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Since the crisis of 2008, new and important regulations have been developed for the financial sector. With the rapid expansion of so-called sustainable and responsible investments, the financial authorities were expected to address this issue as well. The creation of a regulatory framework for sustainability and corporate responsibility issues, both for financial and non-financial companies, has progressed rapidly. In recent months, there has even been a tidal wave of regulations.
The roots are in the European Commission’s 2018 Action Plan and, in particular, in the three key objectives related to EC ambition for sustainable finance:
Redirecting capital to the real economy for sustainable and inclusive growth;
Recognising that environmental and in particular climate risk is a systemic risk that needs to be identified, measured, managed and monitored;
Promoting transparency and long-term investments.
REDIRECTING CAPITAL TO THE REAL ECONOMY
The European Commission’s (EC) Green Deal raises the European Union’s (EU) environmental ambitions by aiming for climate neutrality by 2050. To this effect, the Pact focuses on five concrete themes: energy security and clean and affordable energy, biodiversity, zero pollution, the circular economy and sustainable food production.
Also focused on concrete themes, the European Taxonomy is another framework that for the moment covers the areas of mitigation and adaptation to climate change but will extend to other Commission objectives such as pollution prevention and waste management (delegated act planned for mid-2021) and the balance of ecosystems and water protection (delegated act planned for mid-2022).
With the obligation, as of 2022, for financial actors to evaluate their investments in order to verify that they belong to the sustainable sectors of activity defined by the Taxonomy, this new framework directly or indirectly promotes investment into green activities. An investment fund with environmental objectives must be broadly aligned with the Taxonomy; the credibility of its process is at stake. One unfortunate by-product of the current framework however is that a fund that focuses exclusively on social objectives will have a 0% alignment with the Taxonomy.
Elsewhere still, the Regulation on “low carbon” indices is in line with goals such as the fight against greenwashing and the promotion of financial products with environmental and climate objectives. Two new categories of indices have just been defined by the EC – climate transition indices and indices aligned with the Paris Agreement – and aim to improve transparency on the criteria and methodology used by index creators.
Finally, the new EC Green Bonds Standards also fight against greenwashing through the creation of a well-defined framework of minimum standards that must be met to obtain the Green Bond designation and to be considered as an issuer contributing to energy transition and more sustainable finance.
The new European pieces of legislation in the pipeline or already adopted are therefore numerous and, although imperfect, cover many aspects of financial markets in order to yield concrete sustainability results.
CLIMATE RISK IS SYSTEMIC
Along the same lines as what the former governor of the Bank of England had called for several years ago, environmental and climate risk in particular are now officially recognized by the EU as material and financial risks and must therefore be analysed, managed and monitored like any other financial risk. This management is now part of the fiduciary duty of any portfolio manager.
This is the raison d’être of the Sustainability Disclosure Regulation (SDR), which also aims for more transparency.
This Regulation includes the obligation to publish information on the integration of sustainability risks and the promotion of environmental or social characteristics as part of investment decision-making. The aim is, among others, to ensure that investment products correspond to the profile that is appropriate for and sought by the investor, who, thanks to this data, will be able to make an informed decision. The impact of this regulation will be felt at all activity levels of financial institutions, from the design of new policies and programs to their implementation through new processes, including in IT with data storage, and through a new approach of products and contracts.
This required integration of sustainability risk in investment decisions will be increasingly formalized and further detailed in amendments to existing EC directives and other regulations. For example, it is already enshrined in the Directive on the activities and supervision of institutions for occupational retirement provision (IORP Directive) but will be reinforced through the revision of other directives and regulations governing the sector. The same is true for the insurance sector with the planned revision of the Insurance Distribution Directive and for the retail investor sector with the planned amendments to the Markets in Financial Instruments Directive (MIFID).
TRANSPARENCY & LONG TERM
Transparency and in particular the fight against greenwashing underpin the various texts adopted. One can promote the sustainable character of investments, benchmarks or financial instruments as long as that sustainable character is clearly defined and it is possible to carry out verifications using traceable and comparable indicators and information.
The SDR Regulation facilitates exactly that. But it goes beyond the mere obligation to publish data by also requiring a classification of financial products (mandates and investment funds) according to three categories defined by the Commission: (1) “sustainable” products with environmental and/or social objectives, (2) products that “promote environmental or social characteristics” and (3) other products. The border between the first two categories is still very blurry and unfortunately, the technical texts that are supposed to provide clarification will only be available after the Regulation comes into force (March 2021). Furthermore, as has been the case with many regulations of late, the indicators and information that will have to be disclosed are so complex and technical that implementation of the Regulation becomes very difficult, if not impossible. For this reason, the financial sector is united in its call for a simplification of the content and number of indicators required.
Concerning more specifically the reporting of this sustainable information in accordance with the requirements of the SDR Regulation, the Commission is working in parallel on the Directive on the publication of non-financial information. This Directive only applies to a limited number of companies: European companies with a minimum of 500 employees, or EUR 34 million annual revenue or EUR 17 million on their balance sheet. However, the investment universe of so-called sustainable funds, regardless of their EC category, is not limited to large capitalizations listed in Europe.
Finally, it should be noted that the SDR Regulation also applies to portfolios invested in sovereign bonds. However, all the required indicators have been designed and formulated for the analysis of companies and are therefore difficult to transpose to the analysis of a country.
The impact of the above-mentioned Directive and the SDR Regulation is colossal and creates a reporting burden that calls into question corporate or investment strategies, their implementation and corporate internal policies developed in the area of sustainability disclosure.
The challenge for the EC is considerable, as a difficult balance must be found between:
the critical need for the standardization of a sector that has moved from being a “niche investment” to a “sector that can help solve urgent environmental crises” and
the need to avoid unintended effects due to overly closed and inflexible regulation leading to an excessive and potentially counterproductive system of procedures, administrative and reporting obligations.
As a reminder, the ultimate goal is to raise nearly EUR 180 billion per year to finance the European Sustainable Development Programme by 2030.