What are the main ESG regulations in the UK?

ESG is a “hot topic” among UK investors and asset managers. Larger investors used to say (publicly and privately) that ESG-focused investments were costly but, in the UK, most ESG funds report parity or outperformance over one-, three-, five-, and 10-year periods. Lack of data on ESG-focused funds’ performance made many investors nervous, but multiple reports indicate that ESG funds may have outperformed their non-ESG peers, leading to a recent increase in UK ESG funds. “Responsible investment” has grown over 40% from 2014–2020, and this figure seems set to rise.

The Pensions Regulations described in question 1.1 for pension schemes, which are major investors in UK markets, have led to an increase in ESG-friendly investments, as pension funds pressure fund managers to invest in more ESG-conscious investments.
In the UK, ESG-only firms and “sustainable” funds within larger financial institutions have grown, while asset managers are being trained on ESG-conscious investing and upcoming regulations.

2.2 How do other stakeholders influence ESG?

Younger, “millennial” (and even “Gen Z”) investors, consumers, and stakeholders are more ESG-conscious than their “baby boomer” and other forebears, and have increased demand for responsible investment. Younger investors and other stakeholders place more importance on climate change, global warming, social justice, and other non-financial imperatives than their predecessors. Given the inevitable wealth transfer to these generations (and the desire to move with the times), organisations have been driven to demonstrate their ESG credentials competitively.

Younger, more ESG-conscious generations make up an increasing proportion of the workforce in large UK corporates, encouraging (or forcing) organisations to strengthen their internal ESG measures, such as increased employee engagement, better employee benefits (such as maternity and paternity leave), and more extensive recycling. “Older” generations in (and at the top of) UK businesses appear to have embraced ESG initiatives and be willing to adapt their organisations and business practises accordingly. Debt finance providers have also emphasised ESG investments, especially those seeking to reduce or reverse climate change.

2.3 Who are the main ESG regulators, and what are they pushing?

In the UK, the principal ESG regulators are the FCA, the European Commission (for EU financial services such as MiFID II, the AIFMD, and the UCITS Directive), the UK government, the FRC (to be replaced by ARGA as described in question 1.1 above), securities exchange regulators (such as the LSE), Companies House, and the Pensions Regulator.

Environment Agency, Scottish Environment Protection Agency, and Natural Resources Wales are UK’s environmental regulators. The Environmental Regulators can issue fines for violating environmental laws and regulations such as water treatment and discharge, waste disposal, packaging regulations, oil discharge, and environmental permit management.

The FCA released a Consultation Paper in March 2020 to enhance climate-related disclosures by listed issuers (on a “comply or explain” basis). All commercial companies with a UK premium listing (i.e. Main Market companies subject to the UK’s highest regulation and corporate governance standards) are required to include a statement in their annual financial report stating (1) whether they have made disclosures consistent with the TCFD recommendations, (2) instances where they have not followed the TCFD recommendations (and why), and (3) instances where they have included disclosures in a document. The FCA emphasises the TCFD’s recommended disclosures on risk management and governance, saying companies should only withhold them “exceptionally.” The first compliant reports will be published in 2022 for accounting periods beginning on or after 1 January 2021. The FCA proposes to change its Listing Rules to require companies to disclose annually, on a “comply or explain” basis, whether they meet board diversity targets and to publish diversity data on their boards and executive management. The FCA’s consultation ended in October 2021.

2.4 What ESG enforcement actions have happened?

Much of the UK’s ESG regulation is new, and many regimes are “comply or explain” rather than “comply or face sanctions.” Few significant enforcements have occurred. More section 172 statements (described in question 1.2) and new regulations may increase regulator action (and ability to impose sanctions) in relation to non-compliance.

The Environmental Regulators are the UK’s most active ESG regulators, issuing over £350m in fines since 2010. Southern Water was fined £92m in July 2021 for five years of illegal sewage discharges on the coasts of Kent, Hampshire, and Sussex. The Environmental Regulators can issue fines for climate change violations, which often involve the greenhouse gas emissions trading scheme.

Under the CMCHA 2007, organisations can be guilty of corporate manslaughter if they commit a gross breach of duty of care. While the suitability of the legislation has been questioned because convictions have been rare (fewer than 30 since 2007), the criminal sanctions for breach (and the associated reputational damage) mean that organisations are invariably focused on ensuring adequate measures are in place to ensure compliance with associated health and safety legislation and to avoid any possible breach of the CMCHA 2.

Under the MSA 2015, the UK Home Office has threatened organisations that haven’t published their modern slavery statement on time. Again, reputational damage is a bigger risk than legal consequences. We’ve encountered companies that didn’t publish their statement on time and were given a grace period, or that explained to the Home Office why the rules don’t apply to them (for example, if the turnover threshold is not met).

Multiple UK ads have been banned by the Advertising Standards Authority (ASA), often for misleading environmental claims. While not a direct ESG enforcement action, this is often described in the media as a “greenwashing” attempt by the company (misleading information being disseminated to present a (inaccurately) environmentally responsible public image). Again, ASA bans lead to negative press and investor issues. Ancol Pet Products, BMW, Fischer Future Heat, Ryanair, and Shell had ads banned in recent years.

In 2020, the UKSIF issued a report on pension ESG issues after the introduction of increased disclosure requirements under the Pensions Regulations (described in question 1.1 above). The report found “appallingly poor compliance with the ESG regulations.” “Policies were thin, noncommittal, and suggest pension trustees are not adequately interrogating their investment manager’s approaches to financially material ESG factors” The UKSIF also noted that many pension schemes haven’t published SIPs.

Given the lack of major enforcement actions to date, some critics argue that ESG-related litigation, including against governments and public bodies (such as regulators) for failing to act, as well as against companies to claim damages, may prove to be a more effective way of holding businesses accountable and forcing them to change their practises.

2.5 What are the main ESG-related litigation risks?

ESG litigation is rare in the UK, but this could change soon. Investors increasingly consider a company’s ESG credentials before investing. This action has led to greater scrutiny of ESG-related disclosures in annual reports and prospectuses, and an increased risk of investor and activist claims if disclosures are inaccurate.

We expect more investor class actions against companies that misrepresent their ESG credentials. Shareholder activism has risen, especially in oil and gas and finance. Activist investor groups (such as ShareAction) have given smaller ESG-conscious investors a greater voice and held firms accountable by proposing resolutions, publishing articles on issuer non-compliance with ESG regulations and guidance, and ranking countries and organisations (such as banks).

Climate Action 100+ and Follow This requested two climate change resolutions at BP’s 2019 AGM. One resolution proposed that BP include, in its annual report starting in 2019, a progress report describing how its business strategy is consistent with the Paris Agreement on climate change, supported by relevant capital expenditure, metrics, and targets. This resolution passed with 98% of shareholders’ support, demonstrating the importance of ESG credentials and public disclosures to investors. Barclays, BHP Group, and Royal Dutch Shell have also had shareholders request environmental resolutions. Although not listed in London, activist investors replaced ExxonMobil board members as a sign of global shareholder activism on climate change.

Litigation or regulatory enforcement can cause a rapid drop in a company’s share price, prompting shareholders to sue to recover their losses. “Securities litigation” originated in the US but has increased in the UK in recent years, partly due to third-party litigation funding and insurance, as well as active claimant law firms and claims management companies seeking out these types of claims.

Such claims can be made under section 90A of the Financial Services and Markets Act 2000 (“FSMA”), which states that if an issuer makes a false or misleading statement or a dishonest omission in published information (other than listing particulars or prospectuses), it can be liable to investors who need to prove they acquired, continued to hold, or disposed of shares in reliance on the statement or omission. As of this writing, this section is largely untested in UK courts in relation to ESG matters, and it is unclear how easy it would be to prove reliance (other than by reference to a sustainable investment’s fund or other ESG-conscious investor’s documented ESG goals or principles) and accurately quantify the investor’s loss. The very fact of a claim (rather than damages) may be damaging to a company’s reputation, so businesses must tread carefully in this area.

2.6 What are ESG proponents’ top concerns?

Inconsistency is an ESG issue. As an example, there is no universally agreed definition for each component of “E-S-G,” which hinders effective ESG legislation and enforcement in the UK and globally. While efforts are being made to improve this situation, the varied requirements under the legislative framework (which is fragmented, as noted in question 1.1) and the differing guidance suggestions on reporting and disclosures often result in inconsistent ESG disclosures. Inadvertently excluding or including issuers based on ESG reporting can result (especially if an algorithm or programme is being used to review ESG disclosures).

“Greenwashing” is another ESG concern. Due to inconsistent regulations and guidelines and a lack of enforcement actions (and shareholder claims) regarding ESG disclosure, many companies may have overstated their ESG efforts. ESG-rated companies may have a business strategy that harms society. Some consider this greenwashing. Media reports have historically focused on “greenwashed” products or lines, not entire companies (as described at question 2.4 above in relation to ASA bans). Larger, less ESG-conscious companies may be required to disclose how they consider ESG factors. Fund managers use the UN’s SDGs to describe some investments as “sustainable” or “ESG-conscious” without proving their positive impact. Certain funds are called “ESG funds,” but they simply exclude tobacco and arms (with very few excluding fossil fuels), rather than analysing investments’ “E-S-and-G” credentials. Investors can be confused by “sustainable investing,” “impact investing,” and “ESG investing.” This product classification has helped UK fund managers and investors avoid greenwashing to some extent.

Difficulties assessing an issuer’s ESG credentials can hinder ESG investment. Technological advances are helping analysts in this area by requiring global ESG issues in investments (such as access to clean water, or alignment with the Paris Agreement on climate change). A large portion of UK “sustainable investments” are passive tracker funds that follow the FTSE 100, which is dominated by oil and gas companies. Passive, sustainable investment funds are unlikely to make a significant impact on investors’ ESG goals and can be used to overstate ESG credentials. Some investors argue that a fund invested in finite natural resources (such as oil and gas) cannot be an ESG investment, while others claim that, as many traditional fossil fuel companies look to diversify and become more sustainable, investing in these companies is actually helping this process of change and is therefore the definition of an ESG-conscious investment (many disagree with this view). Inconsistency hurts ESG advocates. The FCA published an analysis of greenwashing in July 2021, but it has not adopted the EU’s SFDR or announced proposals for a UK regime.

3. ESG planning and operations

Who handles ESG issues? What role does management play in setting and changing corporate strategy? The board of directors of a company and the fund managers are primarily responsible for ESG issues. As explained in question 1.2, the Companies Act requires company directors to promote the company’s success for its shareholders, including considering ESG-related factors. Larger companies must disclose how these factors were considered in decision-making.

ESG issues are often delegated to individuals or committees with ESG expertise, key operations executives, and those with legal, regulatory, and compliance responsibilities (such as the general counsel or members of the in-house legal team). Consultants may be hired to develop the initial strategy and implementation plan. Investment firms that are signatories to the PRI must disclose their internal and/or external roles and whether they oversee or implement responsible investment.

ESG strategies were formerly called CR or CSR. Some companies may still have a CSR committee that ensures ESG compliance.
The management body’s role in setting and changing an entity’s ESG strategy is crucial so that those implementing it understand its importance and key drivers. As noted in question 2.2, while ESG issues are often perceived as being driven by younger generations of stakeholders, the buy-in of business leaders and managers is crucial for the success of ESG initiatives.

3.2 What mechanisms oversee ESG management?

As discussed in question 1.2, directors must “have regard” for various stakeholder constituencies (such as employees) when carrying out their primary duty to promote the company’s success for its shareholders. Investors are placing a growing emphasis on workforce engagement, often seen as the “S” in ESG, which means boards are considering employees’ interests and concerns more.

Recent UKCGC amendments require listed companies to adopt one of three engagement methods (as explained in question 1.2 above). A board can choose its own effective measures and not adopt any of these. Most FTSE 350 companies have non-executive directors. The UKCGC’s reference to “workforce” rather than “employees” includes part-time, flexible, and agency workers.

Audit and risk committees often consider ESG issues. Some organisations establish a sustainability, ESG, or health and safety committee to oversee ESG issues and report to the board. Such committees can have a budget and set or change the company’s agenda to align with ESG trends or requirements, recommending changes to the board. In the UK, an ESG committee isn’t required. Many companies have a CSR committee, which may address ESG goals.

3.3 How are ESG-aligned incentives compensated?

Certain listed companies must prepare a directors’ remuneration report each year under section 430 of the Companies Act. This includes a retrospective overview of the director’s remuneration for the previous financial year (the “DRR”) and a forward-looking policy setting the framework and limitations for future director remuneration (the “DRP”). The DRR is voted on annually by non-binding shareholders, while the DRP is voted on annually by binding shareholders.

There is no legal requirement to link remuneration or incentives to ESG metrics, but more ESG-conscious organisations may decide to go beyond their legal obligations. We are beginning to see organisations link achievement of certain ESG outcomes and remuneration.

PRIs (see question 1.3) explain how to link ESG factors to remuneration to hold executive management accountable for sustainable business goals. 45 percent of UK’s FTSE 100 companies have an ESG target linked to variable pay, and 37% include one in their bonus plans (with a typical weighting of 15 percent). In some sectors, identifying ESG factors that affect long-term financial performance is difficult. In high-energy-use industries, it’s easier to see how reducing greenhouse gas emissions reduces energy use and costs. However, measuring consumer satisfaction or workforce engagement is more complicated, and companies must be clear on any metrics or methodologies used.

Signatories must consider “diversity, remuneration, and workforce integration” Given the recent implementation of this code, ESG-linked remuneration is likely to become more common in the future, especially due to the increasing public importance of the “S” factors in ESG during the COVID-19 pandemic (see question 6.1 below).

3.4 What are some common ways companies integrate ESG?

Various funds have publicly committed to integrating ESG into their daily operations and investment processes by signing the PRIs and publishing statements setting out their approach, such as describing the board oversight and committee structure and how ESG is integrated into the investment process.

Investment managers who integrate ESG tend to publicise it, but internal cultural acceptance is harder to measure. Most fund managers now use PRI for ESG reporting and take two to four weeks on average to report PRIs.

4. Finance

In public markets, equity and debt providers rely more on external and internal ESG ratings. ESG rating agencies (such as FTSE ESG, Sustainalytics, Refinitiv, and MSCI) have grown rapidly in recent years. These agencies assess and rate global companies’ ESG performance. This assessment involves reviewing the issuer’s annual accounts, ESG reports, and sustainability report (if applicable).

As described in question 2.6, inconsistent reporting and disclosure levels can hurt (or help) a company’s ESG rating. Lack of consistency in rating methodologies leads to unreliability and lack of comparability in the market (with the same company sometimes seen as ESG-friendly by some rating agencies and harmful by others), which impairs debt and equity finance providers’ ability to make accurate comparisons. Due to the intangible nature of many ESG factors (especially in relation to social and, perhaps surprisingly, governance goals), third-party agencies and automated programmes have been criticised for not digging deeply enough into what companies are doing (as opposed to what they say they are doing) to improve their impact on ESG issues. HM Treasury appointed an independent expert group in June 2021 to advise on green investment standards. GTAG will oversee the UK’s Green Taxonomy. Larger investors are developing their own review and research tools for ESG data.

In private markets, where investors invest in unrated businesses, market participants rely on internally developed policies and procedures informed by the above codes, policies, and reports. Market participants prefer external ESG consultants and advisors to public ratings and ESG due diligence questionnaires when making investment decisions.

4.2 Are green or social bonds important in the market?

Companies or governments issue “use of proceeds” green bonds to fund green projects. The term “sustainable bond” encompasses green, social, sustainability, transition, and sustainability-linked bonds. Green bonds finance low-carbon infrastructure like offshore wind turbines and grid connections. These bonds help access the capital needed for a low(er)-carbon future.

Green bonds include mainstream green bonds (issued to finance environmentally friendly business activities), social bonds (issued to finance activities designed to achieve social outcomes), sustainability bonds (combining environmental and social aims – not to be confused with sustainability-linked bonds, explained in question 4.3 below), SDG bonds (for business activities that promote the SDGs), and the more niche blue bonds, forestry bonds.

Financial institutions, governments, and companies can issue these bonds to finance green projects. Green bonds tend to follow disclosure norms known as the “Green Bond Principles,” which are published by an executive committee of investors, issuers, and underwriters with ICMA as secretariat. These are also the Green Loan Principles published by the UK Loan Market Association (the “LMA”) in 2018 and updated in 2021.

The LSE created a “Green Bond Segment” in 2015 and a Sustainable Bond Market to promote “innovative issuers in sustainable finance and improve access, flexibility, and transparency for investors.”

Green bonds and sustainability-linked bonds are playing an increasing role in the market, and this is likely to change in the coming years (see question 4.3). The UK government will issue a sovereign green bond in 2021, unlike other European governments.

4.3 Are sustainability-linked bonds important?

Sustainability-linked bonds have yet to become mainstream in the UK market (especially compared to other European countries that have been more proactive in addressing climate change in the debt markets), but their use is increasing. Moody’s predicts $125bn in sustainability bond issuance in 2021. These bonds produce similar returns to traditional bonds and will likely be used more (as further discussed at questions 5.1 and 6.1 below).

The main differences between sustainability-linked bonds and traditional bonds are disclosure and marketing requirements for the issuer, plus the economics of the bond being linked to a specific set of key performance indicators around which targets are set.
In ICMA’s Sustainability-Linked Bond Principles, sustainability-linked bonds are described as aligning bond terms to the issuer’s performance against mutually agreed, material, and ambitious SPTs. The purpose of these bonds is not as important as it is for green bonds. Sustainability-linked bonds aren’t yet an issuer favourite, but we expect that to change soon.

4.4 What factors affect these financial instruments?

Lack of a central database and standardisation of ESG data in the EU and UK creates problems for bond issuers, equity finance providers, and other market participants. The UK’s Green Finance Strategy outlines key actions, including working with the British Standards Institution to develop sustainable finance standards. Investor pressure and regulation may increase in the UK, pushing market participants to use ESG financial products. We expect this trend to continue.
4.5 How are green bonds verified? Which processes are regulated?
ICMA’s Green Bond Principles (question 4.2) outline procedure. Voluntary standards encourage bond issuers to:

• List the eligible green projects the bond will be used for.
• Describe how projects get funding.
• how proceeds will be managed (including reinvestment);
• Report on how proceeds were allocated and investment KPIs.

An issuer should obtain a third-party audit, opinion, or certification for I pre-issuance review of their green bond’s alignment to the principles (use of proceeds, project evaluation, management of proceeds, and reporting) and (ii) post-issuance verification of tracking and allocation of funds.

As described above, these processes are not regulated in the UK any more (or less) stringently than a traditional bond, and there are no laws or regulatory frameworks mandating issuers’ sustainability credentials. Sustainability-linked bonds are mostly issued for reputation. Ironically, these bonds can pose reputational risks. This is partly due to increased public and media interest in these bonds and the scrutiny placed on them and the underlying projects to ensure neither the bond holder nor the issuer are greenwashing their ESG credentials.

COVID-19 has affected ESG practises because it has increased the importance of ESG practises in the UK. Pandemic changed the world in many ways, but ESG may be the most important for UK businesses.

As a result of the pandemic, the “S” in ESG was propelled forward (as discussed in question 6.1 below), partly due to press coverage of businesses’ ESG practises during the pandemic and partly due to the need for a greater private sector response in helping with these measures. According to Moody’s, the pandemic boosted social and sustainability bond issuance in 2020, reflecting a change in investor and issuer attitudes.

The UK government says COVID-19 could “green the economy to net-zero by 2050.” COP26, hosted by the UK in Glasgow in November, and the sixth assessment report of the Intergovernmental Panel on Climate Change (the “IPCC”) declared in August 2021 that human activity has warmed the atmosphere, already affecting every inhabited region across the globe. Both the UK government and UK businesses are expected to increase their focus on the “E” of ESG.

6. ESG Trends in Regulation

As explained above, the UK public, investors, and government have increased ESG efforts in recent years. Brexit has affected the UK’s ESG legal framework. The UK government hasn’t yet released a Green Taxonomy. This framework will likely be aligned with the EU Taxonomy, but it will differ in some areas. If green taxonomies aren’t consistent across national and regional boundaries, their effectiveness is uncertain.

The UK government’s “ten-point plan” for a green industrial revolution includes creating 2 million “green collar” jobs by 2030. This plan will mobilise £12bn of government investment and potentially three times as much from the private sector to create 250,000 green jobs. The PM wants to make the UK the world’s leading centre for green technology and finance by achieving net zero emissions. The plan includes creating a UK Infrastructure Bank to increase green infrastructure with £12bn in equity, debt, and guarantees. Private sector investment will likely dominate green initiatives.

More universities, business schools, and financial institutions are offering ESG training. The increasing weight organisations are placing on ESG and the time needed to comply with regulations and principles has led to an increase in ESG-specific jobs, most of which tend to be taken by “millennials” who (as discussed at question 2.2 above) have tended to exhibit a greater interest in this area than previous generations (although one’s age is by no means a hard-and-fast determinant of commitment, or lack thereof, to ESG).

Investors and media outlets are placing a greater emphasis on the social part of ESG, as “human capital” stories have increased during the COVID-19 pandemic, with significantly more media attention than before on how companies are treating their staff and performing during the crisis.

Despite global protests connected to the Black Lives Matter Movement and engagement from communities and businesses, 27 percent of organisations put all or most of their diversity initiatives on hold due to the COVID-19 pandemic, including sponsorship of external events and programmes. This behaviour seems to contradict the increased focus on ESG initiatives, so it’s hoped that businesses will continue to prioritise diversity initiatives after the pandemic (if not more).

6.2 How will COVID-19 affect ESG long-term?

At the time of writing, the UK government has mostly removed restrictions, but it’s unclear whether they’ll be reintroduced due to future COVID-19 variants and surges. The inevitable economic downturn will affect ESG positively and negatively. Greater public and media interest may prompt organisations to avoid ESG failures to avoid negative publicity (and the concomitant adverse financial effects, such as investors pulling investments if ESG measures are not met). COVID-19 is viewed as a long-term catalyst for ESG in the UK because it has increased awareness of worker health and safety, income inequality, and other social and environmental issues.

Overall, we believe there will be a greater emphasis in the UK on ESG in the long term – especially on “social” issues as a result of COVID-19 and “environmental” impact as a result of recent IPCC findings and shifting government policy. How businesses treat their employees and other stakeholders (such as their supply chain and business partners) may become more important, and public disclosures and metrics may become the norm.