May 8, 2023
Artificial intelligence: how to address ESG concerns
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Sustainability: Understanding the regulatory trend
The regulatory landscape
Sustainable finance and corporate responsibility have become strategic topics for corporations, including financial institutions, as clients’ expectations are increasingly shifting towards green and sustainable products.
What is sustainable finance?
Sustainable finance has several definitions. One of the most commonly adopted is the one proposed by the G20 Sustainable Finance Study Group, which says:
Sustainable finance can be broadly understood as financing as well as related institutional and market arrangements that contribute to the achievement of strong, sustainable, balanced and inclusive growth, through supporting directly and indirectly the framework of the Sustainable Development Goals (SDGs). A proper framework for sustainable finance development may also improve the stability and efficiency of the financial markets by adequately addressing risks as well as market failures such as externalities.
The European Union’s regulatory action
Without any doubt, a main trigger for this regulatory revolution has been the actions taken by the European Union, in particular since the publication of the EU Commission’s Action Plan: Financing Sustainable Growth (EU Action Plan on Sustainable Finance) in 2018.
The EU Sustainability Taxonomy Regulation (Regulation (EU) 2020/852 on the Establishment of a Framework to Facilitate Sustainable Investment) has impacted not only financial institutions, but also large companies as it introduced amendments to the EU Non-Financial Reporting Directive (NFRD). In this context, it is important to know that it is not only the EU which is working towards having a fully operational a Sustainability Taxonomy, but, in fact, there are more than 15 countries across the globe moving towards the same direction.
Moreover, the regulation creating the framework for the EU Climate Transition Benchmarks and the EU Paris-aligned Benchmarks encourages the use of and reliance on global standards such as those of the Financial Stability Board’s Taskforce on Climate-related Financial Disclosures (TCFD).
Key EU regulatory frameworks in the area of sustainable finance
EU Sustainable Finance Disclosures Regulation (Regulation (EU) 2019/2088 on Sustainability-Related Disclosures in the Financial Services Sector) lays down harmonized rules on:
- the transparency expectations investors have to abide by when integrating sustainability risks;
- the consideration of sustainability-related adverse impacts in their processes; and
- content requirements for sustainability-related information of financial products.
EU Climate Transition Benchmarks and the EU Paris-aligned Benchmarks (Regulation (EU) 2019/2089 on EU Climate Transition Benchmarks (EU CTB), EU Paris-aligned benchmarks and sustainability-related disclosures for benchmarks (EU PAB) introduces two benchmarks to help investors compare the carbon footprint of investments:
- Climate-transition benchmarks (EU CTB); and
- Paris-aligned benchmarks (EU PAB).
The adoption of these benchmarks is voluntary. However, labelling a portfolio as following either the EU CTB or EU PAB triggers disclosure obligations.
EU Sustainability Taxonomy Regulation (Regulation (EU) 2020/852 on the Establishment of a Framework to Facilitate Sustainable Investment) is instrumental in enabling the EU to become climate neutral by 2050. It creates a unified classification system to define
- climate change mitigation;
- climate change adaptation;
- sustainable use and protection of water and marine resources;
- transition to a circular economy;
- pollution prevention and control; and
- protect and restore biodiversity and ecosystems.
In addition, in July 2021, the EU Commission has launched its Strategy for Financing the Transition to a Sustainable Economy, which aims to build on the work of the EU Action Plan on Sustainable Finance. The Strategy envisages 22 policy-related actions to be taken by the EU pertaining to topics like green loans, green mortgages, and the integration of sustainability-related considerations into prudential rules.
Corporate Responsibility: Mandatory due diligence
When looking at the regulatory landscape from a corporate responsibility perspective it is possible to observe a rapid increase of mandatory regulations in the area of environmental and human rights due diligence. This movement has not only been identified by Policy Outlook research, but also by members of the UN Working Group on Business and Human Rights, who have affirmed that “our future is one of mandatory measures. We now have a strong evidence-base telling us that voluntary measures aren’t getting us where we need to be.”
When assessing how regulators have been addressing the issue of mandatory due diligence laws, two approaches can be identified. On the one hand, some regulators prefer to focus on a particular topic, such as is the case with the UK Modern Slavery Act and the Dutch Child Labor Law.
On the other hand, there are regulators that prefer to enact rules that require companies to adopt environmental and human rights due diligence measures without focusing on a particular topic. This is the case, for example, of the French Duty of Vigilance Law and the German Supply Chain Due Diligence Act. This approach is likely to be the one adopted by the European Union in its upcoming directive on corporate due diligence and corporate accountability.
Regardless of the regulatory approach chosen by regulators a key commonality can be found across due diligence laws, they all build on the foundations laid by internationally standards, in particular the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.
What is Corporate Responsibility?
As with sustainable finance, there is no commonly accepted definition of corporate (social) responsibility. In 2011, the EU Commission proposed the following definition: “the responsibility of enterprises for their impacts on society.”
This means that:
Respect for applicable legislation, and for collective agreements between social partners, is a prerequisite for meeting that responsibility. To fully meet their corporate social responsibility, organizations should have in place a process to integrate social, environmental, ethical, human rights and consumer concerns into their business operations and core strategy in close collaboration with their stakeholders, with the aim of:
- maximising the creation of shared value for their owners/shareholders and for their other stakeholders and society at large;
- identifying, preventing and mitigating their possible adverse impacts.
Climate change
With the adoption of the 2015 Paris Agreement, climate change has become a mainstream topic in the business world, raising the interest not only of civil society organizations, but also of clients, shareholders, and regulators. From a regulatory perspective, a key catalyst of the integration of climate-related expectations has been the Recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).
The approach introduced by the TCFD has been embraced by several regulators, such as the European Union with its Guidelines on reporting climate-related information and national regulators such as the Swiss Financial Market Supervisory Authority (FINMA).
Besides building on the TCFD, regulators, in particular in the financial sector led by the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), have formulated an understanding that climate change correspond to a risk trigger of existing risk categories, such as market, liquidity, and reputational risk. As a consequence, regulated institutions are expected to duly consider climate-related consequences under the already existing regulatory framework.
In addition to climate change another topic has been on the rise: biodiversity. According to Policy Outlook data, since 2018 the number of regulatory actions related to biodiversity has tripled. This momentum is expected to grow with the adoption of the Taskforce on Nature-related Financial Disclosures.
What is the TCFD?
The overall objective of the TCFD recommendations is to provide a set of guidelines for voluntary and consistent financial disclosures that can help investors, lenders, and insurance underwriters understand and manage climate-related material risks.
The TCFD advocates for organizations’ mainstream financial filings to include the disclosure of decision-useful, forward-looking climate-related information about potential financial impacts.
The recommendations primarily focus on the risks and opportunities that organizations face that stem from the transition to a low-carbon economy. They are organized into four thematic areas that represent core elements of how organizations operate: governance, strategy, risk management, and metrics and targets.
Do you know what needs to be done?
As a consequence of this intense regulatory movement, what was deemed to be best practice yesterday—such as the integration of sustainability issues into investment decision-making processes—has now become the baseline regulatory expectation for access to the market. Organizations must not only be aware of their sustainability risks and adverse impacts but must actively work to minimize them.
In particular, organizations must understand what needs to be done and find practical solutions to address complex concepts such as sustainability risk and principle adverse impacts—and this is currently expected to be accomplished using ESG data that rarely meet the requirements of financial regulations.
ECOFACT assists senior managers and decision-makers in focusing on key action items by prioritizing them. We have an in-depth understanding of what needs to be done to implement regulatory requirements pertaining to sustainable finance and corporate responsibility.
What are Sustainability Risks?
According to the Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector, sustainability risks are defined as environmental, social, or governance (ESG) events or conditions that, if they occur, could cause an actual or a potential material negative impact on the value of the investment.
What are sustainability impacts?
An event or condition related to environmental, social, and employee matters, respect for human rights, anti-corruption, and anti-bribery matters that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment.
What are adverse impacts?
Adverse impacts on sustainability factors are the negative impacts on sustainability factors (i.e. environmental, social, and employee matters, respect for human rights, anti-corruption, and anti-bribery matters) resulting from investments.
For example, certain investments might contribute to the violation of Indigenous Peoples’ rights and/or the maintenance of discriminatory practices within corporate structures. These impacts might not necessarily be converted into a sustainability risk—i.e. have a material negative impact on the value of the investment—because the risk evaluation focuses on how rightsholders and the environment are affected.
Note that the concept of adverse impacts is closely aligned with how risk is used in the OECD Due Diligence Guidance for Responsible Business Conduct. In the words of the OECD, assessing “adverse impacts […] is an outward-facing approach to risk,” focusing on assessing the likelihood of adverse impacts on people, the environment, and society that an enterprise may cause—and not about risk for the investor or the financial institution itself.
The time to act is now!
To be able to successfully adjust their practices to these new regulatory expectations, organizations are compelled by regulators to act regardless of the fact that different jurisdictions are adopting different approaches.
On top of this complexity, the implementation deadlines are often short, especially when considering the far-reaching impacts these regulations have on businesses’ products and processes.
We have unique expertise when it comes to establishing policies and processes to address sustainability and corporate responsibility topics in the context of organizations’ operations.