Is more regulation the best route to deliver Net Zero?

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Published Date
Mar 7, 2024
How to accelerate the transition to a sustainable economy is a hot regulatory topic for most major economies around the world - and is set to continue ascending the agenda in the years to come. As sustainability-related regulations proliferate, the legal risks and obligations on global businesses grow. We reflect on the implications of divergent regulatory regimes, and consider whether a regulation-heavy approach is likely to deliver its intended results.

It is perhaps no surprise that there is significant variation in the pace, scope and stringency of sustainability-related regulation across the globe. Regulatory design and implementation are driven by a broad range of jurisdiction-specific aims, including energy security, the competitiveness of domestic industries, jobs, consumer and investor protection, and political philosophies and compromises.

This fragmented regulatory backdrop presents a major compliance challenge for global businesses. Existing regulations already diverge on multiple fronts, including in relation to their level of prescriptiveness, extraterritorial reach, industry coverage, approaches to materiality (i.e. whether disclosures should focus on impacts on the company’s financial position and prospects, or also cover the company’s impacts on sustainability), the extent of applicability to downstream and upstream operations, and the degree to which non-compliance is monitored or subject to sanction.

Globally, the overall momentum for regulatory change is set to grow as new rules are made, implemented and applied. The regulatory landscape will continue to evolve as market consultations are held, existing regulations are fine-tuned to address teething issues, questions of interpretation arise, and obligations extend in scope, moving from a voluntary to a mandatory footing.

Regulatory activity is likely to be high, for instance, in relation to sustainability reporting, with many regulators considering how, and in what policy areas beyond annual reporting, they might implement or align with the global baseline standards created by the International Sustainability Standards Board (ISSB). Inspired by the U.S. Inflation Reduction Act (IRA), there is also a growing willingness across the world to incorporate incentives-based measures into Net Zero transition journeys. Legislators should look to avoid a cut-and-paste approach to accommodate local nuances, while keeping an eye on international developments and impact assessments.

The EU: poster child for a regulation-heavy approach

So far, the EU has been the poster child for a regulation-heavy approach to tackling the Net Zero challenge. The European Commission has made significant progress in driving forward its dedicated program to revise, update and introduce regulations (including a wide range of product- and sector-specific laws) at breakneck speed. These include regulations spanning sustainability reporting, labelling and disclosure; supply chain due diligence; sustainable finance and greenwashing; a carbon border adjustment mechanism (CBAM); and energy taxation, to name just a few.

However, there have been calls in Europe and elsewhere for a “regulatory break”. Politicians are under pressure to be seen as striking the right balance between looking after the socioeconomic prosperity of their electorate and meeting climate targets. To varying extents, businesses are struggling to keep up with the whirlwind of regulatory changes, particularly those driven by the EU. As new measures are devised, shortcomings and impacts are identified and attempts are made to refine them, the EU’s legislative train may take on a different pace. It is notable that, at the time of writing, the text of the proposed EU Corporate Sustainability Due Diligence Directive has not received the necessary final legislative approvals and it is looking increasingly unlikely that the text will be adopted, in this legislative term at least.

The UK: on a path towards tighter rules

Across the Channel, there are clear signs that the UK is traveling down the path of increasing regulation. However, wary of over-regulation, the UK government is treading a delicate path. It is not, for instance, planning to introduce extensive mandatory due diligence laws on human rights and environmental impacts equivalent to those in Germany and France (and potentially at EU level). There were also moves in 2023 by the UK government to water down certain energy- and transport-related policies that were designed to contribute to the Net Zero transition.

That said, there are several regulatory reforms in the pipeline. For example, the UK Sustainability Disclosure Standards are expected to be created based on the ISSB standards by July 2024, and the Financial Conduct Authority’s anti-greenwashing rule and sustainability labelling rules are due to apply from May and July 2024. In addition, the UK government is due to consult and/or legislate on regulatory changes across a range of sustainability related policy areas in 2024, including the UK green taxonomy, transition plans and transition finance, reporting requirements, the design and delivery of a UK CBAM, changes to the UK Emissions Trading Scheme, regulation of ESG ratings providers, and rules to address deforestation risks in supply chains. Several of these initiatives were originally due to take place in 2023, and their delay may be indicative of attempts to take a more measured approach to rolling out regulatory reforms. This may provide businesses with more breathing room and enable a greater focus on complying with their immediate obligations.

Asia-Pacific: a varied climate change regulatory landscape

The regulatory landscape in Asia-Pacific is varied, with a strong focus to date on climate change. Common themes and approaches are evident across the region, with national nuances linked to factors such as the status of national economic development and regulators’ focus on financial risk management. The constantly evolving regulatory landscape increasingly recognizes standards and requirements from elsewhere – including the EU’s sustainable finance rules and regulators’ use of the Taskforce on Climate-Related Financial Disclosures (TCFD) framework. Notably, Hong Kong’s proposed Green Classification Framework, while largely referencing the Common Ground Taxonomy, also aligns with classification systems such as the ASEAN Taxonomy (itself closely linked to individual taxonomies in South-east Asia, such as those in Malaysia and Singapore), with the hope that this will facilitate interoperability in the region. Similarly, in future we expect reporting frameworks based on the ISSB standards (and indeed these have already been proposed for listed companies in Hong Kong and Singapore) and a growing focus on regulatory requirements and guidance on transition planning.

The U.S.: pulling regulatory levers amid a growing anti-ESG wave

Not all jurisdictions are equally focused on using regulatory levers to achieve their Net Zero goals.

The U.S. approach is heavily incentives based, and is best seen in the Inflation Reduction Act (IRA) which is a flagship package of targeted measures to drive investment in selected green technologies and boost domestic supply chains. The IRA is a great example of smart regulatory intervention aimed at rapidly slashing emissions.

The U.S. climate regulatory policy environment continues to be punctuated by anti-ESG sentiments. Notably, the U.S. Securities and Exchange Commission is expected to face legal challenges over its long-delayed climate disclosure rules, which were finalized only on 6 March 2024. In the meantime, new legislation in California will require extensive disclosures of climate-related risks and scope 1, 2 and 3 emissions. The U.S. is therefore adding to the growing global tapestry of climate-related disclosure rules that businesses (and, indirectly, their supply chains) have to contend with.

The Middle East: momentum building for reforms

In the Middle East there are several ESG reporting guidelines and sustainability reporting requirements. For instance, we have recently seen developments in the UAE’s sustainable finance regulatory framework, while other jurisdictions in the region are also starting to gear up their reform programs. However, the momentum for sustainability regulatory reforms appears to be slow in certain jurisdictions, which have largely left it to the private sector to take voluntary steps such as devising sustainability policies and disclosing sustainability-related information. In 2024, we expect that more regulatory measures or guidelines will likely be developed across the region given the renewed focus on sustainability as a result of the recent COP28 in Dubai.

Extra-territorial reverberations in regulatory and market practices

A key question for business as regulations develop globally is the extent of their extra-territorial effect. Extra-territoriality is often intended to level the playing field amid an uneven regulatory landscape, to mitigate problems such as carbon leakage and loss of competitiveness. The desire to extend regulatory reach beyond jurisdictional boundaries reflects a growing assertiveness by countries seeking to raise market standards irrespective of host jurisdiction. In particular, certain in-force and proposed EU laws will implicate non-EU businesses and may accelerate the adoption of sustainable business practices beyond European shores.

In the interests of legal certainty, there are good reasons for other jurisdictions to take a “watch and wait” approach while first-mover jurisdictions deal with regulatory teething problems. Notably, the EU’s experience offers lessons for regulators elsewhere, and identifies challenges that businesses can pre-empt in other jurisdictions. For example, we see compliance challenges and legal risks arising from the misalignment between investor and corporate disclosure rules, and from ambiguities and inconsistencies in key concepts under the EU sustainable finance framework.

However, the verdict is still out on whether the push to achieve Net Zero is better served by pressing ahead with ambitious legislative reforms despite shortcomings in regulations themselves or via a slower but more measured approach to regulatory change. This is a familiar conundrum not just at national level, but also at global level. For example, launching the ISSB’s first two sustainability reporting standards on a single materiality approach may achieve a more widespread uptake of the baseline standard, but taking the time to build consensus for double materiality may ultimately spur more decisive action in favor of sustainability goals.

What is clear is that public sentiment on the environment has shifted in many parts of the world, and businesses must be agile to make decisive changes to further Net Zero goals.

The emergence of “gold standards” – a race to the top?

Across the spectrum of sustainability regulation there are measures that aspire to be “gold standards” (or that may in the future be regarded as such through widespread adoption over time). These include the European Sustainability Reporting Standards (required under the EU Corporate Sustainability Reporting Directive), the EU Green Bond label, the UK transition plan disclosure framework, the Singapore-Asia Taxonomy for Sustainable Finance, and the upcoming UK green taxonomy. There remains, however, a question of whether market participants will pitch themselves above a common baseline, or unite around more exacting frameworks.

It is possible for a market-driven, high standard of regulatory compliance to emerge as industry best practice. This may happen when businesses that are bound to comply with more stringent standards in certain jurisdictions choose to adhere to them everywhere they operate. Widespread observance of higher standards of regulation may also emerge as more businesses require parties in their global value chains to meet the same requirements, in favour of standardizing contractual terms, compliance procedures and data-gathering processes across jurisdictions.

Regulatory fragmentation remains a challenge, and interoperability remains a pursuit

Regulatory fragmentation risks jeopardizing the goal of reallocating capital in a way that genuinely achieves decarbonization. This risk may manifest itself in a variety of ways. First, when businesses reorganize their global footprints, adapt their supply chains and make investment decisions to pivot to less stringently regulated jurisdictions, they lose the regulatory constraints that would have driven them to make meaningful changes to their business practices.

The counter to this type of behavior comes via measures designed to address carbon leakage.

Second, and importantly, inconsistencies across regulations may create a conducive environment for inadvertent or opportunistic greenwashing, thereby sending ambiguous or incorrect signals as to where capital should flow for Net Zero purposes. Notably, there could be conflicting claims of taxonomy eligibility or alignment, given the proliferation of taxonomies with jurisdiction-specific features (e.g. varying definitions of environmentally sustainable activities).

To accelerate the transition, jurisdictions should avoid smothering market innovation with hasty over-regulation. Irrespective of how far-advanced each jurisdiction is in devising its transition strategy, it remains pertinent to consider what effective regulation means and how else to drive Net Zero-aligned market practices. Greater focus should be placed on incentivizing the right levels of investment and disclosure, while factoring in international interoperability from the outset.

There is a strong case for regulators to strive towards a high level of international alignment, but there are also undeniable differences among jurisdictions in terms of economic position, investment needs, and indeed the maturity of financial markets and regulatory regimes. In the pursuit of interoperability, genuine jurisdiction-specific needs should not be neglected. Different countries will opt for different strategies, as there is no single route to driving the transition. Time will tell which strategy is the most effective.