Key takeaways
Welcome to our wrap-up of major events from the end of 2022 and view of key regulatory trends and moves in the year ahead.
In this edition, we review COP27 and COP15 and look at how the importance of nature and biodiversity are rising up the agenda.
We also look at how various environmental, social and governance (ESG) strategies stack up to show that the rules work well for some types of strategies but not for others.
Welcome to our wrap-up of major events from the end of 2022 and look ahead at some key regulatory trends and moves in the year ahead. It’s a blockbuster mid-winter playbook, so let’s get cracking!
Can you COP?
Driving ESG news in November and December was undeniably COP27, and perhaps for some, the lesser known but no less important COP15.
Despite low expectations going into the COP27 negotiations, the session went into overtime and a penalty shoot-out to land a historic deal on loss and damage, which will see the creation of a fund to help poorer countries impacted by climate change impacts. The details of how this will be financed are yet to be thrashed out though.
Beyond the headline-grabbing announcement on loss and damage, another key element in the final cover note from COP27 hints at nature increasingly rising up the agenda. In particular, the Sharm El-Sheikh Implementation Plan (as the final communique is known) specifically called out water and oceans, forests and deforestation and agriculture as key areas for further work. This ties in with announcements made in the margins of COP where Brazil, Indonesia and the Democratic Republic of Congo (DRC) announced a strategic alliance on rainforests, dubbed the “OPEC for rainforests” while the UN launched “FAST” to increase climate finance contributions for agriculture and food systems.
This created a natural segue into the “other COP” taking place in Montreal in December where it was hoped that a landmark deal for nature akin to the Paris Agreement would be struck. While the deal was perhaps not as ambitious as campaigners had anticipated, a target to preserve 30% of the world’s land and water habitats was agreed. The deal included a total of 23 separate targets. These include halving food waste and introducing biodiversity reporting by companies and financial institutions.
A view from Invesco
Confused about the EU Taxonomy? We provide a more practical perspective on the implications of setting EU Taxonomy alignment thresholds for investment portfolios. A key finding here is that even a moderate Taxonomy alignment of 30% at portfolio level would lead to a very concentrated portfolio of around 75 stocks and significant tracking error. Increasing Taxonomy alignment also has portfolio implications for fixed income portfolios, including increasing duration risk and lower credit quality.
More on European sustainable finance developments
When it rains, it pours: As firms enter the final furlong for their EU’s Sustainable Finance Disclosure Regulation (SFDR) implementation in advance of the end of year deadline1, the European regulators published a deluge of consultations and documents to add to the workload. The biggest one was the European Securities and Markets Authority’s (ESMA) surprise consultation to introduce minimum requirements for ESG funds2.
This would require funds with ESG in their name to ensure that the ESG investment policy applied to 80% of the assets of the fund. It also included an extensive list of minimum exclusions and for those using the term “sustainable” to include 50% sustainable investments3. While many might grumble that these rules raise the bar, they are at least better than the eco-label the European Commission had been working on (and seems to have quietly shelved). ESMA found that this would have resulted in only 0.5% of the market achieving the label.
To complete the hat trick, the European Supervisory Authorities (ESAs)4 have also published an extensive range of FAQs on SFDR and a consultation on “greenwashing” in the industry5. Perhaps the one glimmer of good news is that the ESAs have notified the European Commission that the review of the principle adverse impacts (PAIs) that was due in April 2023 has been delayed by six months6.
I got 99 problems and the ESRS is one: Or 84 to be precise. Just as the Corporate Sustainability Reporting Directive was finally ratified by the EU, the European Financial Reporting Advisory Group (EFRAG)7 has now published its final advice on the sustainability reporting standards underpinning the regime8. Investors have been clamouring for more and better ESG data but perhaps the European Sustainability Reporting Standards (ESRS) proves that you can have too much of a good thing?
Responding to concerns about the deluge of data required, EFRAG has vaunted the simplification of the final rules compared to the draft text. It has reduced the number of disclosure requirements from 136 to 84 and the number of quantitative and qualitative datapoints from 2,161 to 1,144. But that’s still a lot of disclosure!
The additional phase-in of between 1-3 years will only slightly alleviate some of the pain for corporates. Of course, this isn’t the final word on this, as the advice still needs to be approved by the European Commission and stakeholders therefore still have the chance to put the case for greater simplification and further alignment with the upcoming International Sustainability Standards Board (ISSB) standards.
In other news, the UK Financial Conduct Authority (FCA)9 has published findings for the first round of reporting under the new TCFD reporting requirements. It announced plans to align the regime with the new ISSB standards, as well as moving to a mandatory basis for compliance.
Not seeing the wood for the trees: The Platform on Sustainable Finance 1.0 published its final report with some additional criteria for the four nature-related objectives as well as some broader recommendations to the European Commission10. However, the divisions within the Platform that have led to some members walking out are also in evidence here, with a dissenting opinion from some members to the proposed forestry criteria. The Platform also re-emphasised the theme from its previous reports about the practical problems with the ‘do no significant harm’ (DNSH) criteria.
In related news, the European Commission also published two guidance notes to help firms prepare for the reporting on Taxonomy alignment in 2023.
You can bank on it: The European Central Bank (ECB) has published their findings of their thematic review of banks’ approaches to climate and environmental risk. The conclusion was “could do better”11. Although 85% of assessed banks had made improvements since last year, a small minority had done little to address the ECB guidance.
Of those that have been making progress, 60% were considered to have material blind spots in their analysis and 55% have policies in theory but questions remain as to whether they are applied in practice.
In a similar vein, the European Commission has asked the European Banking Authority (EBA) to consider how to define green loans and mortgages for retail and SMEs to provide greater access to green finance by the end of 202312. The EBA has updated its Sustainability Roadmap to reflect all the various strands of work they currently have on the go13.
Stressed out: The European Insurance and Occupational Pensions Authority (EIOPA) has published its findings from its 2022 climate stress test of European Institutions for Occupational Retirement Provisions (IORPs). The regulator found that, in its adverse scenario, climate transition risks could lead to losses of 12.9%, implying overall losses in asset valuation of €255 billion. But the EIOPA found that these losses would not impact the financial resilience of most IORPs, with most defined benefit schemes’ funding rations remaining above 100%14.
EIOPA has also published a discussion paper on how sustainability risks15 could eventually be integrated into the prudential treatment under Solvency II16.
Up to code: The FCA has announced that it will create a new Code of Conduct for ESG data and ratings providers. Led by the International Regulatory Strategy Group (IRSG) and ICMA, M&G, LSEG, Moody’s and Slaughter & May will co-chair the work17.
International developments
Trading carbon: The International Organization of Securities Commissions (IOSCO) is currently consulting on how to improve the functioning of carbon credit markets. This includes compliance carbon markets such as those for carbon allowances under the EU’s emissions trading scheme18, as well as scaling up voluntary carbon markets and carbon offsets19. While the issues in each market are slightly different, the central themes of transparency, the trading ecosystem and interoperability are common to both.
Taxonomania: The EU Taxonomy isn’t the only game in town. Both Malaysia and Australia have published drafts of their own taxonomies. The Malaysian Taxonomy is principles-based20 (as opposed to the rules-based approach in the EU) and covers both environmental and social objectives. The Australian project sets out recommendations for developing a project down under, including both entity and activity-level criteria and transition21.
Data, data, data: The Net Zero Public Data Utility has published its final recommendations on the content and functionality of an open data utility that would be free and accessible to all.
Switzerland has also introduced mandatory climate reporting based on the Task Force on Climate-Related Financial Disclosures (TCFD) for all large companies. The rules will be effective from 1 January 202422.
It’s all about transition: The Transition Plan Taskforce has published its final draft proposals for best-in-class transition disclosures. The framework, built around the three pillars of “Ambition, Action and Accountability” aims to build on the existing TCFD guidance on transition planning23.
In related news, the International Platform on Sustainable Finance has published its report on transition finance. It includes a mapping of existing frameworks and sets out a set of common principles for transition finance with a focus on robust transition targets and credible delivery24.
Climate and fiscal policy
When is a gas price cap not a gas price cap? The answer would seem to be when the triggers for it to apply are so high it never gets used. Or at least that is the criticism of several EU member states complaining that the European Commission’s long awaited “Market Correction Mechanism” has set the bar so high. It has a ceiling of €275 as well as other conditions that all but guarantees it’ll never be activated25. The final deal, reached in December, reduced this level down to 180 EUR, but is still well above current gas prices in the market26.
Fitfor55: The EU notched up several wins towards its climate neutrality target. Negotiations on some key files were concluded, including the revised Emissions Trading Scheme, the Carbon Border Adjustment Mechanism and the Social Climate Fund. There were also new rules to fast-track the deployment of renewable projects and ban products that contribute to deforestation.
Members states have also moved one step closer to an agreement on slashing methane emissions and introducing mandatory environmental and human rights due diligence for large companies.
Waste not, want not: the European Commission has proposed new EU-wide rules on packaging. These aim to reduce waste and include requirements on reusable packaging options. The hope is to get rid of unnecessary packaging, limit overpackaging, and provide clear labels to support correct recycling.
Valuing nature: The Biden Administration has unveiled a new roadmap for nature-based solutions that recommends that agencies update federal policies and guidance. This’ll make it easier to consider and adopt nature-based solutions. Major areas for advancement include policies and guidance for federal planning, permitting, cost-sharing, risk management, and benefit cost analysis.
Footnotes:
1 jc_2022_62_jc_sfdr_qas.pdf (europa.eu)
2 esma34-472-373_guidelines_on_funds_names.pdf (europa.eu)
3 ESMA 50-165-2329 TRV Article – EU Ecolabel: Calibrating green criteria for retail funds (europa.eu)
4 The ESAs are the European Banking Authority, the European Insurance and Occupational Pensions Authority, and the European Securities and Markets Authority
5 ESAs launch joint Call for Evidence on greenwashing (europa.eu)
6 JC 2022 64 Letter notifying of delay in SFDR mandate (europa.eu)
7 EFRAG is a private association established in 2001 with the encouragement of the European Commission to serve the public interest.
9 Primary Market Bulletin 42 | FCA
10 PLATFORM ON SUSTAINABLE SUSTAINABLE FINANCE: TECHNICAL WORKING GROUP (europa.eu)
11 Walking the talk – Banks gearing up to manage risks from climate change (europa.eu)
12 EBA Call for Advice Green Loans and Mortgages_Clean.pdf (europa.eu)
13 The EBA publishes its roadmap on sustainable finance | European Banking Authority (europa.eu)
14 2022 IORP Climate Stress Test Report | Eiopa (europa.eu)
15 Discussion paper on the Prudential Treatment of Sustainability Risks | Eiopa (europa.eu)
16 Solvency II sets out regulatory requirements for insurance firms and groups, covering financial resources, governance and accountability, risk assessment and so on.
17 Code of Conduct for ESG data and ratings providers | FCA
18 CR06/2022 Voluntary Carbon Markets (iosco.org)
19 CR07/2022 Compliance Carbon Markets (iosco.org)
Ordinance on Climate Disclosures (admin.ch)
23 TPT-Disclosure-Framework.pdf (transitiontaskforce.net)
24 International Platform on Sustainable Finance transition finance report – November 2022 (europa.eu)
25 New EU instrument to limit excessive gas price spikes (europa.eu)
26 Council agrees on temporary mechanism to limit excessive gas prices – Consilium (europa.eu)
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