The Sustainability Series – ESG Regulation

ESG Regulation: The carrot and stick of green recovery

by Viktor Koleda, Analyst

Earlier this year city centres emptied, long-distance travel slowed, industries came to a halt, and the planet enjoyed a carbon reprieve of sorts. The environment seems to be the coronavirus’s only immediate “winner,” and those of us with an interest in regulation began asking: what effect is the pandemic going to have on legislative commitments to encourage further flow of capital towards greener assets?

A softer stick?

ESG regulation One could, rather fairly, intuit that the economic pressures brought forward by the pandemic would force governments to leave companies alone. The gloom of prospective hikes in debt costs, scrambles for cash to secure liquidity, and higher taxes all stand in the way of an easy recovery. What kind of government, we may ask, would want to burden the economy further with ESG fines and mandatory requirements?

Such presumptions, however, began to shatter as the regulators did not spare struggling companies from hefty fines. In October, the ICO levied £20 million – its biggest-ever GDPR fine – against British Airways for failing to protect their customers’ data against unauthorised access.

Of course, the British Airways penalty was initially announced to be £183 million, but out of the tremendous (89%!) reduction, “only £4m of that reduction has been specifically attributed to Covid-19.” This gives us a good quantitative indication of exactly how little the regulators are prepared to discount under the circumstances we all are facing.

A sweeter carrot?

The “stick” clearly remains in the watchdogs’ hand, so where is the “carrot”? Well, it comes in four types: labelling, disclosure, risk management, and suitability. Jurisdictions are racing to provide access to data and simplify relevant terminology, which should help investors account for the unpriced risks of an asset.

Upcoming legislation

The EU is standing at the helm of the regulatory push, with the following pieces of legislation on the agenda:

  • ESG Disclosures Regulation, which comes into effect at the end of March 2021, will require all financial market participants and advisers to disclose sustainability information in precontractual documents and on their websites.
  • Establishment of a Framework to Facilitate Sustainable Investment, or Taxonomy Regulation. The taxonomy will define “green” and “brown” assets, seeking to standardise classificatory systems. While it entered into force on 12 July 2020, many of its key provisions will be coming into force between 2021 and 2023.
  • Human Rights Due Diligence Legislation, optimistically expected to be introduced in Q1 of 2021, envisages a variety of penalties for businesses that fail to assess and prevent adverse human rights impacts across the supply chain.
  • Further efforts to align current regulation with the European Commission’s Sustainable Finance Action Plan, including draft amendments to UCITS, AIFMD and MiFID rules, which would enrich them with the concept of “sustainability preferences.”

 

At a minimum, the UK is likely to mirror the EU initiatives listed above, to ensure consistency of standards across supply chains which extend outside of its borders. Mounting pressure to get their environmental affairs in order ahead of COP-26 makes it all the more likely that the UK will go even further, in an attempt to take over the position of ESG stewardship. Recent announcements all point in the same direction:

  • The Bank of England has announced a climate stress test for financial institutions to be launched in June 2021, which had been delayed because of the pandemic.
  • The Chancellor has promised that the UK will become the first country in the world to introduce mandatory disclosures, aligned with those developed by the Task Force on Climate-related Financial Disclosures. All requirements are expected to come into force by 2025.
  • Mr Sunak has also articulated plans for the development of UK’s own green taxonomy, in parallel to the EU’s.
  • In September, the Government published its response to public consultations regarding the Modern Slavery Act reporting requirements. Alongside new reporting standards, civil penalties for non-compliance are being considered.
    Boris’s 10 points, published in the FT from his self-isolation, highlight the UK’s intention to lead, not follow.

The proliferation of regulatory activity around ESG suggestsesg regulation an unprecedented level of agreement that making societies resilient to system shocks will pay off. However, it is still uncertain whether the carrot will turn out as sweet as the legislators are hoping. Even though the regulation reviewed here intends to eliminate “greenwashing” and enact full transparency, analysts and investors will unavoidably be flooded with large volumes of standardised, and not always meaningful, information. This, in turn, will place a premium on one’s ability to effectively communicate an ESG narrative amid the sea of compliance-oriented, box-ticking disclosure forms.

How DRD can help

We help our clients understand and articulate their impact in the world, analyse their ESG risks and opportunities, engage their stakeholders, develop strategy and tell their ESG stories. DRD has a dedicated ESG team with deep experience advising clients on ESG issues in both in senior in-house and advisory roles. For a conversation about how DRD might be able to assist please contact sustainability@drdpartnership.com.