Sustainable Entropy. A regulatory tsunami can reduce the impact of sustainability policies.

The second law of thermodynamics states that the entropy of the universe increases with time. In other words, energy tends to disperse. Something similar may be happening in the regulatory development of ESG (Environmental, Social and Governance) issues.

At present, more than 30 jurisdictions, overseeing 12 major markets, are developing regulatory proposals on sustainability reporting around the world. Several regions are developing their own taxonomies of sustainable finance. More than half a dozen central banks are developing bank climate stress tests and myriad other regulatory pieces involve elements such as carbon taxation, supply chain responsibility, waste, circular economy and so on.

The regulatory development of the ESG agenda may be great news, as long as it draws an orderly, homogeneous and consistent framework across regions and markets. On the other hand, it can be a nightmare if these rules of the game are incompatible or at least inconsistent across regions. Where are we right now?

On the consistency side, we can highlight two ideas. On the one hand, that ESG regulation at the global level has a clear focus on capital markets. Proof of this has been the recent takeover of the creators of financial standards on the future of sustainability reporting, where both EFRAG in Europe and IFRS will present their work proposals this year. In the European case, for example, the Commission plans to adopt its standard in October for entry into force in 2024. A second element of consistency has to do with climate prevalence. This is the regulatory area that is making the fastest progress thanks to the broad scientific, political and business consensus on the subject.

However, as we move out of the climate arena we test the limits of the consensus. Proof of this has been the systematic postponement in the presentation of the European sustainable governance package that incorporates a proposal for a directive on environmental and social due diligence, as well as a specific regulation regarding the duties of board members.

From a geographical point of view, another major element of fragmentation has to do with the difference in the European ESG regulatory approach compared to other jurisdictions on three fronts. (i) At the objective level, the European approach aims to influence the market by facilitating the financing of the transition to a sustainable economy, while other regions focus on generating transparency for better decision making. (ii) The definition of materiality diverges. While Europe has coined the concept of dual materiality – reporting those aspects that are material from both a sustainability and financial point of view – other jurisdictions use a simple materiality approach (financial in nature) limiting ESG aspects to risk management. (iii) The degree of stringency is different. Europe has long since abandoned the comply-or-explain principle to become mandatory, other jurisdictions remain anchored in the soft regulation approach.

Predicting the future is always complicated, but we can draw two possible scenarios. One in which European leadership in ESG aspects prevails, as is happening in other areas such as digital rights. Another in which entropy ends up diluting the efforts of sustainability actions due to fragmented regulation. Probably the balancing factor will be the ability on the part of the EU to execute a more orderly regulatory timetable, allowing the market to digest the ESG regulatory tsunami. Sustainability is at stake. The second law of thermodynamics states that the entropy of the universe increases with time. In other words, energy tends to disperse. Something similar may be happening in the regulatory development of ESG (Environmental, Social and Governance) issues.

At present, more than 30 jurisdictions, overseeing 12 major markets, are developing regulatory proposals on sustainability reporting around the world. Several regions are developing their own taxonomies of sustainable finance. More than half a dozen central banks are developing bank climate stress tests and myriad other regulatory pieces involve elements such as carbon taxation, supply chain responsibility, waste, circular economy and so on.

The regulatory development of the ESG agenda may be great news, as long as it draws an orderly, homogeneous and consistent framework across regions and markets. On the other hand, it can be a nightmare if these rules of the game are incompatible or at least inconsistent across regions. Where are we right now?

On the consistency side, we can highlight two ideas. On the one hand, that ESG regulation at the global level has a clear focus on capital markets. Proof of this has been the recent takeover of the creators of financial standards on the future of sustainability reporting, where both EFRAG in Europe and IFRS will present their work proposals this year. In the European case, for example, the Commission plans to adopt its standard in October for entry into force in 2024. A second element of consistency has to do with climate prevalence. This is the regulatory area that is making the fastest progress thanks to the broad scientific, political and business consensus on the subject.

However, as we move out of the climate arena we test the limits of the consensus. Proof of this has been the systematic postponement in the presentation of the European sustainable governance package that incorporates a proposal for a directive on environmental and social due diligence, as well as a specific regulation regarding the duties of board members.

From a geographical point of view, another major element of fragmentation has to do with the difference in the European ESG regulatory approach compared to other jurisdictions on three fronts. (i) At the objective level, the European approach aims to influence the market by facilitating the financing of the transition to a sustainable economy, while other regions focus on generating transparency for better decision making. (ii) The definition of materiality diverges. While Europe has coined the concept of dual materiality – reporting those aspects that are material from both a sustainability and financial point of view – other jurisdictions use a simple materiality approach (financial in nature) limiting ESG aspects to risk management. (iii) The degree of stringency is different. Europe has long since abandoned the comply-or-explain principle to become mandatory, other jurisdictions remain anchored in the soft regulation approach.

Predicting the future is always complicated, but we can draw two possible scenarios. One in which European leadership in ESG aspects prevails, as is happening in other areas such as digital rights. Another in which entropy ends up diluting the efforts of sustainability actions due to fragmented regulation. Probably the balancing factor will be the ability on the part of the EU to execute a more orderly regulatory timetable, allowing the market to digest the ESG regulatory tsunami. Sustainability is at stake. Brace yourselves because there are curves ahead.