The Financial Conduct Authority’s (FCA’s) new requirements took effect on 1 January 2022 for the largest firms and will apply to smaller firms above the £5bn exemption from January 2023.
The disclosure rules will require listed companies to include a statement in their annual reports outlining whether their disclosures meet the recommendations of the Taskforce on Climate-Related Financial Disclosures (TCFD) and, if they don’t, explaining why.
The TCFD climate-related disclosure recommendations, released in 2017, incorporate four key themes (governance, strategy, risk management, and metrics and targets) and aim to help companies provide better information and support informed capital allocation by investors
Under the FCA’s new rules, FCA-regulated asset managers and asset owners, including life insurers and pension providers, will need to publish disclosures at the entity and product level. At the entity level, they must disclose how they take climate-related risks and opportunities into account in managing investments.
At the product level, they must disclose metrics for each of their investment products including greenhouse gas/carbon emissions, carbon footprint and carbon intensity alongside contextual information. Where the products have high exposure to carbon-intensive sectors, the disclosure must provide a qualitative summary of how climate change is likely to impact the assets under different scenarios.
Can disclosure prompt action?
In late 2020, Richard Monks, the FCA’s Director of Strategy, commented that “it is well understood that companies’ non-financial [ESG] disclosures are often incomplete and difficult to compare across companies”.
The aim of recent corporate governance reform has been to ensure that companies disclose information to pension funds and asset managers. The idea is that this should equip them to understand and respond to potential risks and opportunities from environmental, social and governance (ESG) issues in order to safeguard the assets that they invest on behalf of their beneficiaries and clients.
A key strategy of the UK government’s aim to deliver a market-driven solution to climate change is that disclosure of information will lead to behaviour change, including engagement by asset managers to force companies to change and ultimately divestment if they refuse to change. Whilst noting that there had been considerable progress in the disclosure, the government concluded that many organisations were not making sufficiently complete or high-quality climate-related disclosures. As per the Financial Stability Board’s TCFD status report, only around a third of premium listed companies and 13% of the largest occupational pension schemes were making disclosures in line with the TCFD’s recommendations.
In November 2020, the UK government set out a roadmap towards mandatory TCFD-aligned disclosures.
The FCA introduced its new rules on TCFD disclosures as part of this roadmap. It also formed part of a broader strategic theme to promote transparency on climate change and wider sustainability. In November 2021, alongside COP 26, the FCA launched its Strategy for positive change, covering environmental, social and governance (ESG) issues. According to this strategy, “enhanced disclosures to clients and consumers will help them make more informed financial decisions – in turn enhancing competition between providers, protecting consumers from unsuitable financial products… and encourage the flow of funds to more sustainable projects and activities.”
Encouraging engagement by asset managers and asset owners
Improved disclosure is intended to provide greater impetus for asset managers and asset owners to assess the risks within their portfolios and engage with companies to require them to act.
Engagement can be a long-term and iterative process, covering a number of different stages to raise the profile of an issue and put pressure on the company to change. Investors will need to have a clear policy of escalation if their initial engagement is not successful. This should reflect the sense of urgency given to the issue and the risks to the company, customers and society.
Stages of this policy could include:
- Voice: Holding meetings with the company management and raising concerns with higher levels within the company including the CEO, the chair and non-executive directors.
- Escalation and collaboration: This can include making public statements as well as having private meetings and collaborating with other shareholders/asset managers with similar objectives.
- Voting: Asset managers can express concern with the company’s approach by voting for or against resolutions at a general meeting. They can also propose their own resolutions to be voted on by shareholders.
- Divestment: Selling a holding in a company if the engagement is unsuccessful.
Collaborative engagement to increase power
Collaborative shareholder engagement occurs when a group of investors come together to engage with companies on ESG issues. By speaking with a unified voice, investors can more effectively communicate their concerns to corporate management. This can increase the attention given to a specific company to change. Collaborative engagement can also help with prioritisation, with different asset managers or asset owners taking the lead on different issues or with different companies.
Examples of collaborative engagement
Climate Action 100+
Climate Action 100+ aims to ensure that the world’s largest corporate greenhouse gas emitters take necessary action on climate change. The aim is to coordinate engagement activities and unify messaging or dialogue with more than 160 of the world’s most systemically important carbon emitters focusing on emissions reduction, governance and disclosure.
Tailings ponds
Tailings dams represent a threat to the environment if not managed properly. There have been a number of serious failures, such as the Brumadinho dam disaster in Brazil in January 2019 which killed 270 people. In 2020, a collaborative investor initiative led by the Church of England Pensions Board and the Swedish Council on Ethics to raise standards of tailings dam management and disclosure, urgently calling for public disclosure by listed extractives companies of tailings facilities and risks.
Influencing company strategy
Engagement is not simply about conducting regular meetings with management. The ultimate goal should be to influence the company’s strategy and objective. Engagement can be with an individual company or a thematic issue affecting a number of different companies.
Effective engagement should:
- be prioritised based on how sustainability issues may affect the firm, its customers, the environment and wider society;
- have a clear, realisable goal or outcome;
- be specific;
- be based on a series of milestones;
- have key performance indicators (KPIs), either quantitative or qualitative;
- have a clear timeframe;
- report the outcome clearly, including where the engagement did not lead to a successful outcome; and
- learn lessons from successful and unsuccessful engagements.
Engagement around net zero
For commitments around climate change and net zero, investors will want to ensure that there is a clear plan and sufficient interim progress is made towards the targets. They will have to develop expertise in assessing the data and assumptions behind the plans.
In October 2021, the WWF noted that while 74% of the FTSE100 have committed to net zero, only 19% have a technical action plan of how they would meet the target and 24% only had a partial plan. Less than half of the companies set out their approach to using carbon offsetting and only 32% linked executive remuneration to the achievement of targets. Importantly, the WWF reminds in its review of FTSE100 net zero commitments that “climate pledges are not the same thing as emissions cuts in the real world”.
Passive versus active management
Passive managers are expected to be active in stewardship as they cannot exit their investments. Therefore, stewardship is viewed as a way to raise returns across the index for clients. Active managers can use the threat of exit as a disciplining mechanism.
Some index providers and asset managers have developed new ESG or climate-related indexes, allowing investors who favour a passive approach to align the investment with their values. These can exclude certain activities such as fossil fuels, invest in ways aligned to the Paris climate targets or reweight the index to increase exposure to companies with high ESG scores according to various different methodologies. MSCI alone now offers over 1,500 equity and fixed-income indexes including ESG factors.
What does success look like?
The entity-level and product-level TCFD disclosures, and similar requirements set by the Pensions Regulators for occupational schemes, will lead to a significant amount of extra climate-related information. The FCA’s strategy also aims to support international standards and expand this to sustainability-related disclosures to support accurate market pricing, helping consumers choose sustainable investments and drive fair value. In November 2021, it published a discussion paper on sustainability-related disclosures and sustainable investment labels.
This disclosure is always a useful first step, but if it is to lead to a market-driven solution then it will have to be successful in influencing decisions by companies, asset managers, asset owners and pension schemes, and lead to greater pressure from the pension scheme member or end consumer.
A number of problems will need to be overcome:
1. Partial information: The reports will be drafted by the asset managers and will not be written or assessed by a neutral party. It may be very difficult for investors to judge asset managers on the overall quality of their approach to engagement or divestment.
2. Transition plans: Initially, transition plans towards net zero will not have to be disclosed, although the government has stated its intention to move towards mandatory disclosure of transition plans.
3. Lack of data or consistency: It will be hard to ensure consistent data. The use of proxies and assumptions in the event of data gaps and methodological challenges could lead to potentially misleading, inconsistent and inaccurate disclosures.
4. Technological challenges: More work is needed to understand how technology can be deployed to verify ESG disclosures from companies, asset managers and pension schemes and to generate insights from unstructured data sources.
5. Audience: It will be hard to design disclosures that are suitable for the needs of the retail audience and the institutional audience.
6. ESG data not part of Open Finance or Pensions Dashboards: The lack of machine-readable data could mean that it is harder to aggregate and compare information. There will be no requirement to disclose the data in a manner similar to through Open Banking/Open Finance and the first version of Pensions Dashboards will not include any ESG data or information.
Will consumers use the information?
There will continue to be strong commercial drivers for poor ESG performance, which can generate profits in the short-term. The ultimate negative outcome for the firm, customers and wider society may take a significant amount of time to become apparent.
The FCA released the result of an online experiment showing that displaying a sustainability “medal” influenced consumers’ choice of funds. Yet to be tested is how this will work in the real world, where the disclosures will be far more complex and made alongside many other factors that investors may be considering such as asset allocation, past performance and charges.
Relying on end-consumer choice to drive the market when the subject and disclosures are complex and many people are so disengaged could be too slow. Also, as noted by the BT Pension Fund, “Too many products labelled as ‘climate aware’ focus only on investing on companies that are already good – largely due to their business models, not because they are necessarily focused on improving their climate footprint.” Major positive change will require action from the largest asset managers and changes in the default investment solution within the largest pension schemes.