Identifying and mitigating ESG risks for financial services firms

Posted: 30/03/2022

The energy price crunch, exacerbated by the war in Ukraine, has led governments, institutions and individuals to urgently revisit the question of where and how we source our energy. These devastating events may become a catalyst for an earlier transition from fossil fuels to renewable sources of energy and a faster path to net zero, defined as the balance between the amount of greenhouse gas produced and the amount removed from the atmosphere.

Environmental, Social and Governance (ESG) has become the fastest growing compliance issue for financial services firms and this article looks at the key regulatory and legal developments in this area and the risks that financial services firms may face.

Background

The Paris Agreement, a legally binding international treaty on climate change, recognising “the need for an effective and progressive response to the urgent threat of climate change”, set out a key objective of “limiting the increase in the global average temperature to well below 2 °C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5 °C”.  The Agreement obliges countries to determine emissions reductions targets towards net zero. Under the Agreement, states and financial firms were tasked with making “finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development”.

The Financial Conduct Authority (FCA)

The FCA has extended its requirement for premium listed companies to make disclosures in their financial statements in line with the Task Force on Climate Related Financial Disclosures (TCFD) recommendations to include standard issuers of shares and global depositary receipts (GDRs).  The new rules will apply to accounting periods commencing from 1 January 2022 and will be based on TFCD’s four pillars of strategy, governance, risk management, and metrics and targets.

With its outcomes for climate-related disclosures, protecting consumers against greenwashing and promoting companies’ sustainability strategies, the FCA recognises the "need to ensure that ESG claims and credentials stand up to scrutiny, that consumers' interests are protected, and that competition remains effective in the interests of consumers."   

The FCA’s ESG sourcebook also contains new mandatory TCFD-aligned disclosure obligations for the largest asset management funds (£50bn AUM) and owners (£25bn AUA) with effect from 1 January 2022. These rules will gradually be rolled out to mid-size and smaller firms with AUM of over £5bn from 1 January 2023.  

For the period from 6 April 2022, certain larger companies and LLPs with over 500 employees, including banking companies, will need to make environment-related disclosures aligned to the TCFD recommendations. The changes are contained in the Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2021 (Regulations) and will be implemented in the Companies Act 2006.

Sustainable Disclosure Regulation (SDR) and green taxonomy 

In 2020 the EU’s Taxonomy Regulation, a classification system with a list of environmentally sustainable economic activities, established six environmental objectives. These are: climate change mitigation; climate change adaptation; sustainable use and protection of water and marine resources; transition to a circular economy; pollution prevention and control; and the protection and restoration of biodiversity and ecosystems.  The first two objectives came into effect on 1 January 2022.  Investors and stakeholders may well expect UK companies to demonstrate adherence to the EU’s taxonomy before the UK rules come into force.  

Looking ahead, Phase 1 of the UK Government’s Roadmap to Sustainable Investing is being implemented via the UK’s Sustainable Disclosure Regulation (SDR) and green taxonomy. The focus is on financial services firms providing transparency to investors of their products’ sustainability credentials, and the businesses’ own impact on the environment. Clear metrics must be used to allow proper comparison between products and activities in order to build trust in the market, aid investment decisions and avoid greenwashing.

The SDR is likely to come into effect around 2023/2024 and will build on the disclosures recommended by the TCFD. Firms will also need to publish transition plans that include interim milestones and targets to demonstrate how the business will reach the target of net zero by 2050.

Regulatory and litigation risks

Below are some of the major risks that financial services firms should be aware of from these new ESG reporting and disclosure obligations, goals and objectives.

Regulatory action

An investigation by the US Department of Justice, the SEC and Bafin into the DWS Group’s alleged overstatement of its ESG capabilities identified what has been described as a “frozen middle”, the fund managers who were not engaged in following ESG recommendations. 

We expect the FCA to aggressively crackdown on greenwashing and make examples of firms that do not comply. As the main focus of the FCA is maintaining transparency and trust in the market, regulatory action on greenwashing tactics such as making untrue or unsupported statements about the ESG credentials of a business’s activities or products will be high on the agenda.

Disclosure of climate strategies

We anticipate an increase in claims relating to the management and disclosure of climate change-related business risks and actions taken to respond to such risks.  Mark McVeigh’s Australian Federal Court case against REST, a A$57bn retail superannuation fund, settled shortly before trial with the fund aligning itself with the TFCD’s climate change risks. It  stated that: “climate change is a material, direct and current financial risk to the superannuation fund across many risk categories, including investment, market, reputational, strategic, governance and third-party risks".  We may see similar disclosure exercises here.

Greenwashing

The Corporate Climate Responsibility Monitor 2022 reported on the transparency and performance of 25 major companies in relation to their professed ESG credentials.  A number of the companies were graded as having low or very low integrity.  The state of Minnesota brought a claim against Exxon Mobil, the American Petroleum Institute and Koch Industries Inc alleging fraud and a “campaign of deception”.  Firms should expect to see the things they say about their ESG credentials being tested and challenged.

We are also likely to see claims by investors and other stakeholders who may have purchased products on the basis of a company’s ESG disclosures and advertising but later found that those green credentials did not stack up. It will be vital that the public disclosures made generally and directly to investors and consumers are accurate and can withstand scrutiny.

Claims against directors

Where ESG claims are found to be inaccurate, unsupportable or there is no proper plan in place to achieve ESG targets or manage ESG risk, directors may face claims from stakeholders for failing in their statutory and fiduciary duties. ClientEarth and activist shareholders are pursuing a claim against the directors of Shell in their personal capacities to include an alleged breach of their duty to promote the success of the Company under s172 of the Companies Act.

Claims against financial institutions

With claims already being brought against pension funds, asset management companies and central banks, we may expect to see claims against commercial banks, possibly on grounds of taking unacceptable financial risks, a failure to meet climate change goals or mitigate risks, or for inadequate due diligence into corporate customers or projects.

Parent company liability

There have been several actions brought against the parent company in relation to environmental pollution caused by a subsidiary during the extractive or refining process. For instance, where the parent company is found to exercise significant control over the activities of a subsidiary on so called Vedanta grounds. There is likely to be an increase in this type of group litigation.

Employment claims

With hybrid working and an emphasis on a better work-life balance, employment claims may arise from working practices that are seen as harmful to health. These could be due to employees working longer hours or for a failure to take adequate measures to protect mental health while working remotely.

Reputational risk

Damage to reputation is an obvious side effect of ESG-related activism or actions. HSBC was recently targeted by environmental activists who claimed that the bank’s sustainability adverts were misleading and it was reported to the Advertising Standards Authority.  Some lenders have declined to fund and been eager to publicly distance themselves from clients with high profile fossil fuel projects.   We expect firms to carry out greater due diligence on this type of ESG risk and to support more ESG-compliant activities and behaviours.

Conclusion

The growth in ESG-related disclosure and reporting obligations and classification of ESG metrics and litigation means that financial services firms must not only take steps to put in place adequate procedures to meet these requirements but must also ensure that their businesses are doing all they can to achieve their national net zero targets and to support their regulators’ ESG objectives while complying with domestic legislation. 

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