Source: Jones Day
Published: November 2020
In Short
The Situation: The New York State Department of
Financial Services ("DFS") and the European Banking Authority
("EBA") have published guidance relating to Environmental, Social,
and Corporate Governance ("ESG") practices.
The Result: The guidance reflects a heightened interest
on the part of domestic and foreign regulators regarding ESG issues. While the
guidance does not direct regulated entities to take specific actions relating
to ESG, it signals an intent to put companies on notice of future regulatory
involvement in the ESG space.
Looking Ahead: As ESG-related investing
continues to grow and greater attention is paid to ESG issues more broadly,
market participants could see an uptick in regulator involvement in this area.
Financial institutions should assess the extent to which their current
corporate governance frameworks reflect ESG principles and what proactive steps
they can take to keep ahead of the industry curve.
Background
Recent announcements regarding ESG practices have
highlighted the increased demand on the part of investors for financial
institutions to incorporate ESG principles into their business operations. On
October 25, 2020, Bloomberg reported that inflows into ESG exchange-traded
funds ("ETFs") have increased to $22 billion this year, three times
the total in 2019, and research from PricewaterhouseCoopers indicates that ESG
funds could experience a threefold increase in assets by 2025.
Domestic and foreign regulators have taken notice
of these investor trends and the impact of ESG issues more broadly. On October
29, 2020, the DFS issued a letter ("DFS Letter") to its regulated
entities regarding ESG climate risk issues, and on November 3, 2020, the EBA
published a Discussion Paper on ESG risk management and supervision ("EBA
Discussion Paper"). As the market trend toward ESG principles becomes
apparent, financial institutions should be cognizant of the DFS Letter and the
EBA Discussion Paper because both are potential indicators of an increased
governmental role in the ESG space.
DFS Letter
The DFS Letter focuses on the
"environmental" aspect of ESG, i.e., the effect of climate risks on
the financial system broadly and regulated entities' assets and operations
specifically. Linda A. Lacewell, the Superintendent of DFS, writes that DFS
expects regulated entities to begin "integrating the financial risks from
climate change into their governance frameworks, risk management processes, and
business strategies" and "developing their approach to
climate-related financial risk disclosure." Ms. Lacewell also mentions
that DFS expects that, in adopting climate principles, regulated entities will
"take a proportionate approach that reflects [their] exposure to the
financial risks from climate change."
The DFS Letter is an important legal development for
at least three reasons. First, DFS is a major regulator. It regulates about
1,500 banking and other financial institutions, with assets totaling more than
$2.6 trillion—a larger number of entities than the Office of the Comptroller of
the Currency ("OCC"), one of the principal federal banking
regulators. Second, the DFS is a leading voice on financial issues of national
importance, such as fintech charters, cybersecurity, and blockchain. And third,
the DFS Letter appears to be among the first attempts by the DFS to engage with
ESG principles. While the DFS Letter does not provide specific guidance on how
regulated entities should adopt ESG principles, it is a clear indicator that
important banking regulators plan to have their voices heard on the matter.
EBA Discussion Paper
In Europe, the EBA Discussion Paper identifies for
the first time common definitions of ESG risks, and it provides an overview of
current evaluation methods as well as recommendations for incorporating ESG
risks into business strategies. In contrast to the DFS Letter, the EBA
Discussion Paper addresses not only climate risk, but also other ESG
principles. It addresses, for example, social objectives, including diversity
and equal opportunity issues, and governance issues, such as shareholder rights
and executive pay.
The EBA Discussion Paper is the start of a public
consultation period, open until February 3, 2021. During the three-month
period, the EBA will collect comments from market participants so it can
fulfill its mandate of issuing a final report under the Capital Requirements
Directive (EU) 2019/878 and the Investment Firms Directive (EU) 2019/2034,
setting forth uniform definitions, appropriate criteria for the identifying,
assessing, and managing of the impact of ESG-related financial risks, and the
potential inclusion of ESG risks in regulatory reviews. That ESG report is
expected to be published in June 2021.
The EBA Discussion Paper is another indicator that
regulators are serious about ESG issues. Its breadth reflects the progress that
European financial institutions have made toward adopting ESG principles, and
it could be a telltale sign of the direction that U.S. regulators may be
heading towards.
Looking Forward
Market participants should expect other regulators
to follow the lead of the DFS and EBA. On November 5, 2020, for example, SEC
Commissioner Allison Herren Lee spoke at a PLI Conference; she called on the
SEC and market participants to work "toward a disclosure regime
specifically tailored to ensure that financial institutions produce
standardized, comparable, and reliable disclosure of their exposure to climate
risks." Commissioner Lee emphasized that she was speaking on her own
behalf, not on behalf of the SEC, but her remarks suggest that senior officials
at the SEC and likely other regulators are actively considering these issues.
As the ESG legal framework
continues to develop, market participants should consider keeping ahead of the
curve and consulting with their legal counsel and local regulators regarding proactive
steps that can be taken to start integrating ESG principles into their
corporate governance structures now.
Three Key Takeaways
- Investment in ESG funds is increasing at a dramatic
rate. - Domestic and foreign regulators are taking an increased
interest in ESG issues. - Financial institutions should consider proactive steps
to stay ahead of the industry curve on ESG matters.
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