of the board are women
- At least one of the Chair, Chief Executive Officer (CEO), Senior Independent Director (SID) or Chief Financial Officer (CFO) is a woman
- At least one board member is from a minority ethnic background
Corporate governance rules are also expanded to encourage issuers to consider broader aspects of diversity in their reporting on board diversity policies. In-scope companies are required to make disclosures in their annual reports for financial years starting on or after 1 April 2022.
TNFD beta framework for nature-related financial disclosures
In March, the Taskforce on Nature-related Financial Disclosures (TNFD) released a prototype (PDF 10.2 MB) framework for consultation. The framework includes three core components:
- An outline of recommended fundamental concepts and definitions for understanding nature across the four realms of Land, Ocean, Freshwater and Atmosphere. TNFD recommends that market participants use this when assessing and disclosing their nature-related risks and opportunities
- Draft disclosure recommendations for nature-related risks and opportunities — these follow the TCFD's four pillars of: governance, strategy, risk management and metrics and targets
- Guidance for corporates and financial institutions to undertake nature-related risk and opportunity assessments and incorporate these into their enterprise strategy and risk management processes. TNFD introduces an integrated nature-related risk and opportunity assessment process (LEAP — Locate, Evaluate, Assess, Prepare)
Version 2.0 of the framework, published on 28 June, incorporates feedback from the first release and includes three significant additions:
- A first draft architecture for metrics and targets, and draft guidance on, and an illustrative set of, dependency and impact metrics
- A proposed approach to sector-specific guidance
- An update to the LEAP process.
Three further iterations of the framework will follow in October 2022, February 2023 and September 2023.
IFRS Foundation and GRI collaborate on approach for sustainability disclosures
In March, the IFRS Foundation and Global Reporting Initiative (GRI) announced a collaboration agreement under which the International Sustainability Standards Board (ISSB) and the Global Sustainability Standards Board (GSSB) will coordinate their work programmes and standard-setting activities.
By working together, the IFRS Foundation and GRI provide two 'pillars' of international sustainability reporting — a first pillar representing investor-focused capital market standards of IFRS Sustainability Disclosure Standards developed by the ISSB, and a second pillar of GRI sustainability reporting requirements set by the GSSB, compatible with the first, designed to meet multi-stakeholder needs.
ISSB publishes first two exposure drafts for consultation
On 31 March 2022, the new International Sustainability Standards Board (ISSB) released Exposure Drafts (EDs) of its first two sustainability standards. The first ED sets out general sustainability-related disclosure requirements (PDF 288KB) and the second specifies climate-related disclosure requirements (PDF 317KB). The ISSB is gathering feedback until 29 July 2022.
The ISSB disclosure standards build on the work of the TCFD, formalising the recommendations and the way in which information should be presented. They also incorporate the industry-based disclosure requirements of the SASB standards, which were subsumed into the ISSB on its creation in 2021.
The ISSB will refine and make necessary revisions to the standards based on feedback received. The final set of disclosure standards is expected by the end of 2022. The standards will need to be adopted at a national or regional level before organisations are required to disclose against them.
EFRAG consults on package of draft sustainability standards
The European Financial Reporting Advisory Group (EFRAG) is consulting until 8 August on Exposure Drafts (EDs) of the first European Sustainability Reporting Standards (ESRS) which will underpin the EU Corporate Sustainability Reporting Directive (CSRD).
The published EDs correspond to the first set of standards required under the CSRD proposal. Work on the standards has been running in parallel with the legislative process of CSRD. The final first set of ESRS will be submitted to the European Commission in November 2022 so that they can be applied for the first time to large companies' reports in 2024, based on financial year 2023.
The EFRAG package consists of 13 EDs under the 4 broader topics of Cross-cutting standards, Environment, Social and Governance. The EDs are based upon two categories of standards:
- Cross-cutting ESRS which:
- Establish the general principles to be followed when preparing sustainability reporting in line with the CSRD provisions
- Mandate disclosure requirements (DRs) aimed at providing an understanding of (a) strategy and business model, (b) governance and organisation, and (c) materiality assessment, covering all topics
- Topical ESRS which, from a sector-agnostic perspective:
- Provide topic-specific application guidance in relation to the cross-cutting DRs on strategy and business model, governance and materiality assessment
- Mandate DRs about the undertaking's implementation of its sustainability-related objectives (i.e. on its policies, targets, actions and action plans, and allocation of resources)
- Mandate performance measurement metrics
The package also includes a consultation survey on the overall ESRS exposure drafts relevance in three sections (architecture, implementation of CSRD principles, exposure drafts content) and a questionnaire on prioritisation and phasing-in of the standards.
ESA and European Commission updates regarding the SFDR
On 25 March, the European Supervisory Authorities (ESAs), the EBA, EIOPA and ESMA, updated their joint supervisory statement (PDF 232KB) on the application of the Sustainable Finance Disclosure Regulation (SFDR). The statement reiterated that the application date of the SFDR Regulatory Technical Standards (RTS) would be delayed until 1 January 2023 and provided guidance to national competent authorities for the interim period. It also set expectations regarding the application timeline for the entity-level principal adverse impact (PAI) statement, products' periodic disclosures, and the application of the Taxonomy Regulation provisions.
On 6 April, the European Commission adopted the RTS to be used by market participants when disclosing sustainability-related information under the SFDR. The Commission confirmed that the RTS is scheduled to apply from 1 January 2023 (subject to scrutiny by the European Parliament and Council).
On 5 May, the Commission published two letters to the ESAs regarding amendments to the SFDR RTS. The first (PDF 205KB) related to the recent changes to the Taxonomy Regulation regarding fossil gas and nuclear energy (see below), and invited the ESAs to propose amendments to the SFDR RTS to bring them into alignment. The second (PDF 225KB) invited the ESAs to streamline and further develop the regulatory framework, to consider extending the list of universal indicators for PAIs and other indicators, and to refine the content of all the indicators for adverse impacts. It also invited the ESAs to jointly propose amendments to the SFDR RTS regarding information provided in relevant disclosures on decarbonisation targets.
On 25 May, the Commission responded (PDF 795KB) to a list of questions (PDF 133KB) that had been jointly submitted by the ESAs to clarify the interpretation of EU law in the context of the SFDR and Taxonomy Regulation. The responses cover PAI disclosures at entity and product level, financial advisers and investment advice, rules for products that existed as at 10 March 2021 (the application date of the SFDR), good governance practices for investee companies, and disclosures under Article 5 and 6 of the Taxonomy Regulation.
Further clarifications and guidance (PDF 307KB) from the ESAs on the draft RTS were issued on 2 June regarding: uses of sustainability indicators, PAI disclosures, financial product disclosures, direct and indirect investments, taxonomy-related financial product disclosures, “do not significantly harm” (DNSH) disclosures, and disclosures for financial products with investment options. The ESAs plan to promote a better understanding of the RTS through practical application Q&As in due course.
Sustainability disclosures for simple, transparent and standardised securitisations
The EBA, EIOPA and ESMA, are consulting (PDF 630KB) until 2 July on draft RTS for sustainability disclosures for simple, transparent and standardised (STS) securitisations. The draft RTS build on the existing infrastructure for the disclosure of public securitisation information.
Securitisation is not currently a “financial product” as defined under the SFDR, and sustainability disclosures regarding securitisation were considered by the ESAs to be insufficiently developed. Therefore, these draft RTS aim to harmonise information disclosure and ensure consistency (where possible) with the draft SFDR RTS — building as much as possible on the SFDR and adapting it where necessary to the specificities of securitisations. The consultation aims to gather views on the content, methodologies, and presentation of information about the proposed PAI indicators on sustainability factors for certain securitisations.
Banks and other relevant institutions will be able to make Banking book Taxonomy Alignment Ratio and Green Asset Ratio (GAR) disclosures which include securitisation products.
The RTS also propose the requirement for a new "non-green asset ratio" (i.e. 100% — GAR) disclosure in the PAI statement. This would show users of the disclosures the proportion of a securitisation portfolio not aligned with activities classed as green under the EU Taxonomy Regulation.
In March, the Platform for Sustainable Finance (PSF) issued its Final Report (4.94 MB) on Taxonomy extension options supporting a sustainable transition. The current Taxonomy leaves a wide variety of economic activities unclassified and only a very small percentage of existing assets under the included activities are identified as `taxonomy-aligned” or “green'. The PSF acknowledges the problem of non-alignment being perceived as a negative classification, and recommends extending the environmental Taxonomy “beyond green” to increase transparency and encourage more ambitious greening across the entire economy. New categories could signal and support the financing of the most urgent transitions needed:
- Unsustainable performance requiring an urgent transition to avoid significant harm
- Intermediate (or Amber) performance
- Unsustainable, significantly harmful performance where urgent, managed exit/decommissioning is required
- Low environmental impact activities
Further work is required to define and develop specific criteria. The PSF cautions that a balance needs to be struck between additional complexity in reporting versus the benefit of more information being made available.
EU Taxonomy — next step for gas and nuclear
A public hearing was held in May by the European Parliament as part of MEPs' ongoing scrutiny of the European Commission's proposal on how nuclear and gas activities should be classified under the EU Taxonomy. The Complementary Climate Delegated Act was proposed in March 2022 to include, under certain conditions, specific nuclear and gas energy activities in the list of economic activities covered by the EU Taxonomy. The Delegated Act classifies these activities as transitional activities contributing to climate change mitigation under Article 10(2) of the Taxonomy Regulation. Their inclusion is time-limited and dependent upon specific conditions and transparency requirements.
The Parliament and Council have until 10 July 2022 to decide if they want to veto the Commission's proposal. This period may be extended by two months. A joint vote for the two committees is tentatively scheduled for 14 June.
On 24 May, the Bank of England (BOE) published aggregate results for its Climate Biennial Exploratory Scenario (CBES) stress test for the largest UK banks and insurers. The CBES was intended as a learning exercise to (i) improve banks' and insurers' climate risk management, (ii) size the risks faced by participants and (iii) better understand the potential responses of banks and insurers to climate-related risks and their broader implications. Key findings were that:
- Projections of climate losses are uncertain — climate-related financial scenario analysis is still in its infancy and significant data gaps remain. UK banks and insurers have made progress but have much more to do to understand and manage their exposures
- At an aggregate level, UK banks and insurers are likely to be able to absorb the costs of transition. These costs will be lowest where early and well-managed action is taken to reduce greenhouse gas emissions and limit climate change. Some costs that initially fall on banks and insurers will ultimately be passed on to their customers
- Government climate policy will be a key determinant of the speed and impact of changes in the global economy
- Banks and insurers have a collective interest in managing climate related financial risks in a way that supports that transition over time
For more on the CBES results, see our article here/above.
Basel Committee finalises climate risk principles
Following consultation in 2021, the Basel Committee (BCBS) has finalised its principles for the effective management and supervision of climate-related financial risks. The principles have been designed such that they can be adapted to a diverse range of banking systems in a proportional manner.
Finalisation of the principles forms part of the BCBS's broader assessment of potential measures — spanning disclosure, supervisory and regulatory measures — to address climate-related financial risks to the global banking system.
EBA discussion paper on the role of environmental risks in the prudential framework
The EBA is seeking comments until 2 August on an exploratory Discussion Paper (PDF 2.78 MB) on integrating environmental risks into Pillar 1 capital. The paper considers:
- The extent to which environmental risks will be automatically captured by Pillar 1, in the absence of legislative amendments and whether environmental risks will lead to a reallocation of risks between sectors rather than an overall increase in the level of systemic risk
- The extent to which 'double materiality' should be incorporated within the prudential framework
- How credit, market and operational risk frameworks could be adjusted to be explicitly integrate environmental risks and be more forward-looking
The EBA clarifies that strategic and reputational risks would fall under Pillar 2 and not under Pillar 1. It assumes that liquidity and leverage rules will not be significantly affected by environmental risks at this stage. And it suggests that amending the large exposures regime to explicitly address environmental risks would not be warranted as it would require a reorientation of its objective and design. However, it notes that enhancing the regime's reporting obligations could be helpful. The EBA expresses future ambitions to integrate social risks if these can be appropriately quantified but they are not considered in this paper.
FSB consultation on supervisory and regulatory approaches to climate-related risks
The Financial Stability Board (FSB) is consulting until 30 June on a set of guidelines for national competent authorities and regulators to promote consistency in the monitoring, management and mitigation of the financial risks of climate change. Final recommendations will follow towards the end of 2022. The FSB focuses on three areas that it considers to be “cross-sectoral and system-wide aspects of climate-related risk”:
- Supervisory and regulatory reporting and collection of climate-related data as foundational to identifying and monitoring risks
- System-wide supervisory and regulatory approaches to assessing climate-related risks, including the use of analytical tools such as scenario analysis and stress testing
- Early consideration of other macroprudential policies and tools to address systemic risks
ECB assessment of banks' progress on disclosing climate and environmental risks
In March, the ECB reported (based on November 2021 data) on banks' progress against the expectations of its November 2020 guide. Whilst there has been progress since the ECB's 2020 assessment (PDF 357 KB) and some good practices were observed, banks need to do better and significant gaps remain. In particular, the ECB found the overall level of transparency to be insufficient:
- Around 75% of banks are not disclosing whether climate and environmental risks have a material impact on their risk profile
- Around 60% do not describe how physical or transition risk could affect their strategy
- Only around 50% publish key performance or risk indicators
- Only 15% disclose scope 3 emissions
- Almost 30% of banks that have committed to align exposures with the Paris Agreement provide no information to back this up
The ECB has sent individual feedback letters to firms and expects them to take decisive action. The next review will be at end of 2022.
ESMA briefing on asset managers' integration of sustainability risks
ESMA has issued a supervisory briefing on asset managers' integration of sustainability risks and their disclosures. The purpose of the briefing is to promote supervisory convergence - it is aimed at EU regulators and their supervisory approach and covers the following:
- Guidance for the supervision of fund documentation and marketing material: on pre-contractual disclosures, fund documentation and marketing material, website disclosures, periodic disclosures and other supervisory actions
- Guidance for convergent supervision of the integration of sustainability risks by AIFMs and UCITS Management Companies
- Regulatory interventions in case of breaches: ESMA describes potential issues that regulators need to address (e.g. SFDR disclosures have not been made at all, SFDR disclosures that are severely misleading etc.)
In March, the EBA issued a report (PDF 1.59 MB) on how existing EU regulations, including the Green Bond Standard (EUGBS), the Taxonomy Regulation and the SFDR could be applied to securitisation markets, and the extent to which a dedicated regulatory framework for securitisation markets is required. The EBA concludes that:
- The EUGBS would be the most appropriate existing regulation under which to develop regulation of the sustainable securitisation market
- Even though securitisation products are not within the scope of the EU Taxonomy, the sustainability criteria provide a useful and standardised basis for defining sustainable securitisation products
- A dedicated regulatory framework for securitisation markets is not currently required, although as the market matures it may become appropriate to develop one
The European Commission's report to the European Parliament and Council regarding the creation of a sustainable securitisation framework will be informed by the EBA's report. A legislative proposal will follow if deemed appropriate. To note, simple transparent and standardised (STS) securitisations (see above) are not necessarily sustainable and vice versa.
MEPs adopt position on EU Green Bond Standard
In May, MEPs adopted their negotiating position on the EUGBS. The text introduces several changes to the Commission's original proposal, which are intended to better regulate the entire green bond market, improve its supervision, reduce greenwashing, and add clarity when proceeds are allocated to gas or nuclear activities, including:
- Transparency requirements for all bonds marketed as green, including alignment with the EU Taxonomy Regulation and on the use of proceeds derived from the bond issuance
- All EUGBs should have verified transition plans and all issuers should also have processes in place to identify and limit the principal adverse impacts of their activity
- EUGBs may not be issued from countries on the EU's grey or blacklist of tax havens
- Provisions to ensure that authorities could ban companies from issuing EUGBs if they fail to follow the rules. Investors have legal recourse if an issuer's failure to comply leads to the depreciation of a green bond
- When a green bond issuer intends to allocate proceeds to nuclear energy or fossil gas related activities, a statement must appear prominently on the first page of the EUGB Factsheet
European Commission consults on the ESG ratings market
The European Commission's targeted consultation on the functioning of the ESG ratings market in the EU and the integration of sustainability characteristics in credit rating analysis closed on 8 June. The consultation was aimed at ESG ratings providers, credit ratings agencies, investors, companies, public authorities (including supervisors and regulators) and other stakeholders.
The first part of the consultation looked at the determination and use of ESG ratings and the second considered how ESG characteristics are incorporated into credit ratings. The outcomes of the consultation will inform the Commission's decision on whether further regulatory policy is required.
ESMA final report on carbon markets
ESMA's final report on the EU carbon market, specifically the trading of emission allowances, finds no major deficiencies in the functioning of the market, but it makes a number of policy recommendations to improve transparency and monitoring including:
- Extension of position management controls to venues trading derivatives on emission allowances
- Adapting of position reporting on emission allowances to ensure full reporting of positions on spot emission allowance instruments
- Refinement of transparency calibrations to improve pre-trade transparency to market participants
- Increased transparency and reporting of OTC transactions
- ESMA to have access to primary markets transactions in order to monitor activity effectively
- Changes to the EU Allowance (EUA) registry to improve identification of market abuse
- Recalibration of position limits to prevent market abuse and support orderly pricing and settlement conditions
The European Commission, the EU Council and the European Parliament will use the report to determine whether additional measures to regulate the carbon market are necessary.
IOSCO's key activities for 2022 (PDF 107 KB) around sustainable finance will include a thorough review of the ISSB Exposure Drafts of proposed climate and general sustainability disclosure requirements (see above), as well as the final standards once issued. If IOSCO determines that the standards are fit for purpose, its decision would provide all 140 IOSCO member jurisdictions with the basis to decide how they might adopt, apply or be informed by the ISSB standards.
In addition, IOSCO's workplan covers the development of assurance standards to build trust in sustainability reporting, an in-depth review of carbon markets to identify vulnerabilities in voluntary carbon markets and assess the transparency and integrity of market functioning, and pushing for recommendations to asset managers and ESG ratings and data providers to be implemented.
NGFS 2022/23 workplan
The Network for Greening the Financial System (NGFS), the voluntary group of central banks and supervisors, has published its 2022-24 work programme. The key areas of focus, to be covered under four workstreams and by two task forces, are:
- Supervisory practices with respect to managing climate-related risks
- The design and analysis of climate scenarios
- The implications of climate change for monetary policy
- Guidance for central banks on the transition to net zero
- Nature-related financial dangers
- Capacity building and training for NGFS's membership