Series 2 Episode 10: From diversity to data – ESG flashpoints

Andrew Strange:

Hi everyone and welcome to our latest Risk & Regulation Rundown podcast. I am Andrew Strange, your regular host, and as usual, we're recording remotely, so please note this might impact our sound quality. In today's episode, we're discussing ESG: environmental, social, and governance. I know this is an area we covered back in July last year, but this has actually been one of our most popular episodes, and given that it's a really fast moving topic, I thought it'd be a good time to return to it again. I am delighted to be joined by Jon Williams, a Partner in our sustainability and climate change practice and a member of the FSB’s Task Force on Climate Related Financial Disclosures. I am also joined by Luke Nelson from our regulatory insights team, who leads on ESG and banking. Jon, let's start with you. ESG has been a regulatory priority for a few years now, but it's one that continues to gather momentum, particularly in the run up to COP26 in November. Can you start off by setting the scene for us a little in terms of what stage policymakers as well as firms themselves are at in their ESG journey?

Jon Williams:

Hi Andrew, and it is a really great question to ask, and I am not surprised that ESG is the most popular podcast episode, because it is probably the most important issue that firms are facing at the moment. I am going to start actually with the firms and then with the policymakers, because you could argue for the last 20 years, firms have been thinking about how ESG impacts them, but for much of that time, the concern was about association with a company or a project that had negative environmental and social impacts, that could reputationally transfer to the firm. That has really changed over the last five years, for probably two or three reasons. Firstly, investors in financial institutions have been asking the question, how does, for example, climate change impact the value of assets you have in your balance sheet, or how do your policies around diversity and inclusion, or human rights, or modern slavery have an impact on you as a bank financially? The other area though is absolutely the regulators and really on the heels of the TCFD, regulators around the world have been focusing on climate change, and in particular, the risks that that poses to individual firms, and to the market systemically. The UK Prudential Regulation Authority is taking something of a lead here in terms of the work that they are doing with banks and insurers this year, and certainly the requirements to embed climate change fully into risk management frameworks this year, the mandatory disclosure for premium listed firms. These are all things that are piling up on the to-do lists of financial services firms at the moment.

Andrew:

Thanks Jon, yeah, I am sure there is an awful lot going on there, but it feels to me like there's a bit of a strategy play here too, which is probably an important aspect of the focus on net zero that we're seeing. I know lots of firms are making commitments on net zero, how are you seeing firms think about that in their corporate strategy?

Jon:

I said on a webcast that we did a couple of weeks ago, that we need to put some clothes on the naked emperor. What do I mean by that, what I actually meant was that, yes there are many firms and many companies making net zero commitments, some 2,500 have made commitments to-date, but actually what I am seeing is a number of investors and a number of other observers saying, a commitment in 2050 doesn’t to me feel like the action that’s needed in 2021, 2025, 2030, etc. What is beginning to happen is that firms are having to think about what does my net zero commitment mean to me today, what does it mean within five years, what does it mean by 2030? It's timely to think about that, because as policymakers meet in Glasgow at COP26 in November, two things will be happening. Firstly, they will be asking countries to raise their ambition and set more stringent carbon reduction targets; and secondly, to get to a point where we are well on the way to 1.5 degrees by 2030. That has to translate, therefore, into shorter-term regulation, and shorter-term guidance, but also shorter-term strategic planning. The other point I will make is, in many ways, we have a cart-before-horses problem. What do I mean by that, not to overdo anecdotes on this podcast, most firms would like to be able to set up the right vision, the right strategy, the right operating model to deliver over the next two to three years on their ESG strategies and their net zero commitment. But the regulator is really saying, ‘look, we don't have a lot of time to get this right, probably two business cycles, and we really want to start moving on regulation, particularly financial market regulation’. The PRA, the FCA, Department of Work and Pensions are putting much tighter deadlines on financial firms and on pension funds in many ways ahead of the ability for them to put in place a strategy and the right operating model, because clearly failing to meet regulatory requirements, is a bit like my son not completing his homework, he's likely to get an F grade.

Andrew:

Thanks Jon, okay so Luke, turning to you, we can talk about the grading on your homework or we can have a chat about the size of your horse and cart. Jon has giving us some really useful wider context there, but I am aware there's a really busy regulatory agenda that we are also having to deal with. The recent Grid document produced jointly by the regulators seemed to set out a huge number of upcoming regulatory initiatives, with a number of them actually due later on this month of June after we do this recording. Given that there are so many potential publications slated for this month, what are we expecting to see and what are the highlights that firms should be looking out for?

Luke Nelson:

Hi Andrew, it was really interesting to see that Grid, and for listeners who aren't familiar with the Grid, it's essentially the list of everything that's coming out from all the different regulators in the next few quarters. I looked down that list, and usually we get a lot of conduct and prudential regulation, and a bit of ESG at the bottom. This time, it was ESG at the top, and ESG was by far and away the biggest section in the Grid. There's a lot coming and a lot coming this month in June. The first thing that we are expecting is the next phase of the Government's rollout of making TCFD mandatory for different types of companies. This will see the FCA publish a couple of consultations. First of all, for asset managers, life insurers and FCA-regulated pension schemes, so bringing them into the scope of mandatory TCFD disclosure. This is going to be the first time that we see FCA rules on the TCFD. We’ve seen the amendments to the listing rules for the premium listed companies, but for the first time, we will see how the FCA translates the TCFD into its rules. That's going to be really interesting to see. The other thing on TCFD we're going to get is broadening out the scope of listed issuers, who are within the mandatory TCFD regime. We started with the premium listed issuers and we're now going to get to a broader population of listed companies.

The FCA and PRA are due to put out a discussion paper in June on diversity. We've been pretty focused on climate change as a regulatory topic in UK regulation in particular, but diversity is really starting to creep up the agenda. The regulator has been giving some speeches about how actually diversity is a regulatory issue. We're going to see some initial thoughts from the regulator on what that means for the FS industry. We're also going to get a data request. The regulators are going to send out, and we think this is going to happen either in June or July, a data request to some of the largest firms to reveal the state of play on diversity. That's going to be really interesting to see.

Another thing that we're expecting in June - it really is a packed month - from the FCA is guiding principles for sustainable funds. This is really the FCA’s attempt to support consumer access to sustainable investment products, and really to try and combat the risk of greenwashing. We're not sure what form this is going to take. It could be guidance, it could be a Dear CEO letter, but we certainly know it's coming and it's the first step that the UK regulators are taking to really make sure that there is clear disclosure, clear metrics and that the data that asset managers are using is assured and they've got confidence over it. That will be an important development for the asset management community.

The final thing I'll touch on is the taxonomy. Not necessarily expecting anything on that this month in June, but we are keeping a close eye on what the UK is doing with regard to the taxonomy. The plan, as it stands at the moment, is for the UK to issue a consultation paper on its own technical screening criteria, either later this year or early next year. Work is very much underway through the Green Technical Advisory Group, which is being set up to really kick the tyres on the EU’s taxonomy. So there’s lots going on, and those are just some of the issues that were contained within the Grid, and we will see more very soon on those key pieces.

Andrew:

Thanks Luke, really interesting, I suppose there were alarm bells going off in my head there when you were talking about various regulators. Some of those sound like UK initiatives, some of them sound European, some of them sound like almost global standards as well. My own experience in areas of regulation that I work in is that international divergence is something that in a post-Brexit world is becoming increasingly challenging for firms. Is this all consistent, or are we seeing divergence across some of these initiatives too?

Luke:

Yes, spot on, Andrew, and I certainly know from talking to clients that fragmentation is a key issue. There's a lot of concern about additional costs, additional operational complexity. There is a general desire to achieve as much international convergence as possible, but of course, the reality is that regulators are operating in different markets, in different economies, and have got different existing regulatory frameworks to play with. So we are starting to see different approaches being taken.

Just to bring that to life, the EU has taken a much more prescriptive approach to ESG regulation, if you look at things like the Sustainable Finance Disclosure Regulation, if you look at the Taxonomy Regulation. Whereas the UK is taking much more of a principles-based approach, allowing more room for proportionality. As we see things like the way the UK develops the taxonomy, the UK is keen, and this is part of a broader political pressure to really find the so called Brexit dividend, but the UK is keen to explore ways to improve on what the EU has done and make it more applicable for the UK market. What we are likely to see is actually some changes coming through the Green Technical Advisory Group with a great intention of making this better for firms, but actually the unintended consequence is that there's a fragmented regime. There are two regimes to comply with or more as firms are operating across different jurisdictions. All eyes really on how much can be done internationally, and on the taxonomy a lot of work is being done through the international platform for sustainable finance, trying to achieve a common ground taxonomy, but it remains to be seen how much alignment we are going to get. A big push from the UK, and particularly with its G7 hat on and in the lead up to COP26 to try and make some progress, but we will see where we get to.

Andrew:

Thank you very much, Luke. Jon, turning back to sort of UK specific issues, the Bank of England’s climate stress tests are another important initiative, mainly for the largest banks and for insurers and they're meant to be starting later on this month in June. How have you seen firms prepare for this and what's the outcome likely to be?

Jon:

Well, what I am seeing is, firms really focusing on their preparations and trying to understand what is required. This is going to be quite different. Normally when banks do a stress test, they are able to look at the historic data. For example, the impact of an interest rate rise on loan losses, in a mortgage book. They can run those stresses because they've got historic data. The problem with climate is that you don't have the historic data, and therefore they are having use forward looking scenarios, and they’re having to extend those scenarios into economic impact. For example, what would a higher carbon price do to the price of oil, and then you could put that through an oil price shock stress test, for example.

There are quite a lot of gaps in the methodologies. There will be gaps in the completeness of scenarios, and certainly gaps in data. One bank that we were working with, was trying to get accurate carbon emissions data out of its commercial loan book and they got two and a half percent of their clients were able to provide that data, and this was mid-market and small market companies. The PRA has been really helpful. They are expecting firms to do somewhat more than the 2019 insurance stress test, but next week they will be releasing more information just to support the stress test. The PRA is trying to do what they can to facilitate firms to have a successful stress test.

What do I think the outcome will be? Well, the first outcome will be, it's a lot harder to do than people think. The second outcome will be a number of gaps in the results, but the third outcome will be that both the firms and the PRA will understand what it takes to get to a level of stress test with a financial firm, where you might begin to say, well how would we, for example, tax regulatory capitals. We are some way from there, because as I said, the methodologies and the data, not just the climate data, but particularly the client-level data is still full of holes. I will not make an anecdote about a certain type of cheese.

Andrew:

Thanks Jon, that's great. No more anecdotes, please. Okay, let's turn Luke to something else now. The social elements, the S in ESG, are really important. Clearly, COVID-19 has been a big catalyst for a lot of the work that firms have been doing around thinking about social purpose and reputation. How are we seeing that progress as we move into the recovery phase?

Luke:

Well Andrew, you’re absolutely spot on. There has been so much attention on the E of ESG and climate change within that as the main issue, particularly from regulators, but we are now starting to see a greater focus on the S, on the social issues. Partly that's COVID-19, that’s definitely had an impact for FS firms, thinking about what was the role they played in the pandemic, what's their role in the recovery, really what's their role in society/ That's really leading to an examination of purpose, often a new articulation of purpose, and really getting purpose embedded in the broader corporate strategy.

From a regulatory perspective, social issues present challenges that are quite distinct from environmental. The success, if you like, of climate regulations so far has really been built on the fact that there is more or less a consensus globally on what needs to be done, and it is measurable. Jon has just talked about some of the challenges with the data, but fundamentally it is something that is measurable. When it comes to social issues, they are often qualitatively evaluated. There is far less consensus on outcomes. The sustainable development goals provide a very useful starting point, but there's no real - from a regulatory perspective - agreement on the tools that should be used to try and encourage the social outcomes that people want t6 see, and actually which social issues people want to prioritise.

Jon referred to modern slavery earlier on, we're seeing a lot of focus on diversity and inclusion. There are so many different social issues and there isn't really the focus on one that we see with climate change. Having said that, there are some live regulatory issues, particularly for the FCA, that are very much about social issues. There’s a big debate going on at the moment around access to cash, and actually thinking about that as a social issue. There is a very interesting debate around consumer duty and what duty firms have, and you could see that through a social lens, and clearly diversity and inclusion, which is a really hot topic for the FCA and will become more important.

The other thing I'd say on this is that aside from regulation there’s definitely a huge role that states and governments have to play in achieving positive social outcomes. There you get quite quickly to thinking about what's the tax contribution from the FS sector? For a lot of FS firms that will be part of the focus when they are thinking about the S of ESG. With that in mind, later in June, we've got the G7 meeting down in Cornwall, and they're going to be looking very closely on what to do in the issue of multinational tax contribution. So I can see this is an issue that is going to bubble up for FS firms in the near future.

Andrew:

Thank you Luke, really interesting with the tax angle that will emerge from that too. We've covered a load of ground in our discussion so far. A very simple question to both of you, but maybe Luke, I'll come to you first. Of all the initiatives we've talked about, and all that firms need to contend with in the ESG space, where are you seeing some of the biggest challenges for our clients, and crucially where are the biggest opportunities?

Luke:

One of the challenges that I am definitely seeing among the clients I am talking to is just how do we deal with the scope and complexity of regulatory change? ESG regulation is horribly complex and it's particularly in the EU context, really interacting with a lot of the existing regulatory frameworks, so with MiFID, with the Insurance Distribution Directive, with the Capital Requirements Directive. There is a lot of complexity there to deal with. Then just the sheer number of new initiatives leads to a challenge. Then that coupled with the fact that whether it's about risk management, or whether it's about disclosure to regulators or to clients, it all comes back to data. Jon very well described some of the data challenges that we are seeing, but right across all of the regulatory challenges that firms have, data is at the heart of it, and the data isn't quite there yet, so that is a huge issue.

On the opportunity side, there are two things I would highlight. The first is that regulatory challenge, I think firms who are looking upon this as a commercial opportunity, as an excuse to really get to know their clients better, to understand what their clients need to transition to a lower carbon economy through the process of gathering data, will really be the ones who benefit. There are enormous commercial opportunities for firms who see this as a strategic opportunity, who see regulation as being a strategic imperative rather than just a compliance challenge and cost. The other thing I would just mention on opportunities is actually the firms that are doing this well, and particularly coming back to the point I was making around purpose, are actually seeing a benefit in terms of talent attraction and retention. Particularly with younger people coming into their organisation, but not just younger people, we are seeing that as a benefit that's being felt already out in the market.

Andrew:

Brilliant, thank you. Jon, do you agree with Luke, or has he missed anything?

Jon:

Yeah, I do. He's covered very much the risk and regulation, and the talent angles very well. At the end of the day, the role of the financial sector is to finance economic growth and economic transition and we've seen it in previous revolutions, whether it’s the industrial revolution or the technical revolution. Climate change is going to be at least as big as both of those put together. Therefore, how banks manage that transition, both in terms of helping their customers move from where we are today in terms of our resource consumption model and the social impact it has, to one in the future, which is decarbonised, fair and balanced with nature, if I can put it that way, is going to be really important.

Therefore, knowing their customers well, knowing what their customers need to do to move down that trajectory, and supporting, and then recognising that some sectors will decline and some sectors will grow, and therefore, how do they manage that dynamic, whether it's for the large corporate that’s going through a transition or an employee of a company that maybe has to reskill. Actually, the way that banks have supported their customers through COVID, both with channelling Government support, but also the support they’ve given, for example, on mortgage repayment holidays, is a really good test of when financial firms are in that position where they know they have to support a transition, they do it really well, because they actually say how do we help a customer over this bump in the road or this major change in their fortunes. The other area that I would really focus on is having the right talent; there are just aren't enough people with good ESG skills in the market. There will need to be massive upskilling and training of people in banks, insurers and asset managers if they are going to have those conversations with the client.

Andrew:

I hope this podcast can form the basis of some of that very early level training for some people as well. I wanted to end on a final question. We've talked a lot about the initiatives and issues that firms are prioritising today, now, and certainly over June by the sounds of it. If we look ahead beyond this year, what’s further on the horizon that firms need to think about longer term? Luke, I’ll start with you.

Luke:

Thanks Andrew. It is difficult to look beyond this year, because there's so much happening this year, but a couple of things that I'd say thinking about next year. The first is really to keep a close eye on what's going on in the US and in terms of US regulation. We’ve seen a huge change that was highly unsurprising given the change of administration in the US. Really the Biden administration is not messing about. We've recently seen an executive order focusing on the climate-related financial risks. We will see more action from US regulators soon. US regulation, as we saw after the financial crisis, has quite a habit of extending its tentacles around the globe. We might see some extraterritorial impact from what US regulators will do on this agenda. That's definitely one theme to watch out for.

The other one is, we've got this year in the UK regulatory context, there's a lot of deadlines, there's a lot of new initiatives. Next year we'll start to move into the phase where regulators are really taking a look at firms and thinking, ‘right, have you embedded your approach to managing climate risk, how well have you done it, are you giving the right information to investors on your ESG product strategy?’ A whole raft of thematic and supervisory work will really kick off next year. That will be the start of a process of understanding what best practice looks like, when firms have had a few years to really get their heads around some of the risks, and the obligations that they have. That's the other thing I would call out as a thing to watch and prepare for next year.

Andrew:

Thank you, and Jon?

Jon:

A couple of thematic areas and then one issue we've already touched on. Thematically, the next environmental issue is going to be nature. If you think about it, Lord Stern issued the Stern Review in 2006, and the TCFD came along in 2015. Yet within one year, we've had the review on nature and the taskforce on nature related financial disclosures within weeks of each other. So I think that nature will be the next big environmental issue, and actually conserving nature enables us to absorb carbon emissions, which helps deal with the climate crisis, so they are joined at the hip.

The other area is going to be inequality. The one thing that COVID has shown is that actually there has been an increase in inequality, which was already accelerating, and many development gains in developing countries have been set back by maybe one or two decades. Particularly you're going to see, income inequality and racial inequality becoming flashpoints as we are seeing in various parts of the world at the moment. If the financial sector can be the pallbearer for good behaviour around those two areas in terms of its own employment practices, and its own lending and investment policies, and critically the disclosure of how they are managing those issues, then they'll really talk to their purpose in terms of the really positive role financial firms can fulfil. Then the one area we've touched on is data, and I would see data as a valuable asset. Those financial firms that have the very best data on these issues, as it relates to their clients, and their products and services, will be those that will win out on these issues, and I would argue will win out economically as well as environmentally and socially. So, cash used to be king, data is now king.

Andrew:

Thank you, Jon. Thanks to you both. It has been really insightful to hear your thoughts on the breadth of ESG agenda, from this month's regulatory initiatives to some of those longer-term challenges, developments and opportunities for firms too.

To our listeners, I hope you’ve found this episode interesting and helpful, please do subscribe to future episodes and rate and review this series as it really helps other people to find us, and I'll be back with our next episode next month. Thank you.