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Regulatory and quasi-regulatory forces
Regulatory and quasi-regulatory forces

Regulatory and quasi-regulatory forces


Regulation has accelerated the move towards sustainability, encouraging financial institutions to take more account of ESG factors

There are strong risk management reasons for companies and investors to take more account of environmental, social and governance (ESG) issues in their business strategies. But one of the strongest drivers is the growth in regulation and quasi-regulatory initiatives that deal with these issues.

These range from moves at the local level – such as city initiatives to tackle air pollution – right up to supra-national agreements signed by virtually every country in the world.

In the same way that companies and investors have started to realise the importance of sustainability in ensuring healthy companies and long-term returns, governments around the world are increasingly taking it into account as well.

Growing number of global climate change laws

In 2008, the UK introduced the world’s first climate change law, committing the government to set out plans to cut greenhouse gas emissions (GHGs) to 80% below 1990 levels by 2050. Since the introduction of the Climate Change Act, a number of other countries have followed suit.

The European Union introduced its 20/20/20 rules that called for the bloc to derive 20% of its energy from renewable sources, to cut its energy intensity by 20% and reduce GHGs by 20% from 1990 levels, all by 2020. With that deadline almost upon us, the EU is in the process of setting a new, stricter target for 2030.

And although for many years emerging markets insisted that it was the responsibility of industrialised countries to take action on climate change, this is not just a developed world phenomenon any more. The scale of the problem has led to a realisation that it is in every nation’s interests to act.

As a result, China, the world’s largest emitter of GHGs, has set a raft of targets, including cutting its carbon intensity by 40-45% by 2020, from 2005 levels and peaking its emissions by 2030. It is setting up the world’s largest carbon market and is investing huge sums in wind turbines, solar panels and electric vehicles. India’s ambitions are similarly sweeping. It plans to end sales of petrol and diesel cars by 2030 and to source 40% of its electricity from renewable sources by the same date.

Similar actions are taking place all around the world. Since 1997, there has been a 20-fold increase in the number of global climate change laws, according to the most comprehensive database of relevant policy and legislation. The Grantham Research Institute on Climate Change and the Environment and the Sabin Center on Climate Change Law report that in 2017, there were more than 1,200 relevant policies in 164 countries, accounting for 95% of global greenhouse gas emissions.

Even the world’s biggest oil producer, Saudi Arabia, has announced challenging targets to have 10% of its power coming from renewable sources by 2023 as part of its Vision 2030 programme. Meanwhile in the US, where the Trump administration is sceptical about the need to tackle climate change, there is a huge amount of activity at regional, state and city level. The state of California, for example, has a raft of targets including a 40% cut in 1990 emission levels by 2030, while the mayors of more than 400 US communities have pledged to do their part to meet the requirements of the Paris Accord.

The Paris Accord

The Accord is the ultimate expression of the trend towards regulating to tackle the effects of climate change – almost 200 countries agreed to work to limit average temperature rises to “well below” 2°C. As part of the deal, each country published a plan (the Nationally Determined Contribution or NDC) setting out how they intended to cut emissions and reduce vulnerability to the effects of climate change. Such plans – and the policies that flow from them – are already starting to have a significant impact on how companies do business in fields ranging from energy and transport to buildings and agriculture.

Crucially, though, analysis of the NDCs shows that there is a significant gap between what is needed to reach 2°C and what has been pledged so far, says Florence Fontan, head of Asset Owners at BNP Paribas Securities Services. “We know from Paris that what companies have agreed will lead to temperature rises of 2.7°C.” This means that companies can expect regulations to become more stringent over time, and they need to be prepared for that. “Investors need to understand how companies are aligned and what that means for their portfolios – and also what they need to do to systematically alter their portfolios so they align with the Paris targets. That will take a long time to change,” she adds.

“There is a significant gap between what is needed to reach 2°C and what has been pledged so far”

Florence Fontan, head of Asset Owners at BNP Paribas Securities

Sustainable finance initiatives aimed at businesses and investors

It is not just the companies that investors put their money into that are being directly impacted by climate change regulations – investors are facing new requirements, too, such as France’s Article 173, which requires investors to assess and report on the risks they face from climate change. “Governments have given the financial services industry incentives to participate in the climate agenda, but the industry is moving too slowly compared to the ambitious targets that have been set. That means ambitious regulation is coming,” Fontan says.

This trend is being backed up by a number of initiatives aimed at businesses and investors, including the Taskforce on Climate-Related Financial Disclosure (TCFD) and the European Union’s High-Level Expert Group on Sustainable Finance (HLEG).

The TCFD calls on companies to report on what they are doing in four areas:

  • Governance - The organisation’s governance around climate-related risks and opportunities
  • Strategy - The actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy, and financial planning
  • Risk management - The processes used by the organisation to identify, assess, and manage climate-related risks
  • Metrics and targets - The metrics and targets used to assess and manage relevant climate-related risks and opportunities

The recommendations, though voluntary, are already having an effect. Research[1] by CDP and the Climate Disclosure Standards Board says that some of the world’s biggest investors “have stepped up calls to their portfolio holdings to improve the quality of their disclosure”.

However, while the vast majority of companies have made the first step of acknowledging that climate change poses financial risks for their business, when it comes to turning awareness into action, there is still a disconnect in many sectors and countries. For instance, more than 8 in 10 companies oversee climate change at the board level, but only 1 in 10 provides incentives for the management of climate change issues.

20-fold increase in number of global climate change laws since 1977

Source: Grantham Research Institute on Climate Change and the Environment and the Sabin Center on Climate Change Law

The report also highlights that companies from China in the healthcare and financial sectors are lagging behind in disclosure, though the Chinese situation should change in 2018 as new mandatory reporting policies come into force.

“This is a financial issue, not just a sustainability one,” the report says. “Investors and lenders, in particular those exposed to carbon-intensive sectors, need to understand the short and long-term risks and opportunities in order to understand how to preserve and/or redeploy their capital.”

The HLEG report on Sustainable Finance and a follow-up Action Plan will build on the work of the TCFD, for the EU market at least. It sets out almost 30 recommendations, including guidance on what investors should be doing to make the financial system more sustainable, and a call for investors and companies to improve their disclosure on how they factor sustainability into their decision-making. The report also proposes a classification system to make it clearer to investors what is 'sustainable'.

“This is a huge issue,” says Fontan. “We need an agreed lexicon of how to discuss these topics. To make transparency meaningful, we must have a methodology that allows investors to compare the data of different companies, like there is in accounting.”

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