Regulatory requirements trigger fresh ESG push
A hot topic
ESG considerations have gained momentum recently with the convergence of several related developments:
• Increased coverage of ESG topics in the media
• Visible evidence of climate change
• Growing consciousness of environmental pollution
• Enhanced transparency of poor labour practices and governance failures induced by high-profile leaks
Covid-19 has drawn attention to social issues for businesses, as the world comes face-to-face with new and unprecedented concerns around physical wellbeing. Reports of issues of illness and redundancies have also led to greater societal awareness of the individuals who make up the supply chain. This has provided an opportunity to reflect on both “collective behaviour” and “individual behaviour”. As well as this, an absence of road and air travel during the early stages of lockdown has brought new attention to the impact the aviation and road traffic industries have on the environment.
Many financial indices tracking ESG-assessed funds have performed better than the average market during the pandemic, and while the trend of ESG investing has been gaining momentum for years due to climate change and other threats to the capitalist landscape, major investors believe that the pandemic will accelerate an already growing trend towards ESG investments. Not least because non-adherence to sound ESG practices can represent a considerable risk for a company and its shareholders. Activists use governance weaknesses to a help build on campaigns against companies. Similarly, shareholders sue companies that don’t deliver on their ESG promises.
As part of this evolution, governments have identified ESG-related corporate disclosures as an effective tool to create transparency in the market and drive investments towards companies with strong ESG policies and procedures.
In November 2020, the UK declared it would become the first country in the world to make the rules developed by the global regulators’ task force on climate-related financial disclosures (TCFD) mandatory. Consequently, companies will need to report the financial impacts of climate change on their businesses within the next five years.
The rules will apply to most of the nation’s economy, including listed companies, banks, large private businesses, insurers, asset managers and regulated pension funds, and will force annual emissions data and climate risk analysis to be included in annual reports, as well as requiring board-level oversight. A key government goal is to give investors more information about which companies are prepared for the shift to a low-carbon economy, and which are not. The TCFD stipulates that companies should disclose in their financial reports how climate change could increase or reduce sales, among other issues.
More than 1,500 organisations have expressed their support for the TCFD’s recommendations, according to the TCFD’s status report. The report said 42% of companies with a market capitalisation above $10 billion disclosed at least some information in line with each TCFD recommendation in 2019. Energy companies and materials and buildings companies are leading on disclosure, with an average level of TCFD-aligned disclosures of 40% for energy companies and 30% for materials and buildings companies in the 2019 fiscal year.
Regulators in the US have also voiced support for the TCFD. Linda Lacewell, superintendent of the New York State department of financial services, recommended that banks and insurers report through the TCFD. The DFS regulates around 1,500 banks, 1,800 insurers and other financial groups, with assets exceeding $7 trillion.
The EU non-financial reporting directive has required companies with more than 500 members of staff to report on their social and environmental challenges since financial year 2017. In June 2019, the European Commission published guidelines on corporate climate-related information reporting, providing companies with practical recommendations on how to better report the impact that their activities are having on the climate as well as the impact of climate change on their business.
The guidelines provide guidance to around 6,000 EU-listed companies, banks and insurance companies that have to disclose non-financial information under the Non-Financial Reporting Directive and integrate the recommendations of the (TCFD).
Furthermore, the Sustainable Finance Disclosure Regulation (Regulation (EU) 2019/2088) (SFDR) will come into effect on 10 March 2021. The SFDR introduces harmonised rules for financial market participants and financial advisers on transparency in relation to sustainability risks, the consideration of adverse sustainability impacts in their investment processes and the provision of sustainability-related information with respect to financial products. The obligations apply to financial market participants and financial advisors. Additional obligations are placed on firms offering ESG-related products.
An annual investment of €180 billion is needed to meet the EU’s energy and climate 2030 targets and much of the funding will need to come from private capital, according to the EU. On the one hand, the climate-related disclosures should help to guide investors on the most suitable companies to enable the EU to reach its goal. Further, the guidelines should help companies and financial institutions to better understand and address the risks of a negative impact on the climate resulting from their business activities, as well as the risks that climate change poses to their business.
Regulators are also increasingly taking aim at corporate diversity issues. Under a new proposal submitted to the US Securities and Exchange Commission (SEC), companies listed on the Nasdaq stock exchange will be required to have, or explain why they do not have, at least two board of directors members who are either female, an underrepresented minority or LGBTQ+, including at least one female director, and at least one underrepresented minority or LGBTQ+ director. Companies would also have to provide annual disclosures on board diversity if the proposal gets approved. In a recent review, Nasdaq reportedly found that more than three-quarters of its listed companies would have fallen short of the proposed requirements.
A flurry of lawsuits have recently been filed in the US against major technology firms like Facebook, Oracle, Qualcomm and software firm NortonLifeLock, alleging that the companies failed their fiduciary duty by not hiring black board members.
Insurers take note
The increased public scrutiny regarding companies’ ESG performance is also likely to eventually affect insurance costs. Allianz’s corporate insurer AGCS, for example, has partnered with an investment and risk consultant to develop a new data-driven directors and officers liability (D&O) scoring methodology driven by ESG and recognised quality metrics such as corporate governance and compliance standards. AGCS believes that there are specific ESG key performance indicators with strong predictive power about future D&O litigation and underwriters will need to assess how these matters may develop into a litigation trend and/or impact a company’s risk management practices.
Lloyd’s of London has recently announced that it will ask managing agents to no longer provide new insurance cover for thermal coal-fired power plants, thermal coal mines, oil sands, or new Arctic energy exploration activities from 1 January 2022. To enable the market to support their customers as they transition their businesses, the target date for phasing out the renewal of existing insurance cover for these types of businesses is 1 January 2030 (including for companies with business models that derive 30% or more of their revenues from any of these activities).
For further information, please contact:
James Alexander, Environmental Practice Leader
T +44 (0)207 933 2068
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