ESG regulation: is climate risk just the starting point?
With the Biden Administration announcing a federal review of climate-related financial risk, and European regulators advancing their various ESG schemes, how should companies best prepare for regulatory developments from the United States & Europe?
In recent years, Europe and North America have seen a momentous rise in sustainable investing, with $8.3 trillion in assets under management characterized as environmental, social and governance (ESG) assets , however, corporate and investor transparency around ESG has not kept pace with this surge in ESG assets. As a result, companies and investors are facing a new landscape of ESG regulatory requirements which look for ways to increase transparency around ESG risks, channel investment capital into sustainable activities, and curb “greenwashing”. Regulatory changes present an opportunity for companies on both sides of the Atlantic to bolster their existing ESG disclosures and refine their sustainability communication in a way which better reflects the growing demands of regulators and investors.
One of the key issues surrounding ESG which regulators may address is the lack of consistent and comparable sustainability data for stakeholders, including investors, to evaluate companies. Currently, there is no global consensus on the use of one single sustainability reporting framework or set of standards, and the current patchwork of voluntary standards creates confusion and burden for companies. Regulators are therefore looking to bring more consistency and clarity to ESG reporting, allowing for financial markets to assess ESG-related risks and channel investment capital more accurately into sustainable activities.
The rise of ESG has also gone hand-in-hand with the use of sustainable investment labels such as ESG, Climate, and Social or Ethical funds. Without recognized public standards the risk of “greenwashing” by companies and investors has become evident. One of the primary objectives of the European Union’s Sustainable Financial Disclosure Regulation (SFDR), which entered into force this year,  and the upcoming Corporate Sustainability Reporting Directive (CSRD) , is to minimize the overstatement of sustainability integration in both ESG investing and corporate reporting.
To date, the European Union and United Kingdom have been at the forefront of introducing varying ESG regulatory schemes, whereas the US has not developed ESG regulation to the same extent. However, there are early signs that the Biden Administration intends to take a robust approach to ESG regulation and enforcement. On May 21, the White House issued an executive order directing key federal agencies to assess the risks climate change poses to the US financial system and within six months develop recommendations to mitigate these risks . The US Securities and Exchange Commission (SEC) has also shown signs of an increased focus regarding the need to update the current disclosure regime to provide investors with the information they need to evaluate ESG risks. Gary Gensler, SEC Chair, has indicated he would like to go beyond recent initial steps to see more prescriptive rules on climate risk, human capital and potentially other ESG topics .
Climate Risk Disclosure Front and Center for Regulators
Given the potentially severe economic and financial impacts stemming from climate change, most of the new regulations place emphasis on investor activity and corporate disclosures around climate and environmental risk factors, even if they have a broader ESG mandate. For example, under the SFDR, nine of the 14 draft “adverse sustainability impact indicators” relate to climate and broader environmental topics. The SFDR requires investors marketing products in Europe to disclose sustainability data of investee companies, meaning the SFDR has an influence beyond Europe. This is the reason why the leading global ESG data providers, such as MSCI, have started collecting data on these metrics to support investor compliance.
In late 2020, the UK became the first G7 country to introduce mandatory corporate reporting of climate risks aligned with the recommendations of the Financial Stability Board’s (FSB) Task Force on Climate-related Financial Disclosures (TCFD), which large UK listed companies are now required to state in their annual reports .
In the US, the SEC has issued a statement that it is reviewing climate-related disclosures with an eye towards creating more consistent and reliable disclosures for investors and has invited public input that will be considered in the regulator’s climate disclosure proposal expected later in 2021 . Furthermore, the Commodity Futures Trading Commission has created a Climate Risk Unit to set about understanding, pricing, and addressing climate-related risks .
Based on these developments, it seems likely that climate-related risk will be the first big step into ESG-related regulation in the US. Whilst it remains unclear what the requirements would ultimately look like and whether they will reference the TCFD recommendations, a legal acceptance of climate-related risks as financial risks would be a significant development for SEC filings and ESG reporting in the US.
Action Steps Companies Can Take Now
Companies that are seeking to meet the growing demands of regulators and investors for greater transparency regarding their material ESG risks should consider taking the following:
1. Ensure the effectiveness of a cross-functional internal working group in developing an ESG program that is meaningful and incorporates the needs of investors, regulators, and other stakeholders.
2. Monitor regulatory developments emerging from the EU, UK, and US, and their impacts; keep management up to date; plan data collection in advance. Additionally, evaluate regulation which:
may have a direct influence on the company’s reporting scheme, such as the EU’s Sustainable Finance Taxonomy or the UK’s TCFD reporting roadmap; and/or
may have an indirect influence on the company’s reporting scheme, for example, requirements for global investors marketing products in Europe to consider sustainability-related risks and merits of their portfolios, as set out by the SFDR.
3. Assess the company’s current climate risk reporting along with its carbon emissions footprint and other climate-related impacts, in line with the Paris Agreement’s goals . Additionally, consider reporting, or enhance existing reporting, in line with the TCFD’s recommendations given regulators’ increasing focus on TCFD and investors’ encouragement for companies to incorporate this framework in their climate reporting.
4. Review the company’s material ESG factors, which may include conducting or updating a stakeholder materiality assessment. Similarly, consider using the Sustainability Accounting Standards Board (SASB) standards that are relevant to the company, which will help assess material ESG factors, develop KPIs, set goals and targets and incorporate these in the company’s reporting.
Overall, amidst growing regulator and investor expectations on ESG, having an effective communications strategy and roadmap is more important than ever. With 30+ years of deep and direct ESG experience on both sides of the Atlantic, Leaders Arena is well-situated to help companies adapt to emerging regulatory changes, including leveling-up sustainability communication, whilst also reflecting investor demands. To learn more about how you can benefit from our unique support, please email us at email@example.com
 Leaders Arena, https://www.leadersarena.global/esg-market-monitor
 Regulation on sustainability-related disclosures in the financial services sector, (EU) 2019/2088
 European Commission, https://ec.europa.eu/info/publications/210421-sustainable-finance-communication_en
 The White House, 20/May/2021, https://www.whitehouse.gov/briefing-room/statements-releases/2021/05/20/fact-sheet-president-biden-directs-agencies-to-analyze-and-mitigate-the-risk-climate-change-poses-to-homeowners-and-consumers-businesses-and-workers-and-the-financial-system-and-federal-government/
 UK’s Joint Government-Regulator TCFD Taskforce, https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/933782/FINAL_TCFD_REPORT.pdf
 US Securities and Exchange Commission, 15/March/2021, https://www.sec.gov/news/public-statement/lee-climate-change-disclosures
 Commodity Futures Trading Commission, 17/March/2021 https://www.cftc.gov/PressRoom/PressReleases/8368-21
 United Nations Framework Convention on Climate Change, https://unfccc.int/process-and-meetings/the-paris-agreement/the-paris-agreement