ESG matters remain of fundamental importance to financial institutions as they navigate the transition to net zero appropriately, manage risks relating to ESG across the wide range of their businesses and capitalise on the opportunities presented by the increasing demand for sustainable products and services. From a regulatory and litigation perspective, this was the year that several key ESG-related regulatory policies for UK financial institutions were finally articulated, and some long-anticipated risks began to crystallise. In this post, we’ve highlighted some of the most important themes and developments during 2022 and set out our views on the way that they will shape ESG matters for financial institutions in 2023.
Regulation and enforcement actions focussed on preventing greenwashing
The prevention of greenwashing has remained a priority for the FCA this year, in particular given its focus on building trust in the UK’s sustainable investment market and protecting consumers and other investors from potentially misleading advertising. Avoiding criticism for greenwashing can be challenging for firms where the meaning of some ESG-related labels is open to interpretation and there is no formal classification system, or where investors misunderstand the way in which the investment contributes to the sustainability agenda.
The development of the UK’s Sustainability Disclosure Regime has been some time in the making, but in October this year the FCA published its consultation paper on the disclosure and labelling requirements that it intends to introduce (see here for our article summarising the consultation paper). The requirements build on the implementation by the FCA of TCFD disclosure requirements, which we considered in a separate note here. There will be a broad anti-greenwashing rule applicable to all regulated firms, which is expected to be implemented first in June 2023 on the basis that it clarifies existing regulation. The balance of the requirements is primarily directed at asset managers and distributors and will be implemented in 2024 and 2025. The requirements comprise a labelling and classification regime for investment products, together with additional disclosure and naming and marketing rules. The FCA intends to expand the regime over time.
Importantly, the proposed regime leaves significant areas open to firms’ judgement. It remains to be seen whether it achieves the right balance between protecting investors and allowing firms the scope needed to develop sustainable products and services, so that firms’ aspirations in this area are not discouraged.
In making its proposals, the FCA has attempted to achieve coherence (where possible) with other regimes, including the EU’s Sustainable Finance Disclosure Regulation and proposals by the Securities and Exchange Commission (SEC) in the US. Firms will be aware that the SEC has already taken action against two financial institutions this year for perceived inaccuracies in the way that certain ESG funds were marketed.
At a more general level, over the past few years there have been actions taken in the UK against non-financial institutions on the basis of perceived inconsistencies between the type of business being advertised and its climate goals and/or impact, and this general trend made its way to the financial sector this year in the form of an action by the Advertising Standards Authority against a UK financial institution.
Guidance in relation to transition plans and integrity of capital markets during the transition
The way that institutions make the transition to net zero, what they disclose about their transition plans, and the proper functioning of the markets throughout that transition also remained a core area of focus this year.
In November, the Transition Plan Taskforce (TPT) released its consultation papers on its draft framework for disclosure of transition plans and guidance on implementing them. The TPT’s work is designed to help UK-listed companies and financial institutions to produce the transition plans they will be required to disclose from next year on a “comply or explain” basis. The FCA is involved and will draw on this work to strengthen transition plan disclosure rules for listed companies and financial institutions. In very brief terms, the TPT will recommend that transition plans include an institution’s high-level ambitions to mitigate, manage and respond to the changing climate; short, medium and long term actions that the entity plans to take to achieve its strategic ambitions, together with details on how these steps will be financed; governance and accountability mechanisms that support delivery of the plan, together with robust periodic reporting; and measures to address risks and opportunities which may arise as part of these actions. The TPT has also set out practical guidance on preparing credible plans (including, for financial institutions, a recommendation to consider four financing strategies to support economy-wide decarbonisation), as well as disclosing those plans. The framework and final guidance will be published in spring / summer 2023.
ESG data and ratings is another area which has been scrutinised for some time, given the huge variation in approaches taken by providers and the potential impact of inconsistencies on the smooth functioning of the markets. The FCA has made no secret of its desire to regulate ESG data and ratings providers in the UK. In its Feedback Statement on ESG integration in Capital Markets in June this year, it points to the very high use made of ratings products (for example, over 90 percent of large banks and asset managers it surveyed use ESG ratings products to support investment analysis and decision making, and three-quarters use them as an input to the construction of a benchmark index referenced in their investment products and/or client mandates), together with the very low correlation between different providers’ ESG ratings on any given entity. The FCA notes the potential for harm that this presents if providers are not transparent about their methodology, do not determine their outputs using robust processes and controls, do not identify and manage conflicts of interest, and do not operate with good governance. In November this year, the FCA announced the formation of an industry-led working group to develop a code of conduct for ratings providers to follow on a voluntary basis. As part of the Edinburgh Reforms announced in December this year, the government has stated that it will consult in early 2023 on bringing ESG ratings providers within the regulatory perimeter in order to ensure improved transparency and good market conduct.
Maturing of ESG-related litigation
There were fewer new ESG-related decisions with a financial services element this year globally than previous years, but decisions made tended to address more complex questions. One high-profile case in Europe was withdrawn, and others have continued.
This year for the first time we have seen the English courts address the important question of how pension funds, charitable trusts and other investment vehicles balance their financial and other objectives with sustainability objectives. Judgments in both Butler-Sloss v Charity Commission and McGaughey v Universities Superannuation Scheme Limited were handed down during summer this year; although they concerned different legal frameworks (one relating to charities, the other pensions), they highlighted the difficult balancing act that trustees face when exercising their investment powers. The fact that the Court found in favour of the trustees in both cases illustrates the scope that trustees have to operate in the current environment provided that they have exercised their discretions properly. Our full article on the two cases is here.
In terms of potentially influential cases outside the UK, ClientEarth’s appeal in its case against the National Bank of Belgium was withdrawn in November this year, on the basis that ClientEarth considered that the ECB’s updates in September to the policy on its Corporate Sector Purchase Programme remedied the specific harms targeted by the action; the new policy tilts corporate purchases away from companies with poor climate performance. Other cases outside the UK that financial institutions will have been following with interest are continuing through disclosure procedures and/or amendments to statements of case, such as the class action in O’Donnell v Commonwealth of Australia concerning the non-disclosure of climate risk in sovereign bond documentation, and Abraham v Commonwealth Bank of Australia, concerning the disclosure of the bank’s documentation around investment decision-making in light of its climate commitments.
Outside of a financial services context, ClientEarth announced in March this year that it is taking legal action in the UK against the directors of Shell; to date, it has notified Shell of its claim, which it has framed as a derivative action against the directors for breach of their duties by failing to properly manage climate risk and the transition to net zero. If proceedings are ultimately filed, this case will be watched closely given that it is the first of its kind in the UK.
Looking ahead to 2023
Next year, we expect there to be continued focus on sustainability and potential greenwashing at both product and entity levels. As time goes on, clearer and more detailed product disclosures should give investors better visibility about the sustainable characteristics of products but will also enable them to challenge firms where they believe that the product’s aims have not been achieved, which may in turn lead to challenges about entity-level disclosures and the firm’s approach to ESG more generally. Regulators will be monitoring this area closely, but with a view to encouraging the development of the UK’s sustainable finance market as well as building trust in it.
There will also be an intensified focus on the quality of firms’ transition plans as they become mandatory and regulators, action groups and investors have the opportunity to scrutinise them, test them against each other and form views on feasibility. These transition plans should begin to have a greater impact on firms’ values too, although the global context (including factors such as the energy and cost of living crises) will mean that the financial impact of sustainability factors is a nuanced calculation. Finally, we do expect some of these difficult questions to be brought before the courts, whether in the UK or in other jurisdictions, and note that these types of claims may well be brought as a collective action.
Overall, given the substantial commitment that financial regulators and institutions in the UK have demonstrated in relation to sustainability, we expect the pace of development to continue on all fronts.