FCA tests water on broader integration of ESG considerations in financial services firms

The FCA has published a new Discussion Paper (23/1) “Finance for positive sustainable change”, which aims to prompt dialogue about how regulated firms integrate sustainability considerations into their business, focussing on firms’ governance arrangements, incentive structures and competencies.  When it was published, the FCA’s Director of ESG, Sacha Sadan, noted that although significant progress has been made in the financial sector, there is much more to do to drive positive, sustainable change – including “closing the say-do gap” and “mov[ing] from well-meaning commitments to action”.

The Discussion Paper draws together some of the existing initiatives in the area, and then seeks specific feedback on a number of issues, which will shape the FCA’s future regulatory direction. The FCA is keen to emphasise that the scope of the discussion is to extend beyond climate change, and cover wider environmental issues, such as biodiversity and nature, as well as social and governance issues, such as diversity and inclusion, the living wage, fair taxation and supply chains. 

The paper is in line with the FCA’s 2021 ESG strategy, but is the first time the FCA has examined the topic of sustainability with such a broad lens.  The PRA already expects firms to integrate climate risk matters into their governance and risk management arrangements, and the FCA has already warned firms generally about greenwashing (and is introducing new rules to make this expectation clearer, which we considered in a separate post).  However, if the FCA does introduce complementary rules and guidance in the areas it is focussing on in the paper in the wider sustainability context then this will represent another step-change for firms.  

What does the Discussion Paper address?

The paper is divided into four substantive parts.

The first part examines how existing initiatives set the framework that guides the FCA’s thinking on how firms’ governance, incentives and competencies may need to change – including recommendations from the Taskforce on Climate-related Financial Disclosures, and the work of the International Sustainability Standards Board, the UK’s Transition Plan Taskforce, and the Glasgow Financial Alliance for Net Zero. The FCA draws on examples from these initiatives throughout, and it is clear that transition planning has been a particular influence on the FCA’s work.

The second part considers sustainability-related governance, remuneration and incentives, including how firms embed sustainability into their purpose and objectives, and how they are then reflected in its culture, business strategy, governance and incentives.  In this section, the FCA notes that it expects firms to develop and articulate a credible strategy to deliver on their public sustainability-related commitments (e.g. without greenwashing).  The role of asset managers and owners and the governance of investor stewardship is also considered specifically.  

The third part examines the importance of training and competence. The FCA recognises the need to build capability across the financial sector and wants input on where knowledge gaps exist and how they might be closed. The paper underscores that delivering on sustainability objectives may require fundamental changes in firms’ decision-making processes, to include new committee and working group structures, a refresh of MI, and potentially entirely new systems and controls to ensure audit adherence.

The fourth part of the paper is a series of 10 commissioned articles with perspectives from experts. The FCA intends the articles to assist firms in reflecting on the themes identified in the Discussion Paper and encourage them to review their practices without regulatory change.

Highlights of the Discussion Paper

The overarching theme of the Discussion Paper is that a healthy culture in firms drives operational performance which meets customer needs and results in shareholder value; culture is described as “an enabler”.  The FCA considers the four key drivers of culture to be purpose, leadership, governance and the way that a firm rewards and incentivises its people, and it asks for feedback on whether a specific expectations and guidance on culture would help drive sustainable, positive change. 

Some of the other most interesting aspects of the Discussion Paper are:

• Importance of board-level skills and engagement: The FCA notes that ultimately the entire board is responsible for ensuring it has the appropriate skills and knowledge to lead and challenge the company in connection with its sustainability-related risks, opportunities and ambitions.  This may mean having members of the board with a background or expertise in sustainability-related matters, or that the board has access to that expertise either internally (such as via a sustainability committee) or externally.  The FCA wants feedback on whether it would be helpful for it to set guidance on board skills and knowledge in this context, and wants to understand what further governance and organisational structures are in place across firms to manage sustainability considerations (including what type of management information is being used). The FCA is also considering whether it should introduce new regulatory expectations or guidance on senior management responsibilities for a firm’s sustainability related strategy, including the delivery of the firm’s climate transition plan.
• Remuneration and incentives: The FCA acknowledges that firms are increasingly linking rewards to sustainability-related metrics, although it cautions that the effectiveness of these mechanisms will depend on how they are designed.  It suggests that firms may wish to consider whether remuneration and incentive plans emphasise the most important sustainability-related objectives, and that firms should not remunerate those which are easily achievable through normal business (such as health and safety related targets).  It also suggests thinking about linking rewards to sustainability throughout the firm, rather than just at senior management level, and how firms can consider remuneration and incentive plans in the design and delivery of their transition plans. Feedback is requested across all of these matters.
• Training and knowledge gaps: The FCA expressly recognises the need for genuine capability-building across the financial sector, including staff training on climate change and net zero, and sustainability more broadly.  It has started to explore the training and competency gaps at firms in the context of sustainability; the main gaps identified so far were on ESG data and metrics, key definitions (such as “responsible investment”, “impact investing”) and a lack of expertise that cuts across sustainability topics, as an expert in one area (such as climate change) may not have expertise in others (such as biodiversity).  The FCA wants to understand what other training and competency gaps firms have discovered, and whether additional guidance or regulatory expectations from the FCA would be useful.
• Product governance: The FCA rules do not currently include explicit reference to sustainability in relation to product governance, although appropriate governance around sustainable investment products is being considered as part of the FCA’s consultation on a disclosure and labelling regime (CP 22/20, which we considered here). The FCA is considering whether there is a need for specific regulatory expectations or guidance on product governance and oversight in respect of the sustainability characteristics of both products and services offered by firms.
• Interaction with new Consumer Duty: The FCA makes clear that there is overlap between the new Consumer Duty and the topics of the Discussion Paper, as governance is at the heart of the Consumer Duty, and as it will focus firms’ minds on their culture and help them think about how their culture and behaviours support positive outcomes for consumers.  However, the FCA is considering whether it needs to go beyond its work in that area and introduce further regulatory expectations or guidance.  

Next steps

ESG developments generally are turning from a focus on disclosure regimes and risk management to a focus on governance and accountability, and the FCA’s Discussion Paper tracks this trend.  The consultation runs until 10 May 2023.  The FCA has indicated that it will consider the feedback it receives alongside further analysis and supervisory engagements with firms in assessing whether to make any regulatory changes.