Europe’s push on sustainable finance: it matters

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The European Commission’s Action Plan on sustainable finance is the world’s most comprehensive effort to drive businesses across the financial value chain towards integrating sustainability into their activities.

“Between 2007 and 2016, economic losses from extreme weather disasters rose by 86%. The [European Commission’s] proposals… are about harnessing the vast power of capital markets in the fight against climate change and promoting sustainability.” – Valdis Dombrovskis, EC Vice-President, Financial Stability, Financial Services and Capital Markets Union

“To achieve the EU’s 2030 climate targets, we need around EUR 180 billion a year of additional investment in energy efficiency and renewable energy. Mobilising private capital to fund sustainable investment is essential. The EC’s proposals will increase the transparency of sustainable finance and the investment opportunities it offers.” – Jyrki Katainen, EC Vice-President, Jobs, Growth, Investment and Competitiveness

Coming from two senior European Commission (EC) figures, these words cut to the chase in explaining the new laws the EC proposed in 2018 to boost private sector adoption of sustainable finance practices. The laws will underpin the EC’s 10-point Action Plan on sustainable finance.

The suite of legislative measures covers all key players along the financial value chain, compelling each to integrate sustainability into their activities.

A clearer system to help pull in serious capital sums

The EC’s proposals – some of which are due to be agreed by the European Parliament in two months’ time – go beyond making the system more transparent, better governed, less short-term and more sustainable.

They will make it easier and cheaper for investors to identify which investments are genuinely sustainable, and to put environmental, social and governance (ESG) risks at the heart of their investment process.

At the end of the day, the proposed laws are designed to draw in significant private sector capital to help achieve the EU’s global emissions reductions targets.

A large part of the rationale behind the proposals is the recognition that – despite the rapid growth and maturing of sustainable investment in Europe (arguably more than on any other continent) – there are still quite a few factors blocking progress due to investor doubt, scepticism or uncertainty.

Europe’s push on sustainable finance: it matters

Source: Europa 2018

To address these remain roadblocks on the roadmap, the proposed laws have three main goals:

  • To reorient capital flows towards more sustainable technologies and businesses
  • To dovetail sustainability into the mainstream of risk management
  • To foster transparency and long-termism in financial and economic activity

Pushing capital towards ‘green’ investments – once we know what those are

To meet its ambitious targets on climate change, the EU needs EUR 180 billion a year of additional investment, which cannot be achieved without support from the financial sector re-allocating capital towards ‘green’ investments.

What is a ‘green’ investment? Good question. And one that is answered differently depending on which country or financial institution you ask. Re-orientating capital towards such a blurred goal would be difficult.

So, the first step in the EU’s action plan is to develop a common language – ‘taxonomy’ – and understanding of what activities are truly environmentally sustainable.

Green labelling to squeeze out ‘greenwashing’

The EU ‘taxonomy’, or classification system, will act as the base for the development of EU standards and labels for green financial products, sustainability benchmarks and for the selection of projects, particularly those in infrastructure, for which the EC will prioritise funding.

Companies selling financial products marketed as ‘green’ will have to report how they relate to the taxonomy. For a classic ‘green’ equity fund, this will translate into the percentage of the fund that is invested in taxonomy-compliant activities.

Sustainability: in from the fringe of risk management

One new law aims to clarify institutional investors’ and asset managers’ fiduciaries duties. It will explicitly compel institutional investors and asset managers to integrate sustainability factors in their investment decision-making process and be clearer on how they do this, in particular their exposure to sustainability risks. This will apply to credit rating agencies and research providers, too.

And the proposal will also explore how to include climate-related risks in institutions’ risk management policies, as well as the potential calibration of banks’ capital requirements as part of the Capital Requirement Regulation and Directive.

Suits you, sir?

Financial advisors will be similarly affected, with existing laws amended to include sustainability preferences as part of what investment companies and insurance distributors must do to offer ‘suitable’ products to meet their clients’ needs.

Systematically asking clients about their sustainability preferences could be a real game-changer. It will certainly mean financial advisors and intermediaries doing their homework on sustainability and ESG products. Yet it could boost the retail market in future years, not least because by 2025, millennials will form 75% of the labour force and 84% of them view sustainability as a key consideration when investing.

Seeing sustainable finance more clearly – and over a longer horizon

The EC will set clear rules for financial players to significantly improve the transparency of what they do and how they do it, including disclosure on climate-related and other ESG factors. Even so, given that many such players still practise short-termism, the key question is how much capital can be reoriented towards a more sustainable economy.

Tackling short-termism in capital markets will likely include looking at issues such as asset managers’ portfolio turnover and equity holding periods. It could also require corporate boards to develop and disclose a sustainability strategy, including appropriate due diligence throughout the supply chain, and measurable sustainability targets.

The Action Plan sets a precedent for sustainable finance reforms globally, firmly establishing Europe as the global leader. Its intention is to make the financial system a catalyst for the transition to a low-carbon, climate-resilient and circular economy; while making it much more transparent, and environmentally and socially conscious.

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