The importance of environmental, social, and governance (ESG) factors—especially environmental considerations—in financial services has increased over the past several years. Recently, ESG considerations have garnered increased attention in the United States as a key platform and policy focus of the Biden administration. New ESG financial policies are expected in both the European Union and the United States, though the exact scope or depth of any particular regulation is still unclear at the moment. Further, while regulators and independent standard-setters all seem to be mindful of the benefits of a unified international regulatory regime, significant risk still remains that different environmental standards and requirements will end up hindering the cross-border activities of various market participants.
This article briefly summarizes recent, notable regulatory developments in various financial regulatory regimes.
U.S. Regulatory Developments
On 20 May 2021, President Joseph Biden issued the Executive Order on Climate-related Financial Risk (the Executive Order), which stated that the Biden administration would prioritize the development of a government-wide strategy for mitigating climate-related financial risk, including by encouraging various financial regulators to better assess such risks. The Executive Order did not create any enforceable rules; however, it lays the groundwork for future federal financial policy by directing federal entities to develop and report on strategies that promote sustainability.
The Executive Order also instructed the Department of Labor (DOL) to reconsider its ESG Rules. The ESG Rules refer to two final rules that the DOL Employee Benefits Security Administration (EBSA) bureau published in late 2020, at the end of President Trump’s term: the “Financial Factors in Selecting Plan Investments” final rule and the “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights” final rule. The ESG Rules required fiduciaries to make investment and shareholder decisions based on “pecuniary factors” and not subordinate investment returns to further nonpecuniary goals. The EBSA under President Biden had already announced, in March 2021, that it would not enforce the ESG Rules. The Executive Order extended that previous announcement and signaled a political willingness to undergo the administrative process to rescind or substantially amend the ESG Rule. On 14 October 2021, the EBSA published a proposed rule that clarifies the consideration of ESG factors by fiduciaries under the Employee Retirement Income Security Act of 1974 (ESG Proposed Rule). The comment period for the ESG Proposed Rule closes on 13 December 2021.
On 24 February 2021, then-Acting Chair of the Securities and Exchange Commission (SEC), Allison Herren Lee, stated that SEC staff would enhance its focus on climate-related disclosure in public company filings and would update its existing 2010 guidance on disclosure of climate change matters. From mid-March to mid-June 2021, the SEC received over 300 comment letters in response to their Request for Comment. Commenters were mixed on many key issues, such as the following:
- Whether the disclosure regime should be principles based or prescription based;
- To what degree disclosures should be qualitative or quantitative;
- Whether climate-related disclosures needed to be audited;
- Whether the disclosure regime should also apply to private companies; and
- Whether the SEC should adopt the metrics and standards of independent standard setters, such as the Financial Stability Board’s Task Force on Climate-related Financial Disclosures or the Sustainability Accounting Standards Board.
On 7 July 2021, the SEC Asset Management Advisory Committee’s ESG Subcommittee issued its recommendations regarding ESG disclosures. On 28 July 2021, SEC Chairman Gary Gensler stated that the SEC intends to issue a mandatory climate risk disclosure rule proposal for public issuers by the end of 2021. On 22 September 2021, the SEC Division of Corporate Finance published a letter with sample comments that could be issued to companies regarding their climate-related disclosures. The comments ask companies to, among other things, identify material effects on the business from pending or existing climate-related legislation, regulations, and international treaties, as well as to disclose material past or future capital expenditures on climate-related projects.
The SEC is also reorienting its various divisions’ focus on ESG. According to the Division of Examination, its 2021 priorities include an enhanced focus on climate-related risks. The Division of Enforcement created a Climate and ESG Task Force to develop initiatives to proactively identify ESG-related misconduct, particularly regarding material gaps or misstatements in issuers’ disclosure of climate-related financial risks.
The Commodity Futures Trading Commission (CFTC) established a Climate Risk Unit, which is intended to help ensure that new climate- or ESG-related products fairly facilitate hedging, price discovery, market transparency, and capital allocation. The Climate-Related Market Risk Subcommittee of the CFTC’s Market Risk Advisory Committee issued its often-referenced Report on Managing Climate Risk in the U.S. Financial System on 9 September 2020.
On 23 March 2021, the Board of Governors of the Federal Reserve System (the Fed) announced the creation of the Financial Stability Climate Committee, which is charged with developing a program to assess and address climate-related risks to financial stability and coordinate its implementation with the Financial Stability Oversight Council and its member agencies. Two months earlier, the Fed announced the creation of a Supervision Climate Committee to study the implications of climate change for banks and financial markets. Additionally, the Fed co-chairs the Basel Committee on Banking Supervision’s Task Force of Climate-Related Financial Risks, which is charged with addressing climate-related financial risks in order to maintain the global financial system’s stability and security.
On 3 August 2021, the heads of the Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), and National Credit Union Administration (NCUA) testified in front of the Senate Banking Committee regarding their respective agencies’ approach to climate change risk supervision. The written testimonies, as well as a recording of the hearing, are available on the Senate Banking Committee’s website.
The Biden administration has appointed many lead financial regulators who have an extensive history with ESG. Additionally, the Biden administration has also established new regulatory positions to address climate-related matters as they pertain to the financial services industry. Notable regulators and their positions are as follows:
- Janet Yellen, Secretary of the Treasury
- Wally Adeyemo, Deputy Secretary of the Treasury
- Didem Nisanci, Chief of Staff to the Secretary of the Treasury
- John Morton, Climate Counselor for the Department of Treasury
- Brian Deese, Director of the National Economic Council
- Bharat Ramamurti, Deputy Director of the National Economic Council
- Mika Morse, Climate Counsel for the SEC
- Rostin Behnam, Acting-Chairman for the CFTC
- Darrin Benhart, Climate Change Risk Officer for the OCC
- John Kerry, Special Presidential Envoy for Climate
Although beyond the scope of this article, please note that multiple bills regarding various environmental considerations in financial services are currently undergoing the legislative process, such as the Sustainable Investment Policies Act, the Retirees Sustainable Investment Opportunities Act, and the Addressing Climate Financial Risk Act.
State regulators have also been active in the ESG space. For example, the New York State Department of Financial Services (NYDFS) issued an industry letter to New York state-regulated financial institutions on 29 October 2020 that, among other things, set forth the regulator’s expectation that financial institutions will integrate risks from climate change into their governance and risk management frameworks. NYDFS also hired its first Director of Sustainability and Climate Initiatives in 2020. On 9 February 2021, NYDFS announced that it will provide credit under the New York Community Reinvestment Act for financing activities that (in general) reduce or prevent the emission of greenhouse gases.
EU Regulatory Developments
On 21 April 2021, the European Commission issued the Sustainable Finance Package, which is comprised of a proposed Corporate Sustainability Reporting Directive (CSRD), the EU Taxonomy Climate Delegated Act, and the Six Delegated Acts on fiduciary duties, investment, and insurance advice (the Delegated Acts). The measures in the package are intended to help improve capital flows towards sustainable EU businesses and technologies. The proposed CSRD amends the Non-Financial Reporting Directive (NFRD), widening the scope of the nonfinancial and diversity-related disclosure rules to cover all large EU companies and all companies listed on regulated markets (except listed micro-enterprises). The proposed CSRD also mandates additional reporting requirements as well as requirements that all information reported under the NFRD to be audited. The EU Taxonomy Climate Delegated Act clarifies which economic activities most contribute to the European Union’s environmental objectives. The Delegated Acts ensure that financial advisers, asset managers, and insurers include sustainability in their procedures and their investment advice to clients.
On 10 March 2021, Level 1 of the Sustainable Finance Disclosure Regulation (SFDR) became effective. The SFDR imposes mandatory ESG disclosure obligations on asset managers and other financial market participants. A significant number of these disclosure obligations apply to asset managers regardless of whether an express ESG- or sustainability-focused investment strategy is offered. Level 1 disclosures are entity-level disclosures regarding that entity’s policies on the identification and prioritization of principal adverse sustainability impacts. The effective date of the supplemental Level 2 disclosures, which generally consist of detailed pre-contractual and annual reporting disclosures, was recently postponed from 1 January 2022 to 1 July 2022.
Also on 10 March 2021, the European Parliament adopted a resolution stating that the EU should urgently adopt binding requirements for businesses to conduct environmental evaluations of their value chain.
On 8 March 2021, the European Financial Reporting Advisory Group (EFRAG) published a road map for the development of sustainability reporting standards, which are nonfinancial reporting standards. The recommendations in EFRAG’s report likely reveals, in broad strokes, the policy objectives that EU regulators will prioritize in the near future.
Many U.S. climate leaders look to the EU for guidance on ESG policy (some in the industry contend that this is one manifestation of the “Brussels Effect”). Consequently, U.S. financial market participants may wish to consider strategizing for a similar widening of the scope of ESG policy and increased reporting requirements, including nonfinancial disclosures. In contrast, ESG proponents in the United States should closely monitor and learn from the EU’s recent implementation problems. For example, many mandated disclosures have not yet been implemented due to the data protection and privacy measures in the General Data Protection Regulation. Such implementation hurdles reveal that, while political statements and policy mandates can be made relatively quickly, the development of practical implementation processes most likely will take many years.
Third-party stakeholders have played, and continue to play, important roles in addressing climate-related risks.
On 7 July 2021, the Financial Stability Board (FSB), an international body that monitors and makes recommendations about the global financial system to various regulators, published a report titled FSB Roadmap for Addressing Climate-Related Financial Risks. The report focuses on four near-term goals: (1) having firm-level disclosures as the basis for the pricing and management of climate-related financial risks, (2) establishing a consistent set of metrics and disclosures that can provide the raw material for the diagnosis of climate-related vulnerabilities, (3) establishing vulnerability analysis practices that can help serve as the basis for the design and application of regulatory and supervisory frameworks and tools, and (4) supporting the establishment of regulatory and supervisory practices and tools that allow governments to address identified climate-related risks to financial stability.
On 21 April 2021, the Glasgow Financial Alliance for Net Zero (GFANZ) was launched. GFANZ is a coalition of over 160 finance firms with total assets under management in excess of USD $70 trillion. GFANZ is chaired by Mark Carney, the United Kingdom’s Special Envoy on Climate Action and Finance to the United Nations. U.S. Special Presidential Envoy for Climate Kerry and Treasury Secretary Yellen are also involved.
On 14 April 2021, the Bank for International Settlements, an international financial institution that operates as a bank for central banks, released two reports regarding the climate’s potential impact on the financial system. The first report, titled Climate-related Financial Risks – Measurement Methodologies, provides an overview of conceptual issues related to climate-related financial risk measurement and methodologies, as well as practical implementation considerations, by banks and supervisory agencies. The second report, titled Climate-related Risk Drivers and their Transmission Channels, explores how climate-related financial risks can impact the banking system.
In April 2021, the International Financial Reporting Standards Foundation, a nonprofit organization that promotes the development of international financial reporting standards through its International Accounting Standards Board, announced the establishment of the new International Sustainability Standards Board (ISSB). The ISSB is tasked with writing baseline rules for climate change disclosures that aim to replace the various patchwork voluntary disclosure frameworks currently in use. The International Organization of Securities Commissions, an association of national securities regulators, has announced its support for the ISSB. The ISSB is set to be launched by COP26, the UN climate change summit scheduled for the first two weeks of November 2021.
New regulatory policy initiatives are developing rapidly around the world, led by a variety of regulators and third-party stakeholders. Although these actors are aware of the benefits of international coordination, and are currently expending much focus and effort on unifying different standards, it is also clear that there are still many differences that certain financial market participants must navigate.
The financial services team at K&L Gates continues to follow the ESG regulatory developments around the world. This article was prepared at the beginning of October 2021, and there may be many other developments in the weeks prior to its publication. Our financial services team stands ready to assist market participants in navigating these developments.
Mr. Humenik is a partner and Mr. Lee is an associate at K&L Gates, LLP. This article is not intended to be an offer to represent any person. Use of this article does not give rise to a lawyer-client relationship. Please do not consider there to be any lawyer-client relationship between you and K&L Gates or any of its lawyers unless or until: (1) you have sought to retain us, (2) we have had an opportunity to check and clear any conflicts, and (3) you have received a letter from us confirming the retention and its scope.