Financial Markets Regulatory Outlook 2023 - Confronting the polycrisis

At a glance

On 30 March, the UK Government published a variety of papers relating to its green agenda and policies to get the UK to net zero emissions by 2050. This blog focuses on the revised Green Strategy titled ‘Mobilising Green Investment’ and the key issues for financial services firms, namely:

• A restatement of the Government’s commitment to adopt the International Sustainability Standards Board’s (ISSB’s) standards when finalised and to increase the focus on nature and biodiversity disclosures.
• The commitment to consult on a UK Green Taxonomy this autumn that will be voluntary to disclose against for at least the first two years.

• A consultation on the introduction of requirements for the UK’s largest companies to disclose their transition plans ‘if they have them’, due after the Transition Plan Taskforce (TPT) has concluded its work in autumn/winter 2023.

• Plans to bring ESG ratings providers within the regulatory perimeter, alongside a voluntary code of conduct from the industry-led ESG Data and Ratings Working Group, set up by the FCA, that will also cover data providers.

• Broader plans to work with the private sector to increase investment in sustainability, particularly nature and climate adaptation, and improve effective stewardship across a variety of funds, including pensions.

• Overall, the Government has not made any significant new announcements. Instead, the revised strategy aims to bring together all the separate pieces of work on green finance and provide a timeline, albeit one that has been pushed out further from the Government’s original intentions. The crunch point for firms will be this autumn when we expect more details on transition plans, the Taxonomy and disclosures.

The documents published last month show the complexity the Government faces in delivering the transition to net zero. Timelines are increasingly drifting and some initiatives have been softened. These challenges are, of course, similar to those that the EU and other governments are encountering.

The Government strategy indicates that it will rely on the regulators to make rules with ‘teeth’ and, while it supports the work of the FCA to introduce fund labels, regulated financial services firms’ ability to provide accurate labels will remain difficult without credible data sources for scope 3 emissions. Therefore, we expect the focus to remain, for some time, on how to measure emissions reliably and for industry to need to take the initiative in that regard.

This blog summarises the key issues for financial services firms.

Disclosures

The Government sets out the broader agenda for the umbrella UK Sustainable Disclosure Requirements (SDR), emphasising that it will adopt the ISSB’s final standards when approved, working with the FCA and FRC to support the ISSB work more broadly. This will include standards to cover the Taskforce for Nature-related Financial Disclosures’ (TNFD’s) final framework, and the following work on transition plans, scope 3 emissions and fund labels as set out below.

The Government observes that firms are still struggling with reporting requirements in relation to physical climate risks and commits to working with industry to improve adaptation metrics and guidance, as well as promote the development of adaptation metrics within the ISSB Sustainability Disclosure Standards.

UK Taxonomy

The paper confirms that the Government is going ahead with a UK Green Taxonomy which it expects to consult on in autumn 2023. Disclosures will not be mandatory for at least the first two years, and the Government is also still contemplating how to address transitioning activities. We are expecting work on transitioning provisions to be informed by an industry-led transition finance review that is also announced within the paper. Controversially, the Government has announced that nuclear energy will play a key role in the UK’s net zero ambitions and therefore will be within the UK Taxonomy.

What is clear is that the Government intends to build on the proposals from the Green Taxonomy Advisory Group so its recommendations published at the end of the last year and its observations on interoperability are a helpful indication of what the Taxonomy might look like. Therefore, we are anticipating that the approach will be to adopt a Taxonomy that mirrors the EU Taxonomy with only revisions/changes where desirable for a UK market and to make improvements on the EU approach. A Land, Nature and Adapted Systems Advisory Group has also been created to advise on sustainable agriculture and fisheries.

Transition plans and scope 3 GHG emissions

The Government sees the creation and implementation of high-quality transition plans as providing the key vehicle for driving change. As part of the SDR, it commits to consulting on the introduction of requirements for the UK’s largest companies to disclose their transition plans if they have them. The consultation will take place once the TPT, established by the Government in April 2022, has completed its work to develop a disclosure framework and guidance for ’gold standard’ transition plans in autumn/winter 2023. We had expected requirements to be stronger and to be made mandatory for more firms, given the ambition of the TPT’s proposals. The Government’s forthcoming consultation should provide more clarity on these issues.

The Government will work with the FCA to ensure transition plan requirements are delivered across the financial services sector alongside similar requirements for listed and private companies. It intends to advocate for international alignment and encourage other jurisdictions to mandate transition plan requirements. However, without detailed transition plans across sectors, it is going to be even more difficult for regulated financial services firms to source accurate data for their scope 3 emissions.

Given significant market uncertainty around the methodologies used to generate and report scope 3 GHG emissions data, the Government will launch a call for evidence to explore how to support scope 3 reporting. However, this again indicates that getting accurate data and meaningful resources for financial services firms on scope 3 emissions is going to take some time unless large and listed companies take the lead first.

The current TCFD-aligned disclosure requirements on transition plans put in place by the FCA and Government form a patchwork of sometimes overlapping rules. While the Government states that its new rules will apply to the UK’s largest companies, we will need to wait for its consultation to understand the exact scope and how it will interact with the current regimes. However, it appears to be following a similar approach to the EU under the Corporate Sustainability Reporting Directive, by focusing on the largest companies and states that ‘the vast majority of companies will not have additional burdens placed on them’ by the proposals.

There is likely to be increasing focus on climate adaptation, nature, and social impacts, as the TPT moves on to its second phase of work.

ESG ratings providers

With the intention of ensuring transparency and good market conduct, HM Treasury is consulting on bringing ESG ratings providers within the regulatory perimeter. Under the proposals, there would be certain exclusions e.g. for not-for-profit entities, or where asset managers create ratings for internal use only. The proposals would capture the direct provision of ESG ratings to users in the UK, by both UK and overseas firms, and smaller ESG ratings providers may be subject to fewer or less burdensome requirements.

The Government’s intention would be to capture a wide range of ESG ratings used in relation to specific investments, regardless of their name or how they are marketed, or whether assessments are produced by analysts or algorithms. Whilst discussions on ESG data and ESG ratings often go hand in hand, HM Treasury’s proposed scope would exclude ESG data provision where no assessment has been carried out on it (e.g. unprocessed or minimally processed raw data).

The new regime would be one of the first of its kind globally, but we are only at the start of the process and the timings are currently unclear. Once HM Treasury has established the regulatory perimeter, the FCA will then consult on the detailed requirements. The FCA has already indicated that it is likely to take the main elements of IOSCO’s recommendations as a starting point for its rules. An industry-led ESG Data and Ratings Working Group, set up by the FCA at the end of last year, will also develop a voluntary code of conduct for ESG data and ratings providers.

Broader investment and stewardship

The Government notes that as providers and allocators of capital, the UK pension, insurance and investment sectors can influence the businesses in which they invest.

The insurance sector is singled out as one area where the Government identifies long-term investment opportunities. The Government expects the insurance industry to play a significant role in supporting the net zero transition by making investments that target sustainable business models, providing insurance products that support climate change adaptation, and underwriting key risks in the project development process. The UK Solvency II reforms aim to incentivise the insurance industry to invest in long-term productive assets, including innovative green assets and renewable energy infrastructure. Together with industry and the regulator, the Government will begin to implement these reforms in the coming months. Defined Contribution Pension schemes are also identified as another means to invest in illiquid assets (including green projects).

The Government will work with the FRC, FCA, DWP and The Pensions Regulator to review the regulatory framework for effective investor stewardship, including the operation of the Stewardship Code, in Q4 2023. In particular, the aim of the review will be to assess whether the Stewardship Code is creating a market for effective stewardship, and whether there is a need for further regulation in this area.

Voluntary carbon markets

The Government wants to ensure that voluntary carbon markets play a greater role in the transition to net zero, while ensuring that companies are not incentivised to use credits as an alternative to reducing their own emissions. This is a difficult balance to achieve.

The Integrity Council on Voluntary Carbon Markets published their Core Carbon Principles last month, and the Voluntary Carbon Markets Integrity Initiative intend to consult on guidance in the first half of this year. The Government will consider how both initiatives might serve as a basis for international best practice on market integrity, and the extent to which it could be incorporated within relevant regulatory regimes, including through a consultation later this year on mobilising finance through high-integrity voluntary markets.

Conclusion

The Government has affirmed its commitment to the green agenda and underlined its desire to align with international frameworks. It is clear that autumn 2023 will be a critical time for firms to consider their approach to sustainability as the Government has indicated this is when it will consult on transition plans and a UK Green Taxonomy. We are also expecting the FCA to make its policy statement on fund labels around then.

While there is nothing ground-breaking in the revised strategy, what is clear is that the Government is reliant on various industry-led initiatives and investment strategies to drive change. Financial services firms should therefore take the initiative and establish a pragmatic approach to investment strategies and disclosures, to influence progress and guide where regulation would reach a sensible, yet meaningful, balance.