Regulators around the world are taking ambitious steps to improve the sustainability of the financial sector and guide capital towards sustainable economic activity. These regulatory interventions present complex and sensitive legal challenges for financial sector firms, which require senior executive and board-level attention as well as enhanced policies and governance. In our guide below (and here), we introduce some of the key regulatory interventions by UK, EU and international regulatory authorities, to help legal teams and senior staff consider the appropriate governance and policies required across their organisations.

Boards and managers of financial institutions may need to take action on sensitive and complex issues that are not always easily addressed, such as ensuring equal opportunities for ethnic minorities or reducing the impact of supply chains on biodiversity. As regulators require firms to consider sustainability in governance, capital allocation and investment decisions, sustainability will increasingly provide grounds for regulators and stakeholders to question the appropriateness, and potentially legality, of decisions.

To give some examples of the challenges, the PRA expects that by the end of this year banks and insurers will have fully embedded their plans to manage the complex and wide-ranging risks of climate change. This includes managing the potential effects on ‘their clients, counterparties, and organisations in which the firm invests or may invest’. Whilst acknowledging the difficulties presented by a lack of data or expertise, the PRA expects to see evidence that climate risks are considered throughout governance and risk management arrangements, that long term climate change scenario analysis has informed strategies, and that responsibility has been allocated at board level.

For asset managers, regulators increasingly expect them to identify and respond to clients’ sustainability preferences. Given the complexity and growing breadth of the concept of sustainability, this presents the challenge of helping clients identify and articulate sustainability goals. Even more challenging, firms then need to balance clients’ sustainability goals with financial and risk objectives. Existing processes for liaising with clients, researching and identifying suitable investment strategies may need to be re-engineered. For example, existing strategies based on maximising financial return may not always align with the sustainability goals of the firm or its clients. If research points to soaring demand for fossil fuels in the post-COVID-19 recovery, to what extent should fund managers forgo potential financial gains in light of the sustainability concerns associated with fossil fuels? The approach ultimately agreed on and the nuances of why decisions are being made in a certain way will need to be communicated to investors clearly. For analysis of the legal barriers and requirements for institutional investors pursuing sustainability goals, including when the law requires investors proactively to make investment and stewardship decisions that seek positive sustainability impact, see the Legal Framework for Impact report written by Freshfields in collaboration with the United Nations Environment Programme Finance Initiative, UN PRI and the Generation Foundation.

Even once sustainability objectives are established and integrated into decision-making, the concept of sustainability will present challenges when determining what qualifies as a sustainable investment. Should a ‘green bond’ to finance the development of carbon capture technology be considered sustainable if issued by an oil and gas company? What if a potential investee company is making positive contributions to reducing climate change, but performs badly in terms of the gender or racial balance of its board? Decisions on what sustainability issues to prioritise and how to measure performance will need to be carefully thought through to avoid regulatory attention and claims from disappointed stakeholders.

Across the whole financial sector, the availability of reliable data is already presenting challenges. Many regulatory interventions are based on concepts for which the data are not always available or reliable. Even third-party standards or certifications vary significantly in their approach and outcomes. Without sound data, it is difficult to implement and assess sustainability policies. Requirements to disclose detailed sustainability data, even where it is limited, add pressure and potentially provide grounds for claims by those stakeholders who feel they are being let down. To limit liability risks, firms will need to ensure that their investment decisions and internal policies combine robust and consistent use of data with clear explanations.

As outlined in our guide, we see these challenges developing across the four areas of (i) identification of sustainable activity, (ii) governance and risk, (iii) products and services, and (iv) disclosure. There is a great deal of opportunity for firms that can balance the competing pressures, but also considerable risk in a fast-developing regulatory and legal environment.