Wed, Jan 22, 2020

Regulation and the Threat of Climate Change - Priorities for 2020

With shifting Brexit deadlines, regulatory and financial developments, as well as climate change activists taking the world be storm, 2019 has certainly been an eventful year.

In light of this, Malin Nilsson, Managing Director at Duff & Phelps, looks ahead at regulatory trends for 2020 and the evolving environment, social and governance (ESG) landscape, and what this may mean for Jersey firms.

The Usual Suspects – The ‘B Word’, AML/CFT and Transparency

It is always with some caution that one approaches an article on what to expect in the coming year (it is only a forecast, after all), but the trends we have witnessed during 2019 provide an interesting starting point from which we can look towards 2020 and the regulatory developments in store for financial services. 

Jersey has historically had a significant focus on anti-money laundering (AML) and countering the financing of terrorism (CFT) and 2020 will be no exception. The focus on beneficial ownership registers, transparency and economic substance all point to a continued focus on financial crime and transparency. Added to this is the uncertainty that Brexit provides and how Jersey positions itself for opportunities and to guard against threats. 

But let’s face it, Brexit, AML/CFT and transparency developments are nothing new and the financial services industry has become accustomed to a slew of new regulations and uncertainty each year. What has, however, increasingly played on many people’s minds undoubtedly is climate change and what role financial institutions play, or should play, in addressing this monumental challenge.

Climate Change

There are a number of factors that have led to increasing focus, pressure and changes in investment preferences. Perhaps the most visible and voluble in popular media is that of climate activists and general public awareness of the very real impact climate change has on people’s daily lives and the natural environment around us. In Sweden, for instance, the concept of “flight shame”, or ‘flygskam’, has led to an 8% decrease in passenger numbers at Swedish airports in the first half of this year (World Economic Forum, 2019). It is clear that people are changing their habits and therefore their consumption patterns, demands, and expectations. 

Climate change is a risk that firms need to manage just like any other uncertainty. We see this manifesting itself in different ways: sustainable investment, impact investment or ESG. Why is it important? Simply put, if a large portion of the world’s assets will be underwater or subject to other material disruption, such as drought and unpredictable weather patterns, then we have a current problem which we need to deal with. The big investors in these assets are the people on the street, via our pension funds. The power ultimately lies in the hands of the general public to alter investment allocation decisions and strategies. Aside from what may be viewed as “doomsday predictions”, more and more evidence suggests that ESG-compliant investments perform better over the longer term and there is less of a perceived downside to sustainable investing. Further, the United Nations Principles for Responsible Investment (UNPRI) state that “failure to consider all long-term investment value drivers, including ESG issues, is a failure of fiduciary duty”1.  

Pension funds, the custodians of our future economic wellbeing, take a very long-term view and are building ESG and climate change risk into their investment choices. This, in turn, drives standards in the investment industry as a whole, where funds wanting to attract pension fund investment need to comply with and evidence ESG commitments. 

ESG and Regulation

So how does regulation fit into the picture when it comes to ESG? It is not a straightforward answer. At Duff & Phelps’ 11th Annual European Alternative Investments Conference, held at The Savoy Hotel in London on November 7th, 2020, it was found through polls that 67% of attendees who responded believed global regulators are not doing enough on ESG regulation2

Whether or not this is a fair assessment is subject to debate. Regulatory policies are increasingly being introduced on a global basis which means they have universal applicability and these can be grouped into three broad categories. Firstly, pension fund regulations; secondly, stewardship codes; and thirdly, corporate disclosures. For instance, in regard to the first category, the UK Department for Work and Pensions requires ESG factors to be taken into account for pension schemes, and in regard to the third, the UK Shareholder Rights Directive implemented in June 2019 requires asset managers and owners to disclose an engagement policy, which includes aspects relating to ESG.

These are all positive developments for those advocating greater engagement with the ESG agenda. Added to this, central banks, which typically focused on inflation measures and being the lender of last resort, are increasingly focusing on ESG and how the climate crisis impacts on the economy.  

However, a key weakness with current global ESG regulation is that it is voluntary (introduced on a “comply or explain” basis) and supervision and enforcement is yet to fully develop across the board. Further, there is no common or defined global standard of what firms should comply with. We have seen that, in traditional regulation of the finance sector, these shortcomings invariably also lead to weaker standards being adhered to.

Local ESG Developments

A number of pro-ESG initiatives are taking place closer to home than one might think. In Guernsey, for instance, the Green Fund rules have been put in place, and funds complying with those rules are accredited with Green Fund status, which should help investors with access to green investments. In Jersey, the very fundamental aspects that make it an attractive jurisdiction for funds in general (particularly its well-developed legal and regulatory environment, knowledge and experience and fund administration expertise, etc.), already positions Jersey as a jurisdiction for the conscious investor, who would invariably want a stable jurisdiction for green investment holdings. 

Preventing the Next Mis-selling Scandals

Green, sustainable and socially responsible investing is already in train and it is important that regulations keep pace. For instance, the need for regulations to adapt to new technologies such as blockchain and cryptocurrencies is an example in point. Similarly, with investment flows now being directed to green alternatives, and funds in some cases incorrectly holding themselves out as ESG compliant to attract such investment (known as “greenwashing”), ESG may well become our next mis-selling scandal and regulators should take note and engage in helping to set standards.

The Solution

In theory, however, ESG is already built into our local regulations. In Jersey we operate on a principles-based regime, which already requires firms to pay due regard to proper governance and risk management arrangements. Also, the Jersey Financial Services Commission’s Guiding Principles are centered around protecting risk to the public and safeguarding the best economic interests of Jersey. Other regulators have similar objectives, including protection of orderly markets. Climate change is disruptive to both customers and markets, but it is not a huge leap to build ESG requirements into regulators’ principles. ESG boils down to fundamental concepts that already form part of global regulations, as well as local ones, and those are governance, culture and integrity – as long as there is clear communication and guidance on new ESG standards and expectations.

ESG will be an important part of the regulatory agenda in the near future, though when we will see specific changes we cannot be sure. What we can be sure of, however, is that climate change is a very real risk to which we, as professionals, must not turn a blind eye.

This article was first published by the Jersey Evening Post on January 15, 2020.

1 UNPRI: Fiduciary Duty in the 21st Century
2 Poll of attendees at the Duff & Phelps Alternative Investment Conference, 7 November 2019

Financial Services Compliance and Regulation

End-to-end governance, advisory and monitorship solutions to detect, mitigate, drive efficiencies and remediate operational, legal, compliance and regulatory risk.

Regulatory Advisory and Assurance Services

Within our Regulatory Advisory and Assurance Services, we assist financial services firms in a range of engagements across our suite of subject matter expertise.