How financial institutions can keep up with ESG requirements

Financial institutions (FIs) are facing yet another demanding year when it comes to environmental, social and governance (ESG) requirements in the EU and UK. In a difficult economic and geopolitical environment, the challenge for FIs is not only to stay on top of ESG policy and regulatory changes, shifting stakeholder sentiments and supervisory expectations, but to stay one step ahead. 

One aspect of this challenge that will continue to feature prominently in 2023 is ESG regulation. The scale and complexity of ESG regulation is impacting all parts of an FI’s business, from the board to the back office, and will continue to do so for the foreseeable future. When considered in the broader context of the ongoing focus on ESG — evidenced not only by public statements of prioritisation by regulators and stakeholders, but also by the significant litigation and regulatory enforcement over the past few years — FIs need to be preparing now for these regulations. This means strategic planning, capacity building and resource allocation.   

In the EU, regulatory developments will include the Corporate Sustainability Reporting Directive (CSRD), which entered into force in January 2023. In the course of this year, the draft sustainability reporting standards will be finalised (albeit with more to come) and we can expect to see implementation by member states (to be completed by July 2024). CSRD will transform sustainability reporting and the scale of the implementation task should not be underestimated. The EU Taxonomy is expected to be finalised this year, with potential clarification of key concepts, although the exact path and timing for these are not yet clear. Provisional political agreement has recently been reached on the EU Green Bond Standard and detailed documentation is to follow. 

In the UK, the government has made clear its intention to adopt the International Sustainability Standards Board (ISSB) standards and entities are already being advised to prepare for this. The sustainability disclosure requirements (SDRs) are expected to be finalised, at the earliest, this year. While the UK government has said it will not be following the EU’s lead on human rights due diligence regimes or bond standards, the UK Green Taxonomy remains on the agenda. 

Biodiversity, nature-related risks and the need for disclosures, targets and funding are firmly on the EU’s and UK’s radars. FIs should be preparing for more requirements and stakeholder focus on biodiversity risks and opportunities, particularly with the Taskforce on Nature-related Financial Disclosures framework being finalised in September.  

Environmental financial risks and prudential regulation are also set to be a hot topic for 2023, and FIs will want to closely monitor developments. This includes the European Banking Authority’s final report on incorporation of environmental financial risks into the Pillar 1 prudential framework. The Bank of England can also be expected to clarify its current thinking following its climate and capital conference in October 2022.  

A particular challenge for groups which are active both in the European Economic Area and the UK will be the continuing divergence between the regulatory frameworks. Even in areas such as non-financial reporting, where a degree of alignment is to be expected, given the ISSB and European Financial Reporting Advisory Group’s close exchange of information in order to promote the harmonisation of standards, there will still be uncertainties and deviations.

Different regulatory approaches are reflected in the level of detail, as well as conceptually. For example, in the concepts of materiality and application of requirements to the value chain. Or as demonstrated in the contrast between the Sustainable Finance Disclosure Regulation and the draft SDR, the latter being fundamentally a labelling rather than disclosure regime, and which has not incorporated ‘do no significant harm’ or principle adverse impact requirements, which could lead to a less restrictive qualification of ‘sustainability’ in the UK. 

FIs will also need to consider those aspects of ESG regulation that may require changes to the way they operate, transact or report, or where significant work may be required for effective implementation. This includes:

• The implementation of due diligence regimes under the draft Corporate Sustainability Due Diligence Directive and national regimes, such as those in Germany and the Netherlands; 
• The development and implementation of transition plans — an area of focus in 2023, particularly in the UK where ambitious gold standards are being developed by the Transition Plan Taskforce ahead of anticipated new mandatory requirements for transition plans;
• The focus on climate change scenario analysis and stress testing. While already a known challenge, the supervisory expectation is clear that FIs must improve capabilities in this area so as to support decision-making. 

Against this background, the building of ESG-related capacities and competencies will become even more relevant in 2023. As regulators will expect further progress in identifying, monitoring and managing ESG-related risks, keeping track of the ever-changing regulatory framework and implementing the new developments in their strategic approaches will be key for FIs. 

Frederik Winter (Germany) and Kim Rybarczyk (UK) are a partner and counsel, respectively, in the global ESG team at Linklaters.