Insight

Compliance must be a force for good

Written by James Thomas on Tuesday November 16, 2021

ESG has been climbing swiftly up the compliance agenda and, in the wake of COP26, climate change is squarely in the spotlight. This represents a rapidly-evolving and expanding regulatory landscape, which many practitioners are working hard to navigate. In this series of articles, we will consider some key challenges and areas in which progress must be made.

The business case for reducing climate impact is often framed in terms of managing reputational risk, satisfying changing consumer preferences or, increasingly, complying with regulatory expectations. In future articles, we will discuss some of these factors.

But before that, it is essential to start at first principles …

The big picture

In the process of negotiating a path towards a sustainable future, the devastating impacts of unchecked climate change on people and planet are all too easily buried under layers of complexity and conflict.

A consensus may be easily reached that something must be done, but it quickly dissolves in the face of short-term self-interest once concrete proposals are tabled. COP26 continue beyond its scheduled conclusion of Friday 12 November, with negotiations extending into the following day and key elements of early drafts of the COP26 agreement being diluted (notably the final text agrees to “phase down” rather than “phase out” coal fired power generation … with no specific timeline outlined). Respected climate experts were left to conclude that the crucial target of limiting global temperature increases to 1.5C is “alive but on life support”.

But if we are to counter the existential threat of climate change, then our longer-term shared interest – including our continued survival and prosperity as a species – must be constantly restated as the top priority. For example, as Aviva Investors’ Chief Responsible Investment Officer, Steve Waygood, suggests, under the current trajectory of temperature increase, three quarters of the world’s population may have to migrate from places that have become too hot to live in: “If we don’t succeed [in reducing emissions] it is likely to cause a third world war,” he argues. The scale of the threat means that radical action – based on a long-term perspective – is urgently needed, he insists.

Purpose (and repurposing the toolkit)

At a high level, therefore, financial institutions must take a clear position on whether they want to be a part of the problem or a part of the solution to climate change. Ultimately, this is a question of purpose, a fact that the UK’s Financial Conduct Authority (FCA) alluded to in its recently-published ESG strategy in which it outlines the role for financial services in clear, ethical terms, insisting that: “Actors across the spectrum of financial services can be a force for good in this area”.

Responding to climate change will therefore require organisations to mobilise and build upon elements within the compliance toolkit that have been under development for many years, including governance, purpose, and culture. As the FCA continues:

“A firm’s governance, purpose and culture are central to its values as an organisation; to how its people conduct themselves; and to how it embeds ESG considerations in the design and delivery of its products and services for the benefit of clients and consumers.”

This extends to the role of senior management in establishing culture, and to their potential accountability for outcomes (again, concepts that regulated firms should be familiar with). The FCA insists that:

“We will do more work to encourage a strong ‘tone from the top’ on ESG, supported by clear accountability for ESG claims and promises, and the right incentives – including through remuneration.”

“We will consider further the role of firms' culture, governance and leadership in ensuring that firms take appropriate action to manage their risks of climate change and support the wider transition to net-zero emissions. We want to ensure our regulatory framework promotes transparency and accountability around climate change issues; this work could consider wider senior management accountability for stewardship.”

Too big to fail … yet still falling short

In defining and sticking to their purpose, organisations should keep in mind at all times the implications of a failure to address climate change, which have been outlined in increasingly stark terms in the years, months and weeks leading up to COP26. The physical impacts of a warming planet include:

more intense rainfall and flooding
increasing heat waves and more intense droughts
sea level rise, coastal flooding, erosion and extreme sea level events
ocean acidification and reduced oxygen levels damaging marine ecosystems.

The impacts of these upon human lives are, simply put, catastrophic.

The most recent IPCC report has confirmed that human activities are already responsible for a 1.1 degree increase in global average temperatures above pre-industrial levels, and that climate change is “widespread, rapid, and intensifying”, as evidenced by the extreme weather events that we are experiencing with increased frequency. The report warns that “unless there are immediate, rapid and large-scale reductions in greenhouse gas emissions, limiting warming to close to 1.5C or even 2C will be beyond reach”, while highlighting that if global warming exceeds 1.5C “some effects may be … irreversible”. Indeed, “some of the changes already set in motion – such as continued sea level rise – are irreversible over hundreds to thousands of years”.

The devastation and disruption associated with an increase above 1.5C led UN Secretary General António Guterres to describe the IPCC report as “a code red for humanity”. Yet, despite the magnitude of this threat, we have been falling (and remain) woefully short of where we need to be.

Although the IPCC advises that emissions cuts of 45% are needed by 2030, and ‘net zero’ must be achieved by 2050, global carbon emissions are currently on track to rise by 13.7% by 2030, according to a UN analysis, while the Global Carbon Budget 2021 states that: “Global fossil CO2 emissions (excluding cement carbonation) in 2021 are returning towards their 2019 levels after decreasing [5.4%] in 2020.” According to the recent Climate Action Tracker Report countries’ current plans for cutting emissions by 2030 (known as “nationally determined contributions” [NDCs]) currently put the world on target for 2.4C increase, with only one major emitter (India) updating its NDC during the Glasgow conference.

Mission: critical

The stakes could not be higher. As Barbados Prime Minister, Mia Mottley, asserted in her address to the COP26 audience, a two-degree increase is a “death sentence” for millions around the world.

In recent years, anti-financial crime compliance efforts have been galvanised by the aim of ‘stopping money laundering to save lives’. In the face of climate change, there is a similar need to mobilise our organisations to counter this existential threat. Compliance must be central to outlining and meeting the challenge of climate change, in order to save lives.

The financial sector has the potential to make a positive contribution, and initiatives such as the Glasgow Financial Alliance for Net Zero must deliver on their stated objective to “accelerate the transition to a net-zero economy”. While international negotiations are painfully slow, we have seen during the pandemic how agile private sector actors can be, given the right motivation. The need for agility and long sightedness is now paramount. As Steve Waygood, suggests:

“Most regulators are focusing on the time period of their own tenure, maybe two to three years … That’s where the transition risk is. But the physical risk – the things that will happen to the world if we don’t act, like temperatures so high human life becomes impossible – happen over 30, 60, 90 years and regulators need to focus on that and on speeding up transition. We’ve seen the mood in financial institutions and investors change massively in the last three years and regulation needs to change too.”

The next article will look more closely at how organisations can meet, or indeed exceed, regulatory requirements around climate change, and will consider: practical implications of the FCA’S ESG strategy; what a Net Zero aligned financial centre could look like; and how organisations can develop a “clear, deliverable plan setting out how they will decarbonise and transition to Net Zero”.