Sustainable finance in new EU legislation: focus on climate investment
The European Commission (EC) launched its “Financing Sustainable Growth” action plan on sustainable finance on 8 and 22 March 2018. The main purpose of this plan is to steer more investments that can deal with climate change as agreed in the Paris climate commitments, and to prevent the financial sector from being adversely affected by climate change, e.g., the devaluation of assets by storms, drought, etc. The long-term goals are a more comprehensive approach to integrate environmental, social and governance considerations (ESG) in financial sector decision making, orient capital so that it can achieve the sustainable development goals (SDGs) in the EU, and promote longer-term investments. Many of the proposed actions are based on the recommendations included in the final 31 January 2018 report of the High Level Expert Group (HLEG) on Sustainable Finance.
In order to increase the financing of sustainable activities, the EC proposes to:
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- Define, first of all, a clear and detailed EU classification system (“taxonomy”) for sustainable activities, with screening criteria, thresholds and metrics. In 2019, the initial categorisation will identify the activities that will mitigate climate change, and will then classify climate adaptation and other environmental activities. Social sustainability activities and assets will ultimately be categorised in the coming years. An expert technical group comprised of various stakeholders, established mid 2018, will come up with a draft taxonomy. The financial industry considers a taxonomy to be essential for the clarification of what is “green”, “sustainable”, “climate” or “environmental”. The taxonomy will be used to define a variety of climate, environmental and socially sustainable financial products (e.g., labels and bonds). The basis for this EU classification system will be incorporated into law but will be flexible enough to adapt to various EU sustainability policies and situations.
- Draft legislation that mandates that institutional investors and asset managers have a duty to integrate sustainability considerations into their decision-making processes (as a “best way” to integrating their clients’ interests), and compel them to disclose the process to their clients. Legislative proposals in May 2018 should ensure their approval before May 2019, at the time of the European elections.
- Introduce standards and labels for sustainable financial products such as green bonds. Moreover, the information available at the launching of green bonds (through a prospectus) will need to be improved. A voluntary EU Ecolabel framework and perhaps a SRI (socially responsible investment) label scheme might also be established in the longer term. This Ecolabel will ultimately increase consumer trust, make it easier to choose sustainable products, and prevent greenwashing efforts.
- Assess how the integration of ESG risks will lead to loans that are less prone to default so that banks need to maintain smaller capital reserves (“green supportive factor”).
- Explore how to prevent regulations hampering sustainable investments by insurance companies that reinvest their premiums.
- Provide financial support to investors through EU investment funds that, for instance, will give guarantees and advisory or technical assistance to promote sustainable infrastructure investments. For example, the External Investment Plan will encourage sustainable investments outside of the EU, starting with Africa (cf. Partnership with Africa).
- Conduct a sustainability impact assessment of any EC-proposed financial law.
The EC proposes changes to indicators, ratings and investor advice to increase the choice of sustainability activities by:
- Ensuring that advisors ask clients about their (ethical or ESG) preferences and offer the choice to invest in sustainable options/assets as “suitable” investments.
- Enhancing the transparency of how indexes or “benchmarks” and credit rating agencies integrate sustainability, and introduce legislative measures that mandate these improvements. The EC also insists on harmonising low carbon benchmarks.
- Increasing the quality of the present sustainability ratings.
- Improving the transparency of financial and other corporations, namely through the “non-financial” disclosure, which emphasises climate risks and provides information about reducing investments in climate-risky activities, as is currently being promoted by the international, industry-led Task Force on Climate-related Financial Disclosure.
Given that short-term investment goals prevent long-term and sustainable investment, the EC proposes:
- Preventing bank and accounting regulations (mark-to-market valuations) to be prohibitive for financing long-term sustainable activities.
- Analysing how short term thinking can be reduced at the board of directors and through the governance of financial players.
- Clarifying the rules to ensure that top management operates in a company’s long-term interests
- Collecting evidence on the short-term pressure tactics that financial markets apply to influence corporate decision making.
Some critical issues
- The development of this taxonomy is expected to be a complex process and will probably result in a compromise as a result of financial industry pressure. Even a successful taxonomy will need to be complemented by an ESG assessment to ensure that a particular categorised activity is truly sustainable. A “climate class” is not enough for the fulfilment of a company’s obligations to consider all ESG factors. Furthermore, “ESG” has not been clearly defined and the EC fails to mention human rights as one of the social considerations of ESG.
- The current green bond standards promoted by the financial industry do not sufficiently ensure that projects will have a positive environmental impact or contribute to the attaining of the EU’s climate commitments.
- There has been plenty of discussion about the “green supportive factor” because it remains unclear whether financing “green” is less risky and thus requires the allocation of less capital reserves. Opponents argue in favour of a “brown penalising factor” to ensure that non-sustainable investments will require larger capital reserves as a consequence of their higher risk.
- The Action Plan includes a few binding legal measures. But the amount of time before the May 2019 elections is very short for the EC to propose legislation as well as for the European Parliament and Council of Finance Ministers to decide. So, it is unsure how much legislation will end up being voted on. The EC’s staff seems motivated enough to persevere after the 2019 elections.
- The Action Plan does not include restrictions on so-called “brown” activities or on externalities: These are currently not included in the investment costs even though they have a negative climate, environmental and social impact and will have to be paid by society. It remains to be seen how much more capital (loans and investments) will be invested in “green” or “sustainable”, and also how much will drift from “brown” to “green” or (socially) sustainable as a result of the Action Plan.
- While quite some financial sectors are critical of the plan as being too costly and unworkable, NGOs have been indicating its shortcomings (see, for instance: https://shareaction.org/wp-content/uploads/2018/03/EUPolicy-NGO-SustainableFinanceActionPlan.pdf ; http://www.finance-watch.org/component/content/article/89-press-releases/1538-pr-action-plan-susfin-fr ; https://www.somo.nl/wp-content/uploads/2018/02/NGO-responses-HLEG-consultation.pdf).