In this month’s ESG Market Alert, we cover:

• Market Practice Update: Harnessing ESG opportunities in private equity

• EU Parliament votes to require companies to implement internal due diligence processes and introduce climate transition plans

• ClientEarth’s failed judicial review against the FCA

• The International Sustainability Standards Board publishes its inaugural international financial reporting sustainability standards

Market Practice Update: Harnessing ESG opportunities in private equity

For many private equity firms, Europe provides an attractive source of investment. Alongside financial returns, many European investors (LPs) are also seeking investments with ESG impact and are therefore actively embracing a strategy focusing on ‘sustainable investments’. We’ve seen demand for sustainable investments coming from LPs, driven by sustainability commitments made by EU governments and businesses alike.

Meanwhile a tsunami of ESG-related disclosure regulations has been introduced by the EU and is revolutionising sustainable investing. If private equity general partners (GPs) want to sell ESG-related funds to European LP investors, then they need to comply with the Sustainable Finance Disclosure Regulation (EU) 2019/2088 (SFDR) and the Taxonomy Regulation (EU) 2020/852. Both regulations require fund managers based in the EU (or marketing into the EU) to disclose the degree to which they are investing in “sustainable investments” and/or “environmentally sustainable investments”.

As private equity investments have a typical investment cycle of at least 3-5 years it is vital a firm’s ESG strategy is embedded from the start of the investment relationship. If they have not already, GPs need to analyse their investment purpose (and how ESG fits within it) and incorporate this vision into ESG policies and (pre- and post-investment) processes throughout the business. We have advised our clients on the following best practices:

1. development of ESG policies and ensuring that ESG factors are considered and given sufficient weight at all investment committee meetings to satisfy relevant SFDR/compliance obligations;

2. specific ESG due diligence (DD) to understand investments’ ESG risks and opportunities and to ensure that they are consistent with the firm’s strategies, policies and procedures (including exclusion criteria);

3. engagement with portfolio companies pre-investment, including signing side letters/agreements setting ESG standards and key performance indicators (KPIs);

4. ongoing monitoring of progress against ESG standards and KPIs throughout the investment cycle, including provisions to rectify any issues that may have been identified during DD;

5. conducting annual reviews to ensure the continued compatibility of the investee company as an SFDR-compliant investment; and

6. reflecting ESG reporting requirements (the SFDR and others) in templates for annual reports and for clients generally.

Please see here for more information on how we are assisting clients in this area.

EU Parliament votes to require companies to implement internal due diligence processes and introduce climate transition plans

On 1 June 2023, the European Parliament voted to adopt new rules, which are expected to become effective by 2025, requiring companies to conduct due diligence of their value chains and implement climate transition plans in line with the Paris Agreement to the United Nations Framework Convention on Climate Change (the Paris Agreement).

As previously reported on in our March 2022 alert (when the rules were initially proposed by the European Commission) the rules will initially apply to EU companies with more than 500 employees and €150 million in revenue. They will later extend to companies with more than 250 employees and €40 million in revenue. Non-EU companies with revenues in the EU that fall within the thresholds will also be required to comply. Failure to comply could result in fines of up to 5% of global revenue, while non-EU companies may be banned from public procurement in the EU.

Some of the most significant changes are as follows:

1. companies will be required to implement climate transition plans to limit global warming to 1.5°C in line with the Paris Agreement; and

2. companies with more than 1,000 employees will be required to link directors’ variable compensation to the performance of the climate transition plan’s targets.

Companies will also be required to conduct due diligence into their, and their subsidiaries’, operations and value chains to identify, address, prevent, mitigate and account for any actual or potential adverse human rights and environmental impacts.

ClientEarth’s failed judicial review against the FCA

The High Court has refused the environmental law charity, ClientEarth’s, application for a judicial review of the UK Financial Conduct Authority’s (FCA) decision to approve the prospectus of oil and gas company, Ithaca Energy Plc (Ithaca), following its initial public offering (IPO) last year. The UK retained version of the Prospectus Regulation requires that a prospectus must disclose the necessary information which is material to an investor for making an informed assessment of the issuer’s financial position and its prospects.

ClientEarth argued that there were serious deficiencies in Ithaca’s disclosure of climate-related risks which prevented investors from making a fully informed assessment of Ithaca’s financial position, namely that:

1. the way in which Ithaca’s prospectus addressed climate risk was too broad, as Ithaca did not disclose the probability of those risks arising, how they impacted its business specifically, or how significant they were; and

2. the prospectus failed to explain how its business model and financial prospects would be impacted by, or otherwise accommodate, the Paris Agreement goals.

However, the High Court rejected ClientEarth’s application on the basis that the FCA is not required to determine the materiality and specificity of the risks to be included in a prospectus and, balanced against the requirement to be concise, the FCA’s conclusion that the various risk factors were adequately and specifically described was reasonable.

ClientEarth’s challenge is a novel approach to applying pressure to the regulator. Notwithstanding the outcome of the application, the recent prominence of climate-related risk factors and ESG disclosure requirements may lead to the FCA adopting a stricter stance going forward and issuers may also feel the pressure to further disclose how climate risks impact them when approaching an IPO.

The International Sustainability Standards Board publishes its inaugural international financial reporting sustainability standards

The International Sustainability Standards Board (ISSB) issued its inaugural international financial reporting sustainability standards on climate-related disclosures (IFRS S1) and on general sustainability-related disclosures (IFRS S2) on 26 June 2023 (the Standards).

IFRS S1 provides a framework of disclosure requirements to enable companies to communicate sustainability-related risks and opportunities to investors over the short, medium and long term. IFRS S2 sets out specific climate-related disclosures and is designed to be used with IFRS S1. The Standards are designed to be used in conjunction with any accounting requirements and, for the first time, create a common language for disclosing the effect of climate-related risks and opportunities on a company’s prospects.

A number of national and supranational governments have confirmed already their intention to adopt and/or adapt the principles introduced under IFR S1 and IFR S2 for their own climate-related disclosure requirements (to the extent not already introduced), and so we expect further regulatory developments across multiple jurisdictions in the coming years. Meanwhile, the European authorities have continued to issue a number of key updates with respect to ESG-related regulation. On 13 June 2023, the Commission published a new sustainable finance package, which included (i) recommendations in respect of facilitating transition finance, (ii) a proposal in respect of ESG rating activities, (iii) an update on the approval in principle of two Taxonomy Delegated Acts and (iv) further guidance on the Taxonomy Regulation (for further information on recent updates, please see our previous Engage articles here and here).

While these updates may be seen as positive, there remains significant uncertainty within the funds industry in particular, including how to adopt certain regulatory requirements as well as the interaction between regulation and the integration of ESG into their overall strategy. Moreover, with the FCA expected to release its Policy Statement with revised and updated Sustainability Disclosure Requirements by the end of Q3 2023 (see Engage article here), the regulatory arena remains ever changing and rapidly developing.