The FCA’s latest thinking on sustainability – where will UK regulation go next?
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The Financial Conduct Authority (FCA) has published a Discussion Paper (DP) (DP23/1) titled “Finance for positive sustainable change: governance, incentives and competence in regulated firms”1, which explores a number of key questions that will inform the FCA’s policy development in these areas.
The DP follows a statement from the FCA, in November 2021, in which it set out its intention to develop a policy approach to ESG governance, remuneration, incentives and training for regulated firms in its ESG strategy2. In publishing the DP, the FCA has emphasised ‘ESG matters are high on the regulatory agenda’ and increasingly expects firms to assess and reflect material sustainability risks, opportunities and impacts in their business models and strategies.
Looking beyond disclosures and anti-greenwashing
This latest paper follows from the FCA’s Taskforce on Climate-Related Financial Disclosures (TCFD) disclosure requirements3 4 and recent policy proposals to address greenwashing5, but has a far broader scope. In fact, it seems that the regulator has taken the widest possible perspective in considering how to ensure the financial services industry plays a leading role in supporting the transition to net zero and delivering a sustainable future. Interesting parallels with the FCA’s recent work in setting out its Consumer Duty requirements can be drawn – not least the attention paid to the purpose of an organisation, and the expectation of a cultural shift being required.
The DP explores the potential regulatory response to sustainability matters beyond just climate risk, and questions how to successfully drive focus on sustainability across all areas of an organisation, including whether additional regulatory requirements are helpful at this juncture. While the FCA recognises that the financial sector can play a pivotal role in driving positive change, it highlights a risk that this could be limited without supportive regulatory foundations and appropriate guardrails in place.
The FCA states that this paper aims to stimulate wide-ranging debate with stakeholders on how governance, culture and incentives can support regulated firms in delivering on environmental and social objectives, and the transition to a net zero economy.
In doing so, the contents of this DP provide useful insights into the regulator’s current thinking and the potential future direction of regulatory policy and supervisory interventions. The FCA asks a number of questions about areas where it might set additional regulatory expectations or guidance, as well as seeking insights into current practices, signalling a potential uplift in focus from the FCA regarding what it expects to see in practice from the industry across the focus areas of the DP. Firms may wish to consider whether additional regulatory requirements are helpful, or conversely might present additional challenges, in a rapidly evolving area. We set out some of the key issues raised by the FCA below.
We expect firms to be accountable for their sustainability-related claims and commitments, linking their governance arrangements and incentive structures to their stated objectives, and building relevant skills and capabilities across their organisations
Governance and decision-making
The importance of good governance, oversight and challenge, in driving change and ensuring organisational alignment to sustainability commitments, receives significant focus from the FCA, with consideration of appropriate committee structures, management information, decision making processes and the role of the board and senior management. This extends to product governance, where it appears that the FCA is considering setting more specific regulatory expectations, including in relation to the role of governing bodies such as fund boards.
Culture as an enabler
Although the word does not appear in the paper’s title, the importance of culture to successful delivery of strategy and purpose is referenced throughout the paper. The FCA asks whether it should consider setting regulatory expectations or issuing guidance on how firms’ culture can support positive sustainable change.
We are interested in how firms embed a clear purpose, how this relates to sustainability objectives and the strength of the “tone from the top” on sustainability-related matters.
Remuneration and incentives
The FCA has already stated its view that linking progress on sustainability-related commitments to a measurable proportion of pay could be effective in encouraging individuals to take accountability for change6. These ambitions layer on top of the FCA’s assessment that linking progress on diversity and inclusion to remuneration could be a key tool for driving accountability in firms and incentivise progress.7
The DP explores some of the challenges8 firms might face in ensuring that remuneration mechanisms are well-designed and drive senior management focus on the right things, as well as how to incentivise the wider workforce appropriately. It is interesting to note that the FCA asks a significant number of questions about matters that firms should take into account when linking remuneration to sustainability objectives, covering weightings, short term v long term measures, applicability, link to transition plans, and remuneration adjustments when targets are not met. It is likely that the link between remuneration, incentives and delivery of a transition to a net zero economy, as well as wider ESG metrics spanning diversity, risk, conduct and beyond will continue to be a regulatory focus for years to come.
We think remuneration is a crucial tool to help align corporate outcomes with long-term sustainability aims.
Guarding against competency-washing
While much public discussion thus far has been on the ability of boards to demonstrate competence and capability in relation to ESG matters, the FCA is equally focused on how firms will ensure that staff at all levels of the organisation have the right expertise, and what this means for training and competence frameworks at a time when it is generally acknowledged that there is a need to build capability across the industry. Questions in the paper raise the possibility of additional training and competence requirements, as well as seeking input on key knowledge gaps in the industry, metrics to assess capabilities, and any experience of misrepresentation of ESG credentials that may cause harm to customers or markets.
Unsurprisingly, given the continued regulatory focus on accountability, the paper questions whether to set new regulatory expectations on senior management responsibilities. While the PRA already requires dual-regulated firms to allocate responsibility for climate-related financial risks to a Senior Management Function (SMF) holder, the FCA observes that for solo-regulated firms there are not currently any prescribed responsibilities for delivery of climate or sustainability-related objectives. Reference to Board-level champions being required under the Consumer Duty may indicate the FCA is considering whether to introduce something similar for ESG.
To support the objective of open dialogue and exchange of views, the regulator invited a range of industry practitioners and academics to provide input on different elements of the issues raised, set out in 10 separate articles included in the Annex of the DP. The paper notes that while these articles should not be seen as representing the regulator’s views, they may be of use to regulated firms in reviewing their current practices. Topics covered include: increasing investor confidence in corporate carbon commitments; board‑level governance of climate‑related matters; and inadvertent greenwashing.
The issues raised in the paper indicate that the FCA is looking for wide-reaching organisational and cultural change to address sustainability challenges, rather than merely compliance with discrete regulatory requirements. This DP presents an important opportunity to engage with regulators as their thinking develops on how to address one of the key challenges – and opportunities - facing the financial services industry.
Feedback will be accepted until 10 May 2023.
8. We have explored 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-with-remuneration