Identification, management and disclosure of ESG risks is now a meaningful pre-requisite for any organisation’s corporate strategy, business plan and supply chain management.

The EU taxonomy and wider EU and national policy and regulation is driving accounting disclosures, disclosures on financial products, business impacts and services and identification of climate related and environmental risks, ESG risks and their management as a measure of corporate resilience.

In order to address the complex and novel challenges raised by the new and developing regulations affecting [corporates, financial services firms, and SMEs] , a deep level of cross-sectoral expertise is required with an understanding of the issues facing particular client(s) or sectors.

This requires an understanding of the application of the various ESG/sustainability measures in order to determine the best approach, strategy and investment decisions to manage compliance and develop innovative solutions.

Developed and coherent ESG, sustainability and transition strategies are now increasingly important considerations in terms of competitiveness, resilience and for lenders and investors influencing decisions in relation to access to credit and investment.

Part of the difficulty for companies and investors historically has been that ESG has meant different things to different people and there is “no one size fits all” approach, hence the drive by regulators and standard setting bodies to develop taxonomies for standardised definitions and disclosures. ESG is a mix of environmental, social, or governance factors, such as climate risk, human capital, workforce diversity, board diversity and financial sustainability, that may have positive or negative impact on the financial performance or solvency of an entity.

Environmental Risks: Physical Risks from the impacts of global warming which may make some geographies higher risk, and Transition Risk relating to public policy, technological advancements and market sentiment may lead to some activities being phased out.

Social Risks: negative financial impacts linked to factors such as inequality, health or labour relations.

Governance Risks: include the negative financial impacts linked to factors such as executive leadership or bribery and corruption.

ESG matters may have a positive or negative impact on households, corporates and financial institutions.

Banks and investment firms can be impacted by ESG risks through their core business activities of lending and investing and the financial risks stemming from the current or prospective impacts of ESG factors on their counterparties or invested assets.

Counterparties can be affected by the physical effects of climate change, such as floods impacting properties, or by policy, technology or market changes, such as consumer preferences for sustainable products as society moves towards a more sustainable economy.

Banks and investment firms can also have an impact on the environment and society through their lending and investments (the ‘double materiality’ of ESG risks).

Legislation

  • NFRD – The Non-Financial Reporting Directive 2014/95/EU sets the rules on disclosure of non-financial and diversity information relating to the ESG areas
  • CSRD – The Corporate Sustainability Reporting Directive (CSRD) was adopted by the European Commission (EC) on April 21 2021 amending various directives to replace the current NFRD, by adjusting its reporting requirements. CSRD will apply not only to EU-based companies but also to non-EU-based companies that have a subsidiary in the EU, including all companies listed on regulated markets (except micro-enterprises that have a turnover or total assets of less than 2 million or that employ less than 10 individuals) and all large public-interest companies with at least two of the following requirements: 250 or more employees; €40 million in net turnover; €20 million in assets.

Regulation

  • Financial sector exposures to ESG and climate-related risks impact on their business strategy, risk management, prudential treatment, resilience and ultimately have the potential to create systemic risk.
  • Increased regulatory focus on these issues at an institutional level will have repercussions for corporates, businesses and borrowers as banks and large corporates are subjected to deeper reporting obligations.

ESG and Sustainability are key considerations across all sectors of industry, business and regulation. It has implications for corporate governance, finance, strategy and business growth, resilience, corporate culture and attraction and retention of talent.

  • EU Taxonomy Regulation;
    An EU wide classification system for assessing sustainability of economic activities through a common language for environmentally sustainable activities.
  • Sustainable Finance Disclosure Regulation (SFDR);
    Applies to funds and asset managers to disclose at entity and product level sustainability related disclosures.
  • EU Green Bond Standard;
    A voluntary standard for bonds financing sustainable investments aligned with the EU Taxonomy Regulation.
  • Regulation 2021/1119 “Fit for 55” Regulation;
    [An EU framework for achieving climate neutrality with a range of initiatives across climate, energy and fuel, transport, buildings, land use an forestry sectors.
  • Task Force on Climate-Related Financial Disclosures (TCFD)
    Guidelines for financial institutions and non-financial companies to disclose financially material information on climate-related risks and opportunities;
  • Non-Financial Reporting Directive (NFRD)
    Requires annual disclosures on certain non-financial and board diversity matters in the annual directors report attached to statutory financial statements. NFRD applies to banks insurance companies, listed corporates and large corporates with 500+ employees.
  • Corporate Sustainability Reporting Directive (CSRD)
    Amends and extends the scope of NFRD reporting against common EU sustainability standards. CSRD will apply to companies with 250 + employees, annual turnover in excess of €40m and assets in excess of €20m.
  • Corporate Sustainability Due Diligence (CSDD)
    Establishing a due diligence duty for large companies to undertake due diligence checks of their supply chain to identify actual and potential adverse impacts of their activities on the environment, climate change and human rights.

“Over 70% of respondents expect to include ESG or sustainability features in their next financing with the impediments to doing so weakening as ESG and sustainability in debt finance become better understood . . . The more fundamental trend is a company’s attitude towards ESG and sustainability is increasingly likely to drive the binary decision by debt investors and lenders of whether to lend or not.”

“There was a sense from respondents that not incorporating sustainability linked features now when a corporate otherwise could do so could appear short-sighted in the short to medium term”

[Source: HSF/ACT Corporate Debt and Treasury Report, April 2022]