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Trends in financial regulation of climate risk challenge the EU’s leadership of sustainable finance

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Photo by Ah Life on Unsplash

The international trend towards financial regulation of climate change issues is picking up pace.

The flurry of consultation deadlines in the last fortnight suggests that the international trend towards financial regulation of climate change issues is picking up pace. 

In the UK the Financial Conduct Authority (FCA)’s Discussion Paper on Climate Change and Green Finance closed for comment at the end of the month, two weeks after the comment deadline for the Prudential Regulation Authority (PRA)’s Consultation Paper on Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change. Both consultations were launched on the same day alongside an announcement that the two organisations would lead a Climate Financial Risk Forum with private sector participation.

Although the FCA and PRA are working closely together on climate risk the questions put out to consultation differed in line with their institutional mandates. The PRAconsulted on a draft Supervisory Statement for banks and insurance firms which would set out expectations for governance, risk management, scenario analysis and disclosure in relation to the financial risks from climate change, in line with its mandate to maintain monetary and financial stability. The FCA Discussion Paper was more exploratory but included clear arguments for climate risk being a matter for regulatory intervention under the its mandate of protecting and enhancing the integrity of the UK financial system, with an overarching goal of protecting consumers. 

Over the Atlantic, the end of January was the deadline for comment on the Interim Report by Canada’s Expert Panel on Sustainable Finance (the ‘Canada HLEG’). The Panel was appointed by the Ministries of Environment and Finance in 2018 to consult stakeholders on issues relating to sustainable finance and climate-related risk disclosures and to recommend next steps for the Government of Canada in promoting low carbon, clean economic growth. 

Canada’s consultation stood out from others closing in early 2019 for deliberately surveying the global landscape of sustainable finance regulation to put national action in an international context. The Expert Group proposed six ‘foundational elements’ for sustainable finance: a) Clarity on climate and carbon policy, b) Reliable information, c) Effective climate-related financial disclosures, d) Clear interpretation of fiduciary and legal duties, e) A knowledgeable support ecosystem and f) Relevant and consistent financial regulation. Another unique aspect of the Canadian consultation was its thoughtful consideration of Canada’s economic dependence on oil and gas revenues, and the challenges involved in rapidly effecting a transition to a more sustainable economic base without creating a financial shock.

Climate-related financial risk – its governance, and its disclosure into the marketplace – is a central theme of the consultations in the UK and Canada. It was also the topic of the European Commission Technical Expert Group (TEG) on Sustainable Finance’s Report on Report on Climate-related Disclosures which was open to comment until February 1. The TEG had been asked to make recommendations for updates to the Commission’s non-binding guidelines to the Non-Financial Reporting Directive (NFRD) which would provide further guidance to companies on how to disclose climate-related information in line with the TCFD.

The TEG’s report is a well-argued piece of work which makes sensible recommendations – institutional investors should note that a substantial part of the report covers in detail the disclosures which the TEG suggests should be made by financial sector firms.

By doing such a good job the TEG has made it harder for the European Commission to some glaring problems with its approach to climate risk disclosure. For a start, it is becoming increasingly difficult to justify the inclusion of these disclosures under the heading of ‘non-financial reporting’ given their financial materiality. In January the International Organisation of Securities Commissions (IOSCO) said: “ESG matters, though sometimes characterised as non-financial, may have a material short-term and long-term impact on the business operations of the issuers as well as on risks and returns for investors and their investment and voting decisions.”

The other obvious question raised by the TEG report is the question of whether disclosures by non-financial companies and financial firms in line with the TCFDrecommendations should be mandatory, which was recommended by the HLEG but is not planned by the Commission. The TEG identifies three types of disclosure with the majority falling into Type 1: “those that companies should disclose (high expectation that all reporting companies disclose them)”. However the landing point for the recommendations is the Commission’s non-binding guidelines for NFRD. These hardly have an impressive track record of influencing behaviour: in 2018 CDP and the Climate Disclosure Standards Board analysed the first year of corporate climate and environmental disclosures under the NFRDby 80 large European companies, finding “no direct evidence from companies that the Guidelines were being used or having a positive effect on NFRD or TCFD-aligned disclosures”.

Looking away from Europe towards the rest of the world, the regulatory direction of travel is clearly towards mandatory climate risk disclosure. The PRA’s draft Supervisory Statement sets out expectations for disclosure under existing regulatory requirements, and its Executive Director was quoted in January as saying about TCFD: “If it’s not mandatory in five years, that strikes me as a bad outcome.” The FCA asks for views on introducing a new requirement for financial services firms to report publicly on how they manage climate risks to their customers and operations. Canada’s Expert Panel asks whether climate risks are different from other material financial risks and how to integrate them into financial regulatory oversight. The IOSCO statement says that material ESG risk may need to be disclosed under security filings, and at Davos former SEC Chair Mary Schapiro said that regulators are losing patience with the pace of voluntary action by companies and may need to step in to require disclosure.

If it is not to lose its global leadership position on sustainable finance the European Commission will need to wake up and realise that the HLEG was right. Financial regulation of climate risk governance and disclosure is moving fast, and the direction of travel is towards mandatory governance and disclosure of climate-related risk by all firms in line with the urgency of the climate challenge set out so clearly in the IPCC’s report on 1.5 Degrees. Yet the European approach remains stuck the era when climate change was seen only as an aspect of Corporate Social Responsibility, and financial firms were praised for disclosing the emissions from their office energy bills. The ongoing ‘Fitness Check on the EU Framework for Public Reporting by Companies’ is a route to looking at this again, and the next Commission will need to address the issue head on.

This article first appeared in Responsible Investor.