A New Zero Tolerance Era for ESG Reporting

As nations across the globe come to terms with understanding and tackling climate change, mandatory reporting of such risks across capital markets could well become the norm.

In January, the World Economic Forum published its Global Risks Report 2020, revealing findings from a survey of 750 global experts and decision-makers who were asked to rank their biggest concerns over the next ten years. For the first time in the survey’s history, the top five global risks in terms of likelihood were all environmental.

Accepting our influence over our environment is hardly news. Governments across the globe have been making concerted efforts to mitigate our impact on the environment since the 1980s when we realised we were burning a hole in the ozone layer.

Today, while the environmental impact of climate change has been well documented, the economics are just as dramatic. Cumulative damages could reach a staggering USD 8 trillion by 2050, according to the Intergovernmental Panel on Climate Change.

A harder line

Given the heightened urgency of the problem, many nations are now taking a harder line. New Zealand’s government, for example, is aiming to become the first country in the world to compel its financial sector to mandatorily report on climate risks. If passed through Parliament, the newly proposed law will require around 200 organisations to disclose their exposure to climate risk, on a comply-or-explain basis, as early as 2023.

Effectively any bank, credit union, asset manager and insurer with more than NZD 1 billion in AUM, any company with NZX-listed debt or equity, and any overseas incorporated organisation with annual reporting obligations in New Zealand will fall into scope. At the end of 2019, New Zealand’s banking system had total assets of around NZD 574 billion (USD 380 billion), 80 percent of which consists of loans. With banks serving as the primary source of finance for companies in New Zealand, the new mandatory disclosure rules will mean the entire economy will be seen through a climate risk lens.

Establishing what climate risks lie within a financial institution is far from easy. For example, they would need to scale up their ability to estimate flood risk from heavy rain, storms, and sea level rise on residential housing. To New Zealand’s credit, by pinning disclosure to an internationally recognised best practice, the Task Force on Climate-related Financial Disclosure (TCFD) framework, institutions will be able to operate on standards that are already understood or, at least, easily accessible.

Shared vision

In fact, many firms across the globe are already volunteering to disclose climate change risk information in line with the TCFD recommendations. By February this year, more than 1,000 global organisations had declared their support for the TCFD, including almost 500 financial firms responsible for assets of USD nearly USD 140 trillion.

Yet, pressure for sovereign nations to follow the path of New Zealand is only likely to increase. According to an IMF report on global financial stability published in April, the development of mandatory disclosure may be necessary to sustain financial stability.

The IMF said: “Given the climatic trends, financial stability authorities have become concerned that the financial system may be underprepared to cope with this potentially large increase in physical risk, as well as with the so-called transition risk resulting from policy, technology, legal, and market changes that occur during the move to a low-carbon economy.”

Acknowledging the lack of reporting infrastructure currently available, the IMF had suggested that in the short-term, mandatory climate risk disclosure could be based on globally agreed principles. In the longer term, climate change risk disclosure standards could be “incorporated into financial statements compliant with International Financial Reporting Standards,” the report said.

The ball is already moving on this. Five organisations that guide most sustainability and integrated reporting very recently announced a shared vision for corporate reporting. The CDP, the Climate Disclosure Standards Board (CDSB), the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC) and the Sustainability Accounting Standards Board (SASB) have committed to working together and engaging with key actors – including IFRS, IOSCO, the European Commission, and the World Economic Forum’s International Business Council – to achieve a single, coherent global set of sustainability reporting standards.

Key ingredient

While there appears to be a healthy shift toward global harmonisation of reporting standards, how financial institutions go about actually integrating ESG and sustainability factors in their business decisions is still highly fragmented, due in part to a lack of very basic definitions (e.g. what is ‘green’?). “The shifting of capital towards the 2030 agenda for sustainable development and a resilient, low carbon economic model cannot happen without better definitions, standards, and transparency,” says Elena Philipova, Global Head of ESG Proposition at Refinitiv.

Currently, there are more than 250 providers of ESG data, including well-known providers with global coverage, such as Refinitiv, as well as highly specialist data providers covering specific verticals, such as real estate. While the role of ESG data providers is vital, different methodologies lead to wide variance in analytics and scores. Institutions using these scores to inform their own analysis need to be mindful of this. As taxonomies and opinions of what should be classified as green or sustainable vary wildly, the struggle is an uphill one.

“I think that the key ingredient that has been missing so far in the mix is the public sector,” Philipova says. “It has the power and the influence to bring clarity to the market and to make standards and disclosure mandatory. This is critical for the urgent task of mainstreaming sustainable finance practices.”

“As we have seen in the last few years, European regulators acknowledge this gap in the market and have taken a leadership role in the sustainable finance agenda, launching the most comprehensive and ambitious plan so far, which includes the development of a common classification schema – the EU Taxonomy.”

Big strides

The EU has indeed made big strides in this area, committing to reaching net zero carbon emissions by 2050. As part of supporting this ambitious goal, a series of equally ambitious policy actions are coming into place.

In a bid to stamp out greenwashing, for instance, the EU-wide classification system defines which economic activities are environmentally sustainable by setting out six environmental objectives and defining specific requirements which must be met. The final taxonomy is expected to be ready by year-end, initially covering two of the six environmental objectives – climate change mitigation and climate change adaptation.

The EU is also adopting standardised processes through its Sustainable Finance Disclosure Regulation (SFDR), under which investment firms and financial advisers will have to disclose how they are integrating sustainability risks in their decision-making and advisory processes, in addition to providing transparency on the extent to which financial products target sustainable investments.

Importantly, SFDR empowers European Supervisory Authorities to develop regulatory technical standards on the content, methodology and presentation of ESG disclosures at the entity and product level, paving the way for greater harmonisation across the EU. Most SFDR provisions will start to apply as early as March 2021, though certain provisions relating to ESG-focused products will apply from 1 January 2022.

A model that works

Institutions located in Asia, but with operations or clients within the EU, will need to assess the impact of and decide how to act on these regulations and deadlines. “The reach of the regulation is much broader than just Europe. Anyone having a license to operate or service financial consumers in Europe are also impacted and they cannot ignore it,” Philipova says.

In addition, Asia-based firms without significant EU exposure will have to consider using the framework to inform their own actions and decision-making. While the regulatory bar set in the EU is high, it is likely to be replicated elsewhere, given that it targets environmental and social challenges that are global in nature.

“The EU framework seeks to meet the same objective that all regulators are trying to solve for – the environmental and social challenges presented to our societies, and the need for resilience against what scientists expect to be a century of great volatility,” Philipova says. “It’s a matter of coming up with a model that works in practice. If the EU action plan and strategy is proven to be a workable solution, the chance of it being adopted more broadly is quite high, as there is so much hunger for clarity in the market.”

Clearly, there are still huge challenges to address around basic definitions, and the consistency and reliability of disclosures, especially in Asia-Pacific. However, the good news is that there is growing consensus on what those challenges are and there is a strong push for international collaboration to solve them.

As we start to tackle these challenges, mandatory reporting of climate and other ESG-related risks could well become the norm.

To learn more about incorporating ESG factors into due diligence practices, join this webinar.

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