Environmental, social and governance (ESG) concerns are dominating the agenda across the financial and corporate sectors. Sonia Shah looks at ESG disclosure rules and the increasingly prescriptive direction they are taking.
ESG has been around for a long time, and organisations have actively sought to improve each of the three strands. That said, approaches vary considerably, and there’s limited consistency in reporting progress, which is a barrier to transparency and accountability. Like culture, ESG is difficult to measure, so it’s hard to define what 'good' looks like or set tangible goals. This is becoming a real problem, particularly for listed companies and the financial sector, where investors need assurance over products. Greenwashing is concerning, and mis-selling could result in legal action, reducing trust in the market and investment in ESG projects.
The role of ESG disclosure
The solution is two-fold. First off, organisations must create quantitative or qualitative metrics to describe and measure ESG challenges. Second, organisations must use these metrics to inform financial and non-financial disclosures, improving transparency and accountability. Both of these are easier said than done. Creating ESG metrics, tracking dashboards and demonstrating progress will not be straightforward and presents the biggest barrier for most firms. On the other hand, ESG disclosures are not new and should be simpler. But in reality, they need a fundamental rethink around the data feeding into them and how that data is presented.
In recent years, the EU has introduced regulations (outlined below) to standardise the approach to ESG disclosure. In the long-term, this will improve comparability between individual organisations and set a yardstick across all EU member states. Ultimately, it will help to build trust in the market and drive ESG investment.
The EU Non Financial Reporting Directive focuses on non-financial elements, such as social and employee-related factors, the environment, human rights, corruption, and board diversity. Collectively, this includes reporting on gender equality, health and safety, or greenhouse gas emissions, among others.
The regulation applies to large listed and public interest companies, and ESG disclosure is on a comply or explain basis. These reports must cover details of risks, mitigating activities, policies, and due diligence information for the extended supply chain. It's important to consider material risks, those that have already crystallised, and the impact of operations, products, services, and the wider supply chain.
The European Commission recently proposed the Corporate Sustainability Reporting Directive, amending reporting requirements for the EU Non Financial Reporting Directive. Applying to all large and listed companies, these audited reports must align with the EU sustainability reporting standards. They will be digitally tagged as per the European Single Access Point to fulfil the capital markets union action plan.
What is SFDR?
The SFDR regulation took effect in March 2021 and applies to financial markets participants and advisers within the EU or those outside with EU business interests. Some requirements also apply to Institutions for Occupational Retirement Provision (IORPs).
Specifically looking at financial disclosure, the SFDR requires firms to demonstrate ESG indicators to substantiate any sustainability claims. The regulation requires firms to provide the following, keeping them up to date and aligning marketing communications.
Provide greater transparency on the organisation’s website
This includes details of their sustainability-related policies and how they are incorporated into investment decision making or advice. Firms must declare any negative effects their investments' decisions or advice may have on sustainability at an entity and product level or explain why this information hasn’t been provided. For financial markets participants with over 500 employees, this includes a due diligence statement.
For products promoting positive environmental or social outcomes (Article 8), or those specifically designed to be sustainable investments (Article 9), the website must include a description of the intended goal. This will be supported by information on the methodologies used to assess and measure their impact.
These will demonstrate how sustainability risks are integrated into investment decisions or advice and the expected impact on financial returns. If a product promotes positive environmental or social practices, the disclosure must demonstrate how, detailing any benchmark index used. If a financial product goes a step further and specifically intends to be a sustainable investment, the firm must provide information on the index used or demonstrate how the goal will otherwise be met.
Details of remuneration policies in relation to sustainability risks
Remuneration policies must be informed by sustainability risks and include details of how these risks have been taken into account.
For sustainable products, periodic reports will include details of sustainability indicators, the overall impact and, where relevant, comparison against the benchmark index and broader market indices. For products promoting positive environmental or social outcomes, firms will provide a description of how these goals are met.
In short, firms must consider how ESG factors will impact the financial return on a product and how that product will impact sustainability. This will be supported by appropriate measures of success and evidence that remuneration policies are actively reinforcing the right behaviours. Firms must release the relevant financial disclosure and periodic reports to demonstrate these points, with further information publicly available online.
The EU Taxonomy regulation goes hand in hand with both the SFDR regulation and the EU Non Financial Reporting Directive and aims to create consistent standards for environmentally sustainable activities. Across six objectives, firms must actively contribute to at least one, with a minimal or neutral impact on the remainder. The six objectives are:
Sustainable use and protection of water and marine resources
Climate change mitigation
Transition to a circular economy
Pollution prevention and control
Climate change adaptation
Protection and restoration of biodiversity and ecosystems
Firms may contribute to these goals through economic activities that either substantially contributes to, or financially support sustainable activity. From January 2022, firms in scope for ESG disclosures under the EU Non Financial Reporting Directive must state how they are working to reduce climate change and report against all six objectives by January 2023.
The regulation also updates specific elements of the SFDR regulation, introducing new financial disclosure requirements for products based on the EU Taxonomy regulation. The changes include additional rules covering:
Pre-contractual disclosures for investments reflecting social or environmental characteristics
Pre-contractual disclosures for sustainable investments
Periodic reports for both sustainable investments and those incorporating social or environmental characteristics.
A set of Regulatory Technical Standards (RTS) support the SFDR regulation and the EU Taxonomy regulation, requiring further information on pre-contractual disclosures and periodic reports for both sustainable investments and those promoting environmental and social activities. Key changes include:
The need to identify which environmental elements in a product align to the EU Taxonomy regulation, which must be included in the pre-contractual and periodic disclosures
Details on the sustainability of investments underlying a financial product, including alignment of those investments to the EU Taxonomy regulation
Changes to templates for pre-contractual and periodic disclosures
The future of ESG disclosure
While the EU Non Financial Reporting Directive was relatively flexible, the SFDR regulation takes a tougher stance. The EU Taxonomy regulation and the RTS support this approach. Over time, the ESG disclosure rules will become more prescriptive, with new rules emerging in the years to come. Firms with EU business interests must stay on top of the reporting expectations, in addition to ESG disclosure rules from UK regulators and HM Treasury.
Contact Sonia Shah for further information on ESG disclosure.