Commentary

The B in ESG – Part 2: Regulatory Drivers

Dr Anthony Kirby, Head of Regulation and Risk for Asset Management and Capital Markets in Europe at EY, places the TNFD framework in context of regulatory and political developments.

The UK is one of 12 jurisdictions around the world that already include or plan to include nature-related aspects in their environmental taxonomies. This broadly commits them to regulatory approaches which incorporate nature-relevant environmental objectives (covering water conservation, pollution prevention and biodiversity/ecosystem protection) and develop environmental performance metrics and thresholds (including nature-relevant ‘do no significant harm’ (DNSH) criteria.

In addition, several major markets have announced plans to adopt or align domestic frameworks with the International Sustainability Standards Board’s (ISSB) sustainability disclosure standards, including the UK, the EU, Singapore, South Africa, South Korea, Australia, Nigeria, Canada and Brazil. Many governments have been supportive the recommendations of the Taskforce on Nature-related Financial Disclosures (TNFD), but they will inevitably take different paths to nature-focused dislcosures.

UK measures

At the end of last year, the UK regulator, the Financial Conduct Authority (FCA), published an important paper on the topic of nature to accompany other UK government measures.

  • PS23/16 and GC23/03: UK sustainability disclosure rules and anti-greenwashing rules guidance issued 28 November, consisted of a framework for UK sustainability disclosure requirements (SDRs) and a labelling regime. The FCA released a policy statement on the SDRs and labelling regime, as well as a guidance consultation on the proposed anti-greenwashing rule that will enter into force in May 2024 and apply to all regulated firms. The three category labels of sustainable focus, improver (linked to stewardship and transition goals) and impact (linked to use of proceeds), are now joined by an extra ‘mixed goals’ category, which recognises overlaps. The anti-greenwashing rule applies to sustainability claims in the wider sense, which aligns with the EU’s approach to the concept of sustainability. Section 3.4 specifically makes mention of “…developing a UK Green Taxonomy and consideration of nature-related disclosures”. There is also a suggestion of expansion to include portfolio management, pension funds and financial advisors, with clarity to come regarding treatments under the Overseas Fund Regime.
  • Environment Act 2021 – Biodiversity Net Gain (BNG) is a concept used to assess nationally significant infrastructure projects in the UK which aims to leave the natural environment in a measurably better state than it was in beforehand. The UK’s Environment Bill contains a new BNG condition for planning permissions. The biodiversity metric is a habitat-based approach (featuring biodiversity units) which will be used to calculate and assess an area’s biodiversity value to wildlife. The metric uses habitat features to calculate a biodiversity value. The current downside is that unlike climate change, there are currently no regulatory targets for businesses on biodiversity and so these markets tend to lag behind the pricing of carbon codes.

Parallel EU developments

Movements in the UK are accompanied by four critical parallel developments in the EU:

SFDR: The EU was a frontrunner in developing sustainability reporting and disclosures relating to the original six environmental categories listed in the EU Taxonomy, including activities relating to the protection of biodiversity and the prevention of pollution on land and on water. Financial market participants are already required to make rules-based mandatory disclosures at an entity- and product-level pursuant to the Sustainable Financial Disclosures Regulation (SFDR). The EU recently closed a consultation to address certain shortcomings of the regime as of 15 December. This builds on the publication of the technical screening criteria (TSC) informing the EU Taxonomy Regulation Delegated Act Annexes (‘Taxo-4’, and Annex 4 in particular) published on 27 June 2023.

CSRD: The Corporate Sustainability Reporting Directive (CSRD) is designed to revise and enhance the Non-Financial Reporting Directive (NFRD) and apply the measures to an estimated 49,000 firms across the EU. The TNFD framework recommends disclosures in respect of nature-related issues occurring across the value chain, whether they occur upstream or downstream of an organisation’s direct operations, and the EU has also integrated aspects of the TNFD guidance into the CSRD, specifically through the supporting European Sustainability Reporting Standards (ESRS).

From a biodiversity standpoint, ESRS requires firms to identify impact, risks and opportunities with regards to a pre-defined number of topics set out in the ‘topical standards’ – E2: Prevention of Pollution; E3 Water and Marine Resources; E4 Biodiversity and Ecosystems – through the lenses of:

  • Financial materiality (An ESG topic is material when it generates / may generate risks or opportunities that significantly influence / are likely to significantly influence the undertakings future cash flows over the short-, medium- or long term);
  • Impact materiality (An ESG topic is material when it pertains to the undertaking’s actual or potential impacts on people or the environment). The TNFD framework provides a flexible approach with regard to materiality.

CSDDD: The proposed Corporate Sustainability Due Diligence Directive (CSDDD) sets out a corporate due diligence process to identify, mitigate, prevent, end, and account for adverse environmental impacts in the companies’ operations, their subsidiaries, and their value chains. As of 15 December, the agreement was being interpreted by some countries as meaning that financial institutions would be considered exempt from carrying out supply chain due diligence with respect to the relationships with their clients. While this situation places a relative burden on corporations and could well be a temporary measure, the eventual requirements will place an onus on firms needing to:

1) Integrate biodiversity due diligence into policies;

2) Identify actual or potential adverse impacts:

3) Establish and maintain a complaints procedure;

4) Monitor effectiveness of due diligence policy/measures:

5) Prevent or mitigate potential impacts; and

6) Publicly communicate on due diligence.

There could be increased scrutiny and reporting obligations for financial institution investment in the coming years.

EUDR: The EU Deforestation Regulation (EUDR) entered into force on 29 June 2023, and its principal obligations will apply to all in-scope companies (other than micro-undertakings or small undertakings) from 30 December 2024 (and to micro-undertakings or small undertakings from 30 June 2025). Companies in scope will include the buyers and sellers of seven relevant commodities – cattle, cocoa, coffee, oil palm, rubber, soya and wood – or the respective derived products from these sectors listed in the legislation’s annex ,such as meat products, leather, chocolate, palm oil derivatives, natural rubber products, or soya-bean flour.

The current understanding is that financial institutions will not be directly obliged to analyse their investments for deforestation risks per the sectors above. In addition, the EUDR provides significant penalties for non-compliance. The onus will be on individual EU member states to decide the applicable penalties for a breach of the EUDR, including confiscation of the items and related revenues, fines proportionate to the environmental damage (at least 4% of the relevant entity’s annual EU-wide turnover), temporary exclusion from the public procurement process and temporary prohibition from placing relevant commodities or products on the market. As with the CSDDD measures above, there could be increased scrutiny and reporting obligations for financial institution investment in coming years.

The US disclosure regime

Movement in the UK is accompanied by a parallel sustainable reporting regime in the US.

CDR: The Securities and Exchange Commission’s (SEC) announced its plans under its Climate Disclosure Rule (CDR) to introduce mandatory reporting in March 2022. The CDR currently remains pending as regards the timing for climate change mitigation and adaptation, and at the time of writing, there are no plans to extend the mandatory reporting regime to cover the protection of biodiversity nor to prevent pollution on land nor on water. It will likely fall to individual states to introduce such measures, depending on the outcome of the next presidential election in November 2024.

Where next during 2024?

My previous article proposed how governance, controls and policies/procedures supported by data collection will be a critical sustainable investing theme this year, to support alignment of voluntary disclosure frameworks such as TNFD with ISSB/ESRS reporting, which form the basis of mandatory disclosure regimes. Asset manager firms and asset owner clients, such as insurers, pension funds, sovereign wealth funds and corporations, need to extend their approaches to physical and transition risk assessments used for climate change mitigation and adaptation to the arena of biodiversity. In the cash-strapped and politically-fluid environment of 2024, the question is where and how firms will be prepared to commit to investing in ‘no-regret’ activities, not least given that 2024 will see more vendor M&A activities – plus artificial intelligence use cases reaching production – than ever before.

All this is some way downstream from the degradation of habitats on land or water, or the need to preserve the pollinators, but then the current debates on climate change started from humble aspirations too. And just like the implied temperature risk factor in climate change, the rate of deforestation is a critical metric when tracking biodiversity. The world is losing an estimated six million hectares of forest mostly to agricultural production each year – pivoting towards a loss rate of 1% of tree cover every year over the period 2000-2022. This represents roughly the area of a football field lost to deforestation every second around the clock (with 95% of this occurring in the tropics). It’s clear that we can’t afford to delay much longer.

Dr Anthony Kirby is writing in a personal capacity and his views on this subject do not reflect those of EY.

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