UK green labels and sustainability disclosures are coming time to get ready

On 18 October – in advance of the COP26 Summit taking place in Glasgow– the UK Government set out its proposals for "Greening Finance: A Roadmap to Sustainable Investing" (the "Roadmap"). The publication was eagerly anticipated and - whilst not causing shockwaves with its content - sets out more detail what UK financial services firms and corporates can expect over the next few years.

This includes:

1. the introduction of UK Sustainability Disclosure Requirements (which will feed into a green "labelling" system);

2. a UK Green Taxonomy; and

3. new stewardship requirements.

Each of these is looked at in more detail below.

Who should read this briefing?

This briefing will summarise the proposals set out in the Roadmap which will affect UK corporates, UK asset managers and UK asset owners.

Top 4 immediate actions

1. Determine whether you are in scope.

2. If in scope, consider how the sustainability disclosure requirements and taxonomy proposals will apply to you.

3. Gap analyse what your current strategy, governance, policies, processes and ESG data looks like against the Government proposals set out below (our summary table below has been prepared to help).

4. Speak to Ashurst to determine likely timing and how to establish a sustainable disclosure requirement / taxonomy implementation plan.. The annexes at the end of this briefing set out key considerations and steps for firms.

Background

Details on UK sustainability disclosure requirements have been hotly anticipated for quite some time, particularly after a number of speeches and developments in this area. The UK currently lags behind its closest neighbour, the EU, with respect to requirements on ESG disclosures for the finance sector. The EU is now well-advanced on the path towards sustainability related disclosures and the development of a taxonomy as a result of the EU Sustainable Finance Disclosure Regulation ("SFDR") and the Taxonomy Regulation, respectively, both of which have entered into force. The SFDR applied from March 2021 and the first disclosures under the Taxonomy Regulation will be calculated from next year.

Neither of these regulations apply in the UK (or at least not directly) as they were not onshored following Brexit. This means it is an area where the UK is free to forge its own policy. The Roadmap sets out where the UK is heading and importantly how much it intends to diverge from the EU.

At its base, the UK agrees with the EU that ESG disclosures are needed and sustainability ought to be included in the investment process.

"Investors and businesses must have the information they need to understand the full range of environmental risks they face and create. That information should be a key component of every investment decision and the strategy of every business. Climate and environmental considerations should be central to the decision making process of every UK board and every investor's risk and return calculations." Rt Hon Rishi Sunak MP, Chancellor of the Exchequer

The Government expects that the proposals in the Roadmap will have three distinct effects:

1. informing investors and consumers – the proposals will address the information gap for market participants by providing a flow of decision-useful information on environmental sustainability from corporates;

2. acting on ESG information – the proposals will set out requirements that sustainability information is "mainstreamed" into business and financial decisions; and

3. shifting financial flows – the effect of (1) and (2) is expected to result in a change in financial flows across the economy to align with the UK's net zero commitments and wider environmental goals.

The Government also suggests that the proposals in the Roadmap will reduce the likelihood of greenwashing i.e. the misleading or unsubstantiated claims about environmental performance by businesses or in financial products.

1. Sustainability Disclosure Requirements

There are a number of existing sustainability disclosures that exist both in the UK and in other jurisdictions but they are often inconsistent.

In the UK the Chancellor recently announced that the UK would implement Sustainability Disclosure Requirements ("SDR") to create an integrated framework for "decision-useful disclosures". The Roadmap provides further details.

Who would this apply to?

The Roadmap sets out that SDR will apply in three ways:

1. Corporate disclosures – new requirements to make sustainability disclosures will apply to companies (including but not limited to FS companies). There will be an overlap (like the EU SFDR) with the UK Green Taxonomy. The scope and the timing of requirements for companies, and the reporting detail, will be determined following consultation. It is likely that the corporate disclosure requirements will be based on standards to be set by the International Financial Reporting Standards Foundation which is establishing the International Sustainability Standards Board (ISSB). The ISSB will develop global baseline reporting standards for sustainability that build on the four pillars of the Taskforce on Climate related Financial Disclosures (TCFD) reporting standards. The ISSB will provide granular reporting standards. These standards are expected to be developed in 2022.

2. Asset managers and asset owner disclosures – new requirements on asset managers and asset owners (including occupational pension schemes) to disclose how these take sustainability into account. We would expect that these are likely to be based on the key principles that were set out in the Dear Chair letter to Authorised ESG and Sustainable Investment Funds. A key focus of the FCA is how firms substantiate ESG claims that they make.

3. Investment product disclosures – new requirements for creators (i.e. "manufacturers") of investment products on its sustainability impact and relevant financial risks. This is what the UK Government expects will form the basis of a "green label' system". This will be developed by the FCA and HM Treasury. The labels are expected to help consumers select investment products based on "sustainability characteristics" of products (which will be supported by the SDR). There is a Discussion Paper due on this in Autumn 2021.

What information would need to be disclosed under SDR?

The Roadmap sets out further detail of what will be required to be disclosed under the SDR., and follows the four pillars of the TCFD framework. In summary, disclosures will relate to:

 Unlike the SFDR, the SDR does not introduce categories and requirements for funds (namely article 8 funds (i.e. funds that promote, among other characteristics, environmental or social characteristics, or a combination of those characteristics) and article 9 funds (i.e. funds that have sustainable investment as their objective)). Given the challenges experienced in the industry as to how these labels work in practice, the UK government can be perhaps forgiven.

What is the timing of implementation of these disclosures?

ESG data providers

Like the European Commission, the UK Government is considering whether ESG data providers should be brought within the regulatory perimeter (which we would expect to look similar to the regulation of benchmark administrators or credit rating agencies). This reflects the Government's expectation of the increasing importance of ESG data on financial markets.

2. The UK Taxonomy

The Government previously announced that it aims to establish a UK Taxonomy by the end of 2022. This follows the establishment of a taxonomy by the EU under the Taxonomy Regulation, which is already in force and begins to apply from early next year and is intended to provide an EU-wide common classification system for financial services firms and investors..

Like the EU Taxonomy, the UK Taxonomy will set out the criteria which specific economic activities must meet to be considered to be "environmentally sustainable" and therefore UK Taxonomy aligned. The UK Taxonomy will (as currently set out) follow the same framework as the EU Taxonomy.

How it works

There are six proposed environmental objectives set out under the UK Taxonomy which match those in the EU Taxonomy regulation:

1. Climate change mitigation – stabilisation of greenhouse gas emissions consistent with the Paris Agreement and net zero by 2050;

2. Climate change adaptation – reducing the risk of adverse impact of current or future climate change on an economic activity, people, nature, or assets;

3. Sustainable use and protection of water and marine resources – contribution to the good environmental status of bodies of water or marine resources or preventing their deterioration;

4. Transition to a circular economy – maintaining the value of products, materials and resources for as long as possible, thereby reducing the environmental impacts of their use;

5. Pollution prevention and control – including preventing and reducing emissions or adverse impacts on health, improving levels of air, water and soil quality;

6. Protection and restoration of biodiversity and ecosystems – protecting, conserving or restoring biodiversity or to achieving the good condition of ecosystems, or preventing their deterioration.

These environmental objectives will be underpinned by a set of detailed standards, known as Technical Screening Criteria (TSC) the establishment of which will be assisted by the Green Technical Advisory Group (see our briefing here).

To be UK Taxonomy aligned an economic activity must:

1. make a substantial contribution to an environmental objective (set out above);

2. do no significant harm to the other objectives; and

3. meet a set of minimum safeguards (i.e. alignment with OECD Guidelines for multinational enterprises and the UN Guiding Principles on Business and Human Rights).

Taxonomy alignment will then be measured with respect to the revenue from each of these activities.

This largely follows the framework set out under the EU Taxonomy.

How does the taxonomy work for "transitional" activities?

The UK Taxonomy recognises economic activities which are working to meet environmental objectives (even if they are not doing so now). This is done in two ways. Either:

1. Transitional activities – the TSCs will set the threshold for taxonomy alignment in sectors where economic activity cannot be done in a way which is aligned with net zero ambitions. In this case, the UK Taxonomy alignment will be in reference to best in sector emissions level. (Cement manufacturing is given as an example of this.)

2. Investment – companies can also report the proportion of their capital expenditure which is UK Taxonomy aligned which will reflect the company's investment in producing green activities in the future.

How does the UK Taxonomy work for "enabling" activities?

The UK Taxonomy will also include enabling substantial contributions to environmental objectives in other sectors, but which are not yet sustainable themselves. The example given here is the manufacture of components for wind turbines, but another often-cited example may be lithium batteries for electric vehicles.

Can companies which are not in scope of SDR use the UK Taxonomy?

Companies can voluntarily report against the UK Taxonomy (and we expect the Government to encourage this). Although given some of the ESG risks that arise this may be less attractive to some market participants. (See our briefing on ESG litigation risks here.)

When will UK Taxonomy alignment disclosures be required?

Like the EU, the UK Taxonomy will be staggered in its application. The TSC for climate change mitigation and climate change adaptation will come into force first through legislation that is expected by the end of 2022. The other four objectives will follow in 2023.

In practice, this means that Taxonomy alignment disclosures are difficult to understand for the layperson and companies will need to be clear about the strategy they intend to adopt given these disclosure requirements.

Will UK Taxonomy diverge from the EU Taxonomy?

It is likely that the UK Taxonomy will have some divergence from the EU Taxonomy. In the Roadmap, the Government has already identified energy production as an area where clarity is required as a priority. In particular, what the role of nuclear energy should be in the UK's Taxonomy.

Reading between the lines, the Roadmap would seem to suggest that the Government would like to see nuclear energy included in the UK Taxonomy (under the EU Taxonomy, the decision on how to classify nuclear power has been delayed). The Government has established an Energy Working Group to help with the development of the TSCs in this area.

3. Stewardship Requirements

The proposals relating to stewardship are less specific in the Roadmap. The Government emphasises the important role of stewardship engagement to improve returns for investment and long term management of risks presented by climate and environmental change. The Government expects the asset management and pension industries to use the information that will be generated by the SDR to transition to net zero strategies.

To achieve this the Government expects asset managers and pension providers to take ESG considerations into their investment decision making, engagement strategies and voting practices.

The Government cites a number of stewardship standards such as:

1. UK Stewardship Code 2020.

2. The Asset Management Taskforce Stewardship Report.

3. The Taskforce on Pension Scheme Voting and Implementation report.

4. FCA priorities on investor stewardship.

The Government pins much of its aim to improve stewardship on the availability of ESG data under its SDR proposals. It also sets out clearly that it expects investment and pension firms to:

1. progress work on stewardship within their organisation; apply to become a signatory of the UK Stewardship Code 2020; and encourage or require their service providers to sign up to the Code.

2. Take into account the information generated by SDR when allocating capital.

3. Actively monitor, encourage, and challenge companies by using their rights and direct/indirect influence to promote long-term, sustainable value generation (which may include withholding capital or divestment).

4. Be transparent about their own and their service providers’ engagement and voting, including by publishing easily accessible, high-quality quantitative and narrative reporting.

5. Provide leadership, for example by joining a Race to Zero-accredited net zero initiative for the financial sector, and thereby joining GFANZ. They should back up this commitment by publishing by the end of 2022 a high-quality transition plan. This should include near term science-based targets and set out their organisation’s pathway to net zero financed emissions.

The Government intends to assess progress in this area but has not yet gone as far as to mandate any of the above through legislative change.

ANNEX A

COMPARISON OF EU SFDR vs UK SDR

ANNEX B

COMPARISON OF SCOPE OF EU vs UK PROPOSALS