Author : Ylva Cornelia Axelsen, Partner at SANDS
SANDS will address certain aspects of sustainability in a series of short briefings and news letters. In this briefing we will provide you with some general background and context to sustainable finance.
In coming briefings we will address more specific areas of sustainable finance and related topics, such as
- Responsible banking
- Responsible investments
- Green bonds and green loans
- The “S” in ESG – human rights
- Renewable energy
- Technology and sustainability
- Sustainable real estate
- Sustainable shipping
What is the basis of sustainable finance?
The global political commitments made under the Paris Agreement and the UN Sustainable Development Goals form the basis of sustainable finance. The Paris Agreement refers to finance to fund activities that reduce greenhouse gas emissions or help society adapt to the impact of climate change, often named climate finance. However, the scope of sustainable finance is broader, as it also covers wider environmental, social, and governance ("ESG") objectives (footnotes 1 and 2).
Several UN initiatives have been given the prefix "responsible", signaling that they cover more than the environmental aspect of "sustainable", which again typically has also been referred to as "green" initiatives (footnote 3).
At present, a wide range of initiatives, networks and partnerships are established and actively working with developing awareness, guidelines and best practices to enhance sustainability in finance.
In parallel with a number of UN and European Commission initiatives, the Central Banks and Supervisors Network for Greening the Financial System earlier this year published their first report with recommended actions to further a greener financial market (footnotes 4 and 5).
In this briefing we will focus on the main features of the European Commisions’ initiatives for legislative measures to further the objectives of sustainable finance.
What are the main objectives of sustainable finance?
Sustainable finance is strongly tilted towards the environmental factor of ESG, with main objectives being
- to achieve economic growth whilst reducing environmental impact,
- to minimise waste, and
- to reduce greenhouse gas emissions.
However, sustainable finance also has social objectives like tackling inequality, and furthering investments in companies following good governance practices.
Why is the finance sector so important in relation to sustainability?
In order to reach EU’s 2030 targets for a lower-carbon economy, it is estimated that yearly investments of around EUR 180 billion will be required. It is further estimated that in order to reach the 2050 targets the current investment volume of around 2 percent of GDP in sustainable projects will have to increase to around 3 percent of GDP, i.e. with more than EUR 500 billion per year from 2031 to 2050 (footnote 6).
Such investments cannot be made by public sectors alone. By applying the right tools for transparency, risk and pricing related to sustainability, financial institutions, investors, and managers can play an important role in moving capital towards more sustainable investments.
What are the relevant legal developments?
In 2018, the European Commission presented an action plan for financing sustainable growth (footnote 7), with 10 key actions and a package of measures to facilitate private financing of sustainable projects. This package included a number of proposed regulations and amendments, including:
- Classification for sustainable investments
- Regulation aimed at establishing a unified EU classification system (“taxonomy”) for sustainable economic activities (footnote 8)
- Disclosures relating to sustainable investments
- Regulation aimed at improving disclosure requirements on institutional investors’ integration of ESG factors in their risk processes (footnote 9); and
- Low carbon benchmarks
- Regulation aimed at creating benchmarks for investors to compare the carbon footprint of their investments (footnote 10).
In addition, the package adopted by the European Commission include proposed amendments to the UCITS directive, AIFMD, MiFID II and the the Insurance Distribution Directive, all aimed at integration of sustainability risks and factors within the respective areas of application, e.g. in investment and advisory processes, in marketing, in risk management policies and procedures.
Separate from the EU Action Plan, certain large entities will pursuant to the new regulations in the EU Directive on Disclosure of Non-Financial Information be required for certain purposes to disclose information about (footnote 11 and 12):
- its business model;
- its ESG policies, including any due diligence processes implemented pursuant to those policies and the outcome of those policies;
- the principal risks relating to ESG matters in connection with the company's operations;
- how the company manages ESG risks; and
- a description of the company's business relationships, products and services which are likely to cause adverse impacts relating to ESG risks.
What actually qualifies as “sustainable” or “green”?
A main challenge in sustainable finance is to determine applicable metrics and targets. A number of data sources and methodologies can be used to determine what is “sustainable,” and for assessing, managing and reporting ESG performance. At present, no regulatory taxonomy has been implemented globally, other than market-driven taxonomies which are, by definition, not binding.
The European Commission has established a Technical Expert Group ("TEG") to develop a classification system (the "Taxonomy") as a basis for considering what activities are sustainable. The Action Plan also comprise developing sustainability (“eco”) standards and labels.
The Taxonomy can be an important measure for avoiding “green-washing” of financial instruments (i.e. labelling instruments as green without sufficient means for an investor to verify the sources or metrics used to quantify the product’s environmental impact). The Taxonomy seeks to establish a common language for “green”, “responsible”, and “sustainable” products and practices among financial actors, as well as wider stakeholders. It is also followed by a methodology, guidance and case studies for investors preparing to use the Taxonomy.
In addition, there is a proposal for an EU Green Bond Standard. This would be a voluntary, non-legislative standard linked to the Taxonomy for listed or unlisted bond or capital market debt instrument issued by a European or international issuer. We will look closer at this in a separate briefing on green bonds and green loans.
Who is the new sustainability legislation relevant for?
The shift from private and voluntary initiatives to legislative measures initiated by the European Commission will affect a number of stakeholders across different industries.
Financial-sector organizations, including banks, insurance companies, asset managers, pension funds, investors and asset owners will to an increasing degree focus on tangible financial components associated with environment, social and governance that could affect their investments or lending, and will be subject to increased transparency and reporting requirements. The Taxonomy regulation will apply to portfolio managers, management companies of UCITS, AIFs, EuSEFs and EuVECAs, insurance companies offering insurance-based investment products, occupational pension funds and pension product providers.
Correspondingly, regardless of industries, companies’ owners, management and board members now actively seek to “eco-brand” or “ESG-brand” their businesses to attract and retain investors, customers and market shares. Understanding the scope and application of sustainability taxonomies, eco-labels, benchmarks and various transparency requirements could therefore give a competitive edge.
When will the EU sustainability regulations take effect?
The regulations on Disclosure and on Low Carbon Benchmarks are politically agreed within the EU and are expected to be published between September and December 2019. Exact requirements will be further specified through delegated acts, which are expected to be adopted by the European Commission between end-2019 and mid-2022.
In June 2019, the Technical Expert Group on Sustainable Finance published its report on the Taxonomy with a call for feedback from a wide range of stakeholders by mid- September. TEG will by the end of 2019 provide recommendations to the European Commission for the purpose of development of future delegated acts, as proposed in the taxonomy regulation. As currently proposed, the Taxonomy classification system is scheduled to be in place by June 2022.
Norway has, based on the Paris Agreement, enacted climate goals for 2030 and 2050 through the Climate Act of 2018, aiming to become a low emission society by 2050. EU regulations comprised by the EEA agreement will be implemented in Norwegian law through separate legislation or amendments to existing laws.
Will the EU Taxonomy be mandatory?
Institutional investors and asset managers marketing investment products as environmentally sustainable would, pursuant to the Taxonomy regulation, need to (i) explain whether, and how, they have used the Taxonomy criteria, and (ii) disclose the proportion of the underlying fund that is consistent with the Taxonomy. For other financiers, companies and local authorities both within and outside the EU the Taxonomy may be used on a voluntary basis.
Will a certain part of an investment or lending portfolio have to be green?
The European Commission’s action plan on sustainable finance aims to stimulate increased sustainable investments through clarifying responsibility and increase transparency in the financial sector. It does at present not comprise proposed regulations which requires a certain share of financial institutions’ investments or lending to be classified as green or sustainable.
Once a taxonomy system is in place the question is whether further legislative measures will be required to reach necessary levels of investments in and lending to activities with a positive climate, environmental or social impact. However, given the current pace and scale of initiatives by key players and tone setting institutions in the financial industry one may very well see market practice continue to precede legislation and set even stricter requirements as to scope and implementation of measurable ESG actions than what follows from current legislative proposals.
Will sustainability affect bank’s capital risk-weighting?
The EU Action Plan with proposed regulations does currently not comprise changes that would favour sustainable portfolios in the bank’s capital risk-weighting (often called a “green supporting factor”) or set higher capital requirements for non-sustainable assets (a “brown penalising factor”). This is however being explored by the European Commission. It would also require incorporating climate risks into banks' risk management policies beyond such self-regulation that follows from private initiatives like Responsible Banking Principles, which we will look into in a separate newsletter.
What types of questions should I be preparing for?
- To what degree is sustainability part of your investment offerings and procedures?
- Do you have a written policy on the integration of sustainability risk in your decision making?
- What impact do sustainability risk have on the financial products you offer?
- What methodology is used to assess, measure and monitor sustainability-linked investment targets for the relevant financial product(s)?
 Proposal for a Regulation of the European Parliament and of the Council on the establishment of a framework to facilitate sustainable investment.
 Proposal for a Regulation of the European Parliament and of the Council on disclosures relating to sustainable investments and sustainability risks and amending Directive (EU) 2016/2341.
 Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) 2016/1011 on low carbon benchmarks and positive carbon impact benchmarks
 Public-interest entities with more than 500 employees in average during a financial year
 Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups