ESG and sustainability matters for Financial Services

ESG and sustainability for financial services: what are the obligations for the financial sector

Why ESG and sustainability matters for financial services firms

 Climate change is a regulatory requirement and a key business consideration for the financial sector:

  • UK regulators have made climate change risk and the transition to net-zero emissions priorities, alongside other sustainability considerations such as diversity and inclusion
  • Investors, customers, and the workforce are interested in engaging with sustainable firms
  • The transition to net-zero emissions presents new business opportunities which cannot be ignored.

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The Regulatory context

Since 2019, the PRA has expected Banks, Building Societies, and Insurers to have risk management arrangements in place to mitigate climate related financial risks. In addition, both the PRA and the FCA have asked Boards at regulated firms to be responsible for overseeing how their firms manage climate related financial risks. The government, on their side, has also called on the financial sector to play their part in financing the transition to a more sustainable future.

Additional requirements in respect of wider sustainability-related factors, such as around diversity and inclusion, the International Sustainability Standards Board S1 (sustainability) and S2 (climate-specific) reporting requirements add to the considerations for financial institutions.

The best way to understand regulatory requirements, and expectations, is by sector:

ESG-related matters are requiring an increasing amount of attention from asset owners and managers. Some of the most common ESG and sustainability-related topics the sector is focussed on include:

  1. Understanding the potential impact on investment returns of ESG-related factors
  2. Developing and consistently embedding responsible investment policies linked to key initiatives such as the UN’s Principles for Responsible Investment and the FRC’s Stewardship Code
  3. The introduction of mandatory disclosure and reporting requirements at entity level, such as TCFD
  4. Product-level disclosure requirements such as the European Union’s Sustainable Finance Disclosure Regulation (SFDR) and the FCA’s Sustainable Disclosure Requirements (SDR)
  5. Collating and reporting on GHG emissions data from investments.

ESG challenges for asset owners and managers

Common industry-wide challenges exist across all of the above considerations. Our Financial Services ESG Advisory team has experience supporting asset managers in navigating these challenges and many more, whether you are just starting on your ESG strategy journey or are more advanced and are seeking advice and/or assurance to progress to the next stage of development.

The Dear CEO letters from the PRA in October 2022 and January 2023 to CEOs of PRA-regulated firms reinforces the regulator’s expectations in respect of climate-related financial risk, which includes the PRA’s reiteration in that, by now, all firms within scope of their Supervisory Statement (SS) 3/19 must be able to demonstrate how the expectations are being met. The most common weaknesses identified in the sector are governance and oversight, engagement, and data management.

The above requirements extend to international Banks and UK branches of international Banks operating in the UK, as they are covered by the PRA requirements and should have climate change risk management controls in place.

Many large and medium-sized banks will also be subject to additional sustainability-related legal and regulatory requirements, as well as PRA requirements around diversity and inclusion.

ESG challenges for banks

The most common weaknesses identified are:

  • Governance and oversight: There is increased scrutiny on the responsibilities of the designated Senior Manager Function (SMF) for climate, with roles and responsibilities clearly set out. From a business strategy and process perspective, Management needs to be able to show how the results of scenario analysis have been considered when making key decisions. The Board must be prepared to report on how they have exercised their oversight and challenged responsibilities.
  • Stakeholder engagement: The expectation is that firms should develop a counterparty engagement strategy to inform them on how they manage climate risk exposures, for example when developing new products and services. This will aid firms in understanding exposures and building data whist encouraging others to improve their current approach.
  • Data management: Data availability has been identified as a key barrier for firms in measuring their climate risks. The PRA expect firms to set out an approach to identify the gaps in their climate data, and to have a plan to close those gaps. All firms should have contingency solutions in place using appropriately conservative assumptions, judgements, and proxies and should be more focused on bolstering quantitative data availability.

By now, the PRA expects banks and insurers to be able to demonstrate sufficient embeddedness of climate risk management controls, as well as strategies to overcome identified barriers. Firms not meeting these expectations face having to explain their position to regulators, upon their request.

In the UK, as mentioned above PRA regulated firms were required to have fully embedded an approach to managing climate-related financial risks by the end of 2021.

Some of the risks that were once on the long-term horizon are now starting to crystallise, leading to increased attention particularly on the underwriting footprint, the investment portfolio, and insurer’s role in society. Therefore, assessing both the risk exposure and the ability to influence positive change is crucial. As a result, the concept of sustainable insurance is gaining prevalence as a strategic approach that covers identifying and assessing risk to managing and monitoring key performance indicators and exploring new opportunities associated with ESG issues, improving business performance.

In addition, since 2020 Lloyds have increased their ambition to become a truly sustainable market-place and to achieve net-zero carbon emissions by 2050. Lloyds expects each managing agent to implement an ESG strategy and framework that is fit for purpose for their business, and their 2022 ESG guidance sets out best practices on developing sustainable underwriting and responsible investment strategies.

Many large and medium-sized insurers will also be subject to additional sustainability-related legal and regulatory requirements, as well as PRA requirements around diversity and inclusion.

ESG challenges for insurers

Some practical challenges we see for insurance and reinsurance firms with implementing climate risk regulatory requirements include:

  • Depending on whether insurance firms are viewing climate risk from the perspective of insurers, or as investors/allocators of capital, these can drive different considerations and responses, as well as the need for different underlying processes and controls to support these responses.
  • What is a proportional approach? A key theme. The physical and transitional risks associated with climate change have and will impact insurance firms differently depending on their business models and activity. However, regulators globally are stressing the importance of having conducted the relevant risk assessments and preparatory work to support current conclusions in terms of climate risk assessment and to be able to respond to changing climate risk profiles and impacts over time. Proportionality largely depends on the risk levels identified. Comparable to financial crime requirements and expectations, if claiming your business is at low risk of climate change, there is a need to evidence and prove how that conclusion has been drawn.
  • Commercial strategy and getting the balance right. For example, requirement around executive pay, remuneration, and incentives, may be commercially sensitive, and there is a trade-off to consider between commercial sensitivity and regulatory compliance. Climate change should be just one component of an organisation’s sustainability strategy. 

Payments 

In 2023 the FCA asked payment firms to consider ESG risks. Firms authorised or registered under the Payment Services Regulations 2017 (“PSRs”) and the Electronic Money Regulations 2011 (“EMRs”) such as Payment Institutions (“PIs”), Electronic Money Institutions (“EMIs”) and Registered Account Information Service Providers (“RAISPs)”) should familiarise themselves with the FCA’s ESG Strategy and ensure that their firms have appropriate governance arrangements for complete and careful consideration of material risks and opportunities.

This requires at the very least an ESG materiality risk assessment that investigates exposures as a result of climate-change negative impacts and a lack of diversity, equity and inclusion in the firm.

The output should become a plan to develop strong governance to support ESG objectives and promote diversity and inclusion. The plan should be made available to the FCA upon their request so firms should make sure they are prepared to avoid being caught off-guard. We expect the sector will be further regulated in the future.

Lager corporates and listed companies

Where financial services firms are either listed companies, or larger corporates this can bring firms not otherwise covered by the ESG reporting requirement into scope.

Larger firms are defined as those with more than 500 employees and operating income of more than £500m. They need to report on how they are managing their climate-related financial risk in accordance with the Companies (Strategic Report), Climate-related Financial Disclosure Regulations 2022 and the Limited Liability Partnerships. This requires them to have implemented climate change strategies supported by climate change risk management frameworks.

For asset managers and owners that are FCA regulated as the as per their ESG Handbook, they also need to report on their arrangements for managing climate-related financial risks. Initially the FCA requirements covered just listed entities, but was extended to larger regulated financial institutions, including asset managers with AUM of more than £50bn for the financial year beginning 1 January 2022, and extended to asset managers with more than £5bn for FY’s beginning 1 January 2023, to be reported by 30 June the following year.

To clarify, these requirements are slightly different to the Companies Act requirement which requires the TCFD report to be included within a firm’s annual report.

In addition, as indicated in the PRA’s Supervisory Statement SS 3/19, regulated firms, not in the scope of the above listed reporting requirements, are also expected to engage with the TCFD framework and report accordingly.

TCFD reporting for financial services: What do financial services firms need to know to get started?

Given the introduction of additional mandatory sustainability and TCFD-aligned reporting requirements in recent years, the number of companies reporting on climate and other sustainability-related matters has increased significantly in recent years.

In June 2023, the ISSB issued IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information (IFRS S1) and IFRS S2 Climate-related Disclosures (IFRS S2). Global adoption is on the rise, including in the UK which set up its technical advisory committee in May 2024 with a view to making an adoption decision. The ISSB has stated that it will provide guidance and introduce programmes that support those applying its standards as market infrastructure and capacity is built. TCFD reporting guidance was officially disbanded at COP 28, effective from January 2024 and the recommendations have been subsumed into the ISSB S1 and S2 reporting requirements.

You can find out more about how you can drive climate change risk maturity through TCFD reporting here

Greenwashing

Regulators are concerned that some firms may be making exaggerated, misleading or unsubstantiated sustainability-related claims about their products, not only in the UK but also in other countries. To address this concern, the FCA has introduced a general ‘anti-greenwashing’ rule for all authorised firms. All sustainability-related claims must be clear, fair, not misleading and should be able to withstand closer scrutiny over how these claims are executed.

Firms must carefully reflect on the claims they make over the products and services offered to customers. The anti-greenwashing rule has been introduced as part of the Sustainability Disclosure Requirements (SDR) regime introduced by the FCA in November 2023, with a phased implementation of the component requirements. For the anti-greenwashing rule, the use of certain sustainability-related terms in product names and marketing materials for UK-based funds will be restricted unless the product uses a sustainable investment label, as per the SDR. Therefore, fund managers, their distributors and associated advisers can expect to be busy engaging with the new labelling and disclosures regime, ensuring the requirements are fully understood and ready to be implemented. However, to reconfirm, aside from these SDR requirements, the anti-greenwashing rule applies to all FCA authorised firms and not just fund managers and distributors.

Independent Assurance

With an increased global focus on sustainability-related disclosures in the financial sector, many banks, insurers, asset managers and other financial services firms are finding that they need to improve their reporting mechanisms to enable investors and the public to understand and use their data and information with confidence.

Our team provides various forms of assurance in relation to carbon emissions, ESG, and wider sustainability reporting, including under International Standard on Assurance Engagements (ISAE). Assurance adds a layer of oversight and transparency to disclosures and reporting. This includes reviewing and assessing methodologies, processes and controls used by firms to collate, aggregate, validate and report the scope 1, 2 and 3 emissions data and wider sustainability indicators such as water, waste, supply chain, diversity and inclusion, and career opportunities.

Planning in consultation with the assurance provider, or other advisers where necessary, in advance of the assurance process is vital for firms to make the process run smoothly and minimise the risks of their data being unable to be assured. This helps identify and inform of any gaps to be addressed in advance of the assurance process beginning.

The assurance and verification phase of sustainability and environmental data is designed to reduce any reputational and greenwashing risk in disclosing misleading or incorrect data and to check on the value and authenticity of the relevant data reported to the public.

Obtaining independent assurance benefits organisations by minimising the risk of publishing material errors, whilst identifying ways to continue to improve their reporting processes.

ESG Strategy

Our approach to building an effective ESG strategy is to evaluate risk and opportunity, identify specific regulatory requirements, map firm values, assess reputation risk, and conduct testing to the extent to which the strategy is embedded after a period of time.

Our model has three defined steps:

  • Step 1: Understand your key ESG risks and how the ESG expectations of your stakeholders can impact your business success
  • Step 2: Impact evaluation and materiality assessment
  • Step 3: Reconsidering where your business currently is and where you want to be in order to meet your vision. Aligning with your regulatory obligations in respect of the ESG initiatives such as data and reporting, climate change, diversity and inclusion and providing community shared value.

The key element for successful ESG strategy development is the aims & impacts assessment, that underpins the strategy as a whole. This is followed by a development plan of prioritised actions and the associated governance arrangements. An ESG Strategy, when well developed, demonstrates the environmental, social, and governance factors that your business believes to be intrinsically important to your current and future business strategy and operations.

Developing a successful ESG Strategy for Financial Services Firms 

Through supporting clients in developing and implementing ESG strategies, we have built an effective framework for a successful strategy. Our specialist team have produced a guide outlining the key areas of consideration for financial services firms when developing a meaningful strategy, top tips, as well as some common challenges we have seen along ESG strategy journeys that firms should be aware of and safeguard against to help implement their strategy successfully.

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Improving your ESG position

Wherever you are in the process of developing your ESG and sustainability strategy, BDO can help you. Our Financial Services ESG team is providing specialist ESG risk and regulatory advice to clients. We are also providing support to firms in respect of climate and sustainability-related disclosures on firms’ ESG and sustainability strategies and risk management arrangements, as well as related disclosures, and the extent to which these satisfy regulatory expectations. Our specialists also provide assurance engagements in accordance with ISAE 3000 and ISAE 3410, reporting your energy usage and carbon emissions in the UK and internationally.

Download our brochure for more details on our services and explore our client case studies, showcasing the ESG and sustainability support we are providing to financial services firms.

Wherever you are in your ESG journey, our specialist team is ready to help. Get in touch with Sasha Molodtsov, Mark Spencer or with our specialist team to find out how we can best support you.

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