Sustainability is a key priority for firms across the financial services sector. With a raft of new regulatory expectations over the last few years – including Task Force on Climate-Related Financial Disclosures (TCFD) disclosures, climate risk management frameworks, and the upcoming sustainability disclosure requirements – firms are under considerable scrutiny to demonstrate compliance. But this is easier said than done. In its recent discussion paper (DP23/1), the Financial Conduct Authority (FCA) looks at how to embed good governance processes to incentivise the right behaviours, drive tangible change and improve sustainability outcomes.
To encourage an industry-wide dialogue and improve diversity of thought, the paper also includes 10 commissioned articles from industry experts. This offers a broader range of perspectives over sustainability-related governance and incentives. The paper is open for comments until 10 May 2023.
Here we look at the key themes under discussion and what firms need to consider.
Role of disclosures
Disclosures are an integral tool to demonstrate effective governance and monitor sustainability outcomes, with TCFD recommendations as the gold standard. But as environmental, social, and governance (ESG) practices mature, the FCA's looking beyond climate risk as the primary focus. This reflects broader changes across the market and evolving disclosure expectations. For example, the International Sustainability Standards Board's (ISSB) upcoming framework shifts the focus from climate risk to wider sustainability topics. The new standards build on TCFD and consider key governance requirements to support sustainability goals, including ownership of key risks, board oversight, target setting and monitoring.
There’s also the Transition Plan Taskforce (TPT), launched at COP27 and now at draft stage. This new disclosure framework aims to standardise how firms record their transition to Net Zero. It covers transition planning from ambition to action and accountability. It also identifies three key channels of: decarbonisation, climate related-risks and opportunities, and contributing to economy-wide transition. Like the TCFD and ISSB disclosures, governance is an integral pillar, covering topics such as board oversight and reporting, incentives, culture and competencies.
This work is also supported by the Glasgow Financial Alliance for Net Zero (GFANZ), which focuses on transition finance and highlights four key financing strategies to support the government’s ambition to be the first Net Zero financial centre. Like TPT, GFANZ highlights the importance of a robust engagement strategy to include peers, clients, government and the wider public for greater collaboration. It highlights the importance of turning long-term goals into tangible near-term actions.
These are integral tools to drive positive change, improve accountability and provide comparable data to benchmark progress. Firms that can demonstrate how they are putting their plans into action – with details of who’s doing what and when – improve their chances of a successful transition.
Objectives and strategy
Where firms have made sustainability-related commitments, these should be backed by an action plan. A robust strategy should have clear objectives, milestones, timeframes and metrics. It must be clear who is responsible for what. And firms need to understand how ESG objectives fit with wider business goals, embedded them across all governance structures, and reflecting them in business and financial plans.
As a quick note on metrics, most frameworks now encourage firms to track scope 3 emissions as a minimum. Some, such as TPT, suggest also having targets to reduce scope 1 and 2 emissions. As highlighted in the discussion paper's third article, from the London Stock Exchange Group, this will help the UK become the first-ever Net Zero financial hub through standardising comparable metrics to drive change across the sector, as well as helping reduce greenwashing and improve accountability.
Role of culture
Good governance relies on an effective culture and the right behaviours to drive sustainable change. In turn, a firm’s culture must demonstrate good purpose, leadership, governance, and an effective and proportionate approach to management and reward. The FCA expects to see evidence of a firm’s ESG purpose, with consistent messaging across the firm, backed by tangible actions. Firm-wide purpose should ideally be backed by giving individuals purpose that aligns with the firm’s wider ESG goals.
A good culture must be led from the top with a clear echo from the bottom, and allow people to speak up when they identify poor practice (such as greenwashing). Ironically, a powerful indicator of poor practice is that organisations won’t talk about poor practice. Crucially, there also needs to be mechanisms in place to drive change when people do speak up. Under the FRC’s UK Corporate Governance Code, boards need to set the firm’s values, purpose and strategy, and ensure it aligns to the firm’s culture; this includes embedding a culture of risk awareness and ethical behaviours.
As a critical element of ESG, culture is also under greater regulatory focus due to its role in Consumer Duty. For Consumer Duty, firms and individuals must ensure good outcomes for consumers throughout the customer journey. As such, firms need to change how they think about product development, pricing, marketing and customer need. Ongoing diversity, equity, and inclusion (DE&I) initiatives are also driven by culture shifts, but many firms are struggling to frame this as a culture problem and to fully align it to their purpose, strategy and values.
Governance, responsibility, and accountability
Firms need to establish who's responsible for identifying material ESG risks and aligning the associated activity to the firm’s wider strategy. To support this, firms need to ensure board members and non-executive directors have the right skills blend to have meaningful discussions on sustainability and to make effective decisions. This may require additional training or expert input, or bringing additional expertise to add value to the board.
Under Consumer Duty, firms must allocate a consumer champion on the board, which could be an effective way of monitoring key sustainability and ESG issues at senior level. Firms may also establish sub-committees or working groups for key topics, which can help strategically embed these activities. Such groups must consider if current systems, controls and reporting processes are right for ESG decision making – and many firms may need to update them.
Dual regulated firms must have an senior management function (SMF) with ultimate responsibility for climate risk, in line with the regulatory expectations outlined in SS3/19. In its recent Dear CEO letter, the Prudential Regulation Authority (PRA) highlighted that firms have made good progress in their climate risk governance and most now have that SMF in place. While firms don’t currently need to nominate an SMF for sustainability-related strategy, firms do need clear roles and responsibilities. Leadership needs to be senior enough to drive change, and potentially report directly to the CEO for faster reporting and remediation on any issues.
Governance of products and services
Firms need appropriate governance and oversight throughout the product life cycle – particularly important to prevent greenwashing of products that carry sustainable claims. Relevant governing bodies should be clear on their roles and responsibilities, with activities and goals that align to desired sustainability outcomes, regulations and requirements. This is particularly important as firms start to embed the sustainability disclosure requirements, with product governance moving front and centre to support the labelling regime.
ESG incentive structures
Firms also need to consider how to incentivise individuals to achieve these goals. Article two in the discussion paper, from the London Business School and European Corporate Governance Institute highlights that 82% of senior executives have ESG targets in remuneration packages. However, these metrics often aren’t that material to the firm, or transparent enough. They also tended to feature business-as-usual goals, often on ongoing DE&I initiatives, and didn’t push boundaries to achieve ambitious long-term goals. As such, it’s essential to demonstrate why these ESG goals are being targeted, the material impact they’ll have on the business, and the KPIs used to measure them. In short, firms must aim for stretch goals, with clear KPIs to incentivise firms to achieve.
Based on materiality, firms could also consider breaking sustainability-related commitments into factors, giving different weightings to each to ensure stretch achievements are remunerated more highly. Firms can also consider short-term versus long-term achievement, and whether to focus on senior management or a broader pool of employees. If firms do look at sustainability as a factor in their remuneration packages, they need to make sure that sustainability changes are within the individual’s sphere of influence, are factored into transition plans and that remuneration adjustments can be made where targets aren’t met.
Governing investor stewardship
Investment stewardship is integral to positive changes in sustainability, and can help tackle the systemic nature of sustainability risks. Current expectations for investment managers are outlined in the UK Stewardship Code and the FCA’s FS19/7. However, firms often don’t value the role of stewardship highly enough, and need to ensure senior oversight and governance over stewardship. It needs to be integrated into a firm’s investment activities and cover all asset classes (potentially with different committees to consider each class individually). Market collaboration is important to benchmark and develop best practice, but many firms are concerned that it would breach competition rules or Market Abuse Regulations. The FCA is considering if further regulator clarifications are needed to reduce this barrier and support greater management of systemic sustainability risks.
Training and competence
To effectively govern and manage sustainability risks, firms need people with the right skills sets and knowledge base. This includes ensuring individuals have the right competencies and accreditations. The FCA and firms have identified the need for greater standardisation of sustainability-related skills across the sector. Many firms deliver their own, or outsourced, short-form training, which may not meet the demands of the sustainability challenge ahead. As highlighted in article eight in the discussion paper, from Ingenios Ltd, this can lead to greenwashing or ‘competence washing,’ of skills, and false assurance over how sustainability risks are managed. Creating industry-wide training metrics could give ESG professionals greater credibility and make it easier to compare skill sets.
Effective sustainability governance requires a combination of the above factors. Firms need a suitably qualified individual to be responsible for sustainability initiatives, from creating the transition plan to making sure it gets put into action with key milestones KPIs and targets.
Committees and sub-committees can support this work, helping to cultural embed the programme across the organisation and make sure it's integrated into the firm’s wider strategy.
Giving individuals clear roles will improve accountability and incentive structures can help firms achieve challenging sustainability goals.
For further insight and guidance, contact Rashim Arora.