Revolution vs Evolution - The ESG landscape and opportunities on both sides of the Atlantic

Environmental, social and governance (“ESG”) considerations are rapidly becoming a focal point for governments, investors and companies globally, with a particular emphasis on climate risk. The Paris Agreement of 2016 was a landmark agreement to combat climate change and to accelerate and intensify the actions and investment needed for a low carbon future. The UK and EU authorities have expressed strong commitments to the Paris Agreement and have undertaken a concerted effort to introduce significant mandatory legal requirements to align companies and financial institutions with ESG goals – effectively a “revolution” towards incorporating ESG into corporate governance, product, supplier, customer and disclosure frameworks. By contrast, the United States federal government is withdrawing from the Paris Agreement and is generally not focussed on ESG, as a result of which associated changes in the legal and regulatory landscape are being driven by a mixture of US state and local actions and private initiatives, such as litigation and voluntary commitments by companies – effectively more of an “evolution” towards the adoption of climate-related initiatives. This paper compares and contrasts climate-related ESG developments on both sides of the Atlantic, and highlights key issues that continued divergence will create for global asset managers, companies and their shareholders as they seek to navigate and influence the climate change and related ESG debate. The UK and EU authorities have expressed strong commitments to the Paris Agreement … [whereas] the United States federal government is withdrawing from the Paris Agreement and is generally not focussed on ESG. Introduction 4 The UK and EU ESG landscape UK /EU The Sustainable Finance Package As part of its programme to fulfil Paris Agreement commitments, the EU Commission adopted a sustainable finance action plan in March 2018 which aims to: > reorient capital flows towards sustainable investment to achieve sustainable and inclusive growth; > manage the financial risks stemming from climate change, environmental degradation and social issues; and > foster transparency and long-termism in financial and economic activity. From a legal perspective, much of the focus has been on the EU’s “Sustainable Finance Package”, which will be phased in over the period from 2020-2022. In brief, these reforms aim to impose ESG-related disclosure obligations on financial institutions and listed companies and to provide greater consistency and clarity to evaluate which financial investments are contributing to, and facilitating, sustainable investment through three key regulations: > a Taxonomy Regulation, which establishes a methodology for determining whether economic activities are sustainable (focussing on the “E” component of ESG to begin with) and imposes disclosure obligations on large EU-listed issuers; > a Disclosure Regulation, which requires various financial institutions (primarily buy side institutional investors) to disclose at both a product and entity level how they incorporate sustainability into the services they provide, and how products with sustainability objectives or characteristics achieve those objectives or characteristics; and > a Benchmarks Regulation, which establishes two new types of financial benchmarks that are made up of constituent investments which have a carbon intensity profile matching a particular climate transition pathway, such as the 1.5 or 2 degree temperature rise scenarios envisaged by the Paris Agreement. Other key sustainability initiatives The Sustainable Finance Package has been accompanied by a raft of other legislation, which has been focused in particular on the financial sector. These include changes to sectoral legislation such as: > MiFID II (affecting European asset managers and broker-dealers); > AIFMD and the UCITS Directive (affecting fund managers); > the Solvency II Directive (affecting insurance and reinsurers); and > the IDD (affecting insurance distributors). The amendments to the sectoral legislation generally seek to reinforce the obligations set out under the Sustainable Finance Package. In addition, the EU Commission also adopted guidelines on reporting climate-related information in June 2019, which supplements existing guidelines on the disclosure of non-financial and diversity information by, broadly, EU-listed entities, banks and insurers with more than 500 employees. Various other recent EU legislative initiatives not explicitly linked to the Sustainable Finance Package have also incorporated ESG. For example, SRD II has imposed obligations on asset managers and institutional investors to provide disclosure on how they engage with listed investee companies on non-financial metrics, including ESG. Changes in prudential standards for the financial sector (via CRR 2/CRD V and IFR/IFD) have also included new obligations for these firms to disclose their ESGrelated risks. This legislation has also raised the potential for the EU to propose treating ESG assets more favourably for prudential purposes, which could significantly change the incentives for financial institutions to hold these assets. Additional measures are also in the pipeline, ranging from proposals regarding an EU Green Bond Standard to developing a voluntary “EU Ecolabel” for financial products. 5 The UK and EU ESG landscape UK /EU In parallel with the foregoing initiatives, the Taskforce on Climate Related Financial Disclosure (“TCFD”), which was established in 2016 by the OECD’s Financial Stability Board after the Paris Agreement, promulgated a new voluntary standard for reporting on climate-related financial risks that has gradually been adopted by various stakeholders as the reporting methodology of choice. The key pillars of TCFD disclosures fall under four headings: > governance; > strategy; > risk management; and > metrics and targets. Many of the legislative initiatives noted above, as well as others which have been proposed, serve to shift TCFD-style reporting from a voluntary basis to a mandatory requirement for listed companies, large asset owners and some regulated financial institutions. In 2018, the Sustainability Accounting Standards Board (the “SASB”) developed a new industryspecific classification system covering eleven sectors and 77 industries, the taxonomy of which is based on industries’ sustainability profiles. The purpose of the system is to assist companies seeking to identify the financially material sustainability issues that are reasonably likely to impact the financial condition or operating performance of the company. Together with the TCFD, the SASB has also become one of the most widely adopted reporting standards to date. Together with the TCFD, the SASB has also become one of the most widely adopted reporting standards to date. Increasingly, actions are also being brought against private entities. Climate litigation in the EU As discussed below with respect to the United States, climate-related litigation has been developing in the EU. Claims against governments have been advanced under a number of legal theories, and have sought to challenge the climate policy ambition and effectiveness of its implementation by government agencies. Examples include litigation concerning: > Dutch national greenhouse gas emission targets; > Germany’s emission reduction record and its alleged impact on the right to life, health, property and occupational freedom; and > a very recent claim challenging the UK Government’s decision to approve the Drax largescale gas plant on the basis that the project is inconsistent with the UK government’s 2050 net zero target. Increasingly, actions are also being brought against private entities. For example, claims have been initiated against: > a Polish power plant operator alleging liability for damage to the environment; and > a major French oil company, alleging its failure to adequately assess the threats posed to human rights and the environment by an oil project in Tanzania and Uganda as required by the French corporate duty of vigilance. 6 UK /EU A new path for the UK? Whilst there is currently some uncertainty about whether all of the EU legislative changes will form part of UK law following the Brexit transition period which is currently set to expire on 31 December 2020, it is currently our working assumption that the UK will seek to maintain equivalence to, if not exceed, EU ESG standards in the near term. Indeed, the UK has forged ahead with its own national initiatives in this space, which create further legal challenges for companies and financial institutions. These include: > the UK’s Green Finance Strategy setting out an expectation that climate-related risk disclosures would be required for listed companies and large asset owners by 2022; > the Prudential Regulation Authority (the “PRA”) setting out new requirements for UK banks and insurers to embed the management of the financial risks of climate change into their corporate governance arrangements; The UK has forged ahead with its own national initiatives. > the Bank of England consulting on how it can most effectively implement bank sector stress tests keyed off of different climate-related risk scenarios from the end of 2020, with reporting on the results of those tests to be made on an aggregate industry-wide basis from 2021; and > the Financial Conduct Authority (“FCA”) planning to consult on new rules to improve climate-related disclosures and clarify existing obligations. Please see Annex A for an illustrative timeline for key EU and UK ESG legislative and regul