Increasing concerns about the impact of climate change on businesses has led many regulators to strengthen reporting frameworks to include new requirements around ESG.
Central banks and stock exchanges have been among the first to take concrete action. In some jurisdictions, ESG requirements have become mandatory, and risk management frameworks are being updated accordingly. In other jurisdictions, however, ESG reporting remains voluntary.
Voluntary reporting will only take the financial sector so far in increasing the transparency of corporate environmental and social sustainability performance, and supporting investors in quantifying these risks and opportunities in investment decisions. Even if ESG reporting is made mandatory, there is still a long way to go – how can it be enforced? What penalties should be in place? And do central banks need to lead the charge?
Climate change has revealed that the financial sector needs better information around risk exposure both in terms of transition risk and physical risks. The onset of the Covid‑19 pandemic last year, which halted global economic activities but failed to bring emissions in line with the targets set by the 2015 Paris Agreement on climate change, only heightened the gravity of the challenge.
Of particular concern to central banks and financial regulators, whose task is to ensure financial sector resilience, is the potential threat environmental risks pose to financial stability. From a regulatory perspective, climate-related disclosures are an important avenue for banks’ stakeholders to understand the relevant risks they face and their approach to addressing such issues, a representative from the Hong Kong Monetary Authority (HKMA) told Central Banking.
Efforts by central banks and regulators are under way in developing internationally consistent standards for climate and environmental disclosures, which will allow financial institutions and listed companies to provide comparable, high-quality data that offers greater clarity to the market. The Financial Stability Board (FSB) is leading this effort with the Task Force on Climate-related Financial Disclosures (TCFD) initiative.
In 2020, the HKMA – together with other agencies in Hong Kong under the Green and Sustainable Finance Cross-agency Steering Group – mandated banks, fund managers, authorised insurers and listed companies to make climate-related disclosures aligned with the TCFD’s recommendations by 2025.
“Imposing mandatory climate-related disclosures based on an internationally recognised framework will increase the availability of information in the financial markets on how climate change will impact the risks and opportunities faced by companies or their assets,” the HKMA official says.
“[This] is crucial to supporting informed capital allocation and promoting market discipline … Adopting TCFD-aligned disclosures could ensure consistent and comparable disclosures and foster convergence.”
An official from the Monetary Authority of Singapore (MAS) told Central Banking that, while making ESG reporting mandatory would be a challenge for the sector, there would be a greater cost of not having information and data available to enforce appropriate risk management frameworks and instil market discipline.
“[ESG reporting] enables market participants, which include investors and lenders, to price and manage ESG risks as well as allocate capital more effectively,” the MAS official says. “Financial institutions and businesses need to incorporate ESG considerations into their operations, processes and reports to effectively address and mitigate climate risks.”
Transitioning to mandatory
In 2015, France became the first country in Europe to set ESG reporting obligations for institutional investors. Since then, a number of international initiatives have pushed more financial supervisors to take stock of how exposed financial institutions operating in their jurisdictions are to climate risks.
In November 2020, the European Central Bank (ECB) published its final guide on climate-related and environmental risks for banks, with a supervisory stress test focusing on climate-related risks scheduled for 2022. The guide set out ECB’s expectations on banks to prudently manage and transparently disclose such risks under current prudential rules.
The Hong Kong Stock Exchange (HKEX), which first introduced voluntary ESG reporting in 2013 for listed companies, has over the years made gradual moves toward mandatory ESG reporting. Since 2016, HKEX has required listed companies to publish annual ESG reports and upgrade certain disclosure requirements from voluntary-based to a ‘comply or explain’ model.
Katherine Ng, head of policy listing at HKEX, says the exchange introduced new requirements in July 2020 requiring listed companies to consider significant climate-related issues that have affected them, and to make appropriate disclosures on a comply or explain basis. Boards of these institutions are responsible for the oversight of this work, she explains.
Further change is also underway within the Asia region. While the MAS will expect banks, insurers and asset managers to make climate-related disclosures from June 2022, it is also planning a consultation on how to transition these expectations to mandatory requirements that are enforceable. The Singapore Exchange (SGX) has also issued a proposal for consultation to introduce mandatory climate-related disclosures consistent with the TCFD recommendations for listed entities. MAS says SGX will start with sectors most exposed to climate-related risks, and will introduce the requirements by way of SGX’s listing rules.
Both MAS and SGX are consulting the industry on how to transition their expectations into mandatory requirements that are enforceable. An official from MAS says having enforceable requirements will ensure consistent and comprehensive reporting. This is important given that ESG reporting is the foundation upon which the wider sustainability effort is built, the official explains.
To ensure ESG reporting is effectively enforced within the European Union, the proposed Corporate Sustainability Reporting Directive will also implement verification and audit obligations for ESG disclosures. As for banks, the Capital Requirements Regulation already has requirements for large banks to disclose ESG risks, which will be monitored by the ECB according to applicable regulation.
“From a supervisory perspective, transparency of risk profile and risk exposure to ESG are necessary,” says a European regulator who spoke on condition of anonymity.
“For markets to support the transition, policy-makers should create the conditions for the financial sector to do what it does best: allocating capital where it is most needed, guided by investors’ preferences and effective price signals that correctly reflect the externalities associated with climate change and environmental degradation.”
A number of jurisdictions have also announced their plans to adopt a similar approach. The Reserve Bank of New Zealand (RBNZ) made TCFD-based climate-related disclosures mandatory in April 2021 for publicly listed companies as well as large insurers, banks, non-bank deposit-takers and investment managers.
RBNZ governor Adrian Orr, in his March 29 response to the Climate Commission, said the central bank’s draft advice explored the relationship between investment and climate resilience, and recognised the interplay between the environment, economics, finance and wellbeing. “We agree that interventions in all areas need to be properly considered and coherent,” he said.
Common standard needed
Increasingly, central bankers are urging the development of common reporting standards. In a blog post on May 11, 2021, ECB board member Fabio Panetta called for leaders to come to an agreement on “common principles for well-functioning and globally coherent taxonomies”.
The ECB reflected the same sentiment on September 7 in an opinion on the EU’s proposal regarding corporate sustainability reporting: “Common reporting standards of sufficient quality that underpin comparable, transparent and reliable sustainability-related disclosure are essential for developing more comparable and reliable sustainability metrics, the correct assessment of sustainability-
related (financial and non-financial) risks and, therefore, the pricing of assets and the calibration of risk control measures.
“This would be beneficial for credit institutions’ risk management, internal reporting and public disclosures on ESG risks and, as already indicated, for central banks and supervisors in conducting analyses and incorporating climate-related considerations in the execution of their mandates.”
The eurosystem’s recent response to the European Commission’s public consultations on the renewed sustainable finance strategy and the revision of the Non-financial Reporting Directive also pointed out the importance of “close international co-ordination to promote internationally consistent frameworks and prevent regulatory fragmentation”.
The lack of a common global baseline for sustainability reporting standards has resulted in selective reporting against different frameworks, impeding the growth of sustainable finance globally, says an official from MAS. This official acknowledges that there were “promising signs of convergence”.
Work conducted by the Financial Stability Board, the TCFD initiaitve and the International Financial Reporting Standards Foundation (IFRS) are key examples of work aimed at developing common sustainability reporting standards. Similarly, the Network for Greening the Financial System – a consortium of the world’s central banks and financial regulators – has also set out its expectations for financial institutions to enhance transparency to help supervisors understand their approach to climate-related and environmental risks.
These international initiatives have seen a growing number of central banks and regulators make ESG reporting mandatory for financial institutions and listed companies. Mandatory ESG disclosures and reporting will soon be required within the EU as part of the Sustainable Finance Disclosure Regulation (SFDR). The SFDR imposes mandatory ESG disclosure obligations for asset managers and large financial market participants.
Developing the norm
The IFRS established an International Sustainability Standards Board (ISSB) in November 2021 on the sidelines of the UN Climate Change Conference, COP26. The IFRS’s efforts will build on the recommendations of the TCFD, which have gained wide international acceptance from central banks, regulators, the International Organization of Securities Commissions (Iosco) and the FSB.
Iosco is also monitoring the IFRS Foundation Trustees’ technical preparatory work on the design and establishment of the ISSB, a regulator from the Asia region tells Central Banking. The Iosco Sustainable Finance Taskforce (STF) published a report in June 2021 reiterating the need to improve the “consistency, comparability and reliability” of sustainability reporting for investors.
It also elaborated three main elements in Iosco’s vision for improving issuers’ sustainability-related disclosures. These include establishing the ISSB with a strong governance oversight under the IFRS.
“It was found that asset managers viewed the creation and adoption of a mandatory common international standard for sustainability-related financial reporting as the most important area for improvement in sustainability-related disclosures,” the Asian regulator explains.
Asset managers have also called for regulators to globally adopt mandatory reporting requirements based on TCFD and Sustainability Accounting Standards Board initiatives as an initial step while a global standard is being developed.
“Provided Iosco’s expectations are satisfied, Iosco will consider market acceptance of the ISSB’s future standards and set a pathway for the ISSB’s sustainability reporting standards to serve as the global baseline for consistent and comparable approaches to mandatory sustainability-related disclosures across jurisdictions, in line with domestic legal frameworks,” the Asian regulator added.
MAS is one central bank involved in the Iosco STF, acting as a co-lead to the Technical Expert Group with the US Securities Exchange Commission. In this role, MAS is evaluating whether a prototype climate reporting standard and related materials developed by an IFRS work group could form the basis for a baseline global climate reporting standard.
Iosco also recognises individual jurisdictions have different domestic arrangements for adopting and applying international standards. As a result, the standard-setter has recommended that individual jurisdictions consider how a common global baseline might be applied within the wider legal and regulatory frameworks.
After net zero: what next?
The goal of meeting net-zero targets underpin the financial sector’s efforts to introduce ESG requirements as a way of ensuring the global economy remains resilient in the face of climate risk. As a result, some market observers have raised questions about whether mandatory reporting will become more lenient once countries hit their net-zero targets.
The official from MAS notes that, while net-zero targets help countries work towards a defined goal, the underlying transformation of an economy’s mindset needed to achieve those targets will have positive effects that last beyond net zero.
“We foresee that ESG reporting will become a baseline that is akin to financial reporting today,” the MAS official says.
An official from a European regulator also stressed the aim of ESG reporting should be “as important” as financial reporting. “The two should be connected and provide the basis for strategic decisions. ESG disclosures are not limited to climate targets. The environmental reporting element is important as well, also from a financial perspective,” the regulator said.
A report published by the ECB in November 2020 is a good indicator that ESG reporting is likely here to stay. The report revealed almost none of the ECB’s supervised institutions would meet a minimum level of disclosures set out within the central bank’s guide and related recommendations by the deadline.
“The disclosures gap is still very significant and banks, like other corporates, are only starting to take steps to comprehensively disclose relevant information and metrics relating to ESG risks,” the central bank official said.
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