Sustainable finance

What is Sustainable Finance and why does it matter?

Sustainable finance is one of the biggest and most important challenges of our time.

It refers to the integration of environmental, social and governance (ESG) criteria by financial institutions into business or investment decisions, leading to increased longer-term investments into sustainable economic activities and projects.

In response to the Paris Agreement[1] in 2015, participating governments and intra-governmental organisations launched a number of measures to promote sustainable finance, which at first have focused on voluntary measures, relying on self-monitoring of businesses and investors. But as the global move towards a more sustainable economy gathers pace, and the need to respond to the risks presented by climate change becomes more urgent, these measures are beginning to be transposed into legislation and regulation, lead with good example by the actions of the European Union[2].

While many financial institutions are already on their way or trying to implement internal systems for assessing and monitoring the sustainability of their businesses, the introduction of regulatory frameworks focused on sustainable finance should lead to overall standardisation in this diverse area, requiring financial institutions to assess and report on sustainability issues within their existing governance and risk management structures.

Under the Paris Agreement it is referred to as finance to fund activities that reduce greenhouse gas emissions or help in adapting to the impact of climate change. In the EU's policy context, sustainable finance is understood as finance to support economic growth while reducing pressures on the environment and taking into account social and governance aspects. Nevertheless, the scope of sustainable finance is much broader, including also the UN Sustainable Development Goals, and its prominence has increased due to global environmental movements like “Fridays for Future”.

In this context, environmental considerations may refer to climate change mitigation and adaptation, the preservation of biodiversity, as well as pollution prevention and reducing environmental impact, circular economy and minimising waste, or reducing greenhouse gas emissions.

Social considerations may refer to issues of inequality, inclusiveness, labour relations, investment in human capital and local communities, working conditions, conflict, as well as human rights issues.

Whereas the governance of public and private institutions, including management structures, bribery and corruption, board structure and tax strategy, employee relations and executive remuneration, plays a fundamental role in ensuring the inclusion of social and environmental considerations in the decision-making process. Moreover it also encompasses transparency on risks related to ESG factors that may impact the financial system, and the mitigation of such risks through the appropriate governance of financial and corporate actors.

Investment criteria are often focused on short-term results, but to properly assess environmental and social risk factors, which are more apparent only in the long-term, requires the finance sector to develop an investment framework which takes into account long-term risks. In order to encourage this shift towards a more resilient, longer-term view, governmental and inter-governmental initiatives have increased, to encourage financial institutions to include sustainability issues in their governance and risk management functions.

However, such initiatives have so far focused on risk disclosure, to provide greater transparency for investors, which is why financial institutions are encouraged to inform investors of the environmental impact of their investments, and to disclose their method of environmental risk assessments. Existing measures have concentrated on environmental, rather than social or governance-related risk disclosure, but this will extend in the near future driven by regulatory changes.

By encouraging financial institutions to implement sustainability risk disclosure initiatives, the aim of regulators has been to increase voluntary climate-friendly investing, reducing the need for legislative intervention in this area, but this approach lacks standardisation in risk assessment and labelling and thus creates a system that is opaque to investors and regulators alike. This in turn has placed the burden on the investors to satisfy themselves that a particular investment is sustainable and does not allow direct comparison between different investment opportunities. It has also not produced the necessary increased flow of funds to sustainable investments, which is required if countries are to meet their Paris Agreement commitments.

While Europe alone needs €175 to €290 billion in additional yearly investment in the coming decades in order to meet the Paris Agreement targets and make the EU climate-neutral by 2050, this target cannot be reached with public money alone. For this reason, the EU has proposed hard law to incentivize and redirect private capital to flow to green projects and with all the action already taken, the EU wants a quarter of the EU budget to contribute to climate action as of 2021.[3]

Overview of EU actions

Since the EU is committed to becoming a global leader in sustainable finance, the European Commission (EC) established the High-Level Expert Group on Sustainable Finance (HLEG) in 2016, tasked with developing a comprehensive EU strategy on sustainable finance. In January 2018 the HLEG published its final report[4], detailing priority recommendations (including taxonomies, labelling, advice, sustainability benchmarks, credit ratings, fiduciary duties, risk management and disclosure) that formed the basis of the EC’s action plan on sustainable finance adopted in March 2018[5], which has three main objectives:

·         Reorient capital flows towards sustainable investment, to achieve sustainable and inclusive growth,

·         Manage financial risks stemming from climate change, environmental degradation and social issues, and

·         Foster transparency and long-termism in financial and economic activity.

In May 2018, the EC adopted measures implementing some aspects of its action plan which included a proposal for a regulation on the establishment of a unified taxonomy on what can be considered an environmentally sustainable economic activity (the Taxonomy Regulation) and a proposal for a regulation on disclosure obligations relating to sustainable investments and risks (the Disclosures Regulation). Moreover it included an amendment of the Benchmarks Regulation[6] to create a new category of low-carbon and positive carbon impact benchmarks and a proposal of measures in relation to including ESG considerations into the advice that investment firms and distributors offer clients, and to clarify how asset managers, insurance companies, and investment or insurance advisors should integrate sustainability risks.

For this reason, a Technical Expert Group (TEG)[7] was established to assist in developing the EC’s proposals and has published a number of reports:

·         A final report on climate-related disclosures (January 2019)

·         A final report on the EU taxonomy designed to support the Commission in the development of future Delegated Acts, as proposed in the Taxonomy Regulation (March 2020))

·         A report on an EU Green Bond Standard (June 2019) and a usability guide (March 2020)

·         A final report on climate benchmarks and benchmarks’ ESG disclosures (September 2019), and

·         The Disclosures Regulation and the Regulation on low-carbon and positive carbon impact benchmarks were adopted and published in the official journal in December 2019.

The EC was mandated to develop and adopt delegated acts which will further specify presentation and content of the information to be disclosed. With regards to the Taxonomy Regulation proposal, the co-legislators reached agreement on a unified EU classification system in December 2019. However, delegated acts will need to be adopted by Member States for all of the provisions of the Taxonomy Regulation to come into effect.

Further, on June 18, 2019, the EC published new, non-binding, guidelines[8] for company reporting on climate-related information under the Non-Financial Reporting Directive 2014/95/EU, as part of its sustainable finance action plan. The guidance applies to large listed companies, banks and insurance companies, with more than 500 employees, proposes ways of assessing climate change impacts on the financial performance of companies and incorporates the recommended disclosures of the TCFD. They build on the report published in January 2019 by the Technical Expert Group on Sustainable Finance.[9]

At the end of 2020, a renewed sustainable finance strategy is expected to be published, which will strengthen the foundations for sustainable investment, make it easier for investors and companies to identify sustainable investments and ensure that they are credible, and enable climate and environmental risks to be managed and integrated into financial system. This will also include a revision of the Non-Financial Reporting Directive.

Building on the objectives of the Sustainable Finance Package, the EC also launched its Green Deal[10] in December 2019, a plan to implement the United Nation’s 2030 Agenda and the sustainable development goals amongst other priorities. The European Investment Bank (EIB) is expected to play an important role in delivering the EU Green Deal. In November 2019 the EIB approved a new climate strategy and energy lending policy which aims at mobilizing €1 trillion into climate action and environmental sustainable investment up to 2030 and proposes to increase its financing activity in these sectors so that by 2025 this comprises 50 percent of its operations, at a value of €30 billion per year. The bank has also committed to aligning all of its financing principles to reflect the goals of the Paris Agreement from the end of 2020 and to include a cessation of financing for all energy projects based on fossil fuels, including gas, into its energy lending policy by the end of 2021.

The Green Deal’s primary objective is economic growth, with the aim of decoupling economic growth from resource use and protecting natural capital. The transition will be achieved by aligning policy across every sector of the economy, including energy, buildings, mobility, industry, food and agriculture, as well as taxation and social benefits. A cornerstone of the EU Green Deal is the target of achieving net zero emissions for EU member states as a whole by 2050. The EC will propose a European Climate Law[11] to enact the target of climate-neutrality by 2050 into law.

Moreover, the EC launched the European Green Deal Investment Plan[12] (also known as the Sustainable Europe Investment Plan) to mobilise EU funding and create an enabling framework to facilitate and stimulate the public and private investments needed for the transition to a climate-neutral, green, competitive and inclusive economy. This includes the Just Transition Mechanism, to support those regions and sectors most impacted by the transition.

Furthermore, on 6 February 2020, the European Securities and Markets Authority (ESMA) published its strategy on sustainable finance. ESMA will take into account sustainable business models and integrating ESG related factors across its activities, including the single rulebook, supervisory convergence, direct supervision and risk assessment. ESMA’s key priorities include completing the regulatory framework relating to transparency obligations arising under the Disclosure Regulation, and to work with the European Banking Authority and European Insurance and Occupational Pensions Authority to produce draft technical standards on this.

ESMA will also include a dedicated chapter on risks related to sustainable finance in its reports on trends, risks and vulnerabilities (TRV)[13] and will aim to foster supervisory convergence of EU law in the ESG area, focusing on mitigating risk of greenwashing, preventing misselling and misrepresentation, and improving transparency and reliability in reporting non-financial information. ESMA also intends to participate in the EU platform on sustainable finance under the proposed Taxonomy Regulation, which will develop and maintain the EU taxonomy and monitor capital flows to sustainable finance.

Overview of global initiatives

The Financial Stability Board, an international body established by the G20, responsible for monitoring the global financial system, established the Task Force on Climate-related Financial Disclosures (TCFD), which published its final recommendations for effective disclosure of climate-related risks in June 2017.

The TCFD recommendations are applicable to financial-sector organisations, including banks, insurance companies, asset managers and asset owners. Although only a voluntary framework, the recommendations on governance, strategy, risk management as well as metrics and targets are drafted to be widely adoptable, to be useful to both investors and lenders.

The Climate Disclosure Standards Board has outlined certain challenges in implementing such recommendations, including a lack of internal and investor engagement, a lack of education at board level, difficulty adapting to longer-term horizons as well as outdated risk management and financial modelling tools. As a result, the extent of implementation varies widely in different countries and while there has been an increase in regulatory guidance at the national level, the aim of the TCFD is to facilitate an approach driven by the private sector.

The United Nations is also providing guidance to the financial sector in transitioning to a green economy.

In 2006 the UN-supported Principles for Responsible Investment (PRI) were launched. There are around 2,250 signatories to the PRI from over 50 countries representing over USD 70 trillion of assets (as reported at the end of August 2017). Amongst other things, the signatories to the PRI agree to factor in ESG issues when making investment decisions. Additionally, the recommendations of the TFCD have been incorporated into the PRI.

In May 2019, the United Nations Environment Programme Finance Initiative (UNEP FI) published a report on a pilot project on TCFD adoption, together with leading global banks. The UNEP FI has also published principles for responsible banking, which includes a requirement to set targets to drive alignment with appropriate Sustainable Development Goals, the goals of the Paris Agreement, and other relevant international, national or regional frameworks.

Separately, the Sustainable Banking Network (SBN) is a unique global initiative comprising a voluntary community of regulatory agencies and banking associations, established to facilitate the collective learning of its members and to provide support in the development of initiatives aimed at promoting sustainable investing. In February 2018, the SBN published its Global Progress Report, evaluating sustainable finance policies in 34 member countries and suggesting practical indicators and tools, which members can apply to their own domestic markets.

The Network for Greening the Financial System similarly comprises a group of central banks and supervisors to green the financial system with the aim of enhancing the role of the financial system to manage risks and to mobilize capital for green and low-carbon investments in the broader context of environmentally sustainable development, by promoting best practice and commissioning analysis.

Furthermore, an international platform on sustainable finance was launched in October 2019 by public authorities from Argentina, Canada, Chile, China, India, Kenya, Morocco and the European Union, representing almost half of the world’s greenhouse gas emissions. The aim of the platform is to promote best practice in sustainable finance, and enhancing coordination where appropriate.

Linked to these initiatives are moves to develop sustainable finance focused products (especially green bonds), including developing voluntary guidelines to encourage transparency and disclosure, and promote their development in a number of markets, including e.g. Islamic finance.

Overview of UK initiatives

Also the UK government has introduced measures to better integrate sustainable investing concerns into the decision making frameworks of businesses. Measures already adopted include amendments made in 2013 by the Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013 (SI 2013/1970), which require certain companies to disclose ESG matters, including their greenhouse gas emissions, in their directors’ report or, if of strategic importance, in their strategic report.

In June 2018, the House of Commons published its green finance report[14] aimed at embedding sustainability in financial decision making, according to which businesses and regulators must factor long-term environmental risks into financial decision making.

It recommends the government to clarify in law that pension schemes and company directors have a duty to protect long-term value and should be considering environmental risks in light of this, as opposed to short-term returns. Moreover, TCFD reporting should become mandatory on a ‘comply or explain’ basis by 2022 for all large asset owners and the government should work with the Committee on Climate Change to help with this transition and to produce policy/scenarios that can be utilised by companies and asset owners. It should be made clear to all financial entities that companies are already required to report on climate change where it is a material risk to business under the Companies Act 2006.

Furthermore, in case there is no improvement in the monitoring and management of climate-related risks, the government should pass sustainability reporting legislation similar to that in France under Article 173 of the Energy Transition for Green Growth Act, which would require organisations with a balance sheet of more than €500m to disclose in their annual reports how they integrate ESG and climate change concerns into their investment policies and risk management. This obligation is implemented on a ‘comply or explain’ basis, providing flexibility to investors in choosing how best to fulfil the criteria under the Act.

Rather than being legislative intervention, both the recommendations made by the above report as well as the report produced by the Green Finance Taskforce (GFT)[15] shall encourage the cooperation of the government, regulators and the private sector to help accelerate the growth of green finance in the UK, which the UK government welcomed and began implementing some of these recommendations. It also published its Green Finance Strategy on 2 July 2019 that includes the establishment of a Green Finance Institute to foster greater cooperation between the public and private sectors.

Furthermore, UK regulators are implementing measures to embed climate risk into the regulatory framework. On September 26, 2018, the Prudential Regulatory Authority (PRA) published a report[16] on the financial risks facing the UK banking sector as a result of climate change, that identified two risk factors which manifest as increasing credit, market and operational risk:

·         Physical risks arising from climate and weather-related events, potentially resulting in large financial losses and impairing the creditworthiness of borrowers, and

·         Transition risks arising from the process of adjustment towards a low-carbon economy.

Afterwards, in April 2019, the PRA published a policy statement (PS11/19)[17] and a supervisory statement (SS3/19)[18] setting out the PRA’s proposed expectations of enhancing banks’ and insurers’ approaches to managing the financial risks from climate change. The overall purpose is to encourage firms to not only reflect on their current approach to governance and risk management structures in responding to the financial risks arising from climate change, but also to strategically manage the financial risks from climate change, by taking account of current and future risks, and actions required to mitigate those risks. The PRA requires firms to have an initial plan in place to address the expectations and submit an updated Senior Management Function form since October 15, 2019.

The Financial Conduct Authority (FCA) also looked into these issues and published a Discussion Paper[19] on the impact of climate change and green finance on financial services in October 2018, setting out how the impacts of climate change are relevant to the protection of consumers and market integrity. The FCA also considered the opportunities for financial services, as a result of the transition to a low carbon economy, including the opportunity to grow as a centre for green finance, but noted that there are currently no minimum standards and guiding principles for measuring performance and impact of green finance products.

In October 2019, the FCA published a feedback statement (FS19/6)[20], summarizing the responses the FCA received from stakeholders to its discussion paper DP18/8 and setting out its actions, next steps and proposals to improve climate change disclosures by issuers, regulated firms’ integration of climate change risk and opportunities into their decision-making, and consumers’ access to green financial products and services. This includes further consultation, focused on new disclosure rules for firms, and enhanced governance in relation to ESG and stewardship policies.

While the regulatory focus is primarily on climate risk management, the Bank of England (BoE) published a discussion paper[21] that sets out its proposed framework for the 2021 Biennial Exploratory Scenario exercise, whose objective is to test the resilience of the largest banks and insurers to the physical and transition risks associated with different possible climate scenarios, and the financial system’s exposure more broadly to climate-related risk.

Last but not least, in order to help build capacity and share best practice across financial regulators and industry to respond to the financial risks arising from climate change, the PRA and FCA have established a Climate Financial Risk Forum[22], aimed at improving data and furthering the development of climate-related scenario planning.

What does that mean?

As clearly shown, financial institutions and investors will increasingly be required to assess, monitor and disclose the sustainability of their investments. While regulatory intervention is increasing in some markets, voluntary initiatives are being adopted in others and although measures are likely to represent an increased cost to businesses, they also present an opportunity for the development of new products and services. In the face of climate risk, the financial market has an opportunity to innovate which, within the appropriate framework, can redirect necessary capital and drive value as well as further climate-related and ESG objectives.

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[1] https://unfccc.int/process-and-meetings#:a0659cbd-3b30-4c05-a4f9-268f16e5dd6b; https://ec.europa.eu/clima/policies/international/negotiations/paris_en

[2] https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance_en

[3] https://ec.europa.eu/info/files/200108-financing-sustainable-growth-factsheet_en

[4] https://ec.europa.eu/info/publications/sustainable-finance-high-level-expert-group_en

[5] https://ec.europa.eu/info/publications/sustainable-finance-renewed-strategy_en

[6] https://eur-lex.europa.eu/legal-content/en/TXT/?uri=CELEX:32016R1011

[7] https://ec.europa.eu/info/publications/sustainable-finance-technical-expert-group_en

[8] https://ec.europa.eu/finance/docs/policy/190618-climate-related-information-reporting-guidelines_en.pdf; https://ec.europa.eu/info/publications/non-financial-reporting-guidelines_en

[9] https://ec.europa.eu/info/publications/190110-sustainable-finance-teg-report-climate-related-disclosures_en

[10] https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal_en

[11] https://ec.europa.eu/clima/policies/eu-climate-action/law_en

[12] https://ec.europa.eu/commission/presscorner/detail/en/ip_20_17

[13] https://www.esma.europa.eu/databases-library/esma-library/trends

[14] https://publications.parliament.uk/pa/cm201719/cmselect/cmenvaud/1063/1063.pdf

[15] https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/703816/green-finance-taskforce-accelerating-green-finance-report.pdf

[16] https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/report/transition-in-thinking-the-impact-of-climate-change-on-the-uk-banking-sector.pdf

[17] https://www.bankofengland.co.uk/prudential-regulation/publication/2018/enhancing-banks-and-insurers-approaches-to-managing-the-financial-risks-from-climate-change

[18] https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/supervisory-statement/2019/ss319

[19] https://www.fca.org.uk/publication/discussion/dp18-08.pdf

[20] https://www.fca.org.uk/publications/feedback-statements/fs19-6-climate-change-and-green-finance

[21] https://www.bankofengland.co.uk/news/2019/december/boe-consults-on-proposals-for-stress-testing-the-financial-stability-implications-of-climate-change

[22] https://www.bankofengland.co.uk/climate-change/climate-financial-risk-forum