The Situation: The New York State Department of Financial Services ("DFS") and the European Banking Authority ("EBA") have published guidance relating to Environmental, Social, and Corporate Governance ("ESG") practices.
The Result: The guidance reflects a heightened interest on the part of domestic and foreign regulators regarding ESG issues. While the guidance does not direct regulated entities to take specific actions relating to ESG, it signals an intent to put companies on notice of future regulatory involvement in the ESG space.
Looking Ahead: As ESG-related investing continues to grow and greater attention is paid to ESG issues more broadly, market participants could see an uptick in regulator involvement in this area. Financial institutions should assess the extent to which their current corporate governance frameworks reflect ESG principles and what proactive steps they can take to keep ahead of the industry curve.
Recent announcements regarding ESG practices have highlighted the increased demand on the part of investors for financial institutions to incorporate ESG principles into their business operations. On October 25, 2020, Bloomberg reported that inflows into ESG exchange-traded funds ("ETFs") have increased to $22 billion this year, three times the total in 2019, and research from PricewaterhouseCoopers indicates that ESG funds could experience a threefold increase in assets by 2025.
Domestic and foreign regulators have taken notice of these investor trends and the impact of ESG issues more broadly. On October 29, 2020, the DFS issued a letter ("DFS Letter") to its regulated entities regarding ESG climate risk issues, and on November 3, 2020, the EBA published a Discussion Paper on ESG risk management and supervision ("EBA Discussion Paper"). As the market trend toward ESG principles becomes apparent, financial institutions should be cognizant of the DFS Letter and the EBA Discussion Paper because both are potential indicators of an increased governmental role in the ESG space.
The DFS Letter focuses on the "environmental" aspect of ESG, i.e., the effect of climate risks on the financial system broadly and regulated entities' assets and operations specifically. Linda A. Lacewell, the Superintendent of DFS, writes that DFS expects regulated entities to begin "integrating the financial risks from climate change into their governance frameworks, risk management processes, and business strategies" and "developing their approach to climate-related financial risk disclosure." Ms. Lacewell also mentions that DFS expects that, in adopting climate principles, regulated entities will "take a proportionate approach that reflects [their] exposure to the financial risks from climate change."
The DFS Letter is an important legal development for at least three reasons. First, DFS is a major regulator. It regulates about 1,500 banking and other financial institutions, with assets totaling more than $2.6 trillion—a larger number of entities than the Office of the Comptroller of the Currency ("OCC"), one of the principal federal banking regulators. Second, the DFS is a leading voice on financial issues of national importance, such as fintech charters, cybersecurity, and blockchain. And third, the DFS Letter appears to be among the first attempts by the DFS to engage with ESG principles. While the DFS Letter does not provide specific guidance on how regulated entities should adopt ESG principles, it is a clear indicator that important banking regulators plan to have their voices heard on the matter.
EBA Discussion Paper
In Europe, the EBA Discussion Paper identifies for the first time common definitions of ESG risks, and it provides an overview of current evaluation methods as well as recommendations for incorporating ESG risks into business strategies. In contrast to the DFS Letter, the EBA Discussion Paper addresses not only climate risk, but also other ESG principles. It addresses, for example, social objectives, including diversity and equal opportunity issues, and governance issues, such as shareholder rights and executive pay.
The EBA Discussion Paper is the start of a public consultation period, open until February 3, 2021. During the three-month period, the EBA will collect comments from market participants so it can fulfill its mandate of issuing a final report under the Capital Requirements Directive (EU) 2019/878 and the Investment Firms Directive (EU) 2019/2034, setting forth uniform definitions, appropriate criteria for the identifying, assessing, and managing of the impact of ESG-related financial risks, and the potential inclusion of ESG risks in regulatory reviews. That ESG report is expected to be published in June 2021.
The EBA Discussion Paper is another indicator that regulators are serious about ESG issues. Its breadth reflects the progress that European financial institutions have made toward adopting ESG principles, and it could be a telltale sign of the direction that U.S. regulators may be heading towards.
Market participants should expect other regulators to follow the lead of the DFS and EBA. On November 5, 2020, for example, SEC Commissioner Allison Herren Lee spoke at a PLI Conference; she called on the SEC and market participants to work "toward a disclosure regime specifically tailored to ensure that financial institutions produce standardized, comparable, and reliable disclosure of their exposure to climate risks." Commissioner Lee emphasized that she was speaking on her own behalf, not on behalf of the SEC, but her remarks suggest that senior officials at the SEC and likely other regulators are actively considering these issues.
As the ESG legal framework continues to develop, market participants should consider keeping ahead of the curve and consulting with their legal counsel and local regulators regarding proactive steps that can be taken to start integrating ESG principles into their corporate governance structures now.
Three Key Takeaways
- Investment in ESG funds is increasing at a dramatic rate.
- Domestic and foreign regulators are taking an increased interest in ESG issues.
- Financial institutions should consider proactive steps to stay ahead of the industry curve on ESG matters.