Financing Sustainable Change: What Does Good Governance Look Like?

Robert G. Eccles is Visiting Professor of Management Practice at Oxford University Said Business School and Vanessa Havard-Williams is partner and Global Head of Environment & Climate Change at Linklaters LLP. This post is based on their FCA paper. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders? (discussed on the Forum here) both by Lucian A. Bebchuk and Roberto Tallarita; Stakeholder Capitalism in the Time of COVID (discussed on the Forum here) by Lucian Bebchuk, Kobi Kastiel, Roberto Tallarita; and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr.

In February 2023 the UK Financial Conduct Authority (FCA) publishedDiscussion Paper DP23/1: Finance for positive sustainable change: governance, incentives and competence in regulated firms.” The purpose of the DP is “to encourage an industry‑wide dialogue on firms’ sustainability‑related governance, incentives, and competencies. In a field where there are many initiatives taking place, our aim is to help narrow this field and help with highlighting good, evolving practices if finance is to deliver on its potential to drive positive sustainable change.” The focus of the DP is “regulated firms” (i.e., financial institutions of various kinds) in the UK and comments are due by May 10, 2023.

It is our view that the ideas and recommendations made in this paper have broader applicability than simply UK-based financial institutions and their regulators. Addressing climate change and integrating sustainability more generally into corporate strategy is a challenge facing companies and financial institutions all over the world. Thus, it is useful to put this DP into a broader context by acknowledging a multitude of incipient sustainability reporting standards. It is also important to acknowledge the increasingly politicized nature of sustainability, especially in the U.S. Without the appropriate governance structures and processes, incentives, and the necessary competencies from the board down to middle management, it will be impossible for any organization to deal with the complex field of sustainability reporting standards while simultaneously being caught between opposing political forces.

The popularity of ESG amongst the investor community, the saliency of climate change, and the evolution of ESG regulation have all led to a proliferation of net zero and sustainability ambitions from multinational corporations and financial institutions. And objectively the scale of change required and the opportunity that this creates is enormous.  Last year’s COP 27 Implementation Plan estimated the investment in renewable energy required for a global transformation to a low-carbon economy as USD 4–6 trillion per year from now until at least 2030.

As a result, financial institutions have increased their sustainable finance targets, reiterated their net zero goals, and started to build sector pathways for financed emissions for the period to 2030. However, this is proving an increasingly tricky road.  Geopolitical forces have created turbulence across the markets, energy security has become a dominant theme, and an increase in anti-ESG sentiment and greenwashing cases have combined to create a high stakes environment. Against this backdrop, firms are moving from an initial phase of setting targets to the harder task of implementing and disclosing performance against them.

The need for effective governance, staffing, and compliance processes to provide effective controls and robust data on performance in these circumstances is clear and is now supported by regulation. Incoming climate and sustainability disclosure requirements in the EU, the UK and the US mean that, while there is still some optionality as to their climate ambition, companies and investors will have to report their climate and sustainability performance according to a set of standards, just as they do for their financial performance. Standards do not establish ambitions and targets, such as for carbon emissions, but they do enable those interested in this information to assess the extent to which these are being met.

Already many large corporates and financial institutions must navigate several different sustainability reporting standards that apply directly to them (and they may also feel the indirect effects of disclosure obligations applicable to their investors and business partners). This year’s principal new reporting regimes are the European Sustainability Reporting Standards which will apply to companies reporting under the EU Corporate Sustainability Reporting Directive under a phased process starting from 2025 (in respect of the 2024 year), and the International Sustainability Standards Board’s standards which are expected to be applied in many other countries within a couple of years (and to be mandated, for example, under the proposed UK Sustainability Disclosure Requirements). The SEC is also expected to publish its own Climate Disclosure Rule very shortly.

While these standards all set governance expectations, the real test for boards will be in overseeing the complex and expensive preparation of disclosures that need to respond to different standards and the strategy that underpins them. Interoperability and equivalence are still a demand of preparers but are not a realistic prospect in the short term. Different disclosures will be necessary in different regions. For example, the EU requires sustainability disclosures to be determined by reference to impact materiality as well as financial materiality, while the other regimes focus on financial materiality alone. In the round, these new disclosure rules will drive a more detailed, accurate, and rigorous approach to sustainability reporting and the strategy that underlies it. For reporting organizations, it will be complex to navigate these different regulatory needs while maintaining consistent messaging on group sustainability strategy, risk management, and performance throughout.

More problematic than having to respond to different sets of reporting standards, companies and financial institutions are being subjected to conflicting forces from the left and from the right. On the left, pressures continue to mount for more ambitious targets regarding sustainability performance, particularly in relation to greenhouse gas emissions. On the right, there is a growing anti-ESG movement, especially in the U.S. led by some red states and prominent politicians. Those in this camp oppose any kind of standards for climate and sustainability disclosure more generally, are dubious about the reality and urgency of dealing with climate change. According to the Center for American Progress, 139 members of the 117th Congress are climate deniers, 106 Representatives and 30 Senators.  They see those on the left as seeking to undermine the oil and gas energy and national energy security.

Chairs, non-executive directors, and Chief Sustainability Officers should be spending time regularly with a representative range of investors and other stakeholders to understand their views and appetite on salient sustainability topics and to explain their own thinking. What sustainability means to investors and how institutional investors integrate it into their decision-making is not always clear and is certainly neither static nor consistent. This is particularly relevant in relation to views on how to balance current and short-term future financial performance and the longer-term sustainability of the business, approaches to hard to abate sectors, and proposed changes in approach.

In this context, a combination of active stakeholder engagement and good governance can enable organizations to navigate these choppy waters thoughtfully and to show and tell how they are doing so. The components of governance and adequate procedures are well established in other areas of risk management (like financial regulation, anti-trust, and anti-bribery and corruption). Much of that experience is transferable to sustainability and climate strategy and forms a good starting point to develop the tools to ensure good governance over sustainability issues.

The FCA Discussion Paper contains a set of papers prepared by external experts. These offer suggestions on how to put in place effective governance over climate and sustainability related risk and opportunity. The value of building both senior and firm-wide competence in these areas and of developing roles and responsibilities to include sustainability elements is explained. The papers also explore the linkage between sustainability strategy and incentive packages, currently relatively nascent. Firms are starting to think harder about perverse incentives and whether appropriate reporting lines are in place. A thoughtful deployment of institutional governance mechanisms should help organizations to respond to the energy transition (and the risks and volatility inherent in it). This is likely also to be useful in a defensive capacity if mishaps occur or as emission pathways prove not to be linear. In any case, the expectation of good governance is firming up into an area for regulatory focus. Existing UK climate disclosure requirements already include a governance pillar and apply to listed companies, asset managers, large private companies, and LLPs and asset owners. The UK’s draft Transition Plan disclosure framework proposed for listed companies and large private companies is likely to build on this as regards companies’ transition plans.

The FCA Paper reflects this appetite to encourage firms and companies to help themselves by bringing sustainability into the heart of governance and strategy early, rather than treating it as an unwanted burden or even worse as a matter of optional social responsibility or PR. That instinct is sound, even if performance still sometimes lags regulatory expectation and corporate rhetoric. Some firms are still tasking managers who have plenty of other existing responsibilities with building the firm’s approach to climate and sustainability “on the side of their desk.” Advocating for budget is still often a challenge. Even if the necessary resources are made available it will take time to integrate climate and other sustainability risks fully into enterprise risk management, and to feed climate and other sustainability factors into group strategies, decision making, product governance, incentive programs, and other processes.

The role of directors is to test the adequacy of management approaches to collection and analysis of data, target setting, and other strategic objectives and implementation plans and to test strategy and narratives from all angles to mitigate potential weaknesses and counter over-optimism.  Regulators, including prudential regulators, are now starting to press for evidence of action. It will involve greater effort still to embed these issues into business as usual across the whole firm and to change the culture on issues that most financial market actors have historically viewed as externalities (except of course for instances where things went horribly wrong). The FCA Paper flags not only “tone from the top” but also the importance of “tone in the middle” as a potential indicator of effective governance. This will be one to watch.

There are limits to what policy makers can achieve through disclosure related regulation, since it relies upon market discipline to drive actual change. The UK Listing Rules already state that where a company is making disclosures on its transition plans as part of its climate disclosures, if it is headquartered or operates in a country like the UK that has made a commitment to a net-zero economy, then it is encouraged to assess the extent to which it has considered such commitments in its plan. If it has not done so, it is encouraged to explain why not.  This may be intended as a very British nudge to companies to align with these national targets. However, absent more direct policy, this will only work where the boards of reporting firms and companies perceive alignment to be in the company’s interests for its members’ benefit. In this context, investor views are highly influential. Scrutiny of how investors are voting and acting and their role in driving corporate behavior is an obvious area for ongoing, clear-eyed attention.

For the first time, in 2023 the challenges faced by boards in grappling with these issues and stakeholder opinions are beginning to feature in climate disclosures. Reports are starting to call out the obstacles firms perceive to achievement of near and medium term emission reduction targets. These may be infrastructure gaps, market failures, skills shortfalls, or policy concerns and often involve a combination of factors. We should expect more of this and it is a sign that robust governance is beginning to be put into place, that boards are taking their corporate targets seriously, and that the disclosure process is starting to work. Investors and regulators are unlikely to be hostile to realistic descriptions of dependencies, mixed results or other tensions provided these are explained in a straightforward way and there is no evidence of hypocrisy (for example, support of lobbying at odds with stated corporate strategy). We need to ensure these more nuanced messages are heard and considered as they highlight the wider issues we face. These challenges are not ones that corporates or financial institutions can address by themselves. Preparers, investors, citizens, civil society groups, regulators, and governments all have a responsibility and a role to play in delivery of the necessary energy transition.

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