Series 4 Episode 3 - Setting up for success: Driving value from sustainability regulation

Transcript

Andrew Strange: Hi everyone and welcome to our latest episode of Risk and Regulation Rundown, giving you our latest insight and analysis on hot topics of financial services risk and regulation. I'm Andrew Strange and I lead PwC's Financial Services Regulatory Insights team and I'm your usual host. In this month's episode, ESG is the prime topic for our agenda. In particular, we're actually going to talk about the E of ESG. With an increase in activity from the government and regulators, both in the UK and internationally, there's a lot for financial services firms to be thinking about in the months and years ahead. But it's not only financial services firms that are impacted by these changes, and in this episode we're going to take a look at what the E of ESG means for corporates and the wider economy as well as financial services firms, and discuss the steps that they should be taking to embrace this agenda. I'm delighted to be joined by two esteemed guests as usual. We have Lynne Baber, a partner leading PwC's UK Sustainability practice. And Lucas Penfold, Senior Manager in the Regulatory Insights team, who leads on ESG regulatory insights. So, welcome to you both.

Lynne Baber: Hello.

Lucas Penfold: Hi, Andrew.

Andrew: So, Lucas, to start, ESG, especially the environmental aspects of it, has got a lot of attention across the global economy and from a financial services perspective, and I know it's something we often see at the top of our clients' priority lists. So as I said at the start, in recent months, we've seen a real flurry of regulatory activity relating to sustainability here in the UK and actually internationally as well. Before we dive into the detail of what this means for financial services firms and the economy more broadly, can you give us a bit of a scene-setter on where the UK is when it comes to sustainability regulation?

Lucas: Yes. Thanks Andrew and thanks for having me on. Good to be here. I think a flurry of sustainability regulatory activity is a good phrase for it. We've seen quite a lot come out from the regulators in recent months. And actually, it's a fairly, sort of, quiet spell in the year running up to that, actually. I think back to COP26 last November in 2021, the UK published its UK sustainable investment roadmap, which sets out a bit of a flavour of essentially what the UK regulatory framework in this area is likely to shape up to be. We had a bit of a quiet spell but we're now beginning to see the regulators come forward with more developed thinking on some of the initiatives that were floated in that roadmap. For example, the UK transition plan taskforce has published some recommendations on a sector-neutral framework for transition plan disclosure. We've got the G-TAG, so the Green Technical Advisory Group, that's also put out its own advice on the principles for a UK green taxonomy, which has the potential to be really significant for the UK market. And more recently something a little bit more concrete actually, the FCA published some proposals in October on sustainability disclosure requirements for asset managers, slightly broader in their application, although largely they're focusing on the asset management sector. So, lots going on. And I think we've now got a much clearer sense of how the regulatory framework is shaping up. But we know there's also a lot more to come down the track in months ahead.

Andrew: Yes, thank you. And certainly if you look at the agenda we've seen through the Edinburgh Reforms coming out of the Treasury and, you know, from our conversations with regulators we know, as you say, there's a huge amount more to be coming over coming years. I mean, let's pick on one of those areas you've just discussed in a little bit more detail. I know in the UK there's been a lot of focus on the UK SDRs, can you speak a bit more about this? What are we seeing so far on this piece of regulation?

Lucas: Yes. So the UK Sustainability Disclosure Requirements is going to be an economy-wide framework for sustainability disclosures, so something that applies to corporates but also across the financial sector as well. Really building on the mandatory TCFD framework that we have in place here in the UK but broadening that out to look at a wide range of sustainability issues, beyond just climate. So what the FCA has proposed here is essentially how the SDRs would apply to asset managers. To an extent they're looking at distributors a bit further down the investment chain as well, although the FCA does have plans to extend its proposals to other firms and there are going to be further consultations coming on that. I think there are, sort of, three key bits, the proposals that the FCA put forward. So, the first is, as title of the regulation suggests, focusing on some of the disclosures and reporting that asset managers are going to need to put out to investors in their investment products. And these are a mixture of obligations that apply at an entity level but also at a specific product level. You've got a labelling in your framework that the FCA's setting out. So that's something that's covering different types of sustainable investment products that are out there in the market and will form the basis of essentially how you market your products to consumers.

And then there's a separate concept that the FCA proposes that essentially is an anti-green-washing rule, which is slightly separate to the SDR framework, albeit they still included that within the package of proposals they put forward in this particular consultation. That's sort of a fairly broad principle applying actually to a wide range of firms, all FCA-regulated financial services firms, around really trying to get a handle on managing potential green-washing risk that might arise in the context of any products and services that you're offering to consumers. So, it's a sort of, broad principle that applies that they're trying to get a handle on. So, those are the, sort of, three key bits to the proposals. So quite a lot in there. And, you know, certainly from speaking to our clients we know that there's quite a bit to unpack and firms are busy trying to get on the front foot in responding to some of this.

Andrew: Thanks Lucas. That green-washing point, I think, is really important because I think, you know, the focus of that consultation, as you say, was asset managers but the green-washing was, well, all firms, or regulated firms, are a much wider application there that I'm sure some of our listeners will be glad you've highlighted for them. So what, though, are your main observations so far since it's been introduced?

Lucas: Yes. So I mean, there's a lot within that but I think, for me, the sort of key observation on the SDR proposals, something that relates to the label actually, and that's that the FCA is setting a pretty high bar for a product to qualify for one of the labels that they've put forward. Essentially, all of those products would need to have a sustainability objective baked into the mandate of the product. So, we might see quite a lot of products out there in the market that are currently positioning themselves as having a pretty strong material sustainability focus that actually aren't going to be able to make use of one of the FCA's labels going forward. I think if you take what that means in practice under the FCA's proposals, it would essentially mean that those products wouldn't be able to reference ESG terms in product names or any of the marketing material that they push out in relation to that product.

You mentioned there, Andrew, some of the, sort of, linkages with what we're seeing come out of the EU, in particular SFDR, which is obviously a big bit of regulation that's shaping the market in this area. If you take one of the concepts there, so you have an Article 8 product under SFDR, which, you know, clearly is something that is a type of product that is positioned as having a fairly strong ESG focus, but under the FCA rules, if a product is caught by SFDR and the UK SDR regime, you might find that that product would have to essentially, sort of, level up to align with one of the FCA's labels. On the face of it, fine, that sounds fairly straightforward but that could have some pretty significant implications for the types of assets that those products invest in. So I think that's certainly something that a lot of our listeners will be trying to get their heads round as they work through the detail of the consultation. I think another observation I would have relates to one of the other labels, so the sustainable improvers label. So this is all about investing in assets that will become more sustainable over time. So it's the concept of, sort of, transition finance.

And I think with that label, firms are going to have to be really careful in how they apply that to their products because potentially there could be some green-washing risk that comes with using the label itself. You take the concept of improvement, I think there's a risk that the net of assets that could potentially be invested in through a product that uses that label, could be really, really wide and maybe actually those assets don't realise improvement for a number of years. So, I think firms are going to have to be really careful that, you know, they're setting very clear measurable KPIs that have a reasonable time-frame around achieving those improvements of the sustainability profile of those assets. And which are really clearly articulated in the product disclosures that are put out to consumers, because otherwise I think there's a real risk that consumers could get quite confused by that.

Andrew: Thanks Lucas, that was really interesting, really helpful. So Lynne, can I turn to you? The sustainable finance regulatory agenda is partly about using the financial sector to support the transition to a more sustainable economy, so there are clearly some impacts on the real economy. It's interesting, we work in regulation a lot and actually there are occasions when sometimes you forget there's a whole real economy being supported by stuff. This feels very much more tangible. Lynne, so how is this impacting corporates, and what have you been hearing from clients in this space?

Lynne: Thank you, Andrew. I mean, it really is impacting corporates, and in a number of ways. But, of course, we do like to do things in threes here. The kind of three key ways, I think, two are indirect but one is very much a direct impact. Firstly, the regulations applicable to FS firms. You know, they require them to gather a large amount of data on the ESG credentials of companies they're exposed to. So, for example, an asset manager will need data on companies they're investing in, and so we're seeing lots of asset managers, lots of private equity firms really lean more heavily on corporates to provide them with the ESG data that they need to then go on and fulfil their own regulatory obligations. I think the second impact, and actually really important to our clients and corporate organisations out there, is the impact that the FS ESG regulations are having in actually shaping the ability of a corporate to access finance. We're seeing this with the EU SFDR. So, where Articles 8 and 9 product classifications are shaping asset managers' investment decisions from an ESG perspective. So, I'm certainly seeing, you know, a lot of corporate clients doing work to align themselves with those product classifications to make sure that they remain investible based on their ESG credentials. I'm sure we're going going to see more of this with the FCA's ESG labels and other similar initiatives globally.

And finally, my number three, my third point, you know, there are a number of really important sustainability reporting regulations that apply directly to corporates. You know, mandatory climate-related financial disclosure reporting, TCFD for UK companies, is part of this. But corporates are now becoming increasingly focused on the EU sustainability reporting directives, CSRD, which is applying a range of non-EU companies and seeks to put sustainability reporting on the same footing as financial reporting. So, these regulations applicable to corporates will hopefully drive improved sustainability reporting and better data for financial services firms too.

Andrew: Thank you, Lynne. If I put my asset manager hat on for a second, it's interesting when you think about just, I mean, you talk about the data there from corporates and I'm avoiding thinking about, you know, the data that asset managers have been struggling to get in terms of public distribution and then the data they need for consumer duty. It's almost like there's more data going on that there's asset management sometimes, I feel. I feel for them all very much. Having already started putting myself in the shoes of a firm there, how should firms be preparing to embrace this agenda? I mean, clearly the focus on sustainability is going to continue, so what's the thinking long term here? You know, what's the long-term picture? Maybe, sort of, broader than financial services. What should clients be thinking about in order to try and set them up for success?

Lynne: Well, I mean, it's no doubt that the ESG regulatory landscape is incredibly complex, and actually I think we're going to have a period of time of even more complexity before we start to see, kind of, the greater convergence that we all want. And so, during this time, I think it's important for firms to adopt a strategic approach to how they're implementing this regulation. So, you know, identifying the overlaps between different initiatives and having an approach that is flexible enough to meet the requirements of new regulations as they arise. And I do really feel that the real winners here are going to be those that approach these regulations with a real, kind of, value creation mindset. You know, it's much more than a pure compliance exercise, it's about using regulation as a lever for looking at your end-to-end sustainability approach, embedding sustainability across your risk management in relation to innovation, products, and really using this to drive value creation for your business and then into wider society as well.

Andrew: Thank you, Lynne, that was great. And Lucas, if we then zero in on financial services firms, what should they be thinking about?

Lucas: It's a good point. I suppose, earlier I was touching on the SDR proposals and product labels but, you know, those are, albeit very important, they are one aspect of a much bigger regulatory agenda on sustainable finance. In the UK, we've got various mandatory TCFD regimes, which I think Lynne mentioned. We're expecting the UK green taxonomy, we've got the corporate SDR regime, which are going to draw on the ISSB standard. So, there's so much complexity going on there and I think, you know, that already is on top of the busy EU agenda, so things like SFDR, EU taxonomy, CSRD. So, there's a lot here. So, I think a lot of those regulations are having very similar impacts on businesses, in terms of the types of requirements that they need to meet but also the business impacts across the organisational structure. I think that really just reinforces the points that Lynne has already made about, you know, being strategic about how you're thinking about regulation, really thinking through what the impacts of those regulations are, identifying some of those overlaps, and using this as a bigger opportunity. It goes beyond the compliance sector, as Lynne said. So, yes, I think a lot of the same themes and concepts apply in the financial services sector as well.

Andrew: Thank you. There's already quite a lot for firms to be taking in here and responding to and engaging with, and some of these are obviously live consultations, but just to upset people even more, what more should we be expecting from policy-makers and regulators and standard-setters in 2023?

Lucas: So, there is a lot, you're right. So, if I think about what's going to be coming down the track, you've got obviously the FCA's work on SDRs, that's going to get finalised, they're looking to publish final rules by mid-2023. And that will then kick off the implementation of those rules for asset managers. So, you know, essentially there will be a lot of work for firms to engage with those final rules and really start to embed the changes across their business. I think I alluded to this earlier, the FCA is also going to be consulting on extending the SDRs to other types of firms, so it's going to be looking at asset owners, so life insurers, regulated pension providers. But also looking at how the SDR proposals would apply to overseas funds that are selling into the UK at the moment, the proposals are very much geared towards UK-based asset managers. So, I think there is an overseas element to this as well that's going to be consulted on. And then the FCA is also, on SDRs, going to be looking at the role of financial advisors and how ESG regulation might apply to them. We've seen a similar focus on financial advisors in the EU through some of the changes that have been made to MiFID II, for example. So, I think we're expecting the FCA to be looking at similar things here in the UK market.

And then probably the last one I'd call out would be some of the, it was flagged actually in the Chancellor's Edinburgh Reforms, earlier in December, which will be a greater focus on the regulation of ESG data and rating providers. So that was something that we know has been, sort of, in the minds of regulators over the past year or so. But what the Chancellor set out as part of that package would be a formal consultation in Q1 2023, looking at bringing those types of firms into the regulatory perimeter. So that's going to be a really important step in developing that broader ESG ecosystem in the UK that is clearly data ratings, agencies, and the ESGs are playing a really important role in that ecosystem. It's an important area for regulators to be focusing on.

Lynne: And Lucas, actually, if I build on that. I mean, I think the ratings piece is so important, it’s the kind of the number one topic I'm having at the moment with corporates is just trying to understand actually how they do what they do. So, I think it would be very welcomed. Just building on it from an international perspective, if I can Andrew. So, I think early in 2023 we do expect the International Sustainability Standards Board to finalise their first two standards, and so that will then provide, you know, a real trigger for the UK to consider how to incorporate them into formal regulation. And, will really provide the backbone of the SDR regime for corporates, and reflect the transition plan taskforce output on transition plans. And, of course, bringing it right back home to the UK, I think we will hopefully see some developments on the UK green taxonomy. So the G-TAG has issued its first piece of advice but we are still yet to see any updates from the government on the extent to which that is going to be taken forward. But this has the potential to be another significant piece of regulation introducing reporting requirements. But also underpinning other areas of ESG regulation, such as SDRs.

Andrew: Thanks Lynne, yes. And I think the international aspect of this is really important, clearly firms are having to deal with multiple regimes and international standards that are going to be crucial to this too. So, before we leave, Lynne, Lucas, as we look across the future of 2023, what's the one prediction, nothing too exciting but a prediction or one thing to think about or look out for or a thought you want to leave with our listeners for today. Lynne, you can go first.

Lynne: Thanks, Andrew. I think, for me actually, an interesting one I'm having conversations with, and I think we'll hear more about next year, is the interconnectivity of the E, you know, environment and S in relation to the social. And in particular more focus on the just transition. It would be remiss of me not to mention nature, just given COP15 during December. But as I was only allowed one, I'll stick with just transition.

Lucas: Yes, I completely agree with that biodiversity point, Lynne. That's going to be my point as well, actually. So, you know, I think there's a big agenda clearly around nature and biodiversity. We're in the middle of COP15, which is focused on this. And I think that's going to be a theme that regulators increasingly focus on. It's cropping up in places already in some regulations but I think there's more to come in that space.

Andrew: Thank you both, that's been really interesting. And I actually think the first ever podcast I hosted on the Risk and Regulation Rundown series was actually around the S of ESG, so we've only got one more letter than to go and then I can, I think, gracefully retire. To our listeners, I hope you've also enjoyed this and thank you very much for listening. As always, please do subscribe to future episodes and rate and review this series as it helps other listeners to find us. If you'd like to hear more from us on risk and regulation, please look out for our regulator publications on our website, where you can also subscribe to our monthly newsletter on regulations developments. Thank you.