The FCA’s latest thinking on sustainability – where will UK regulation go next? | Allen & Overy LLP
The Financial Conduct Authority (FCA) has published a Discussion Paper (DP) (DP23/1) entitled “Finance for positive sustainable change: governance, incentives and competence in regulated companies”.1which examines a number of key issues that will influence FCA policy development in these areas.
The DP follows a November 2021 FCA statement in which it outlined its intention to develop a policy approach to ESG governance, compensation, incentives and training for regulated entities in its ESG strategy2. In publishing the DP, the FCA has emphasized that “ESG matters are high on the regulatory agenda” and increasingly expects companies to assess and address key sustainability risks, opportunities and impacts in their business models and strategies.
Looking beyond disclosures and anti-greenwashing
This latest paper follows the disclosure requirements of the FCA’s Taskforce on Climate-Related Financial Disclosures (TCFD).3 4 and recent policy proposals to combat greenwashing5, but has a much wider scope. Indeed, it appears that the regulator has taken the widest possible perspective to consider how to ensure that the financial services industry plays a leading role in supporting the transition to net zero and creating a sustainable future. Interesting parallels can be drawn with the FCA’s recent work in setting its excise tax requirements – not least the attention given to an organisation’s purpose and the expectation that a cultural shift is required.
The DP examines the potential regulatory response to sustainability issues beyond mere climate risk and questions how to successfully drive a focus on sustainability across all aspects of an organization, including whether additional regulatory requirements would help at this point. While the FCA recognizes that the financial sector can play a pivotal role in driving positive change, it notes the risk that without a supportive regulatory base and proper guard rails, this could be limited.
The FCA states that this paper aims to stimulate a wide-ranging debate with stakeholders on how governance, culture and incentives can support regulated companies in achieving environmental and social goals and the transition to a net-zero economy.
In doing so, the contents of this DP provide useful insights into the current mindset of the regulator and the potential future direction of regulatory policy and supervisory intervention. The FCA is asking a series of questions on areas where it could set additional regulatory expectations or guidance and is seeking insight into current practices, suggesting a potential focus on the part of the FCA in relation to what they expect from the practice in practice Industry in the entire industry expects focal points of the DP. Organizations may wish to assess whether additional regulatory requirements would help in a rapidly evolving area or, conversely, could pose additional challenges. Below we have outlined some of the key issues raised by the FCA.
We expect companies to be accountable for their sustainability-related claims and commitments, link their governance arrangements and incentive structures to their stated goals, and build relevant skills and capabilities within their organizations
FCA, DP23/1
governance and decision-making
The importance of good governance, oversight and challenge to drive change and ensure organizational alignment with sustainability commitments is given a strong focus by the FCA, considering appropriate committee structures, management information, decision-making processes and the role of the board and senior management. This also extends to product oversight, where it appears the FCA is considering formulating more specific regulatory expectations, including in relation to the role of governing bodies such as fund boards.
Culture as enabler
Although the word does not appear in the title of the paper, reference is made throughout the paper to the importance of culture in successfully executing strategy and purpose. The FCA asks whether it should consider setting regulatory expectations or issuing guidance on how corporate culture can support positive sustainable change.
We are interested in how companies enshrine a clear purpose, how this relates to sustainability goals and how strong the tone from the top is on sustainability-related matters.
FCA, DP23/1
Compensation and Incentives
The FCA has previously expressed its view that linking progress in sustainability-related commitments to a measurable salary component could be effective in encouraging individuals to take ownership of change6. These ambitions are beyond the FCA’s assessment that linking advances in diversity and inclusion to pay could be a key tool to drive corporate accountability and incentivize progress.7
The DP examines some of the challenges8th Companies may be challenged to ensure that compensation mechanisms are well designed, motivating management to focus on the right things and how to provide appropriate incentives to the broader workforce. It is interesting to note that the FCA poses a significant number of questions on issues companies should consider when linking compensation to sustainability goals, considering weightings, short-term vs. long-term measures, applicability, linking to transition plans and adjustments to compensation goals are not reached. It is likely that the link between compensation, incentives and the transition to a net-zero economy, as well as broader ESG metrics encompassing diversity, risk, behavior and more, will remain a regulatory focus for years to come.
We believe that compensation is a critical tool to align corporate results with long-term sustainability goals.
FCA, DP23/1
Protection against laundering of competences
While there has been much public debate about the ability of boards to demonstrate competency and skills in relation to ESG matters, the FCA is equally focused on how companies ensure employees at all levels of the organization have the right expertise and what this means for training and competency frameworks at a time when it is widely recognized that there is a need to build skills across the industry. Questions in the paper raise the possibility of additional training and competency requirements, as well as seeking input on key industry knowledge gaps, skill assessment metrics, and experiences of misrepresenting ESG credentials that may harm customers or markets.
Individual accountability
Not surprisingly, given the ongoing regulatory focus on accountability, the paper questions whether to set new regulatory expectations for senior management responsibilities. While the PRA already requires dual-regulated companies to assign responsibility for climate-related financial risks to a Senior Management Function (SMF) holder, the FCA notes that there are currently no mandated climate or sustainability delivery responsibilities for solely regulated companies -related goals. The reference to board-level champions required under the consumer duty may indicate that the FCA is considering introducing something similar for ESG.
Independent Findings
To support the goal of open dialogue and exchange of views, the regulator invited a number of industry practitioners and academics to provide input on various elements of the issues raised, set out in 10 separate articles annexed to the DP. The paper notes that while these articles should not be taken as a representation of the regulator’s views, they may be helpful for regulated entities in reviewing their current practices. Topics covered will include: increasing investor confidence in companies’ carbon commitments; Board-level governance on climate-related matters; and unintentional greenwashing.
Next Steps
The issues raised in the paper indicate that the FCA is seeking far-reaching organizational and cultural changes to address sustainability challenges, rather than just meeting discrete regulatory requirements. This DP represents an important opportunity to engage with regulators as their thinking evolves to address one of the key challenges – and opportunities – facing the financial services industry.
Feedback will be accepted until May 10, 2023.
footnotes
1. https://www.fca.org.uk/publication/discussion/dp23-1_updated.pdf
2. https://www.fca.org.uk/publications/corporate-documents/strategy-positive-change-our-esg-priorities
3. https://www.fca.org.uk/publication/policy/ps21-23.pdf
4. https://www.fca.org.uk/publication/policy/ps21-24.pdf
5. https://www.fca.org.uk/publications/consultation-papers/cp22-20-sustainability-disclosure-requirements-sdr-investment-labels
6. https://www.fca.org.uk/publication/correspondence/dear-chair-remuneration-committee-2022.pdf
7. https://www.fca.org.uk/publication/discussion/dp21-2.pdf
8. We addressed some of these challenges in our recent article https://www.allenovery.com/en-gb/global/news-and-insights/publications/reshaping-bank-compensation-strategy-aligning-corporate-values examined-for-fee