Guest Post – Beyond Disclosures: What is the Direction of Travel for ESG Regulation – and How Could Evolving Regulatory Developments Impact your Business?
By Michelle T Davies, EY Global Sustainability Legal Services Leader, and Ben Taylor, EY Global Strategy and Markets Leader, Climate Change and Sustainability Services
When the Task Force on Climate-Related Financial Disclosures (TCFD) launched in 2015, its primary aim was to prevent a potential meltdown in the financial markets. Policymakers were concerned that businesses might not be effectively managing their climate-related risks, which could potentially lead to economic losses and threaten global financial stability. Accordingly, the TCFD’s recommendations promoted better reporting of climate-related financial information. The logic was that disclosure would encourage businesses to identify the climate risks they faced, plan for them, and develop initiatives to mitigate those risks. Disclosure would also help investors to make more informed capital allocation decisions and channel investment toward sustainable assets.
The TCFD recommendations began as voluntary disclosure guidelines and are starting to be adopted more widely. In this respect, they echoed other sustainability reporting frameworks, such as those provided by the Global Reporting Initiative (GRI), the Carbon Disclosure Project (CDP), and the Sustainability Accounting Standards Board. The TCFD recommendations have rapidly either become part of the mandatory regulatory frameworks in many jurisdictions or are set to do so.
The global baseline of sustainability disclosures being developed by the International Sustainability Standards Board (ISSB), such as the recently released disclosures IFRS S1 and IFRS S2, builds on the whole set of voluntary standards, as does the EU Corporate Sustainability Reporting Directive (CSRD). Climate change is a core focus, but sustainability standards are going much further into wider nature issues, social considerations relating to workforce and communities, and internal governance and business conduct. Having clear global standards for disclosures also benefits investors, providing a framework to assess enterprise value and make commercial decisions, including allocating capital.
From compliance to action
Initially, some financial institutions and corporations tended to treat the TCFD recommendations in the same way they had treated pre-existing sustainability frameworks – essentially as a tick-box exercise. Although organizations recognized the need to source and collate accurate sustainability data, they viewed disclosure as being fundamentally about compliance and investor relations rather than transformation.
Over time, however, that compliance mindset has been challenged by unfolding regulatory developments and increasing stakeholder pressure, especially from investors, but also from customers and employees. As a result of some notable initiatives, including the CSRD and the UK’s Transition Plan Taskforce (TPT), company leadership teams are increasingly being held to account, not just on climate but also on other sustainability issues. It is not enough to simply make disclosures. Companies are expected to properly implement their climate commitments into action – for example, through transition plans.
This shift from compliance to action presents a whole new area of legal risk for companies – a risk that currently attracts little attention beyond the general counsel’s office. As companies’ key stakeholders gain better visibility of their transition plans, they should be able to track the company’s progress against the plan. What’s more, if stakeholders – such as banks or investors – can prove that they have suffered a financial loss from relying on this information, a potential legal liability can arise.
The EU has already proposed a draft law to combat greenwashing, requiring companies that make environmental claims about their products or services to abide by minimum norms when substantiating these claims. The law aims to provide legal certainty around environmental claims and will facilitate enforcement activities around claims made.
At present, the real economy is still catching up with the shift that is taking place, however. EY research has found that just 5% of FTSE 100 businesses surveyed disclosed transition plans that would be sufficiently detailed to meet the UK government’s TPT Framework guidance and have started to put these plans into action.
Key considerations for companies
Going forward, companies will likely experience far greater scrutiny over their environmental, social and governance (ESG) performance from a wide range of stakeholders, including their auditors, banks, customers, investors, and insurers. This will put them under pressure to be genuinely transparent and to manage their data in more sophisticated ways. In due course, they also will likely need third parties to provide them with accurate data so that they can calculate their scope three emissions (emissions that arise from their value chain).
There are several ways in which your company can respond to the demands of the evolving ESG regulatory landscape. If it has not already done so, your company should consider undertaking a baseline assessment of its current carbon footprint and the climate risks facing the business. Then it will be able to set targets and metrics, and decide how it will measure and communicate progress.
First, ensure you provide genuine visibility to your key stakeholders as you develop your plans, regularly engaging with them around transition. For example, a bank or an insurer may use your transition plan when pricing risk. But if you fail to update – or deliver on – your plan, you are likely to find that your banks and insurers will want to change the terms of their engagement with your organization, to better align their pricing and their risk. The interplay between contractual obligations and the representations made by a transition plan will be critical.
Second, communication and transparency are essential, given that transitioning to net zero is not a linear process. To green its business, a company may need to invest in carbon-intensive projects in the short term, which reduces its carbon emissions over the longer term. It may buy and sell businesses, decommission assets, and launch new sustainability initiatives. What’s more, it will likely need to report on this process in a reliable and consistent way – which is not easy, despite the move toward more standardized frameworks.
Inevitably market dynamics will change over time, necessitating changes to the plan. To maintain positive stakeholder engagement, it is essential to create visibility and engagement around any changes – this is about risk management and how to generate value from those changes. A prerequisite to maximizing value from the plan will likely be to ensure that it is understood by those with the ability to impact value in an organization.
Governance is also key. There are various models for providing governance around ESG, from overall board-level accountability through to sustainability committees and working groups. A vital element of governance is the overall accountability framework in the sense of who within the business has responsibility for delivering on a particular target and considering whether you have their buy-in. If you make someone accountable for delivering on a target, they should believe that target is realistic and attainable.
But accountability for delivering ESG goes well beyond individual targets. Organizations may potentially limit themselves if they “box off” sustainability to certain people or departments. For a transition plan to work, it needs to be embedded across the entire organization. Sustainability should be part of the company’s DNA – something every individual understands so that they are clear on how their behavior can have a positive or negative impact.
The finance function is critical to the governance process. Not only can it verify that the reported numbers are right; it can also ensure that sustainability targets are feasible from a financial perspective. Certain targets can be economically unviable because the technology needed to achieve them is not yet available at scale. For that reason, companies should prioritize value-led sustainability – sustainability initiatives that don’t just sound impressive but deliver real financial returns. Returns linked to cost are probably the lowest-hanging fruit – particularly costs that are priced on risk, such as insurance or bank debt.
Finally, it is crucial to operationalize sustainability throughout your business. This is much easier to achieve if you do not “box off” sustainability. The objective is for every contracting framework and process to be fit for purpose and future-proofed from a sustainability perspective. To achieve this objective, you should consider due diligence, employee engagement, mergers and acquisitions strategy and terms, supply chain management, tax structuring, and technology deployment, plus many more frameworks and processes besides – the list can go on and on. Real sustainability is about creating long-term value, which requires an element of horizon-scanning to assess what will be perceived as valuable within the relevant investment timeframe. It also requires a different mindset – recognizing that what may have been a “nice to have” approach or arrangement now needs to be legally enforceable.
Regulation is becoming a driver of real transition, both at a financial institution level and a real-economy level. By bringing visibility to companies’ transition plans, regulation helps stakeholders to properly assess the risks of engagement with a particular organization so that they can adapt the terms of their engagement or exit the relationship if required. Already, financial institutions are making it clear that they will not invest in companies that treat sustainability reporting and transition plans merely as a tick-box exercise. The shift away from ESG compliance to real transformation is happening – and it’s happening now.
The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global EY organization or its member firms. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.