What EU and UK regulatory developments are on the ESG horizon in 2024 for financial services?

This article first appeared in Thomson Reuters Regulatory Intelligence. 

2023 was characterised by the frenetic development of environmental, social and governance (ESG) regulation across the globe, and 2024 looks to be when policymakers and regulators will focus on implementing and enforcing the new rules. That is not to say there will be no new ESG regulation — plenty of new initiatives are in store for 2024. 

The authors expect the pace of regulatory change to slow, giving regulated entities much-needed space to determine what changes must be made to their business strategies, operations, and underlying corporate governance systems and processes.

2024 is also a big election year, including in the European Union, United States, and UK. This is bound to significantly impact the worldwide ESG landscape toward the latter part of the year.  

Ramping up sustainability disclosures, both at the corporate and the product level, has dominated the financial services landscape, but there are more bumps ahead. 

An uncertain future for SFDR 

The EU's Sustainable Finance Disclosure Regulation (SFDR), in force since 2021, is already facing a review, and its future looks uncertain. As a result, the asset management sector, in particular, needs to pay close attention to forthcoming developments affecting its compliance with this regulation. Far-reaching questions on the SFDR were raised by the EU Commission in 2023. While certain steps have been taken to try to address identified shortcomings (most notably in relation to fund labels, being remedied through the European Securities and Markets Authority's (ESMA) fund naming proposal), there seems to be a longer-term journey where the SFDR is converted into a labelling regime similar to the UK SDR.  

Alongside this proposed review of the framework Level 1 SFDR, changes to the SFDR's detailed implementing standards are also in motion. Proposals were published last year, and their adoption is expected in 2024. As they currently stand, the proposals will have significant implications for financial market participants, who will not only have to revisit their SFDR product and website disclosures (given the changes proposed to the templates and data points) but also revisit their entity-level "principal adverse indicator" and "do no significant harm" methodology and disclosures (given the various changes to PAI indicators).  

Improvements to the SFDR and greater convergence between EU and UK product disclosure frameworks are certainly preferable for the European asset management sector — particularly with the focus on building trust in sustainable products. The legal, operational, and compliance consequences of further change in this area mean it continues to require close and timely scrutiny and engagement.  

UK's anti-greenwashing rule set to apply to all regulated firms  

While it looks to be "all change" for SFDR in the EU, the UK's equivalent, the Sustainability Disclosure Requirements and Investment Labels regime, was only finalised in November 2023. The new rules include a fund labelling regime, a disclosure regime, naming and marketing rules, and a general "anti-greenwashing" rule.

Although most rules directly impact the buy side, the anti-greenwashing rule applies to all regulated firms. It reiterates existing rules to clarify that sustainability-related claims must be clear, fair, and not misleading. This rule requires all FCA-regulated firms to revisit their approach to ESG and sustainability across all product types (not just investment products in scope of the SDR) and disclosures.

The "anti-greenwashing" rule was expected to come into effect immediately but has been delayed until the end of May 2024 while the FCA consults on supporting guidance. Even so, the regulated sector does not have long to review and implement firm- and product-wide compliance and governance changes to adhere to this new obligation. 

Beyond product disclosure, the challenges of corporate-level ESG reporting are coming sharply into focus as reporting regimes around the globe embed and evolve in 2024. Serious questions about how these regimes work together and what this will mean in practice for multinationals having to report in several jurisdictions will begin to be ironed out, although the answers are unlikely to be clear-cut. 

What's next for CSRD? 

The EU's reporting requirements, the Corporate Sustainability Reporting Directive (CSRD), entered into force last year, although the phasing-in of the reporting obligations means that the first reports will be published in 2025 based on this year's data. EU member states have until July to transpose the directive into national law.

Few countries have made much progress with transposition as yet. France leads the pack, having already published its national law, with some further elements outstanding. Others, including The Netherlands, Spain, and Belgium, have published draft proposals, but many have said nothing yet.

The concern for in-scope firms with wide EU footprints will be whether CSRD is "gold-plated" in any of their affected jurisdictions and how/if any national uplifts dovetail with the production of a single, group-wide report likely driven by the head office.

Early indicators are that several jurisdictions expect to gold-plate, with effects across fundamental areas of the CSRD, such as its scope and exemptions. Local subsidiaries will need to understand what any national uplifts mean for them and the rules with which they must comply. They must also establish the necessary processes and governance to ensure their compliance with national requirements against the strictures of a global organisational framework.  

Interoperability of reporting regimes is the main challenge for managing corporate disclosure across a global institution. Work is ongoing in the EU on the interplay between CSRD disclosure standards and International Sustainability Standards Board (ISSB) standards, which could become the prevailing global standard. Currently, though, the EU CSRD and ISSB standards diverge over important issues, particularly materiality.

In the UK, work is underway to establish the extent to which the country will endorse the ISSB standards in the forthcoming Sustainability Disclosure Standards (SDS) regime. Currently, UK corporate climate disclosure is measured against standards developed by the Task Force on Climate-Related Financial Disclosures (TCFD). Listed companies and asset managers are subject to mandatory TCFD reporting (on a comply or explain basis), with smaller asset managers set to make their first TCFD reports in 2024.

Certain large companies subject to the Companies Act are already subject to mandatory TCFD-aligned reporting. These requirements will likely change over the next couple of years to reference the ISSB standards. This may not ultimately involve material changes to reporting practices or content requirements. The ISSB chair said companies applying the ISSB standards will comply with the TCFD recommendations. Firms, nonetheless, need to keep track of these changes and assess necessary adjustments.  

Transition plans  

The need to have and disclose a transition plan moved up the list of priorities in 2023, and the UK's Transition Plan Taskforce (TPT) made strides in setting out the UK's expectations. The sector-neutral disclosure framework was finalised in October 2023, and the sector-specific guidance, including for financial services, is expected to be finalised soon. 

The TPT's publications are part of the commitment by the UK government to mandate transition plan disclosure, meaning there are numerous developments to track. In the 2023 Green Finance Strategy, the UK government promised to consult on requirements for the UK's largest companies to disclose their transition plans if they have them: that is awaited. Further, the FCA has indicated it will consult in the first half of 2024 on strengthening requirements for transition plan disclosures in line with the TPT disclosure framework, alongside its consultation on implementing UK-endorsed ISSB standards. 

The UK's efforts sit alongside global moves toward transition plan disclosure. In the EU, the forthcoming Corporate Sustainability Due Diligence Directive (CSDDD) and reforms to the capital requirements for banks (known as the EU's Banking Package) mandate transition plan disclosure. 

CSDDD and financial services

2023 was a tortuous year for reaching agreement on the CSDDD, with EU countries sharply divided on the right approach. CSDDD will impose far-reaching obligations to conduct due diligence and mitigate actual and potential adverse impacts on human rights and the environment. Political agreement was finally reached in December 2023, including on the controversial question of whether the financial services sector should be subject to due diligence obligations.  

The outcome of this question is that financial services will only be included relative to their own operations and upstream supply chains. It has been agreed that their downstream financial operations will be excluded (at least for the time being). This contradicts the Parliament's initial position and the European Central Bank's (ECB) latest input. It is, therefore, a big win for the EU Council and those member states who pushed for the exclusion of financial services altogether. The Parliament insisted, however, on a review clause that allows for the inclusion of downstream activities at a later stage based on an impact assessment. Howsoever this assessment goes, firms in the financial sector will be affected by these rules indirectly, because they will likely be business partners of in-scope companies, who will then perform due diligence on them from a CSDDD perspective. 

Change is on the horizon for ESG rating and data providers

Finally, more and more ESG rating and data providers worldwide will likely find themselves governed by the regulation. While voluntary codes are proliferating in Asia, the UK and the EU are battling to become the first to legislate.

In the UK, the proposed approach to capturing ESG ratings in regulation is by including a new regulated activity in financial services legislation. The consequence is that a regulated activity can only be carried out by regulated firms, thereby bringing ESG rating providers within the scope of FCA regulation and supervision.

In the EU, a similar authorisation requirement is proposed, affecting EU ESG rating providers and non-EU ESG rating providers that provide such ratings in the EU. The ESG rater would need to be hived off into a separate entity, away from certain activities deemed to create conflicts. The concern with the EU proposal largely focuses on its broad definition of an ESG rating, in that it could be seen to capture a bank's research division.

The industry is lobbying to prevent this from being the case. Negotiations between the European Parliament and Council are taking place at the end of January, with political agreement expected in February.

The outcome will be followed closely.