The European Banking Authority (EBA) recently launched a public consultation on draft Guidelines on the management of Environmental, Social and Governance (ESG) risks. The draft Guidelines set out requirements for institutions for the identification, measurement, management and monitoring of ESG risks, including through plans aimed at addressing the risks arising from the transition towards an EU climate-neutral economy. The consultation runs until 18 April 2024.
Climate change, environmental degradation, social issues and other environmental, social and governance factors are posing considerable challenges for the economy that impact the financial sector. The risk profile and business model of institutions may be affected by ESG risks, in particular environmental risks through transition and physical risk drivers.
The principles the EBA are proposing would be a game changer for financial institutions operating in the European Union.
Some of the main proposals include:
- ESG risks should be fully integrated into the institution-wide risk management framework including credit, market, operational, reputational, liquidity, business model, and concentration risks.
- ESG materiality should be performed annually and a risk mitigation plan should be developed for the short, medium and long term, including a time horizon of at least 10 years.
- Financial terms and/or pricing should be adjusted to account for ESG risks.
- ESG risks should be part of risk management strategies including policies, limits and risk appetite.
The consultation paper can be found here.
Importance of ESG Regulation Alignment
Environmental, Social, and Governance (ESG) has become an important topic across business. It has become an increased priority, not only to meet customer demands, but also an increasingly complex regulatory environment. Regulators around the world are expanding the legal frameworks around ESG. The EU’s European Sustainability Reporting Standards (ESRS) is probably the ESG regulation at the top of the priority list for many, but there are several others on the horizon.
The EU has put in place a world-leading regulatory rulebook for sustainable finance. To make this work more standardised and high-quality, ESG data from corporates is required. The EU’s rules on sustainability disclosures aim to achieve that, but there is a politically motivated push to water those down. The lack of standardisation makes ESG processes more complex as companies try to assess and adhere to the rules of the various countries they are engaged in. Work towards a standardised ESG framework is already underway. The International Sustainability Standards Board (ISSB) was created in 2021 with the aim of bringing some consistency to ESG reporting space. The body recently teamed up with the Global Reporting Initiative to create common ground for Asian companies to report on their environmental, social and governance impacts.
The ESG landscape is evolving fast and is likely to look very different in the near future. Over the next five years, disclosure and ESG data quality will continue to be a high priority for regulators around the world. It is likely some regions will align with international standards and others will follow the EU’s best-practice approach. A global alignment on ESG reporting though would seem to make sense for all.
Codes of Conduct Drive Best Practices
Last week, the LSEG hosted an event to launch the Code of Conduct for ESG Ratings and Data Products Providers. This is an international voluntary code that puts forward six best practice principles, which are based on and fully aligned with IOSCO’s recommendations, promoting global consistency in policy frameworks for ESG ratings and data.
The Code of Conduct has been created by an industry-led working group and was launched on 14 December 2023. It is grounded in the recommendations published by the International Organization of Securities Commissions (IOSCO), with a focus on promoting transparency, good governance, management of conflicts of interest, and robust systems and controls. As such, it is intended to be internationally interoperable and could be used by jurisdictions where no local Code or regulation is in place.
Norges Bank Investment Management (NBIM), who are responsible for the management of the Norwegian Government Pension Fund, in a recent paper on ESG ratings cited a few developments in the space to watch. The market and regulatory standards for ESG ratings are evolving rapidly, and their view may change accordingly. For now, they will play close attention to the following:
- Regulatory developments on ESG ratings, such as legislative initiatives, and adoption of best practices across key markets.
- Introduction of mandatory sustainability disclosure requirements, which can result in more reliable and comparable data inputs for rating providers’ methodologies.
- Monitoring research and market driven developments such as consolidation between providers or rated entities.
NBIM made a number of recommendations including that ESG rating providers should provide rated entities with an opportunity to correct any factual mistakes contained in the published explanation of their ESG rating. That the rating providers should collect information from publicly disclosed reports rather than ad-hoc questionnaires whenever possible, to avoid unnecessary complexity and reporting burden for companies. Also, that rated entities should be encouraged to publish the data provided to rating providers, where this information is not available in public reports.
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