Regulators Push ESG

As ESG continues to trend throughout the world, more regulations for disclosing methods are being put in place.

The United Nations first coined the acronym ESG (environmental, social and governance) in the early 2000s. But it wasn’t until the Covid-19 pandemic that demand for socially responsible investments spiked. Companies started zeroing in on a sustainable recovery following the pandemic-related economic fallout.

For treasurers, the increasing prevalence of ESG-related goals reflected a wider trend: a complete reshaping of the economic landscape.

Companies now face pressure from stakeholders to adopt ESG principles. Those that fail to embrace, define and deliver on ESG-related initiatives risk losing out to the competition—and not just in terms of reputation or of the perception of “doing the right thing.” Studies increasingly show that investments and companies with strong ESG profiles outperform others over periods of market volatility.

Perhaps the greatest catalyst for change, however, has been in the regulatory arena.

A Bold New Taxonomy

The EU Taxonomy Regulation, which came about in July 2020, represents a significant shift in reporting requirements by offering a classification system for companies and investors to determine whether an economic activity is green or not.

Starting this year, companies with more than 500 employees that fall under the Non-Financial Reporting Directive (NFRD) will have to disclose their taxonomy alignment on three key performance indicators: Capex, Opex and turnover.

The taxonomy also applies to financial market participants that offer and distribute products in the EU. And EU member states must set public measures, standards or labels for green financial products or corporate bonds

Even though large European corporates have been required to report on ESG aspects of their business under the NFRD since 2017, the new taxonomy is different because it seeks to address the now familiar challenge around a lack of uniform definitions of economic activities that are considered “sustainable.”

The Sustainable Finance Disclosure Regulation (SFDR), which became applicable in March 2021, supports these requirements. It also sets rules for EU financial market participants when it comes to disclosing sustainability-related information. The directive’s overall mission is to integrate sustainability considerations into the financial system; steer the flow of capital towardssustainable investments; avert greenwashing and ensure that EU investors have the disclosures they need to make investment choices that are compatible with their sustainability goals.

Global Coordination

The EU may be an ESG leader, but work is also being done elsewhere. In March, the US Securities and Exchange Commission proposed major new climate disclosure requirements. And Goldman Sachs’ sustainability analysts say 2022 will be a “watershed year for ESG-related capital markets regulation” as proposals open the door for the “broadest federally mandated corporate ESG data disclosure requirement ever” in the U.S.

Transparent disclosure of sustainability performance requires consistent metrics around a yet emerging set of criteria—some of which (the S elements) evolve with time.

For decades, stakeholders recognized the need for internationally accepted standards that would allow them to compare consistent disclosures across the ESG spectrum. The Global Reporting Initiative was established in 1997 to provide just that. Since then, it developed 200 Sustainability Reporting Guidelines.

In September 2020, five institutions banded together to produce a shared vision of the necessary elements needed for comprehensive corporate reporting. The group—including environmental disclosure charity CDP; the Climate Disclosure Standards Board (CDSB); the Global Reporting Initiative (GRI); the International Integrated Reporting Council (IIRC); and the Sustainability Accounting Standards Board (SASB)—work alongside The International Organization of Securities Commissions (IOSCO), the IFRS, the European Commission and the World Economic Forum to improve financial accounting and sustainability disclosure via integrated reporting.

Meanwhile, companies are ramping up efforts to support the identification and understanding of ESG-driven risks and opportunities in order to support corporates and financial intermediaries in their sustainability policies, practices and capital projects. Morningstar’s Sustainalytics is considered one of the most popular ratings tools.

There’s also Fitch’s Environmental, Social, and Governance Relevance Scores (ESG.RS), which communicates how ESG factors affect credit ratings. The ratings agency says that governance is currently the most important ESG factor in the ratings it assigns. However, the impact of social and environmental issues on corporate ratings is increasing as regulations and the financial consequences of non-compliance rise.

As the issues become increasingly better understood and solutions more readily available, some treasurers are beginning to consider ESG and sustainability as the norm in their principal debt financings.

Corporates Embrace Green Debt

According to the 2022 Corporate Debt and Treasury Report from UK law firm Herbert Smith Freehills and the Association of Corporate Treasurers (ACT), this is the case for almost half of the 80 treasury functions taking part in the research earlier this year. More than two-thirds of respondents expect to include ESG or sustainability features in their next financing—a steady increase from over the past two years (50% in 2020 and 65% in 2021). Some 47% of respondents say sustainability-linked loans are the most likely to be implemented followed by sustainability-linked bonds and green bonds, each at 28%.

The trend toward ever-greater proportions of debt containing ESG or sustainability-linked features is accelerating, the report’s authors say. Barriers are subsiding, and banks are stepping up efforts to support corporate treasury clients with their ESG activities.

“We provide support through our ESG expertise, product solutions that are geared toward the client’s specific industry and geographic coverage that help meet their ESG financing and/or investment needs,” says Suraj Kalati, global head of Liquidity & Investments Products, Global Liquidity and Cash Management at HSBC.

Kalati says that the bank has expanded its Green Deposit products across numerous markets globally. More recently, it started supporting clients by investing their excess liquidity into ESG thematic funds. “The coverage of markets where our solutions are offered enables multinational corporates to invest their liquidity across a number of currencies through a common set of standards, helping them achieve consistency and convenience,” he says.

Asked if progress is keeping pace in emerging markets, Kalati explains that efforts across different sectors and geographies has been far from consistent. “There has been an overall heightened interest from corporates in this domain, which has driven growth in ESG-related solutions,” he adds. “However, markets continue to move forward and evolve at different trajectories. This pace is also informed by macro factors, such as regulations, in the markets they operate within.”

Climate Transition

So far, the greatest focus under the ESG umbrella has been within climate, and the transition to net-zero. As a result, banks and lenders face a magnification of liabilities on their own balance sheets.

There are two key challenges: Under-standing counterparties’ emissions as a baseline for identifying their positioning for the transition, and accurately assessing and disclosing their financed emissions.

In a recent Moody’s report, the firm explores how banks can use a range of data sets to inform lending and engagement strategies, while working toward an assessment of their financed emissions. Its analysis shows that the electric and gas utilities sector has the highest percentage of assessed companies disclosing the development of a low-carbon transition plan (16%). The oil equipment and services sector, however, only has 4% of assessed companies doing so—a reflection perhaps of “where and why” the greatest strides are being made.

There could be some bumps in the road ahead for the EU’s taxonomy. For example, market reaction to the inclusion of gas and nuclear in the EU green taxonomy has been labeled “a blow to the credibility of its resolve to combat the climate crisis.”

Decisions such as these are pivotal to the activities that corporates and banks commit to undertaking in this still-emerging field, and agreement among policymakers themselves is fundamental to progress.