Cryptoassets are in the spotlight for many reasons. The use of cryptocurrencies as an alternative to fiat currencies is being explored and tested further by global events. Cryptoassets and blockchain also remain sources of deep and rapid innovation in financial markets. They are proving to be both investable and adoptable in financial markets. With financial services institutions increasingly being involved in the infrastructure and trading of crypto currencies, firms should be aware of how these activities relate to the focus on ESG and the new rules that are entering into force. This article provides an introduction to this area and outlines 11 things you need to know.
1. What is ESG?
ESG stands for the broad term of “environmental, social and governance”. However, what this means in practice is different from one sector to another and from one jurisdiction to another. In the UK, climate change reporting obligations for a range of businesses have been the key focus area so far, using the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations as the main reference point. For financial services entities, the UK regulator, the Financial Conduct Authority (FCA) has used TCFD as a basis for its ESG Sourcebook, containing onerous and ongoing disclosure requirements. In contrast, the European Union has implemented different requirements, covering both environmental and social reporting for financial services entities, albeit with the “social” currently less well defined than the “environmental”. Across all jurisdictions, ESG regulation is developing rapidly and will continue to do so. This means that groups with various international offices will need to consider the different ESG requirements in each different jurisdiction. This note focusses on the UK requirements.
2. What are the ESG requirements in the UK?
For asset managers and asset owners (in-scope firms subject to thresholds detailed below), the FCA’s ESG Sourcebook requires climate-focussed ESG disclosures at both the entity and product levels on a pre-contractual and ongoing basis. The disclosures made by the in-scope firms are intended to help meet the information needs of financial market participants, with information on governance, risk management, metrics and targets, and scenario analysis with quantitative metrics published.
3. Which part of an in-scope firm’s business is within scope of the ESG disclosure requirements?
For asset managers, disclosures are required at entity level as well as at product level for authorised funds, unauthorised alternative investment funds (AIFs) and with regards to portfolio management services (which includes private equity firms providing ongoing advice on private market activities). The scope is therefore broader than might be expected for “asset managers” as it also includes entities providing advisory services.
For asset owners, disclosures are also required at entity level as well as at product level for insurance based and non-insurance based direct contribution schemes and insurance or non-insurance based self-invested personal pensions (SIPPs).
In the future, with the FCA’s ambitious ESG Strategy some level of reporting requirements may be rolled out to further FCA-authorised entities in future, although there is nothing published on this at the present time.
4. When will these ESG disclosure requirements apply?
The ESG Sourcebook came into effect on 1 January 2022 for the largest asset managers and asset owners with more than £50 billion in assets under management or administration. The first sets of reports will be due by 30 June 2023, reflecting the 2022 calendar year. In-scope firms with more than £5 billion assets under management or administration’s reports follow one year later, with the timeline for other financial services entities to be confirmed. As stated above, in the future, the FCA may potentially apply such disclosure requirements to a broader range of FCA-authorised entities but there is no current publication from the FCA on this.
5. How do the ESG requirements apply to crypto?
Not all “crypto” is the same. It has been well publicised that some types of cryptocurrency, generally referred to as requiring “proof of work”, use a competitive validation method known as “mining” to achieve goals, such as issuing new crypto currency, and uses a huge amount of computer processing power. Others carry out what is referred to as “proof of stake”, which because they do not require miners to spend electricity on duplicative processes operate with a substantially lower resource consumption. All crypto firms that fall within (4) above will need to consider their ESG position, as in-scope firms within (3) will request this information to comply with their own disclosure requirements.
6. My crypto firm is not currently caught by these ESG disclosure requirements, why should I care?
Crypto firms will need to consider the new ESG obligations that will apply to their investors and other business partners. For investors such as asset managers, they will be mindful of their reporting obligations and when investing in crypto businesses may assess how that investment will impact their ESG reporting requirements, including the data availability from crypto businesses with regards to the climate metrics to be disclosed. Furthermore, although many crypto businesses will not initially be caught by the ESG disclosure requirements, the regulatory landscape in this area is dynamic and continually shifting. We can help you track the direction of developments in this area and prepare your firm for any regulatory compliance. The regulations will also impact how firms do business – for example, the fact that portfolio companies are also subject to disclosure requirements may limit their use as investment vehicles.
7. Can ESG disclosures cross-refer to information produced by crypto related businesses?
Yes. ESG disclosures can include hyperlinks and cross-references to relevant climate-related financial disclosures contained in a third party’s climate reporting, where such information enables the in-scope firm to make climate-related financial disclosures. As a result, crypto firms within (4) could consider making their own ESG disclosures to support with information requests.
8. Which part of the ESG disclosure is particularly relevant for crypto?
Whilst there is optionality around how to calculate carbon emissions under TCFD, which the ESG Sourcebook refers to, ultimately the electricity required for crypto businesses and the resulting emissions will be the likely focus point for in-scope firms considering or continuing investment in crypto businesses, however calculated.
9. What ESG targets are in-scope firms required to have?
There are no prescribed targets, but ESG disclosures must describe any targets the in-scope firm has set to manage climate-related risks and opportunities, including the KPIs it uses to measure progress against these targets. In-scope firms within (3) will need to take into account their overall business, including any crypto related activities, when deciding and measuring progress against these targets.
10. What is happening in Europe?
There are various ESG and crypto related developments taking place in different jurisdictions. In the EU, the Markets in Cryptoassets Regulation (MiCA) has recently been agreed and will apply to crypto firms in the EU. As part of these new measures, the European Securities and Markets Authority (ESMA) has been tasked with developing draft regulatory technical standards on the content, methodologies and presentation of information related to ESG.
11. What should crypto firms be doing now?
Crypto firms should be engaging with their shareholders and advisers to confirm whether parts of their business are subject to disclosure requests for those in-scope firms and ensuring that any necessary data can be provided and verified in the appropriate formats. Firms should also be considering to what extent the documentation governing their portfolio of assets accurately corresponds to any marketing of assets as “ESG friendly”.