ESG Market Alert – October 2022

In this month’s ESG Market Alert, we cover:

• The FCA and other market regulators’ criticism of ESG benchmarking;

• The European Commission’s ban on goods being produced using forced labour;

• Anti-ESG backlash; and

• What’s new in market practice: the practical ESG steps being taken by corporates and central banks.

FCA and other market regulators criticise ESG benchmarking

Despite the prevalence of ESG efforts and with more than half of FTSE 100 companies having dedicated ESG committees, regulators are questioning the credibility of investment firms’ ESG benchmarking practices due to lack of standardised methodologies of measuring and reporting. In a portfolio letter published on 8^th September 2022, the FCA warned that the “subjective nature of ESG factors” give rise to an “increased risk for poor disclosures” in relation to ESG.

This stance echoes the underlying concern expressed by the EU authorities, who published their own benchmarking rules for ESG that were subsequently adopted by the European Commission in April 2022. Notable concerns include companies ‘cherry-picking’ how they assess themselves on an ESG basis (commonly known as ‘greenwashing’) or investment firms developing and using their own ESG rating systems to assess their funds.

Across the Atlantic, regulators are taking similar action, with the U.S. Securities and Exchange Commission having enhanced its scrutiny of ESG funds and practices earlier this year. The SEC’s proposal requires more detailed disclosures in prospectuses and extends its Name Rules and the 80% investment policy to require, respectively, ESG funds to define the terms in its name in plain English and to have a minimum of 80% of a fund’s assets being consistent with its name. For example, a fund that considers ESG factors alongside but not more centrally than other, non-ESG factors in its investment decision-making would not be permitted to use ESG or similar terminology in its name.

European Commission bans goods produced using forced labour

The European Commission has made a proposal to prohibit products made with forced labour being sold in the EU- a stance which will be discussed by the European Parliament and the Council of the EU. If passed, the new regulation would apply to both imported goods and goods produced within the EU. The proposal is based on definitions and standards established by the International Labour Organisation (ILO) and, if enacted as law, would apply to products for which forced labour has been used at any stage of production by all “economic operators”, making it one of the broadest product-related forced labour bans in the world.

As part of the regulation, each EU Member State would have to designate national authorities who would be responsible for enforcing the regulation. These authorities would conduct investigations across multiple phases, with a ban being implemented on any products within the EU market that were determined to have been made using forced labour. It is expected that, if the regulation were to be enacted, it would take effect in 2025 at the earliest.

This proposal is part of a general global trend towards policing forced labour issues, as evidenced by the Uyghur Forced Labour Prevention Act passed in the United States in June 2022. The legislation presumes that any product originating from the Xinjiang Uygur Autonomous Region is a product of forced labour, and unless contrary evidence is provided at border control, such products are not be allowed to enter the United States.

Anti-ESG backlash

Despite increasing focus on ESG driven by the United Nations’ Sustainable Development Goals, an anti-ESG exchange traded fund (ETF) has attracted over US$300 million in funds in less than a month. The ETF in question, Strive Asset Management’s US Energy ETF “DRLL”, is listed on the New York Stock Exchange. Launched in August by Vivek Ramaswamy, Strive Asset Management’s co-founder and Executive Chairman, this ETF aims to refocus companies on delivering shareholder returns rather than setting social, political, cultural and environmental goals.

In this new ETF, Ramaswamy has called on energy companies to reduce their focus on cutting carbon emissions unless doing so can be proven to increase shareholder value.

The launch of Ramaswamy’s ETF comes in light of increasing anti-ESG sentiment in certain political spheres in the United States. The state of Florida has passed a resolution barring its pension funds from using ESG factors in decision-making. Glenn Hegar, the comptroller for Texas, has targeted ESG investing by blacklisting ten financial groups for "boycotting energy companies" in their investment strategies. Under a law passed by the Texas administration in 2021, state pension and school funds may be forced to divest shares they hold in financial groups that appear on this list.

What’s new in market practice: Practical ESG steps being taken by corporates and central banks

At a minimum, the UK Corporate Governance Code requires companies with a premium listing in the UK to have in place audit, remuneration and nomination committees. However, 54% of FTSE 100 companies have now taken the additional step of putting in place a committee dedicated to focusing on ESG issues. By contrast, analysis from 2020-2021 in the United States has shown only 13% of S&P 500 companies had assigned responsibility to an ESG or sustainability committee.

This practical shift from the leading UK companies is particularly prevalent in the oil, gas and mining sectors, where a number of the big energy giants have a dedicated ESG committee. This step demonstrates a recognition that a dedicated ESG committee can enhance a company's ability to meet its sustainability and net-zero goals, with better ESG credentials also supporting share price and improving eligibility for ESG-focused funds.

At the European level, following an announcement in July 2022 of its intention to incorporate climate change considerations into its monetary policy framework, the European Central Bank (the ECB) has revealed its commitment to decarbonising its approximately €385 billion of corporate bond holdings. This move by the ECB aims to reduce the Eurosystem's exposure to climate-related financial risk and to support a green transition of the economy in line with the EU's climate neutrality objectives.

The ECB's plan includes decarbonising its corporate bond holdings portfolio as well as the introduction of new climate scores (assessed in terms of greenhouse gas emissions, carbon reduction targets, and climate-related disclosures), which will be taken into account in all Eurosystem corporate bond purchases. The ECB also intends to start publishing climate-related information on its corporate bond holdings during the first quarter of 2023 and will regularly report on its progress in aligning with the EU's climate neutrality objectives.

ESG Counsel™

The Hogan Lovells ESG team is here to help, including on all the issues raised in this snapshot. Hogan Lovells is one of the leading ESG firms in the world, delivering uniquely tailored cross-practice and -geographic holistic advice as ESG Counsel to clients globally. Our holistic and solutions-driven approach to managing ESG issues draws on the full scope of our global practice and sector capabilities (including our leading global corporate, environmental, governmental relations and regulatory, employment, and dispute resolution teams) to drive sustainable value and maximize positive impact for clients. Please contact us to discuss next steps or for our latest ESG-related materials, including our ESG Academy.

How we can help

Our knowledge of ESG matters, coupled with our sector-focused expertise and experience can help businesses navigate this complex area. In particular, we can help by:

• bringing clarity to the complex and fast developing legal and regulatory background driving ESG considerations and helping your business shape its response to those requirements, opportunities and risks;

• engaging effectively with policy-makers and regulators that will shape the environment in which your business operates;

• undertaking a sustainability and business integrity ‘healthcheck’ to identify and establish corporate purpose and clear ESG initiatives/targets;

• evaluating supply chains and procurement processes to ensure that they appropriately deal with ESG considerations;

• ensuring that governance structures are “fit for purpose” and drive appropriate behaviours within your organisation;

• evaluating best practice with regards to talent management, diversity and inclusion, employee engagement, corporate purpose, culture, reward and remuneration and tax practices; and

• in cases of crisis, assisting in responding to and dealing with that crisis.

Our recent ESG public markets experience

• Advising SABMiller plc on governance transitions and reforms.

• Advising a number of companies and stakeholders on ESG-related activist and stakeholder engagement.

• Advising ITV on ongoing corporate governance matters.

• Advising Shaftesbury on numerous corporate governance matters.

• Advising an international ride-sharing company on its governance arrangements in the UK in the context of an ongoing license appeal.

• Advising Brookfield on the environmental aspects of its acquisition of Greenergy, including its interest that owns Thames Oilport and Thames Enterprise Park.

Authored by Nicola Evans, Patrick Sarch, Scott Prior, Aayush Kainya, Kaushik Karunakaran, Katie Barton, Rory Hazelton, and Susan Lee.