The Situation: The European Union continues to roll out its Action Plan for Financing Sustainable Growth with its latest proposal concerning climate-related disclosures and the European Commission's launch of a public consultation process to close on March 20, 2019.
The Result: Certain EU entities will have increased climate-related disclosure obligations; the bar is being raised, in particular, for large entities, banks, and insurance companies.
Looking Ahead: New final guidelines are expected by June 2019, and covered entities will need to take a fresh, in-depth look at their business models, policies, and due diligence processes in order to provide specific information on environmental outcomes, principal risks and their management, and key performance indicators that are traceable, relevant, and consistent over time.
The "E" for "environmental" in environmental, social, and governance ("ESG") has skyrocketed to prominence worldwide. Regulatory proposals and certification schemes by governments and industry offer fresh perspectives and opportunities. However, without a common technical and legal foundation, investors, issuers, and the financial industry find measuring "greenness" to be nebulous at best.
In perhaps the most far-reaching attempt to confront such challenges to date, in March 2018, the European Commission released an action plan setting forth a multi-pronged approach to finance sustainable growth. Key elements of the action plan include promoting transparency and standardization to shift private sector resources toward environmentally friendly and socially responsible initiatives. The European Commission considers that covered entities will benefit from effecting such changes by potentially lowering their cost of capital and fostering a more diverse investor base and better corporate reputation.
To this end, the European Commission is taking steps to update its nonbinding guidelines on non-financial disclosure obligations ("Guidelines") under EU law for covered entities. The proposed updated Guidelines seek to integrate the concepts contained in the Non-Financial Disclosure Directive 2014/95 ("Directive") and the recommendations published by the G20 Financial Stability Board's Task Force on Climate-Related Financial Disclosures ("TCFD"). The updated Guidelines also reflect the recommendations in the January 2019 report published by the European Commission's Technical Expert Group and related public feedback. The European Commission's public consultation on the proposed updated Guidelines is open through March 20, 2019.
Adapting Existing EU Disclosure Rules for Material Climate-Related Information
In November 2014, the Directive amended EU reporting requirements to include certain non-financial disclosures related to ESG. The Directive covers entities (and parent entities of a group) that: (i) are considered public interest entities; (ii) have a balance sheet total of at least €20 million or a net turnover of €40 million; and (iii) had more than 500 employees on average during the prior financial year. The Directive did not specify how covered entities should disclose climate-related information—a task now taken up by the European Commission.
What Climate-Related Information Should Covered Entities Disclose?
To comply with the Directive, covered entities must disclose ESG information that "is necessary for an understanding of the undertaking's [or group's] development, performance, position and impact of its activity."
In determining materiality of ESG information, covered entities should apply a so-called "double materiality" threshold to climate-related information, whereby information should be disclosed if it is "necessary to understanding":
The climate change impact on the development, performance, and position of the entity, which the Guidelines read to relate to financial materiality; and/or
The entity's impact on climate.
Note that the existing Guidelines incorporate the EU Accounting Directive (2013/34) definition of materiality: "information where its omission or misstatement could reasonably be expected to influence decisions that users make on the basis of the financial statements."
The working assumption of the proposed Guidelines is that most covered entities will determine that climate is a material issue, under one or both of these prongs—which are expected to increasingly overlap going forward. The proposed Guidelines further suggest that, if an entity determines that climate is not material, it should provide a negative statement with a reasoned description of how it reached that conclusion.
How Should Covered Entities Disclose Material Climate-Related Information?
The proposed Guidelines follow the Technical Expert Group's approach by advising covered entities to provide material information falling within several climate-related disclosure buckets, including:
How climate change may affect the entity's business model;
The entity's due diligence, governance, and control policies relating to climate-related issues, including involvement of the board and management;
Climate-related policies and an assessment of the entity's development, position, performance, and climate impact as a result of its policies;
Climate-related risk factors that the entity has identified and a description of its risk determination and risk-management processes; and
Supporting key performance indicators ("KPIs"), to be defined in the updated Guidelines, including specific KPIs for the insurance and banking sectors.
Banks and insurance companies occupy a double role in the climate context as providers and users of climate-related information. Given their access to funds, the European Commission deems such companies of systemic importance for the transition to a climate-resilient economy. Therefore, banks and insurance companies should look to the updated Guidelines for sector-specific disclosures and KPIs to apply to their climate analysis, and they will have to juggle these changes with existing regulations and industry-specific confidentiality requirements.
For example, the updated Guidelines contemplate a banking-sector KPI disclosing the amount (percentage and value) of a portfolio that is green-bond certified and an insurance-sector KPI disclosing the maximum expected loss from natural catastrophes caused by climate change. The first KPI would demonstrate the degree of commitment to green finance, while the second would demonstrate risk management maturity and resilience to adverse conditions.
The updated Guidelines distinguish between two types of disclosure: information that an entity should disclose (Type 1) and information an entity may consider disclosing (Type 2). For example, an entity should disclose the board's oversight of climate-related risks and opportunities but may consider disclosing employee policies that relate to climate. While perhaps confusing (the Guidelines are nonbinding), this distinction appears intended to increase covered entities' flexibility in making materiality, risk factor, and other disclosure determinations.
Climate-Related Disclosure Going Forward
The European Commission's updated Guidelines on non-financial disclosure of climate-related information, when published, will assist covered entities in determining whether climate-related information is material for disclosure purposes and, if so, how to disclose it. It is expected that large entities will be moving to adopt these disclosure guidelines given investors' and other stakeholders' heightened awareness of these issues. The Commission's effort is based on the recognition that good disclosure is a critical contributor to efficiently directing capital to investment in sustainable economic growth.
European countries are now well aware that transparency and reporting consistency is necessary to increase investor and shareholder confidence. For example, June 2018 amendments to the French Corporate Governance Code of Listed Corporations reflect the strategic importance of ESG disclosure, stating that a listed company's board of directors should seek to "promote long-term value creation … by considering the social and environmental aspects of its activities." These amendments further recommend incorporating ESG criteria when compensating directors and officers, criteria that listed companies will need to publicly disclose. France and its companies are among the most active participants in green finance.
However, initiatives such as the updated Guidelines are just one piece of the bigger puzzle of the European Union's ongoing effort to harmonize Europe's capital markets and reorient private capital flows toward sustainable investments. Importantly, the European Commission is set to release a much-awaited final report on a new European green bond certification standard in the second quarter of 2019.
Both buy-side and sell-side stakeholders are closely watching Europe's changes to sustainable finance rules, and Jones Day is monitoring developments as well.
Two Key Takeaways
It appears that the European Commission will take a broad interpretation of materiality of climate-related information. Covered entities will need to consider carefully the updated Guidelines when updating their non-financial disclosure statements, as well as their corporate governance and internal processes.
The updated Guidelines are likely to assist in standardizing the format and content of climate-related disclosures, in an ongoing effort to provide a common language and basis for comparison. The European Commission and European Union as a whole are moving quickly to implement far-reaching sustainable finance rules.