For those readers unfamiliar with the sustainable finance agenda and the discussions currently underway in the European Commission (“the EC”), this briefing is intended to give you a high-level view of the forthcoming package of legislation from the European Commission’s Action Plan on Sustainable Finance (“the Action Plan”), write Conor Holland and Caroline Pope of KPMG.
Although ostensibly relevant to the capital markets and institutions operating within that environment, there is a need for corporates to understand these developments as they will define how you raise and access finance in the near term and ultimately your longer term relationships with investors.
First, a recap on what is meant by Sustainable Finance:
“Sustainable finance generally refers to the process of taking due account of environmental, social and governance (“ESG”) considerations when making investment decisions, leading to increased investment in long term and sustainable activities”. (Click here for source)
Before getting into the details, it is important to set the scene to understand the context in which this package of legislation is being developed. In December 2019 the EC presented The European Green Deal (“the Green Deal”) – a roadmap for making the EU's economy sustainable by turning climate and environmental challenges into opportunities across all policy areas and making the transition just and inclusive for all. The Action Plan is a work stream aimed at supporting the Green Deal (although it’s formation pre-dates the Green Deal) by channelling private investment towards the transition.
During its formation the Action Plan identified three core sustainable finance objectives:
These three objectives and the resulting package of measures aim to address some of the key challenges with the sustainability agenda:
The Action Plan includes core legislative proposals and comprises the following key recommendations:
Perhaps the most ambitious and heavily debated element of the Action Plan is the Taxonomy Regulation. This provides the bedrock for a unified EU “green” classification system of economic activities. Importantly, it is a key development which will prevent financial market participants (“FMPs”) from “greenwashing” investment products and designate investments as environmentally sustainable. In order to do this, FMPs must comply with the taxonomy technical screening criteria which is due to be legislated through delegated acts between July 2020 through to December 2022. Furthermore, the taxonomy is intended to enable investors to identify the proportion of their investment holdings in entities carrying out environmentally sustainable economic activities as a percentage of all economic activities.
For an investment to be considered environmentally sustainable, the screening criteria will measure the degree of environmental impact and sustainability of the economic activities underpinning the investment. This is the most salient aspect of the Action Plan, which supports the EC’s core objective to channel investments into sustainable activities.
In order to be considered “environmentally sustainable” an economic activity will be required to meet the following criteria:
“It must “contribute substantially” (as described in detail in the draft legislation) to one or more of the following six objectives and must not “significantly harm” to any of them:
The Disclosures Regulation is intended to ensure that FMPs and financial advisers systematically consider and integrate sustainability risks and adverse sustainability impacts in their processes. Moreover, it ensures that investors are provided with sustainability-related information on the financial products they offer or advise on. The nature, extent and exact location of these disclosures remains subject to public consultation. However, for clarity, there will be an elevated level of disclosure requirements for investment vehicles expressly focused on ESG (“green funds”.) For all other FMPs, websites and contractual documents with potential investors will need – at a minimum – to include detail on their sustainability policies. This includes how such policies interact with investment due diligence decisions.
In tandem with the requirements of the Disclosures Regulation, it is the EC’s intention to clarify through amendments to existing legislation under the UCITS, AIFMD and MiFID regimes, how asset managers, investment advisors and others should integrate climate risks. Where relevant, other sustainability factors in the areas of organisational requirements, operating conditions, risk management and target market assessment should be integrated. In this regard, ESMA has issued technical advice regarding the integration of sustainability risks and factors in the UCITS Directive, and has proposed a principles-based approach. This applies the proportionality principle for the proposed new rules. The necessary amendments to the relevant legislation for UCITS and AIFs have not yet been finalised by the EC.
The proposed amendments to the existing Benchmarks’ Regulation will create a new category of benchmarks comprising low-carbon or “decarbonised” versions of standard indices and positive carbon impact benchmarks. Benchmarks’ providers will be required to disclose how their methodology takes into account ESG factors. However, the ESG disclosure requirements will not apply solely to these new benchmarks. As of 31 December 2021, all benchmarks, except for interest rate and currency benchmarks should include information as to the degree to which they align with the Paris Climate Agreement.
While the Action Plan will predominantly impact the FMPs, there is a direct relationship between the integrity of sustainability metrics provided by the FMPs and what is disclosed by companies.
The EC has identified that non-financial information currently disclosed by companies does not meet the needs of investors. Specifically, the EC considers that disclosed information does not adequately detail how non-financial issues impact companies and how companies themselves impact society and the environment. In this regard, in December 2019, as part of the European Green Deal, the European Commission committed to reviewing the Non-Financial Reporting Directive 2014/95/EU (“the NFRD”)
Some of the concerns the EC identified included:
As such, the EC is seeking to enhance the existing NFRD framework so that corporates and other issuers under the NFRD provide reliable, comparable and relevant non-financial information.
On 30 January 2020, the EC published an initial roadmap for consultation on possible changes to the NFRD. Since its release the EC has indicated its intention to revise and strengthen the NFRD owing to concerns that the current system of voluntary guidance is not effective in responding to the non-financial information needs of the investment community. As such, an update is likely to:
In February 2020, the Commission published a second, more detailed consultation, on changes to the NFRD, which closes on 14 May.
The EC has also noted its intention to develop an EU-wide non-financial information standard to support the consistency and integrity of non-financial disclosures. In this regard, the EC has requested the European Financial Reporting Advisory Group (“EFRAG”) to begin preparatory work for those standards as quickly as possible. For context, they have noted their intention to leverage off the “best and most widely accepted elements” of existing international non-financial/ESG reporting standards such as GRI, SASB, TCFD as their starting point. The second NFRD consultation seeks views on which elements of these existing standards should be incorporated into an EU standard.
Sustainable Finance is increasingly becoming a mainstream operational and strategic imperative for companies. Furthermore, it has been identified as a lever for change post Covid-19, which underscores some of the subtle links and risks associated with human activity, climate change, and biodiversity loss, as well as the subsequently critical need to strengthen the sustainability and resilience of our societies and economies.
This thesis is supported by economic data - sustainable businesses enjoyed a higher degree of investor confidence before the economic shut-down and seem to continue to enjoy a higher degree of investor confidence as the shut-down continues. Figures published by Funds Europe suggest that values of European sustainable funds dropped by 10.6%, compared with the “overall European fund universe” which declined by 16.2%.
Robeco, the global asset manager has also found a positive relationship between lower credit risk and sector alignment with sustainability. The RobecoSAM Global SDG Credits strategy outperformed the Bloomberg Barclays Global Aggregate Corporate Index by +90 basis points in March of this year.
The financial sector will increasingly play a major role in promoting sustainability and sustainable management. While the regulatory developments outlined in this article are yet to be fully implemented into law, companies should start preparing now for the inevitably changing landscape.
We set out below some boardroom questions which we hope will challenge current thinking on sustainable finance and prompt your business to better comprehend and prepare for the imminent tide of sustainable regulation: