FCA’s ESG strategy: a focus on diversity and inclusion

Here we consider the implications of the FCA’s diversity and inclusion proposals for listed companies^[1] and look at how some of the issues raised in the regulators’ discussion paper on diversity and inclusion in the financial sector^[2] may support listed companies in considering their diversity and inclusion strategies, and provide some indication of future direction of travel for D&I disclosure requirements.  While this article is concerned with the FCA’s recent papers, a number of other regulators around the world are taking similar steps including NASDAQ in the USA, Hong Kong Stock Exchange, and ASX in Australia.

_{Why does the FCA care about diversity and inclusion?}

“Diversity and inclusion is a key component of ESG – both in its own right, and as an enabler of creative solutions to other environmental and social challenges.” FCA ESG Strategy, November 2021.

Following the financial crisis, regulators around the world looked closely at the root causes of flawed decision making, individual misconduct and poor behaviour, concluding that a “healthy” corporate culture, supported by effective leadership and clear articulation of purpose and values, is a critical factor in minimising these problems and driving long-term success.

The FCA considers that diversity and inclusion is integral to a healthy organisational culture, and in a number of recent publications has highlighted studies showing that greater diversity supports better decision making and risk management.  Diversity at board and senior management level, and indeed throughout an organisation, is seen as important in driving effective debate and challenge, supporting robust decision making and innovation - and avoiding groupthink.  A culture that is inclusive means everyone is respected and valued, and allows individuals to feel able to speak up and share their views (even if those views are not aligned with the majority in the room), meaning that the benefits of diversity are more likely to be realised.

The FCA’s initial aim for enhanced transparency on D&I is to support better investment decisions and shareholder engagement, in line with its market integrity objective, although the potential benefits in terms of quality of corporate governance and company performance are noted, as are the potential wider social benefit and public interest.

Globally, the events of the past 18 months or so have led to a fundamental change in the level of society’s interest in, and discussion of, corporate performance on diversity and inclusion.  This has precipitated valuable discussion and debate within organisations, with a clear desire from employees for honest and open (and challenging) conversations on how to achieve meaningful change. Externally, this has resulted in increased investor scrutiny of performance on a range of social and governance matters, and rising levels of shareholder activism.

This regulatory push for mandatory reporting against formal targets and disclosure of consistent data sets is therefore reflective of both the societal desire for a faster rate of change, and a response to heightened focus on D&I as an ESG issue by investors and other market participants, recognising the benefits this can bring to company performance and value.

_{The proposed changes to the Listing Rules} 

In July this year the FCA consulted on a number of proposed changes to its Listing Rules, building on major voluntary initiatives that many listed companies are currently committed to. Firstly, a proposal to require firms to disclose publicly whether they meet the following specific board targets on a “comply or explain” basis:

• at least 40% of the board should be women
• at least one of the senior board positions (Chair, CEO, SID or CFO) should be a woman
• at least one member of the board should be from a non-White ethnic minority background

It is proposed that companies will also have to publish data on the composition of their board and the most senior level of executive management by gender and ethnicity; furthermore, the FCA requested feedback on whether data by sexual orientation should be included, and whether to include data reporting to capture one level below executive management.

The FCA also proposes to include guidance to in-scope companies on additional information that they may wish to include in the annual report alongside the data above, including summaries of key policies and processes, mitigating factors or circumstances, and risks to meeting targets in the next accounting period.

“Better, comparable information on board and executive diversity will allow investors to make investment decisions in line with their values, reduce investor search costs, and inform shareholder engagement. Over time, we expect enhanced transparency to strengthen incentives for companies to progress toward greater diversity on their boards. This may have broader benefits in terms of the quality of corporate governance and company performance.” FCA Consultation Paper CP21/24.

Many companies will already be collecting this data and more, and actively engaging with investors and other stakeholders on D&I policy and strategic objectives including internal targets, succession planning and talent pipeline development. However, the move to a formal requirement for disclosure of this data and accompanying narrative means that at a minimum, companies should be looking at the frameworks currently in place to collect and report data, and assessing whether this is sufficiently robust. In addition, in order to be prepared for the greater scrutiny, exposure and peer comparison that will come with publication of this data, companies should consider whether they have a comprehensive and effective programme in place to drive results.

_{Diversity and inclusion – working together to drive change}

 More broadly, boards and senior management teams may wish to reflect on their overall diversity and inclusion strategy and consider whether now is the time to take a more proactive approach to any element of their work. Although the July discussion paper published by the PRA, FCA and Bank of England was written in relation to the financial services sector, there are a number of insights worthy of consideration by any company looking to develop their diversity and inclusion strategy further.

Key issues that companies might consider include:

• Leadership – an organisation is unlikely to be diverse and inclusive without a board and senior management team that role model these characteristics at its core.  The chair and CEO must drive diverse composition of the board and foster inclusion and a boardroom culture that values debate and challenge to enhance decision making. 
• Policies and practices – the most successful firms are challenging themselves by looking at all aspects of policy and procedures through a diversity and inclusion lens, for example reviewing the recruitment lifecycle, from job adverts to CV screening to interview practices. Succession planning and a longer term strategy for managing talent should be a focus, including for the Nominations Committee.
• Internal targets - in order to improve diversity and inclusion throughout an organisation, a range of targets at business or functional level is valuable in driving action and ensure outliers are identified and addressed. 
• Oversight – Regular progress reporting to Board and senior managers will maintain focus. This should also include measuring the success of changes implemented and of support mechanisms such as training.
• Training and communication – firms should consider how to train different cohorts of the workforce on what diversity and inclusion means, and how to foster a working environment that is inclusive and where staff feel safe speaking up.
• Remuneration - including diversity and inclusion objectives in personal or business level scorecards, and linking these to remuneration is critical for driving accountability and underlining the importance of delivery. The FCA is considering whether more explicit requirements for financial services firms would be beneficial here.

The FCA’s focus on improving diversity and inclusion in the financial services sector continues to increase - to enhance decision making, drive innovation, and ensure that the sector reflects the society it serves,.  It is a good time for regulated firms to reflect on how they can effectively demonstrate a proactive, strategic approach to diversity and inclusion in all its forms - both in relation to representation within the firm, and in meeting the diverse needs of customers. 

_{Where next for the FCA}

Although the FCA’s initial proposals for diversity and inclusion disclosure are focused on gender and ethnicity at the most senior levels of an organisation, the consultation paper underlines that this is very much a starting point for disclosures on diversity and inclusion. The regulator will look at the way in which data is used and more qualitative feedback from market participants when considering whether further rule changes are needed.  

Therefore, it would not be surprising to see the FCA expanding its formal reporting requirements to include other aspects of diversity, whether that is disability, socio-economic background or sexual orientation, building on the additional examples it is now including in the rulebook. In view of the importance of a strong talent pipeline throughout an organisation in driving improved diversity at Board and ExCo level, data on representation below the most senior levels of a company is also likely to receive more focus over time.

_{Future publications to look out for}

The FCA’s policy statement on Listing Rules regarding Diversity and Inclusion setting out how the proposals will be implemented in practice is now expected in early 2022 (from an original date of end 2021). 

A further consultation paper on Diversity and Inclusion in Financial Services, reflecting feedback received on DP21/2, is expected sometime in Q1 2022. 

^{[1] CP21/24: Diversity and inclusion on company boards and executive committees, 28 July 2021.
[2] DP21/2: Diversity and inclusion in the financial sector – working together to drive change, 7 July 2021.}