New FCA sustainability rules won’t deliver accountability for climate harm

Forthcoming EU regulations could, if enforced robustly, help civil society hold economic entities operating in the EU to account for the harm they cause to the environment. [1] The regulations will also apply to human and workers’ rights abuses but this article focuses on climate harm.

As a financial campaigner based in the UK, the question I have is: what needs to be done to hold UK financial institutions to account for the climate harm they enable?

They say money makes the world go around, but money also harms the planet. Economic entities could not cause the scale of environmental harm they do without the investment, loans, or insurance provided by financial institutions. Despite the hype about sustainable and responsible finance, the City of London continues to finance, at scale, activities that harm the planet.

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The EU Corporate Sustainability Due Diligence Directive (CSDDD)

The CSDDD aims to promote more sustainable and responsible behaviours by large companies operating in the EU. Larger companies[2] would be required to report on how their activities adversely impact on the environment.[3] Interestingly, the measures would apply to global supply chains, not just those inside the EU.

The full details of the Directive will be developed in 2024. From 2025 larger companies will be required to disclose their Scope 3 emissions.[4] True to form, the finance lobby used its power and influence to exclude financial institutions from the full scope of the Directive.

We need hard data on emissions and independent ratings in the UK

The UK is still considering whether to introduce Scope 3 reporting requirements. To hold economic entities and financial institutions to account for climate harm, we need reliable data on all types of emissions, not just Scope 3. But Scope 3 emissions are very important. For example, a manufacturing company may be responsible for generating significant emissions from the extraction and processing of raw materials used in its products.

Financial portfolios and products – loan books and pension, investment, and insurance funds etc – are comprised of relationships with underlying economic entities eg. listed and private companies, sovereign states, local government and other agencies e.g., transport/housing authorities.[5] To build up a true picture of how much climate harm financial institutions are responsible for we need emissions data on these constituent entities.

Trustworthy, meaningful data on emissions generated by economic entities could help independent civil society organisations and others such as pension fund trustees produce ‘green ratios’ or ‘climate harm ratios’[6] for loan books and pensions, investment, and insurance fund portfolios. Financial institutions which refused to subject their activities to independent analysis could be publicly exposed.

If policymakers and regulators are serious about tackling climate change and holding finance to account, they should require financial institutions to publish independently-verified green ratios for their loan books and funds. Banks are required to tell customers how much they charge for loans and overdrafts. Asset managers are required to disclose the impact of costs on people’s pensions and investments. It is a bizarre anomaly that financial institutions are not required to clearly disclose how much climate harm they are enabling.

Requiring financial institutions to produce independent green ratios would allow for the establishment of a meaningful, objective ratings system.[7] Credit ratings for banks and portfolios are built up from the ratings of individual economic entities. We should do the same for climate harm ratings.

Why is trustworthy emissions data and an independent ratings scheme important? Unless we do have robust rating systems based on hard data, financial institutions that continue to finance climate harm will escape being held to account. A rating system built on hard data would also be more effective at preventing greenwashing.

Independent ratings are needed because of the conflicts of interest inherent in the commercial ESG ratings industry.

The FCA’s sustainability disclosure and investment label regime won’t work

The Financial Conduct Authority (FCA) is introducing a sustainability disclosure and investment label regime for investment funds.[8] It only covers investment funds so it is obviously very limited in its scope.

Even though it is limited to investment funds, it will not hold investment firms to account for the climate harm they finance.[9] It is to all intents-and-purposes a voluntary approach. Investment firms can choose whether to subject their investment funds to scrutiny to see if the funds might qualify for a sustainable investment label. Investment firms that continue to finance climate harm will not be subject to mandatory assessment or independent rating of their climate performance.

Even with regards to those firms that do opt for a label, the FCA’s approach is unlikely to be effective. It conflates and confuses different ESG goals (environmental and ‘social impact’[10]) into a single sustainable label. This will allow firms to disguise poor performance on climate goals.

The FCA approach conflates ESG goals with the approach adopted by funds. Funds can opt for one of four labels – Sustainability Impact™, Sustainability Focus™, Sustainability Improvers™, and Sustainability Mixed Goals™. The FCA decided not to go for a clear rating system eg. 1 – 5 stars even though consumers understand and value ratings.

The qualifying criteria for claiming funds are sustainable are vague and subject to manipulation and abuse. The investment industry will have far too much leeway to ‘mark its own homework’ on fund compliance with green goals.

To be fair, the FCA is introducing a general anti-greenwashing rule. But, this is unlikely to be effective as the vagueness of the criteria means it will be difficult to enforce.

What next?

Unfortunately, the FCA has made its decision to implement its misguided approach. We cannot reverse that decision now. So, the question is how do we make the best of a bad job? At the Financial Inclusion Centre, we argue that civil society organisations should now prioritise:

· ensuring that trustworthy and comprehensive emissions data on individual economic entities is produced; and

· campaigning for regulators to require financial institutions to produce independently verified green ratios for their portfolios, funds, and products.[11]

Narrative based reporting and disclosure is not effective at changing behaviours. We need hard data and independent ratings to hold finance to account on climate harm.

[1] What the drive for cleaner capitalism will look like in 2024 (ft.com)

[2] For definitions see: Corporate sustainability due diligence - European Commission (europa.eu)

[3] The CSDDD also applies to human and labour rights. But, for this article I focus on climate harm.

[4] Scope 1 emissions cover emissions from sources directly owned or controlled by a company. Scope 2 emissions covers indirect emissions from the purchase and use of energy. Scope 3 emissions includes indirect emissions generated in the company’s supply chains (upstream and downstream).

[5] For an explanation of where foundational emissions data fits in see: Time for action: the Devil is in the policy detail (inclusioncentre.co.uk) Figure 1, p79

[6] This would be similar to the Portfolio Greenness Ratio developed by ESMA. ESMA 50-165-2329 TRV Article - EU Ecolabel: Calibrating green criteria for retail funds (europa.eu)

[7] For an explanation of how such a rating system would work see: Time for action: the Devil is in the policy detail (inclusioncentre.co.uk) , p70

[8] Sustainability disclosure and labelling regime confirmed by the FCA | FCA

[9] For a full explanation of why the FCA’s approach won’t work see: Financial Conduct Authority consultation on Sustainability Disclosure Requirements (SDR) and Investment Labels CP22/20 | The Financial Inclusion Centre

[10] There is a real issue with social impact washing as well as greenwashing. FIC will be publishing a new paper on this soon.

[11] Additional measures are needed. These are set out in: Time for action: the Devil is in the policy detail (inclusioncentre.co.uk)