Sustainable Finance: the drive for consistency and harmonisation in global regulation
By Owen Lysak and Jacqueline Jones, Clifford Chance
Published: 14 June 2019
Sustainable finance, in broad terms investments which take into consideration environmental, social and governance (ESG) factors alongside financial ones, are becoming increasingly popular with investors, resulting in a significant increase in demand for sustainable financial products and investment funds in recent years. This trend is likely to continue, driven not only by growing institutional investor demand, but also from the retail sector, particularly from younger, 'millennial' investors. Another driver has been the increased focus by policymakers and regulators on sustainability and the role played by ESG factors, which has led in some instances to the strengthening of voluntary codes, such as the UK Stewardship Code for example, or the introduction of specific regulatory rules, such as the EU Disclosure Regulation.
In these circumstances, there is the potential for overlapping or inconsistent requirements to arise, which can be cumbersome and costly for global firms to overcome. This can also harm competition by raising barriers to entry, with consequent cost implications for investors.
This prompts the question of what could be done to avoid these potentially negative consequences. In this article, we outline some recent attempts by policymakers, legislators and regulators to co-ordinate on sustainable finance regulation and guidance, with a view to achieving a degree of international consistency and harmonisation. These recent developments build upon earlier co-ordination efforts such as the FSB Task Force on Climate Related Disclosures, which was launched in 2015 and the Central Banks and Supervisors Network for Greening the Financial System, launched in 2017.
Further moves towards global regulatory co-ordination
In their 2018 Final Report Making Waves – Aligning the financial system with sustainable development, the UN Environment Programme noted some of the global policy measures to advance aspects of sustainable finance and the 'striking growth in international initiatives to share experience, stimulate action and promote cooperation on key rules and standards'. Given such proliferation, and particularly as this is likely to continue, the International Organisation of Securities Commissions (IOSCO) current work on Sustainable Finance focuses on "stocktaking" existing requirements to ensure as much as is possible a co-ordinated and harmonised approach. In order to assist regulators and other market participants to better understand how sustainability issues may relate to the markets in which they operate, in October 2018 IOSCO established the Sustainability Network to provide a platform for IOSCO’s members to share their experiences and discuss sustainability-related issues. One of the initial tasks of the Network, as outlined in the IOSCO 2019 Work Plan, has been to undertake a survey, essentially a 'stocktake' of national initiatives taken by securities regulators and other international organisations in the field of sustainable finance, in order to assess the current position and determine a firm foundation on which to build.
IOSCO's second main workstream on sustainable finance focusses on growth and emerging markets, which are considered key to future global sustainability. The Growth and Emerging Markets Committee (GEMC) has been investigating the challenges impacting the development of sustainable finance in capital markets in emerging markets and the role of securities regulators. In June 2019 it published a report containing 10 recommendations aimed at facilitating the development of sustainable finance and to help achieve a degree of international consistency and harmonisation, factors considered increasingly important given the cross-border nature of financial markets. The recommendations are shown in Table 1 below.
Aside from these two main workstreams, in January 2019 IOSCO published a statement on issuer disclosure on ESG matters (see Figure 1 below). This illustrates attempts by IOSCO to address the difficulties caused by differing voluntary and compulsory ESG requirements at the national level, which are often problematic for asset managers seeking to obtain consistent and accurate ESG data from issuers.
Figure 1: IOSCO publishes statement on issuer disclosure of environmental, social and governance matters
In January 2019, IOSCO issued a statement on the inclusion of environmental, social and governance matters when issuers disclose information material to investors' decisions.
The statement notes that there is an increasing demand from investors for ESG disclosures to help inform their investment and voting decisions. The number of issuers disclosing ESG information, either on a voluntary basis or as a result of compulsory requirements at a local level, is also increasing. However, IOSCO notes that the type and quality of ESG information disclosed varies in and between markets, depending on, amongst other things, the disclosure frameworks used, the disclosure requirements and the definition of materiality imposed by the jurisdiction. IOSCO therefore encourages issuers to:
- consider the materiality of ESG matters to their businesses, as well as the risks and opportunities they pose in light of their business strategy and risk assessment methodology;
- disclose the impact or potential impact of ESG matters considered to be material;
- provide insight into the governance and oversight of ESG-related material risks by, for example, disclosing risk assessment methodologies and the steps take to mitigate any identified risks; and
- clearly disclose the framework(s) that have been used in preparing and disclosing material ESG information
Table 1: IOSCO recommendations for emerging markets jurisdictions to consider when issuing regulations on sustainable finance
- Integrating ESG-specific issues in overall risk assessment and governance: Issuers and other regulated entities should integrate ESG-specific issues, where these are material, in the overall risk assessment and governance of these entities including at the Board level.
- Institutional investors: Consistent with their fiduciary duties, institutional investors, including asset managers and asset owners, are encouraged to incorporate ESG-specific issues into their investment analysis, strategies and overall governance, and take into account material ESG disclosures of the entities in which they invest.
- ESG-specific disclosures, reporting, and data quality: Regulators should require disclosure with regard to material ESG-specific risks (including transition risks) and opportunities in relation to governance, strategy and risk management of an issuer. This information should be part of the overall disclosure that the issuer makes under Principle 16. Where regulators determine that ESG-specific reporting is needed, regulators and issuers should aim to ensure adequate data quality for ESG-specific reporting, including, among others, through updating listing rules, the use of external reviews and through the operation of other information service providers e.g., ESG rating providers, benchmarks and auditors.
- Definition of sustainable instruments: Sustainable instruments should be clearly defined and should refer to the categories of eligible projects and activities that the funds raised through their issuance can be used for.
- Eligible projects and activities: Funds raised through sustainable instruments should be used for projects and activities falling under one or a combination of the broad ESG categories listed below:
- Environmental (renewable resources; combatting/mitigating climate change; pollution and waste; and other environmental opportunities);
- Social (human capital; product liability; and other social opportunities);
- Governance (corporate governance; corporate behaviour).
It will be up to each GEMC member to define the list of eligible projects and activities for their jurisdictions, taking into account that an eligible project or activity cannot, at the same time, do any significant harm to any of the other ESG categories.
- Offering document requirements: Regulators should establish requirements for the offerings of sustainable instruments including, among others, the use and management of the funds raised through the issuance of such instruments, and the processes used by issuers for project evaluation and selection.
- Ongoing disclosure requirements: Regulators should establish ongoing disclosure requirements regarding the use of the funds raised through the issuance of sustainable instruments including the extent of unutilized funds, if any. This could include the use of scenario analysis in the context of the recommendations made by the Task Force on Climate-related Financial Disclosures (TCFD).
- Proper use of funds: Regulation should provide for measures to prevent, detect and sanction the misuse of the funds raised through the issuance of sustainable instruments.
- External reviews: Issuers should consider the use of external reviews to ensure consistency with the definition of the sustainable instruments and eligible projects as provided in Recommendation 4 and 5.
- Building capacity and expertise for ESG issues: Regulators should analyse the gaps in capacity and expertise with regard to ESG-related issues mentioned in the above recommendations and consider targeted capacity building to address these gaps. Regulators should also have appropriate monitoring mechanisms in place to encourage application of these recommendations.
The European Union has been at the forefront of regulating for sustainable finance with a package of regulatory proposals announced in May 2018 to further the objectives of the European Commission's Action Plan for Sustainable Finance in order to harmonise practices across the EU.
The Commission has now been given the green light to push ahead with its plans to create an International Platform on Sustainable Finance, which was initially referred to in its reflection paper of January 2019 "Towards a sustainable Europe by 2030". The aim of the Platform is to create an international network to advance sustainable finance, bringing together developed and developing countries to deepen international cooperation on sustainable finance. The Council of the European Union has approved the EU negotiating position, so the Commission now intends to enter discussions on the setup of the Platform with Argentina, Canada, Chile, China, India, Japan, Kenya, Mexico, Morocco and South Africa. The platform would be open to other third countries willing to join in the future.
No indication is given at present of whether the Platform will address harmonisation of regulation, although this is a possibility, given the stance taken by the European Commission so far on this topic as reflected regulatory proposals that came from the Action Plan.
The EU Sustainable Finance Action Plan – key regulatory measures for asset managers
- The Disclosure Regulation, which formalises investor duties and disclosure obligations in relation to ESG factors
- Requirements to integrate ESG factors in investment decision-making processes as part of the asset manager's fiduciary duty towards investors and beneficiaries. These will be further specified through delegated acts amending MiFID2, AIFMD, UCITS, IDD and Solvency II
- Requirements to incorporate sustainability when providing financial advice. These will be implemented through delegated acts amending the suitability requirements in MiFID2 and IDD.
ESMA Co-ordination Network on Sustainability
While sustainable finance has been at the forefront of the Commission's political agenda, steps have also been taken at the national level by several EU member states including, for example, Germany and France. The UK has also taken steps to further ESG and sustainability objectives, which are likely to continue in a similar tack post Brexit. This prompted the EU Securities Regulator, ESMA, to establish the Co-ordination Network on Sustainability (CNS) in May 2019, in order to foster the co-ordination of national competent authorities’ work on sustainability. The CNS will be responsible for the development of policy in this area, with a strategic view on issues related to integrating sustainability considerations into financial regulation.
Co-ordination or more regulation?
With the increasing global focus on sustainability, together with ESG measures being introduced in more and more countries, it is perhaps inevitable for there to be calls for greater international co-ordination and harmonisation of the many 'hard' and 'soft' rules. In some respects, clearer regulatory guidance could help to promote consistency that would be beneficial to the market e.g. on the scope of ESG disclosure requirements. However, this does not necessarily mean that new regulations are required, as it could be argued that market demand, from both investors and customers of portfolio companies, has resulted in ESG factors being integrated into their dealings in any event, without the catalyst of regulation. Investors increasingly demand ESG disclosures from managers, for example, often in relation to the manager's own ESG credentials, as well as in relation to their investments and such managers are often contractually bound to report on ESG to their investors under negotiated fund agreements.
In addition, achieving international co-ordination and harmonisation across the spectrum is likely to be difficult, not least because the political appetite for introducing regulation on sustainable finance and in precisely what form, varies considerably from country to country and from sector to sector. This explains the preference in the market for a ‘principles-based approach’, being a practical and flexible way forward which allows a tailored solution to the ESG considerations relevant to a particular scenario, rather than imposing a 'one-size fits all' set of overly prescriptive and granular regulatory requirements.
At this point, it seems that standard setters and regulators are for the most part at the 'fact-finding stage', attempting to establish a baseline of global ESG initiatives and the ways in which these can be better co-ordinated. Working towards a degree of global co-ordination and minimum standards could be beneficial, particularly if predicated by a principles-based approach. As such, the output of the various initiatives currently in progress could provide a valuable contribution to global understanding and promotion of sustainability issues and drive the development of ESG practices globally.