Sustainability Assembled

Sukhvir Basran ESG Partner, King & Spalding

In the final publication for 2024 of Sustainability Assembled, we take stock of the UK and EU’s plans, examine the reaction to plans to “simplify” regulation and consider how market participants can improve analysis of climate-related risk.

As we near the end of 2024, the impact of geopolitical events on global sustainability goals is being weighed up and the EU is continuing to lead the charge on developing sustainable regulation and guidance.

The good news is that end-of-year reports and updates such as the third annual “Report on disclosures of principal adverse impacts under the Sustainable Finance Disclosure Regulation” highlight positive progress, good practices and the provision of quality data. This is further bolstered by the recent report, “Progress on Corporate Climate-related Disclosures”, by the IFRS Foundation which highlights the wider alignment benefits of companies using ISSB Standards.

The bad news is, according to The Climate Action Monitor 2024, there remains a significant gap in policy ambition between globally agreed temperature goals and the emissions reductions of national climate targets. According to The Global Carbon Project, carbon dioxide emissions have risen in 2024 by 0.8% from 2023, and 2024 is set breach the 1.5°C threshold under the Paris Agreement.

With the media now more likely to link incidences of extreme weather events to climate change, financial institutions and investors are also becoming more transparent on how they are responding to the need for climate-stress testing (see below).

Last but not least - just as market participants are getting (somewhat) comfortable with the complexity of EU sustainability-related regulation, Ursula von der Leyen has referred to a new “omnibus regulation” intended to “simplify” the 'Big Three' (at least), namely: the EU Taxonomy Regulation, the Corporate Sustainability Reporting Directive and the Corporate Sustainability Due Diligence Directive. Media reports suggest that the proposal has (perhaps unsurprisingly) been met with limited enthusiasm. Given the significant resources that have gone into understanding and implementing EU sustainability regulation so far, various market participants have expressed concern at the uncertainty and additional work that this potential omnibus instrument is likely to bring. As at the date of publication, there is little additional information available, but the LMA will be actively engaging on this proposal and would welcome any views you have on this matter.

Finally, I would like to wish you all a very merry Christmas and a happy new year!

Greenwashing – are we there yet?

No regulatory summary would, of course, be complete without examining the continuing efforts of policymakers, standard-setters and industry bodies (including the LMA) to address greenwashing risk across the sustainable investment value chain. Key developments this quarter include:

the EU has adopted the proposed ESG Ratings Regulation (see below) and HM Treasury has published a response to the ESG Rating consultation, along with a draft statutory instrument for technical comments (see below);

as the European Securities and Markets Authority’s (ESMA) “Guidelines on funds’ names using ESG or sustainability-related terms” take effect, funds are focussing on careful consideration of sustainability-related terms in fund names, ESG integration in investment processes and alignment of investments with the Climate Transition Benchmark and the Paris-aligned Benchmark. As we go into 2025, amendments to funds names and analysis of “transitioning” assets is very likely to increase (see King & Spalding's latest article on this subject here); and

ESMA has indicated that, as part of its 2025 work programme (see below), monitoring the implementation of guidelines (such as those on fund names) and developing additional technical standards (including in relation to the regime for external reviewers and ESG ratings) will be a priority.

What's next for the UK and EU?

In the UK

The UK Government has made a series of announcements including: a 2035 target of reducing territorial greenhouse gas emissions by 81% compared to 1990 levels, a Global Clean Power Alliance, a Clean Industry Bonus Scheme, and a CIF Capital Market Mechanism on the London Stock Exchange. The UK Chancellor meanwhile indicated a commitment to deliver the foundations of “a robust sustainable finance framework” which include a number of consultations relating to, amongst other things, the value case for a UK Green Taxonomy, streamlined sustainability disclosures for economically significant companies and the implementation of transition plans (see below).

In the EU

The Joint Committee of the European Supervisory Authorities (ESAs) has published their work programmes for 2025, with the promotion of sustainability in the EU financial system remaining a key priority for all three ESAs.

According to the ESMA 2025 Annual Work Programme, it will increase its focus on:

implementing the sustainable finance legal and supervisory framework;
combating greenwashing; and
promoting transparency in sustainable investments.

As referred to above, this will include monitoring the implementation of guidelines (such as those on fund names) and developing additional technical standards (including in relation to the regime for external reviewers and ESG ratings). Market need for additional guidance and Q&As in respect of legislative texts (including, for example, under the Sustainable Finance Disclosure Regulation, the EU Taxonomy Regulation and the Corporate Sustainability Reporting Directive) will also be monitored as will developments relating to transition finance.

The European Banking Authority’s (EBA) Work Programme 2025 includes a focus on enhancing risk-based and forward-looking financial stability for a sustainable economy which will include building out the EBA’s risk monitoring framework in order to efficiently monitor ESG risks in the banking sector. These risks include transition and physical risks, market developments relating to the development of sustainable finance products, and the increase of internal and external relevant ESG risk data. Work is also intended to be undertaken to develop a regular climate stress test and guidelines on an institution’s climate stress testing. The Joint Committee Annual Work Programme 2025 can be accessed here.

Enforcement

ESMA’s publication of the “European Common Enforcement Priorities statement for 2024 corporate reporting” (the Statement) has been met with a mixed response.

The Statement refers to: (i) materiality considerations in reporting under the European Sustainability Reporting Standards; (ii) scope and structure of sustainability statements; and (iii) disclosures relating to Article 8 of the EU Taxonomy Regulation as priority topics for ESMA.

The Statement highlights a number of key issues for each priority topic including: (i) the need to pay attention to EFRAG’s Implementation Guidance on Materiality Assessment (see previous publications of Horizons); (ii) the importance of quantitative information to determine materiality; (iii) application of transitional reliefs (i.e. issuers are required to explain efforts made to obtain the information relating to their value chain etc); and (iv) for Article 8 of the Commission Delegated Regulation (EU) 2021/2178, the use of templates (without adaptation or amendment) is emphasised, as is the need to carefully consider scenarios where an activity may be eligible for multiple environmental objectives.

The Statement underlines that ESMA, together with national enforcers in the EEA, will take enforcement actions whenever material misstatements in the areas highlighted in the reports are identified.

Climate-scenario analysis and stress testing

Commentary

As well as the focus on greenwashing, across the market there is also now an increased emphasis on understanding the impact of climate-related risk on investment portfolios. Careful consideration and consistent use of metrics and better measurement is important, as is ensuring the alignment of investment portfolios with entity-level sustainability strategies and disclosures and product level frameworks and standards.

Regulators and standard setters are looking across the sustainable investment value chain using a wide lens – this will require a broader and deeper response to climate-risks analysis from market participants. What does this mean in practice for the loan market? Market participants will need a deep understanding of a broad range of sustainability issues, a robust grasp of available guidance and tools in the market and how to apply them and the ability to “connect the dots” across policies, investment processes, entity-level disclosures and product-level frameworks, structuring, terms and disclosures.

Below we take a look at recent developments.

Fit-for-55 Climate Scenario Analysis

In November 2024, the ESAs, together with the European Central Bank, published the results of the “Fit-for-55 climate scenario analysis”. The report assesses the resilience of the EU financial sector (specifically the EU banking, investment fund, occupational pension fund and insurance sectors) to withstand climate-related shocks and to support the green transition under conditions of stress.

The scenarios and methodology are based on the following three transition scenarios over an 8-year period assuming implementation of the Fit-for-55 package:

baseline scenario: the Fit-for-55 package is implemented in an economic environment that reflects the European System of Central Banks’ June 2023 forecasts with additional costs relating to the green transition.
first adverse scenario: “Run-on-Brown” shocks are taken into account, wherein investors divest assets of carbon-intensive firms, thereby adversely affecting the green transition due to lack of financing available for “brown” firms.
second adverse scenario: “Run-on-Brown” shocks are amplified with additional standard macro-financial stress factors taken into account.

The impact of these scenarios has been assessed on 110 banks, 2,331 insurers, 629 IORPs and around 59,000 funds (of which 22,000 in the EU), accounting for less than half of their total assets at aggregate level.

Key findings from the report are as follows:

Estimated losses resulting from a “Run-on-Brown” scenario have a limited impact on the EU financial system with total first-round losses over the 8-year horizon between 5.2% and 6.7% of starting point exposure in each sector;
Second-round losses are most relevant for investment funds amounting to 11.2% of starting point exposures; and
In the second adverse scenario, depending on the sector, first round losses by banks; and insurers, occupational pension funds and investment funds stands between 10.9% and 21.5% depending on the sector.

The report emphasises that given the novelty of climate stress testing approaches, the outcomes are subject to inherent uncertainty.

The ECB’s “FAQ on one-off “Fit-for-55”climate scenario analysis” can be accessed here.

The European Central Bank’s Financial Stability Review for November 2024 can be accessed here.

PRA: Thematic feedback on accounting - climate-risk

In late September 2024, the Prudential Regulation Authority (PRA) sent a “Dear CFO Letter ” (PRA Letter) to banks with feedback based on a review of auditor responses to questions relating to IFRS 9 expected credit loss accounting (ECL), including the progress made in 2023 to develop capabilities in order to quantify the impact of climate risk on ECL.

The PRA Letter acknowledges the continued efforts of firms to expand the analysis of climate-related risk in order to identify exposures most at risk and adapt economic scenarios to incorporate climate risks. The PRA’s thematic findings note that there is scope for improvement to assessments used to quantify the impact of climate-related risk drivers including (i) expanding the coverage of portfolios to take into account for example drivers potentially impacting underlying collateral, refinance risk and borrowers’ ability to repay (ii) ensuring that climate risks are embedded in loan-level credit risk assessments; and (iii) considering a broader range of climate scenarios and indicators.

Annex 2 of the PRA Letter sets out the range of practices identified from the PRA’s review, as well as areas of focus in the short and medium term. Key findings include:

the fact that metrics used to assess climate related risk in loan portfolios include the costs incurred to reduce emissions and the potential impact of higher carbon prices on the ability to repay debt;
better practice examples seen in relation to the identification of climate-related risk drivers, including expanding the scope of risk drivers considered at a product level (e.g. supply chain, litigation, and refinancing risk), including climate risk in the horizon scanning process, and consideration of the impact from potential changes in policy (e.g. EPC ratings);
the fact that there is a need to consider the impact of refinancing risk for higher risk portfolios; and
the development of frameworks (including scorecards) to support assessments of climate risk into counterparty or loan-level assessments are another example of better practice in the market.

The PRA Letter includes further examples of better practice. Market participants should note that, for the next round of written auditor reporting, the PRA has asked for auditors’ views on a firm’s progress against the areas of focus set out in the PRA Letter.