I. INTRODUCTION
The COVID-19 pandemic has put a spotlight on the vulnerability of the modern economic system to non-financial risks. The incorporation of environmental, social and governance (“ESG”) factors in investment decisions is an important acknowledgment of many of those risks, and in some cases, goes a step further by aiming to achieve certain ESG goals when making investments. While ESG concepts have been gaining momentum for almost two decades, the pandemic, coupled with growing concerns around climate change, has elevated their importance. This article discusses the evolution of ESG investing, provides an overview of the current regulatory landscape in Europe and the UK, and examines the potential effects of ESG developments on private equity sponsors in the short, medium and long term.
The Rise of ESG in Mainstream Private Equity
Increased investor appetite is the clearest indication that ESG has now hit the mainstream. In 2006, the United Nations Principles for Responsible Investment (“UN PRI”) was formed, and by the end of 2020, the network had garnered more than 3,000 signatories representing over $110 trillion of assets under management (“AUM”). More UN PRI signatories naturally means more AUM reflecting ESG considerations: the past five years have seen a 30 percent year-on-year increase in ESG assets and ESG selection strategies, representing 45 percent of total European AUM at the end of 2019.
Funds and portfolio companies have embraced ESG as well; Larry Fink, BlackRock’s CEO, noted in his 2021 letter that there has been a systemic shift on this issue, given the evidence that companies with strong ESG profiles outperform those without.
In addition to the growing acceptance of ESG by investors and sponsors, the pandemic has broadened the ESG remit beyond primarily climate-related concerns to fully encompass the broader range of environmental, social and governance matters. This shift is underscored by EU-led regulatory developments.
II. THE DEVELOPMENT OF REGULATORY REQUIREMENTS
The European Union
Before 2014, the EU preferred soft-law options for wholesale ESG reporting, such as promoting the UN Global Compact and the UN PRI. That year, however, the EU took a decidedly harder line with the introduction of Directive 2014/95/ EU (the Non-Financial Reporting Directive, or “NFRD”), which amended the Accounting Directive 2013/34/EU. The amendments required certain large undertakings and groups to disclose information on policies, risks and outcomes regarding environmental matters, social responsibility, human rights, anticorruption issues and the diversity of corporate boards. While radical in the scope of the disclosures it required, the NFRD was conservative in reach, affecting only around 6,000 companies across the EU. Despite that limitation, however, the amendments had a significant impact by introducing concrete ESG reporting requirements to the market. The response was positive—not surprising, given that the global financial crisis, still fresh in everyone’s mind, had provided a stark reminder of the importance of non-financial considerations in risk management.
ESG momentum was strengthened by the 2015 Paris Agreement and 2030 Sustainable Development Goals, which prompted the announcement of the EU’s Action Plan on Sustainable Finance. The Action Plan, which was developed to reorient capital flows toward a more sustainable economy, included three headline regulations: the Low Carbon Benchmark Regulation,1 the Disclosure Regulation2 and the Taxonomy Regulation.3 Importantly, these regulations cast a wide net, applying to (among others) anyone marketing or managing funds in the EU.
The United Kingdom
With the Brexit transition period having ended on January 1, 2021, the United Kingdom has begun to define how its own green finance strategy will depart from the EU’s Action Plan. In November 2020, Rishi Sunak, the Chancellor of the Exchequer, laid out the UK’s roadmap to developing and implementing environmental disclosure standards that are more robust than the EU’s Disclosure Regulation. The UK will require mandatory disclosures in line with the Task Force on Climate related Financial Disclosures (“TCFD”) by 2025, going beyond the Disclosure Regulation’s “comply or explain” approach. This alignment has already begun its phase in, with premium listed commercial companies now required to provide disclosures in their annual reports consistent with the TCFD. Sunak also stated in the announcement that the UK will review the EU Taxonomy’s thresholds and metrics and adapt them as needed for the UK market.
III. WHAT DOES THE FUTURE ESG REGULATORY LANDSCAPE LOOK LIKE?
We expect the ESG regulatory landscape to develop rapidly as we approach the 2030 SDG deadline. Below we set out our expectations for the next twelve months, the next three years and up to the SDG 2030 deadline.
Short term – twelve months
- The EU Will Progress the Action Plan
Currently, the Disclosure Regulation is partially in effect, with relevant Level II requirements anticipated on January 1, 2022. It requires financial market participants and financial advisers—including most private equity fund managers in the EU, as well as non-EU managers marketing in the EU under national private placement regimes—to disclose how ESG risks are incorporated into their investment decision-making process and whether (or, for larger firms, how) they consider the principal adverse impacts of investment decisions on sustainability factors. Products that specifically promote environmental or social characteristics and products with sustainable investments as their objective are subject to further special pre-contractual and ongoing disclosures regarding the sustainability indicators used to monitor performance against their objectives.
The Disclosure Regulation will be complemented by the Taxonomy Regulation, which will introduce uniform technical screening criteria to determine whether and to what extent an economic activity qualifies as environmentally sustainable. The Taxonomy Regulation’s two climate change objectives are scheduled to become effective on January 1, 2022, with the remaining four environmental objectives taking effect on January 1, 2023.
In addition, existing regulations like the AIFMD will be revised to further incorporate ESG factors. Fund managers will soon be required to introduce procedures to address ESG risks; in particular, sustainability risks will need to be taken into account in the fund manager’s risk management policy.
- The EU Will Introduce Broader Supply Chain Disclosures
The European Commission has announced its intention to introduce far-reaching supply chain due diligence legislation by this July; in anticipation, the European Parliament recently passed a far-reaching Draft Directive on Corporate Due Diligence and Corporate Accountability (“Draft CDDCA Directive”). The Draft CDDCA Directive covers large undertakings and high-risk small- and medium-sized undertakings, both within and outside the EU, that “operate in the internal market selling goods or providing services.” Those companies are required to consider whether their operations and business relationships cause adverse sustainability impacts; wherever adverse impacts are found, companies must address them. Companies must also build such considerations into their contractual relationships, codes of conduct and audits. The Draft CDDCA Directive is at an early stage of development, but its breadth and scope is notable.
- COP 26 Will Prompt Further Private Sector Regulation
The 2015 Paris Agreement committed signatory states to limiting global temperature increases to “well below” 2 degrees Celsius. Since then, the policies of individual governments have fallen short of that goal. Given that the pandemic has pushed back the date of the 2021 UN Climate Change Conference (COP 26), and the growing consciousness of stakeholder capitalism, we expect further climate commitments from governments and consequently further climate-related regulations affecting the private sector.
Medium term – three years
- Addressing the Biodiversity Crisis
Since the inception of ESG, the “E” has been synonymous with climate-focused investing. However, there is a growing awareness that this approach needs to be broadened. In September 2020, the World Wildlife Federation reported that wildlife populations have fallen by more than two-thirds in less than half a century; further, $44 trillion of economic activity— more than half of global GDP—is at least moderately dependent on nature. The UK Treasury’s Dasgupta Report, published in February this year, built on these conclusions, noting that the loss of natural capital lowers crop yields, weakens supply chains and exacerbates natural disasters. The revelatory findings of these reports will likely be discussed at the UN’s Biodiversity Conference (CDB COP 15) taking place in Kunming, China, later this year. With the EU and UK both considering biodiversity-related disclosures in the coming years, biodiversity will become an increasingly important aspect of the ESG landscape.
- Social Considerations to Stay on the Agenda
The COVID-19 pandemic brought to the fore the problem of economic inequality and elevated its place on the regulatory agenda, with the IMF, World Bank and OECD all noting that the pandemic has deepened the economic divide. With increasing investor acceptance of stakeholder capitalism and disclosure obligations mandating greater corporate transparency, corporates and private equity sponsors alike will be expected to play not just an economic but a social role in the global recovery. Of particular importance to this dialogue is the social taxonomy currently being developed by the European Platform on Sustainable Finance (“EPSF”), which will seek to foster more equitable employment and safe working conditions by promoting investment in education, health and housing. However, the EPSF’s social taxonomy may well engender considerable debate and take longer to come to fruition than its environmental counterpart.
- Public and Private Environmental Litigation
There are currently 22 cases before courts around the globe invoking obligations under the Paris Agreement, and many more focused on climate change more broadly. The highest-profile decisions so far have been against governments accused of not meeting their international obligations, most notably the Dutch Supreme Court’s 2019 decision in Urgenda Foundation v Netherlands. In that case, the court held that the Dutch government had acted negligently when setting a CO2 target which did not align with the Paris Agreement. Such judgments will force governments to address any deficiencies in regulatory regimes that do not align with increasingly stringent international environmental commitments, affecting private sector targets and allowances.
More ESG regulation will invariably increase the number of claims brought against private companies. An early example arose in January 2020, when 14 French local authorities and five French NGOs brought a claim against Total under the French Vigilance Law, claiming that Total had failed to identify and take appropriate steps to mitigate climate risks and that the company’s vigilance plan “does not ensure that the Total group aligns with a trajectory compatible with the objectives of the Paris Agreement.”
Long Term – 2030
- The SDG Commitments
Become Reality
Many investors are aligning their portfolios with the UN Sustainable Development Goals, comprising 17 goals and 169 targets addressing economic, social and environmental development. Such alignment is a good indicator of the direction of portfolio risk mitigation. However, given the economic and social impact of the pandemic, achieving all of the SDGs by 2030 will prove difficult. Fund managers should be conscious of the wording they use when committing to align their portfolios with the SDGs, being careful not to overcommit to macroeconomic targets which are outside of their control.
ESG litigation is likely to grow on multiple fronts. Alongside the general climate litigation discussed above, courts will also be faced with the question of the extent to which fiduciaries must take ESG considerations into account when making investment decisions. As mandatory ESG disclosure obligations increase, so too will alleged breaches of commitments to align with a particular sustainability benchmark. Courts will
have to decide questions of compliance with, and perhaps more importantly, the accuracy of, non-financial reporting, whether mandatory or voluntary. Courts must also determine the limit of corporate separateness and the circumstances in which the “corporate veil” can be pierced.
While the EU has so far taken the lead in ESG regulation, governments elsewhere are crafting their own approaches. In the United States, the Securities and Exchange Commission has made a number of announcements reflecting the worldview of the new administration. Most notable is the SEC’s 2021 Priorities, which set forth a new approach to climate change and other ESG considerations. There is no doubt the SEC’s ESG disclosure regime will be influential, but it is unlikely to undermine the EU’s current position as the global ESG standard setter.
Similarly, as China becomes an increasingly important player in the global financial markets, more attention will be paid to its still-nascent ESG regulatory environment. However, the World Economic Forum has observed that China is at a tipping point in terms of environmental commitments, noting its ambition to reach peak carbon before 2030 and carbon neutrality by 2060.
IV. CONCLUSION
Regulatory developments and international commitments in Europe, the United States and elsewhere reflect the permanent place ESG has achieved in the economic landscape. Private equity sponsors should keep abreast of this fast-moving regulatory environment.
For more Debevoise insights in the ESG space, visit the firm’s ESG Resource Center here.