Few areas will receive as much attention in 2021 as the rapidly expanding Environmental, Social and Governance (ESG) framework, which remains a key priority on the global agenda.
In a nutshell:
Much of the focus to date has been on the disclosure and reporting of ESG performance, but policy makers have already started mapping out a more ambitious regime with wider ranging consequences.
Amongst this rapid expansion, one issue looms large: the need for harmonised global ESG standards. This is not simply a case of ensuring that ESG regulation meets the political commitments and shifting market attitudes underpinning its development; it has a tangible impact on the ability of the financial industry to follow, work within and benefit from the ESG framework. As the framework expands, fragmented standards will present ever more significant challenges.
- investors (including asset managers) being unable to compare investments on a “like for like” basis between different jurisdictions;
- challenges associated with global financial institutions implementing effective group governance and risk management controls;
- a greater risk of jurisdictional arbitrage, with product providers potentially choosing jurisdictions perceived as having less rigorous standards, which may contribute to the risk of “greenwashing” (i.e. overstating ESG performance); and
- greater difficulty incentivising desired behaviour (e.g. through tax and other fiscal incentives) where there is insufficient clarity around the treatment of ESG products and investments.
Investors and other stakeholders need a clearer picture of how companies are managing sustainability today and planning for the future.”
The current position reflects the failure of a single global body to set effective ESG standards. At present, standards are derived from a number of different sources, ranging from those produced by international bodies such as the Task Force on Climate-related Financial Disclosures (TCFD – established by the Financial Stability Board at the request of the G20) through to regional and national regulations and private industry guidelines.
This has resulted in an “alphabet soup” of standards, with three common themes:
- multiple standards which often take divergent approaches;
- a lack of common definitions for sustainable activities; and
- the lack of a coordinated approach to avoiding “greenwashing” and ensuring investor protection.
Moving towards global standards
Pressure has been mounting from both the financial industry and broader stakeholders to improve the clarity and consistency of the current standards. In the last few years, a number of initiatives have emerged with a view to achieving this objective, but many are limited in sectoral or geographical scope.
The development of global standards will require an authoritative global platform with the ability to co-ordinate numerous stakeholders. There are two obvious candidates for this:
- the TCFD, whose 2017 Recommendations continue to be the most influential and widely endorsed standards, but which are generally thematic and principles-based. Given its remit, its primary role may be to consolidate the wide number of existing initiatives and provide the leadership required to agree global standards; and
- the IFRS Foundation, which has existing expertise in setting global standards through its work on IFRS, and which is currently considering establishing a Sustainability Standards Board. We expect IOSCO and the IASB to be closely involved with these efforts. Given its track record, some financial institutions have already identified the IFRS option as the most likely to succeed – a view that we share.
While the “who” question remains open, a broader consensus is emerging that the output should be a global framework that balances the need to ensure clarity and consistency with the ability for users to develop more detailed standards and best practice guidelines.
... it would be wise for public authorities not to keep on adding to the diversity and (possible overload of) ESG reporting requirements."
We expect a Biden administration to be supportive of efforts both at the FSB/TCFD level and internationally; the FSB under Federal Reserve Vice Chairman Quarles has already demonstrated its support and the TCFD is chaired by Michael Bloomberg.
Engaging in the debate
In light of the growing push for global standards, financial institutions should be asking themselves how they can most effectively engage in the debate. Those that want to actively participate in shaping the new standards will need to consider how they can best make their voice heard. In most cases, this will mean identifying the most appropriate route for engagement – whether directly through relationships with regulators and policy makers, participation in industry associations, or through existing initiatives. To contribute effectively, firms will need to look to their own experiences to identify both the challenges and opportunities presented by a move to global standards.
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© Herbert Smith Freehills 2021