Ten lessons in sustainability regulation

From trade agreements to taxonomies, carbon adjustment mechanisms to corporate sustainability disclosure rules, a vast array of regulatory frameworks have been introduced to accelerate decarbonisation. But as our research shows, the financing required to deliver Net Zero far outstrips current investment flows. And the gap is set to grow wider unless we can find the right incentives to channel more private investment towards low-carbon technologies, fast.

The quickest way to drive meaningful change across the world will entail jurisdictions adapting successful mechanisms that have been developed elsewhere – and in some cases loosening existing rules to release the shackles on markets. Opening the financial floodgates will require precision regulation, and it is therefore critical to understand what unites effective regulatory regimes and what we can learn from unsuccessful regulatory implementations to ensure the mistakes of the past are not repeated.

With this in mind, our global team have analysed a range of regulatory systems across the world to pinpoint these critical characteristics, as well as the ways businesses are building sustainability into their decision-making and governance structures. Their insights are distilled below into ten lessons that point the way to a more effective global regulatory and compliance framework.

Taxonomies

1. The plethora of taxonomies across the world is creating trade barriers and acting as a hindrance to international investment. Greater effort should be made to ensure harmonisation, recognising regional energy transition and security priorities.

The role of taxonomies cannot be overstated. While they remain under development in a number of jurisdictions, it’s clear that the frameworks being created should, in principle, help drive investment in the right direction. Perhaps it’s inevitable that taxonomies will reflect local political and energy infrastructure requirements. However, there is an urgent need for greater harmonisation to support the cross-border flow of capital into strategic low carbon industries; any failure to do so will further highlight the divide between how different states and regions are approaching the climate transition. We also shouldn’t lose sight of the overriding purpose, namely, to reduce uncertainty around what can be classified as a sustainable activity and create greater market confidence.

State support mechanisms

2. Governments should learn the lessons of the past when designing support mechanisms for emerging transition technologies, recognising that different markets demand bespoke solutions. No one size fits all. We are also seeing these mechanisms increasingly intertwined with the desire to create clean energy jobs.

Driven by domestic energy, social and political considerations, a range of measures are being implemented to support transition technologies. Early mechanisms such as feed-in tariffs are still present in some jurisdictions for certain technologies. However, as low carbon systems have matured, and the cost of renewables has fallen, new support mechanisms have emerged. The impact of the US Inflation Reduction Act has been clear to see and reminds us that no one size fits all. Designing support mechanisms that reflect the realities of a particular market is critical. Governments need to ensure these measures remain relevant and fit for purpose if they’re going to have the desired outcomes.

More regulation – or less?

3. Businesses are facing a regulatory overload in key markets which may hamper progress in the long-term. Recognising that policy measures have a high degree of interdependency, greater focus needs to be given to how effective regulation will be in achieving the desired outcomes.

Time will tell as to which regulatory approach is best placed to drive the energy transition. For certain economies, a “top down” regulatory approach simply won’t work. Market flexibility is essential. Striking the balance between robust market safeguards and allowing the market to innovate is going to be critical. We also need to be laser focused on prioritisation. There are a range of wider environmental issues (e.g. biodiversity) which need to be tackled. The question is how do we phase that approach in a manner that ensures regulation will be impactful while allowing businesses to adapt and invest in the right way? Simply imposing heavy regulation in an ill-thought-out way across multiple jurisdictions will not achieve the desired goals and will ultimately delay the recasting of the global economy.

Antitrust

4. The transition will drive the need for greater collaboration across industries, and more effort is needed to enhance antitrust laws and exemptions to facilitate effective cooperation.

Collaboration within an industry can only go as far as competition law will permit, and where the application of competition law is unclear, businesses will understandably tread carefully. Some antitrust authorities put significant effort into providing better clarity for businesses on how competition rules intersect with sustainability commitments, including low-carbon collaboration. But we need to see more. Competition law should not be used as an impediment – there must be recognition of the fact that the climate transition is going to require a greater degree of collaboration to drive the necessary market changes.

Voluntary carbon markets

5. Voluntary carbon markets have a key role to play in the transition but there is an urgent need for robust market infrastructure. Frameworks for the UN-based Article 6 mechanisms must be fully baked particularly given the need for greater rigour across markets.

We have been waiting for considerable time for the build out of the infrastructure for the carbon mechanisms envisaged under Article 6 of the Paris Agreement. There is an urgent need to bring greater surety and transparency to the voluntary carbon markets. Good work is underway through a series of wider initiatives, but a UN-backed trading regime will be important. We would also want to see, outside this mechanism, greater market standardisation and consistency of rules. While the carbon markets have their critics, they have a role to play in the Net Zero transition and that role can only be fulfilled if we see an effective build out of essential market infrastructure.

Debt capital markets

6. Excessive rigidity in the debt capital markets has the potential to drive away issuers. If debt capital markets are to achieve their critical role in the transition, flexibility is needed. Let the market do its work.

Regulators must ensure issuers aren’t driven away from markets by overly rigid regulatory developments while at the same time providing investors with the information they need to invest in green financial products that can be used to finance projects that will help achieve Net Zero. The current efficiency of the debt capital markets in relation to, for example, ESG bonds issued in line with the existing ICMA principles needs to be respected by providing sufficient flexibility in order to deliver that change. Ensuring guardrails are in place is welcomed, but we should let the market do its work.

Sustainability disclosure

7. Sustainability disclosure and reporting will continue to be fragmented across markets for some time to come. The need for greater harmonisation and more of an impact-driven approach is critical.

The calls for greater consistency in disclosure and reporting standards globally have never been louder. We are starting to see the early signs of greater harmonisation through the work of the International Sustainability Standards Board (ISSB) but we are still some way off genuine alignment. Europe’s Corporate Sustainability Reporting Directive (CSRD) will further highlight global differences in approach, particularly in light of its extra-territorial effect. The need for better, more robust data on how businesses impact the environment (and vice versa) is clear. The extent of the data required and how it is presented to market participants however is a harder nut to crack. We need to simplify reporting frameworks and avoid sustainability disclosure becoming an industry in itself – while keeping a clear eye on the overall purpose of disclosure in this context.

Transposing rules across borders

8. Countries should avoid a regulatory “cut and paste” approach. Market infrastructure needs to be tailored and some countries will clearly benefit from a more market-driven, rather than regulation-driven, approach.

Over the past decade, Europe has demonstrated global leadership on setting environmental standards and market innovations. There are clear advantages to being a first mover but countries outside Europe attempting to simply cut and paste emerging regulations need to be wary. A thoughtful approach to market adaptation and regulatory frameworks needs to be adopted.

Trade agreements

9. We need to see a more sophisticated deployment of international trade agreements to facilitate trade in green goods and technologies, which may include the use of tariffs to drive a shift away from certain technologies. This will not deliver an immediate solution but needs to be part of a longer-term shift.

Trade policy has a key role to play in driving the sustainability agenda. Environmental and climate measures are being increasingly deployed in free trade agreements and this trend is set to grow. Geopolitical tensions, and a willingness to restrict market access, may, in the near term, drive the greater use of tariffs to increase domestic growth in green jobs while also acting as a protectionist measure for early phase industries. Subsidies are being deployed aggressively to support clean energy industries. However, where free trade agreements are leading to greater liberalisation, environmental measures are being included with increasing frequency. This will continue but will be a slow-burn and should be seen as part of a longer-term shift.

Corporate governance

10. Ensuring internal governance and controls are fit for purpose in this new regulatory era is an important part of the puzzle. Businesses must be clear on their transition strategy and ensure they give sufficient resource and oversight to its implementation.

The steps any business takes to address sustainability challenges will vary according to its market and organisational structure. However, policy measures are demanding that businesses review their commercial strategies (such as through the development of transition plans) and look at regulatory change and implementation in a way never seen before in relation to environmental and climate matters. This is far from an easy task. In many markets, the shift is under way, and the plethora of new regulation demands a change in approach. The need to better integrate sustainability into day-to-day decision making is clear, and will require governance models to adapt.