Brexit continues to pose unique challenges for financial sector policymakers in the European Union (EU) as the most important financial centre in Europe it is now outside its regulatory framework, a challenge especially when it comes to clearing....
The Paris Agreement of 2015 marked a turning point in the global awareness and action on climate change and sustainability. Since then, there has been a growing demand for more transparent and consistent information on how banks and companies are managing their environmental, social and governance (ESG) impacts and performance. ESG factors are increasingly important for the financial sector, as they may have positive or negative impacts on households, corporates and financial institutions. In recent years, financial regulatory authorities across the globe have increasingly adopting and strengthening policies and schemes for the prudential treatment of climate and environmental related risks, which include ESG disclosures and reporting requirements.
The rationale has been that by taking ESG factors into account, it is possible to better assess the financial risks to which banks are exposed and the investment opportunities, as well as the environmental and social outcomes of their lending and investment decisions, and thus, contribute to a more sustainable economy.
ESG disclosures are clearly important for investors, regulators, customers and other stakeholders who want to know how a company or bank manages ESG risks and how it contributes to sustainable value creation. Broadly speaking, they have emerged as a form of public reporting by an organisation or company on its performance on a variety of ESG issues or criteria, such as greenhouse gas emissions, water use, human rights, diversity, ethics and governance practices (see Schoenmaker and Schramade 2021). Prudential supervisors increasingly recognise the importance of ESG factors in assessing the risks and opportunities faced by financial institutions, and in promoting their resilience and sustainability. For example, the European Central Bank (ECB) published a guide on climate and environment-related risks that outlines its supervisory expectations for banks on how to carefully manage and disclose these risks in the current prudential framework. There are also other important global initiatives that provide guidance or requirements for ESG reporting, such as find Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), the Task Force on Climate-related Financial Disclosures (TCFD), and the International Integrated Reporting Council (Cf. Bergman, Deckelbaum et al, 2020).
However, despite efforts to create frameworks to guide and orient corporate disclosures, information is not yet consistent, comparable or reliable across jurisdictions and sectors. The latter poses significant challenges for financial supervisors, firms and the banking sector. ESG disclosure frameworks and practices face a number of challenges that limit their effectiveness and comparability. One of the main challenges is the lack of standardisation and comparability between different ESG reporting frameworks and metrics. There are multiple ESG reporting standards, frameworks and initiatives that have different objectives, scopes, definitions and metrics. This leads to inconsistency, incomparability and “confusion” among ESG reporters and users (See Berg et. al 2019).
Related to the latter, it is worth to highlight the challenge of inconsistency and accuracy of ESG data and information. Some companies may not disclose all relevant ESG information or may use selective or misleading indicators to present a favourable image. For example, some companies may report only their direct GHG emissions (Scope 1) and indirect emissions from consumption of purchased electricity, heat or steam (Scope 2), but not their indirect emissions, that is “ the full corporate value chain emissions from the products a company buys, manufacture and sell (Scope 3)” (Shoenmaker and Shramade 2021:153). Moreover, some companies may also face difficulties in collecting, verifying, and assuring the quality and reliability of ESG data, especially from their suppliers. This represents an important challenge for prudential supervisors who need reliable, consistent, and comparable ESG data from financial institutions to assess their risk exposures, capital adequacy, and stress testing scenarios.
At the EU level, financial supervisors have set out their priorities and expectations for companies in their monitoring and management of ESG risks, especially climate-related financial risks, though, companies are facing increasing pressure to disclose their ESG performance and strategy to various stakeholders, such as investors, regulators and customers. Sustainability disclosures are also expanding with the implementation of the Taxonomy Regulation, which establishes a classification system and criteria for economic activities that contribute to environmental objectives such as climate change mitigation and adaptation, the SFDR and the CSRD. Likewise, to address the issue of accuracy and quality of ESG data, the European Commission has recently launched a new Sustainable Finance Package which, among other things, aims to improve the quality of ESG ratings through a proposal for a regulation on the transparency operations of ESG rating agencies. Yet, it is still too early to say whether this proposal (if adopted) will actually improve the quality of the data and methodologies used by these agencies and which are fundamental to ESG reporting.
All these initiatives undoubtedly represent an important step and an opportunity to improve the quality and usefulness of ESG disclosure for all stakeholders. However, the complex and evolving regulatory and policy landscape in this area also poses significant challenges for investors, central banks, financial regulators, supervisors, companies and financial institutions.
These topics are at the forefront of policy events and training activities at the Florence School of Banking and Finance (FBF). Last spring, the FBF held its annual conference focusing on ESG, climate change and the regulatory and policy challenges for the banking sector, where the topic of sustainability disclosure was widely discussed. One of the main takeaways was that, in order to address these challenges, there is a need for greater coordination and cooperation between different stakeholders, as well as more clarity and consistency in ESG definitions, methodologies and disclosure standards.
Also on the topic, watch the #FBFDiscuss debate on Will ESG disclosure help us reach the objectives of the Paris Agreement?