Long reads

The Future of Regulation: Time for ESG consolidation and cooperation

Paige McNamee

Paige McNamee

Senior Reporter, Finextra

This is an extract from Finextra's 'The Future of Regulation 2022' report.

At COP26 in Glasgow, the formation of a new International Sustainability Standards Board (ISSB) was announced, with the intention of developing a comprehensive global baseline of high-quality sustainability disclosure standards to meet investors’ information needs. The announcement received a mixed reception, with some claiming that the body risks being just another sustainability board without teeth.

Rick Lacaille, global head of ESG at State Street, believes that endorsement from major investors and issuers will go a long way towards the goal of having a wide range of issuers disclose data under the new proposed standards. “The parentage of ISSB – specifically the IFRS Foundation, the SASB and GRI create credibility with investors and acceptance by issuers.”

“Looking for ‘teeth’, in the form of making disclosure compulsory might have the unintended consequence of slowing down the ISSB’s development, and/or exacting too high a price in terms of the additional items that the process of adoption by national regulators might require.”

Sam Donoghue, senior consultant, Climate Transition Practice, P2 Consulting, feels that the ISSB represents a good start towards developing some international disclosure standards, and will help guide investors when comparing global sustainability related disclosures. The guidelines on data are laying the foundation for attempting to get consistent disclosures globally. “However, it is important to note whatever credibility the ISSB has, in the end, it can only provide guidance – it is not legally mandated. Eventually it will need regulatory backing and without the likes of IOSCO’s endorsement, it will struggle to get the requisite authority.”

Sarah Sinclair, co-founder, Change Gap, furthers that IOSCO has pledged ongoing support whilst it further reviews the foundational work of the ISSB, and have stated that ‘endorsement will follow ‘if it is satisfied that the standard sets a practical and effective global baseline for climate disclosures to financial markets across the globe’. IOSCO is honouring the responsibility it has toward its 130 members to perform this assessment prior to consideration of endorsing the ISSB.

The move to consolidate into the ISSB is a critical step toward convergence and more reliable, consistent and comparable disclosure requirements, according Sinclair.

“The magnitude and urgency of improving ESG reporting, disclosure, and more importantly the actions directed as a result is colossal, and can only improve with cross-party, cross-industry and cross-jurisdiction collaboration. In the context of such magnitude and urgency, a positive step forward is so vital, and should catalyse supportive progress.”

Convergence toward a global baseline is necessary, to steer quality improvements and understanding of ‘what good looks like’, believes Sinclair, and it will also mitigate further proliferation of disparate and confusing views. However, this must be accompanied by a concerted, co-ordinated and collaborative set of actions from key parties across the ESG ecosystem.

Given that the ISSB standards build on existing voluntary frameworks and guidance, this means that prior and ongoing work by organisations to prepare for their reporting readiness, will still be valuable and reusable as far as possible. The ISSB standards work will also provide much needed impetus in helping organisations accelerate and focus their reporting and disclosures readiness preparation.

Rather than asking whether the ISSB has teeth, Sinclair believes it is more constructive to focus on the fact that ESG inherently demands an all-in approach. That is, individual and collective responsibility and commitment to putting in a best-efforts approach to reporting and disclosures despite the challenges, whilst standards are maturing – supported by appropriate governance mechanisms from boards such as ISSB.

“Other reporting governance bodies have not previously had a challenge as broad and urgent as ESG, so the task of establishing and embedding standards and consistency across such a wide spectrum is in unchartered territory.”

Globalisation has brought great new opportunities for many, whilst also introducing new types and levels of issues for industry and regulators to deal with. On the up-side however, this is fuelling a growing momentum and recognition for the need to think and act innovatively around collaboration mechanisms and public-private partnerships – so we can look forward to an increasing sense of positivity, and ‘can-do’ for the ESG challenges ahead.

COP26 fallout: Phase down, not phase out

UK Chancellor of the Exchequer Rishi Sunak said the financial system must be rewired for net zero, but what does this mean for clients? Should banks ultimately be held responsible for educating clients and improving the footprint of their clients’ portfolios?

Lacaille explains that the whole financial system must be able to ensure that the private sector can play its part in financing the new energy and other investments needed to replace current carbon-centric energy and industrial base.

“This needs to be done in an economically and socially responsible fashion and includes the progressive elimination of legacy assets. The financial sector will need to support the existence of some legacy assets (such as coal generated power in emerging economies) for some time while replacements are financed and built.”

Donoghue refers to the importance of maintaining active engagement with clients as a potentially more effective way for banks to educate them, influence how they run their businesses and ultimately, help them build more sustainable business models.

“Banks hold the cheque books – they provide the financial backing – so clients who are not moving in the direction of net zero or are practicing socially unacceptable working practices need to sit up and take note of what their bank is advising. Banks have a responsibility in this respect. Companies that do not have sustainable business models are not future proofed – so it’s in banks’ collective interest to funnel them in the right direction.”

Agreeing with the idea that banks play a critical role in the education of the clients, Sinclair caveats that they should not bear sole responsibility for educating their clients, nor the improvement of their clients’ portfolios.

“The financial ecosystem is more interconnected than ever before due to the impacts of globalisation and ESG considerations, which means that the responsibility for educating and managing ESG and other risks, should lie proportionately across the key parties in the ecosystem.”

Is divestment ever a valid ESG strategy?

Donoghue argues that approach to divestment depends on both the client and the bank.

“Take coal – it is now responsible for up to one in five deaths worldwide – so can a coal mining company ever have a sustainable business model? And would a bank want to be associated with that? Ideally, banks should be working with high emitting companies to produce credible transition plans rather than leaving them (and their business) by the wayside. Divestment is a last resort. It means you lose a seat at the table of these companies, but sometimes it is the only credible option.”

Lacaille notes that divestment is not State Street’s favoured strategy, but has two important roles to play; both as a potential last resort in sending clear capital pricing signals to ensure that there is less wasteful investment in new assets, and in ensuring that investors are not exposed to mis-priced legacy assets.

Sinclair highlights that, if supported by a holistic set of strategy components and levers, divestment is a key part of a valid ESG strategy.

Describing ESG as essentially a wider and more globally tempered set of decision measures and factors which are to be used at all stages of the investment lifecycle, Sinclair argues that divestment decisions are therefore part of this lifecycle. “The difference now being that there is a heightened requirement to support the decision process using a set of defined and agreed ESG measures and assessment processes, with adequate controls, evidencing and governance.”

Beyond meeting emissions targets, decarbonising, and reducing waste, the questions evolves into how financial institutions can practically build out and achieve their ESG requirements in a realistic way.

Donoghue believes that for real change to be achieved, sustainability should be embedded into every decision made within financial institutions. “In that same way that profit/loss is a factor in every decision made by a bank, and regulation has to be adhered to, so should ESG principles. This would involve a bank-wide education initiative, to ensure all parts of the bank are measured and report on a ‘climate change budget’ just like a financial budget, or an adherence to regulatory protocol.”

“Undoubtedly this should be linked to executive compensation.”

Lacaille feels that the practicality of what institutions can realistically achieve depends on their role in the financial system. For example, asset managers should ensure that their investment processes take account of transition, physical and liability risks within portfolios. “Where they have discretion and these risks are in the judgement of the manager material; they should offer their clients choices, so that there is control over carbon exposure and risks.”

Improving understanding, comprehension and ongoing trend analysis in the ESG space is key to ensuring that financial institutions are prioritising and channelling their time, money, and people resources effectively and proportionately toward meeting the appropriate ESG-related targets according to Sinclair. Access to external counsel, advice and knowledge of emerging developments is therefore key to achieving this.

“Continuous improvement and development of reliable systems, data and processes should be a priority – developing repeatable, best practice capabilities that will produce well controlled and governed outputs, able to stand up to stakeholder, assurance, audit and regulatory scrutiny.”

“Whilst metric definitions, benchmarks and reporting standards are still evolving, it is key that systems, data, and processes are developed with a degree of proportionality, flexibility and future-proofing in mind. This will mitigate the level of re-work required, when further guidance and standards evolve.”

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