In the recent weeks we have seen the world face an unprecedented pandemic, and our societies and economies slowly grind to a halt. While our leaders are scrambling to prepare an immediate response, both in terms of public health and to mitigate the economic slowdown, long-term challenges such as climate change will not disappear.
While the emissions of Green House Gases (GHG) have momentarily dropped, they will probably pick up again once the economy recovers from the COVID-19 pandemic.
For years, scientists have warned us that man-made global warming is happening at a very fast pace. Last year, the Intergovernmental Panel on Climate Change (IPCC) made clear that our window of opportunity to avoid an excessive increase in global temperature is closing fast. News flashes about a burning Amazon forest, and more recently, scenes of burning land and beach evacuations of inhabitants by warships in Australia, are making people much more aware of the dire consequence climate change will have for the planet.
What is sustainable finance?
Limiting global warming requires us to fundamentally re-think and re-tool large parts of our economy to make sure it becomes carbon-neutral as fast as possible. This requires us to mobilise vast sums of money (in the trillions) to ensure the following:
- upgrade existing infrastructure such as housing, office buildings and factories,
- finance research and innovation in new low-carbon technologies,
- scale up existing technologies such as wind farms, solar panels and hydrogen or as yet undeveloped technologies.
For example, the ‘funding gap’ for the European Union (EU) to reach its long-term goal of having a carbon neutral economy by 2050 is estimated to be around EUR 250bn per year until 2030.
As citizens, we may also be savers, investors and pensioners – and hopefully for some of us all three at once. In a similar fashion to deciding consciously to purchase environmentally friendly groceries, local products, going on eco-friendly holidays, we should also be able to deploy our savings or our pensions in investment opportunities that can contribute positively to the sustainability of our economy.
As such, the aim of the sustainable finance policy agenda is twofold:
- helping investors to put their money in sustainable investment opportunities with a neutral or positive contribution,
- mobilize capital to deal with the‘funding gap’ for sustainable investments and infrastructure.
The European Union has taken the lead since the Paris Agreement
Since the Paris Climate Agreement of 2016, the EU has sought to become the international leader in combating global warming.
Representing globally around 11% of green house gas emissions, the EU has set itself high ambitions to significantly reduce these emissions by 2030 and operate a fully ‘carbon neutral’ economy by 2050. To achieve this, the EU quickly identified the financial industry as a powerful tool in achieving the transition to a low carbon economy.
Since early 2018, the EU published a Sustainable Finance Action Plan with a significant number of policy actions. It used that plan to publish and steer through the EU legislative process several pieces of legislation. This includes…
- a Taxonomy for sustainable investments,
- more rules on disclosure for investment funds, and
- rules on building index and benchmarks around the climate transition and the Paris agreements.
The Taxonomy aims at providing investors, as well as a range of other stakeholders (companies, NGOs, public authorities), a definition of sustainable economic activities for a wide range of sectors of the economy. It is the combination of a sort of dictionary and interactive map. Ultimately the aim is to define, per sector of the economy, based on existing technologies and scientific evidence, how efficient that sector should be to ensure it is aligned with the 2050 objective of carbon neutrality. It aims to help investors, as well as other stakeholders, by providing a transition pathway for most industries in attaining that objective.
The Taxonomy is accompanied by another legislative proposal on disclosure by investment vehicles.
The market for sustainable investment funds, often commonly referred to as ESG funds (Environmental, Societal and Governance) has grown dramatically, with huge varieties in investment strategies, theme, sectoral and geographic focus. This has sometimes made it difficult for small investors to make sense of all the information, as well as understanding in how his/her investments are on a trajectory (or not) to contribute to the long-term 2050 objective.
The aim of the proposal is to usher more transparency for investment funds on a number of key sustainability-related investment issues that ask the following questions…
- How far is the portfolio of investments aligned with the Taxonomy, and hence indirectly with the 2050 carbon-neutrality objective?
- How far is an investor’s money actually invested in way that promotes sustainability?
- And what is the impact of these investments on sustainability factors?
As of March 2021, and gradually thereafter, investment funds will be required to increasingly provide more detailed and accurate information to investors on these issues.
The largest impact – from financial returns to sustainable impact
Sustainable Finance could usher fundamental change within the financial system. And we could expect for this to materialise in the coming years. A cornerstone of the investment management industry since time immemorial has been the principle of fiduciary duty: a fund manager has a duty of loyalty, care and trust to act in the best interest of his client. Often, this has been equated with achieving the highest possible returns on investments. The Taxonomy and rules on disclosure has the potential to profoundly change this.
From now on, fund managers will also be required to report on the impact of their investments on the environment at large. This is a fundamental shift of paradigm, from measuring financial returns to measuring non-financial impact.
The concept of measuring impact is solidly embedded throughout the legislation via the introduction of the ‘Do No Significant Harm’ (DNSH) principle. An economic activity or investment can only be qualified as sustainable if they do not have a significant negative impact on one of the core objectives of the Taxonomy: climate mitigation, climate adaptation, sustainable use and protection of waters, transition to a circular economy, pollution prevention and the protection of heathy ecosystems.
Where to now?
Since 2018, the EU had clearly taken the leadership in policy discussions on sustainable finance. This culminated in the autumn of 2019 with the creation of the International Platform on Sustainable Finance, which aims to bring countries together across the world to share best practices and policies on sustainable finance. The Sustainable Finance agenda forms a core element of the European Green Deal launched by the European Commission for the next mandate until 2024.
Much has been achieved, but many issues remain, as we can see from the European Commission consultation on the new Green Finance Strategy launched on the 8th of April.
What will the area of focus be?
First, it is clear that the whole sustainable finance architecture as proposed only works if investors can get the necessary information from the companies in which they invest. Only then can investors make better inform investment decisions. Moreover, the taxonomy dictionary can only be applied to a particular company or economic activity if you have the necessary data to apply the definitions and assess whether it qualifies as sustainable. What is the average C02g per/km for cars produced by a car manufacturer? What is the tCO2e/t produced for a steel maker? This is the type of data investors will need to get from companies if the Taxonomy is to work.
Second, if the Taxonomy is to become a true interactive map for the transition to 2050, it is quite likely it will have to evolve from the current ‘positive’ list towards a list that looks at neutral activities (e.g. pharmaceutical, which depends on the energy mix used) as well as negative activities (e.g. oil and coal), so that investors are truly able to assess how well a particularly industry or company is faring versus the 2050 carbon neutrality objective. However, this will face tremendous political resistance to be adopted.
Ultimately, all these initatives must take into account an often overlooked dimension – the role of financial institutions in the economy. Banks must be financially sound to avoid a banking crisis. (Remember the financial crisis of 2008?) Insurers need to be profitable and sound to be able to pay out insurance claims to clients. Pension funds need to be profitable to be able to meet future pension commitments to citizens, which in many countries will be a tremendous financial and political challenge over the next years. Therefore, these institutions will only put capital in sustainable investments if these are profitable. If policymakers force investors to put capital in sustainable investments, regardless of their profitability, it will only sow the seeds of a financial crisis further down the line.
Therefore, sustainable finance can ultimately only be a success if governemtnts, through taxation, subsidies and externality pricing (i.e. carbon price) as well as de-risking tools (public guarantees) can make sustainable investments sufficiently attractive financially. As long as that is not the case, sustainable investments will remain a niche rather than the mainstrem. In the end, success will require a combination of financing ‘green activities’ as well as getting ‘brown activities’ to transition towards ‘green’. Only then will we succeed.