The EU’s 2018 action plan on sustainable finance has been partially implemented before elections of the new European Parliament and the new European Commission. The action plan aims especially at promoting investments to deal with climate change through regulatory measures. Other initiatives, for example by supervisors, also prevent the financing of non-sustainable activities.
Regulating climate-friendly investments to avoid “greenwashing”
Two new EU laws on 1) compulsory disclosure by professional investors how they do environmental, social and good governance sustainability (ESG) assessments (DSR) and 2) the voluntary use of investment benchmarks or indexes that include assets which reduce climate change (climate benchmarks), were agreed in the spring of 2019, but have not yet come into force.
A third proposed law and related technical advice to have an EU definition of climate mitigating and climate adaption activities (i.e. a “taxonomy”) have met with fierce resistance from the financial lobby and some EU member states, even though the use of the taxonomy would not be compulsory. The EC also wants to set an EU Green Bond Standard to avoid false claims in this popular investment instrument, but is being advised to keep the use of the standard voluntary.
Notwithstanding the EU’s willingness to legislate and ensure the implementation is regulated and supervised, the slow process, voluntary nature and shortcomings may still not sufficiently prevent the enormous problem of false climate or environmental claims (“greenwashing”) by investment products. Investment in activities that damage the climate and other sustainability objectives are still being allowed and are cheaper to invest in. As a result, just 1 to 5% of the investment market is expressly green.
Legal standards to finance socially sustainable activities will certainly take many more years to be adopted.
The banking sector still needs to be regulated to finance sustainably
So far, banks have no explicit EU obligations to finance sustainable activities under the new EU bank laws (CRD V – CRR II, May 2019). There has already been fierce debate about whether banks need less capital buffers of their own when financing sustainable activities (“green supportive factor”, which makes such financing cheaper for banks), or more of their own capital for financing non-sustainable activities (“brown penalising factor”). The decision will be delayed until the EU’s bank supervisory authority (EBA) assesses how a bank’s own capital requirements can be reduced or increased when financing activities with substantial environmental and/or social objectives. The EBA also has to develop criteria to assess the risks from negative physical, transition and value impacts after social, environmental and governance (ESG) aspects and regulation have been taken into account. Legislative proposals are only expected after the EBA’s report by June 2025 (CRR II, Art. 501c).
The new law has already stipulated that banks can reduce their own fund requirements when financing infrastructure for essential public services, amongst others, if an assessment has been completed on whether the borrower has contributed to six environmentally sustainable economic objectives as defined in the future Taxonomy Law (climate mitigation, climate adaptation, water, pollution, circular economy and healthy ecosystems) (CRR II, Art. 501a, 1.(o)). Very large banks will be required to disclose bi-annual information about ESG risks and related physical and transitional risks from late June 2022 onwards (CRR II, Art. 449a).
The supervisory authorities might also need to integrate ESG risks that decrease financial values after the EBA has defined these risks and the methods to assess the related financial instability (e.g. through stress testing) as well as the related bank strategies (CRD V, Art. 98, 8). After its report by the end of June 2021, the EBA may issue guidelines on how the EU and the member states’ competent authorities can upgrade their supervisory practices.
In parallel, there are many initiatives to promote social and environmental benefits from banks’ lending and practices. For instance, at the OECD guidelines were negotiated how banks should apply due diligence regarding ESG impacts when lending or underwriting the issuance of shares and bonds. They have been adopted at the OECD Forum on Green Finance and Investment on 29 October 2019. These so-called “key considerations” explain in detail how banks should implement the OECD Guidelines for Multinational Corporations and the OECD Due Diligence Guidance, in line with such considerations already issued for institutional investors in 2017.
Supervisors and central banks active on climate change risks
Since 2015, central banks and supervisors have raised concerns and undertaken supervisory actions to prevent that rapid climate change will result in “stranded assets”, i.e. loans that cannot be repaid or financial investments that no longer have any value due to climate change damage (e.g. droughts, storms, fires, water shortages or floods) and related new regulations to stop it.
A central banks’ and supervisors’ Network for Greening the Financial System (NGFS) has grown steadily to 48 members and ten observers on five continents. It works on climate and environmental factors to be integrated in 1) supervision, 2) macro-financial policies, and 3) in all financial activities (mainstreaming green finance). One example of research to improve the supervision of climate change risk is a report by the Dutch Central Bank (DNB) about a carbon stress test of the Dutch financial sector. This concluded that banks, insurance companies and pension funds could face financial losses of 3 to 11% following a disruptive energy transition without ESG risk management.
In April 2019, the NGFS launched a call for action to all supervisors, urging them take climate change risks into account while coordinating when integrating sustainability into their own financial management and monetary policy. It also called for robust transparency and the definition (taxonomy) of activities that contribute to the energy transition as well as those that are climate risky.
Nevertheless, further pressure has been placed on central banks to modify their monetary policies. The new governor of the European Central Bank, Christine Lagarde, has already promised to buy green bonds and securities when purchasing corporate assets to implement loose monetary policy (quantitative easing, QE).
Central banks, financial regulatory authorities and some banking associations from 38 developing and emerging market countries are members of the Sustainable Banking Network (SBN). They promote environmental and social risk management in the financial sector and increased capital flows to climate-friendly activities through a range of capacity building activities. The SBN is member of the NGFS and one example of many sustainable finance initiatives around the world.
The corporate problem is not yet solved
In order to assess ESG risks and impacts or to apply the EU taxonomy, investors and banks need information from the corporations they finance or invest in. However, a good deal of disclosure of information about corporate risks and impacts on climate, the environment, human rights, workers and social issues, as well as information about (the lack of) good governance is still needed. The industry-led Task force on Climate Related Financial risk Disclosures (TCFD, supported by the Financial Stability Board) continues to provide guidance on how to implement its transparency recommendations (2017), although these are voluntary. The EU has so far failed to impose a clear legal reporting standards under the Non-Financial Reporting Directive (NFRD) and issued in June 2019 new non-binding NFRD guidelines on reporting climate-related information based on the TCFD recommendations. IOSCO, the global standard setter for the investment industry, has issued a statement to improve how companies or other issuers of shares and bonds should disclose ESG issues to investors.
The pressure from shareholders, investment funds and other investors to achieve high short-term financial returns frequently drives companies’ non-sustainable activities and short term strategies. On 1 February 2019, the EC requested advice from the European Supervisory Authorities as to whether corporations face undue short-term pressure from the financial sector. The issue of tempering short-termism in capital markets is part of the EU’s action plan on sustainable finance, which the new Commission should continue to implement.
A major problem that has not yet been solved in increasing sustainable investments and loans is the lack of companies, projects or activities that effectively, fully and transparently reduce climate change or have positive ESG impacts. This does not come as a surprise, given the lack of legally binding obligations to finance environmentally and socially sustainable activities: 95 to 99% of loans and financial investments are readily available for non-sustainable activities. Among other factors, the lack of stringent regulations results from the fear of making the EU’s financial sector and economy less competitive, i.e. profitable, if other countries do not introduce equally high sustainability laws. Adhering to sustainable standards is seen by the financial sector as a costs that non-sustainable investments do not yet have to make, especially if countries issue inconsistent requirements. Therefore, the EU promoted global standards by launching on 18 October 2019 an “International Platform on Sustainable Finance” with relevant authorities from Argentina, Canada, Chili, India, Kenya and Morocco. The aim is to exchange best practices and coordinate regulatory policy tools for environmentally sustainable finance and investment, including taxonomies, (green bond) standards and benchmarks. In parallel, a newly formed Coalition of Finance Ministers for Climate Action of more than 20 countries endorsed the Helsinki Principles in April 2019, to promote national climate action plans through fiscal policy, the use of public finance and private finance mobilisation.
In order to stimulate sustainable and climate-friendly activities, the new head of the EC, Ursula von der Leyen, has launched a new green deal supported by public money. Many others have ideas on what a green deal could look like. For instance, some NGOs are calling for more stringent sustainable private finance regulations and standards, such as a taxonomy of activities that should not be financed (“brown taxonomy”), harmonised ESG reporting, and greener central bank polices.
Overall, the EU initiatives to promote financial investments oriented on climate-friendly and sustainable activities are just some of many others that exist around the world. However, the EU initiatives are somewhat more advanced as they have already been integrated into law. Nevertheless, the lack of prohibitions on financing non-sustainable activities, non-compulsory regulatory standards (e.g. taxonomy, benchmarks, green bonds) and the lack of willingness to fully integrate social sustainability aspects show that the EU still has a long way to go in listening to urgent messages from the European public instead of heeding the opposition of the financial lobby.