January 7, 2022
Estimated reading time: 6 minutes
Are financial services prepared for new ESG regulations?
There are currently more than 200 environmental laws for financial services across the world.
But for today’s banks, FinTechs and investment houses, the question isn’t about what ESG regulations are already in place. After all, these laws and regulations should already be neatly embedded within your company’s framework by now. The real question is, what sustainable and ESG (environmental, social, governance) requirements are lurking around the corner? What will the next major upheaval be for compliance teams?
EU Taxonomy & EU Sustainable Finance Disclosure Regulation
Do you use the word “sustainable” in your content and product material? Before you send it out to clients, have you triple-checked that the information you share about your product meets the official EU sustainability criteria?
Just because your investments or financial service may reduce some harm to the planet, does not make it “sustainable”, according to the European Commission. That’s the major change this legislation is introducing.
In the past, your marketing team could decide what words they wanted to use. “Sustainability” was so subjective, it hardly mattered. Nowadays, however, it does.
The Organization for Economic Co-operation and Development (OECD) estimate that ordinary people and governments will need to put an eye-watering €6.35 trillion into truly “sustainable” investments before 2030 if we have any chance of meeting the net-zero goals. So now, the words financial services use matter. A lot.
If you sell your product to member states in the EU, you should ensure that you meet the strict requirements set out in the regulations.
Sustainable taxonomies and ESG regulations outside the EU
Elsewhere in the world, it’s expected that similar taxonomy ESG regulations will soon be enshrined in law too.
Some forward-thinking countries have had preliminary taxonomies in place for a while now. For example, Japan famously launched its Green Bond Guidelines in 2017 and the Netherlands have had green lending definitions since 1995.
However, over the past year, things have started to heat up and many more countries are getting serious about what financial services say about “sustainability”.
In April, the US entered talks with France about a common set of sustainable definitions in finance. Canada, Kazakhstan and Indonesia have also started building their own taxonomies, to ensure that financial services are held to account.
And in the UK, the government have confirmed that there will be a ‘Green Taxonomy’ for financial services, which will likely be aligned to the EU version.
Sustainable and ESG amendments to MiFID II/MiFIR
Most compliance teams will remember the painful admin headache that was MiFID II. Every piece of marketing material and sales pitch needed to be edited or checked to ensure it aligned with the strict new rules. For many firms, this amounted to thousands of documents.
In April 2021, the European Commission announced further amendments to MiFID II, as well as others including UCITS, AIFMD and the insurance regimes. These amendments are all about sustainability and environmental, social and corporate governance (ESG) factors.
If the regulation passes, firms will be obliged to make a sustainability assessment for each client. So, if your client or customer wants to invest in, for example, protecting the climate, a portion of their money must go towards that – as measured and defined by the EU Taxonomy. Regulators will clamp down on firms to make sure that if their client wants sustainability, they’ll get it.
Alongside this, we could expect to see much stricter rules around greenwashing as part of the MiFID II transparency requirements. So, if you’re touting slippery oil companies, deforesting fast food chains or any other questionable companies in your ESG products, you could now find yourself in hot water.
Advisers will also be forbidden from recommending investments or services which go against the client’s sustainable preferences. They cannot try to convince customers that something is sustainable if it is not or encourage them to move away from their sustainable goals for profit.
Likely climate risk amendments to BASEL III
Global international banking regulation is overseen by the Basel Committee on Banking Supervision. The majority of developed countries have already adopted the Basel III framework into their national legislation. This means that banks need to follow the Basel III rules by law. So far, environmental requirements remain few and far between, mainly requiring banks to assess the environmental impact of a few of their dealings, such as credit and operational exposures. Nothing too heavy.
But change is afoot. Basel III has been severely criticized by academics for not doing more to protect the climate. And it looks like they’re responding to the feedback.
On the 14 April 2021, the Basel Committee published two reports on how banks are driving climate change, and how they can measure the risks. You can feel it in the air, things are about to get a lot greener around here…ESG regulations are on the horizon.
Banks who cannot keep pace with the upcoming legislation could feel the sharp sting of the regulator, alongside reputational risk in line with shifting public opinions.
We don’t have a crystal ball… but we do have the EU
The EU has long been a trailblazer in regulating sustainable finance. And as we’ve seen time and time again, where they lead, the rest of the world follows.
Take the EU Emissions Trading System for example. In 2005, the EU created a way to monetize and reduce the amount of carbon companies can emit. Fast-forward to today, and more than 50 jurisdictions have adopted the same approach, developing their own carbon markets.
In December 2019, the EU presented it’s ‘Green Deal’, it’s trillion-euro strategy to become carbon-neutral. The deal will revolutionize the legal landscape. And as a big part of that, the strategy specifically ear-marks financial services as the best route to achieve their goals. For banks, financial services and insurance companies over the next year – expect to see a swathe of new climate regulation.
Sure enough, the rest of the world is doing the same. China created its rigorous strategy to become carbon-neutral, with the People’s Bank of China laying down the ‘Guidelines for Establishing the Green Financial System’. US President, Joe Biden has pledged dramatic reforms for greening the economy. Singapore is arguably the most advanced, with its 2017 ‘comply or explain’ regime for sustainable reporting (picked up by the FCA in January 2021).
For UK banks, financial services, and insurance companies, the change may be even more dramatic. In April 2021, the UK government became the first in the world to enshrine carbon emission reductions in law. It’s set an extremely ambitious target to cut emissions by a whopping 78% before 2035. This will undoubtedly change the future of finance.
Governments will try to make sure that their laws and standards match-up to avoid repeating work across different countries. But almost inevitably, there will be huge workloads for financial services as they try to meet the deadlines of different standards and different jurisdictions on time. Getting ahead now will surely separate the winners from the losers.
At the beginning of the year, we published a report, ‘What’s on the horizon for regulatory change in 2021?’. In that report we predicted that 2021 would see a seismic shift in the global regulatory approach towards ESG. Following numerous speeches, consultations and industry murmurings – we knew that change was afoot. As we approach the halfway point of 2021, it’s clear to see that this prediction has now become a reality. Governments, regulators and financial organizations are making bold new promises to tackle climate change.
These are exciting times, driven by shifting societal attitudes and the threat of future devalued assets. However, the shifting landscape won’t be free of challenge, especially for compliance teams who will now have a new wave of regulatory developments to track and implement. Alongside major industry shifts – from Brexit to Biden – this may seem like a difficult mountain to climb. Teams that have automated their compliance programs and taken the bold leap towards embracing AI-powered solutions will likely have the upper hand.