Regulators and firms will continue to develop ESG frameworks in 2022. Sonia Shah looks at the key trends for financial services: from scope 3 emissions, double materiality, nature-related reporting, and climate-related disclosures to social issues and carbon trading.
The spotlight remains fixed on ESG and sustainability. The last few years have been a watershed moment for the space and now it’s an area of focus for stakeholder at all levels – regulators, firms and consumers. In 2022, we'll see a rise in important conversations and the development of regulation aimed at improving sustainability.
Key trends and topics for the financial sector include the importance of Scope 3 emissions, leveraging double materiality, nature-related reporting and biodiversity, the development of global disclosure standards, the impact of social issues, trading and offsetting carbon, as well as ESG-driven investments.
These issues could have a considerable impact on firms – both from a regulatory and commercial standpoint.
Scope 3 emissions
For financial services, the implications for these emissions are huge. The greenhouse gas (GHG) emissions associated with financial institutions' investing, lending and underwriting activities are on average over 700 times higher than their direct emissions, according to non-profit organisation CDP.
GHG emissions are internationally grouped into three categories – Scope 1, 2 and 3 – by a widely-accepted international accounting tool, the GHG Protocol. They're defined as:
Scope 1 – GHG emissions that a firm produces from their own activities
Scope 2 – Emissions that are indirectly produced from the firm’s operation
Scope 3 – All the GHG emissions that are associated with the firm’s value chain
Scope 3 emissions are therefore much larger than Scope 1 and 2. This category considers all other activities that the firm is indirectly responsible for. For example, it includes the emissions from purchasing goods from a manufacturer, as well as the emissions from the use of the goods by the end consumer. However, the methodology around how to quantify and then report Scope 3 emissions still requires work.
To develop models and calculate Scope 3 emissions, firms need to carefully map their value chains and establish a reliable and verifiable collection of data. But this requires regulatory oversight, as the GHG Protocol acts only as guidance. Nonetheless, given that regulators are thinking about how to address the climate issue and working on standards, it's likely that these types of emissions will be considered for the financial sector.
To add a further layer of complexity, the current definition of Scope 3 emissions will need to cover activities outside of financed emissions, including emissions that are interacted with through the provision of services, consulting and advisory activities. This could severely impact many firms’ operating models.
For financial services firms, double materiality could significantly improve transparency and address greenwashing. If the information is widely standardised and disclosed, firms could easily see the sustainability impact of other firms and investments - helping accelerate the transition to more responsible and sustainable practices.
Double materiality comes from a key accounting concept of materiality of financial information. Information about a firm is material and therefore should be disclosed. Climate-related impact on a firm can now also be considered as material – largely thanks to the TCFD – and therefore must be disclosed.
Double materiality, however, goes further. The environmental and social-related impact on the firm is material and companies need to manage the financial risk, but this concept says that the impact of a firm on the people and the planet is also material. This also incorporates other sustainability-linked areas outside of climate, for example, considering the human rights records of companies and their supply chains.
The basic definition seems simple enough, but in practice the exact meaning is still uncertain, and firms will struggle with defining what a material impact is. However, the concept is embedded in the EU’s sustainability legislation - Corporate Sustainability Reporting Directive (CSRD) - and will be included in the UK’s equivalent.
Disclosing the firm’s impact on climate issues can serve some key purposes:
Identifying and responding to concerns from stakeholders
Help push the organisation to communicate and reach goals that could affect the business
Nature-related reporting refers to a framework that can quantify the value of nature, including biodiversity. The Financial Stability Board (FSB) created the Taskforce on Nature-related Financial Disclosures (TNFD). This group is focused on developing and delivering a risk management and disclosure framework for organisations to report and act on evolving nature-related risks, which aims to support a shift in global financial flows away from nature-negative outcomes and toward nature-positive outcomes.
TNFD estimates that USD 44 trillion of economic value generation is moderately or highly dependent on nature, while the OECD places the figure at between USD 125 trillion to USD 140 trillion for the value of services provided by nature.
While this can be difficult to wrap your head around, one way of thinking about this is about pollinators and food supply. The global food supply chain is heavily dependent on a range of pollinators. If the diversity and number of pollinators continue to decline to a critical point, there will be significant repercussions on food production. However, there is currently no way to measure the value of the work that these pollinators carry out – this is what nature-related reporting seeks to solve.
If this information becomes available, it will allow financial institutions and companies to incorporate nature-related risks and opportunities into their strategic planning, risk management, and asset allocation decisions. Conversations on the value of nature and biodiversity will likely increase over the next few years and firms should consider this concept in their wider sustainability thinking.
However, the TNFD is not seeking to create a new disclosure standard, but rather promote global consistency for nature-related reporting. It will also leverage the structure of the TCFD, so both can be adopted by regulators and market participants.
The focus in this area has mainly been on deforestation, but we're likely to see a broader reach this year – the oceans and marine biodiversity will begin to surface.
Stakeholders and developing regulatory requirements will also start to demand that firms incorporate the impact on biodiversity and mitigating actions into their transition plans.
Global disclosure accounting frameworks
The IFRS unveiled the International Sustainability Standards Board (ISSB) at COP26, with work beginning in 2022. The board is tasked with building a global standard of robust disclosure requirements. The creation of the ISSB signals first step towards a standardised framework for sustainability-linked disclosures.
Conversations around a globally accepted ESG disclosure standard will pick up this year, as national governments and regulators make this an area of priority. The first ISSB disclosure standards are expected to be complete before the end of 2022.
The financial services sector should keep an eye on the ISSB and any standards that it puts forward, as they are interlinked to other disclosure initiatives, such as the TCFD and will influence the development of other national measures.
However, if other global reporting standards have shown anything, it’s that harmonising rules is incredibly difficult. We're likely to see similar but divergent approaches to disclosure, which could add to the compliance burden for firms. Nonetheless, given the urgency and focus on ESG, multilateral frameworks could loosely form over time and provide general guidelines.
Social issues must also be addressed
The Social element of ESG will likely start to spark some conversation in relation to employee engagement. Social issues are increasingly becoming more important to employees and firms will find it increasingly difficult to attract and retain talent with a poor ESG record.
Employees want firms to have a stance on social issues and can turn into a difficult cycle in the ESG space, where employees feel that the firm is not doing enough on sustainability and could potentially leave, which could accelerate the current workforce shortages. Firms that act too late or do not do enough to improve their sustainability strategy could suffer the most from this.
The social impact assessment of a firm needs to consider the direct and indirect activities conducted. Geopolitical events need to be taken into consideration as can impact companies supply chain, production and distribution. The sector must consider how to offer opportunities that are aligned with social values, not just financial growth.
The financial service sector should assess the social impact of companies when reviewing their portfolios.
Carbon trading and offsetting
More countries are providing clearer roadmaps to achieving net-zero – which means you're adding as many GHG emissions into the atmosphere are you are taking out. Firms are facing pressure from stakeholders to commit to net-zero and produce realistic strategies on a corporate level.
One way to achieve this is to leverage carbon trading markets, allowing firms to trade emission allowances to achieve their emission reduction targets. Carbon markets have continued to grow and with a renewed emphasis on net-zero, we're likely to see further development of these markets.
Firms can also look at carbon offsetting - compensating for CO2 emissions by cutting CO2 elsewhere to an extent. Firms should be careful to use this as a complementary tool in reducing carbon emissions, not as a blanket remedy.
A mixture of both these tools must be a part of a firm’s net-zero path and will have wider commercial implications. Firms that want to lead in this space will also be considering being climate positive, or in other words, removing more CO2 than they release into the atmosphere.
The ESG investment market will continue to grow. Stakeholders at all levels have recognised both the social value and the opportunity around sustainability, as it increasingly becomes a factor that influences decision-making. Boards, investors, and consumers are ever more driven by ESG, meaning that firms that fail to repivot themselves could be risking longer-term growth.
Some firms are also looking at offering green bonds to finance the transition as part of their sustainable finance strategy. This will grow into a much larger market and financial firms should be aware of both the opportunities and risks of exposure to these types of investments.
The demand for ESG-driven investment will also need robust data to support decisions. Firms may struggle to rely on rating agencies that have different methods and weightings to score companies. Data inconsistencies and the risk of greenwashing are still rife, and firms will have to find ways to navigate this.
Due diligence also needs to adapt to the needs of the market. Firms must consider the ESG exposure of mergers and acquisitions (M&A) and develop a framework to quantify sustainability-related risk within these transactions.
Some leading global investors have already warned business leaders that they will hold them accountable if fail to deliver on ESG goals and targets. Stakeholders will also pressure firms to adjust executive remuneration depending on ESG-related performance.
Financial services also need to focus on climate finance adaptation to support organisations in addressing the climate risks and opportunities. Firms must set up frameworks to manage on how public and private funding for climate adaptation is to be applied, measured and monitored.
What can firms do now?
Financial service firms should define their ESG strategy along with the purpose of their business. Those that have defined their strategy should build upon specific initiatives and define a roadmap. Those that have communicated their sustainability initiatives should continue to build tangible steps with clearly defined metrics and targets. Ensure that your ESG strategy is embedded across all areas of your organisation. Provide transparency on how your firm is performing against your set targets.
Firms will need to understand the Scope 1, 2 and 3 emissions that apply to themselves and their clients to meet their pathway to net-zero plan. Consideration should be made on how decarbonisation plans are to be achieved including access to data and understanding the value chain.
Plans and actions on how firms are supporting their clients and suppliers to reduce carbon emissions and transition to a green agenda should also be made transparent when reporting on sustainability. The product offerings should be reviewed to assess how they meet the sustainability criteria to avoid greenwashing.
Close outlook should be maintained on the upcoming regulatory requirements including the Sustainable Disclosure Requirements (SDR) and the UK’s Greening Finance Roadmap.
If you want access to leading advice, consultancy and support, we offer a range of services across ESG for financial services. To learn more about any of these trends and topics and how to reposition your firm for the future, contact Sonia Shah.