Megatrends, and particularly climate change, have become key topics on the agenda of corporates, investors and governments. The costs they would incur are greater than the costs of steps that can be taken now to mitigate some of their effects. The fallout from the 2007-2009 financial crisis has caused governments to launch considerable efforts to prevent similar crises from happening in the future and has also imbued European economies and the financial markets with a strong climate change perspective. The key lessons learnt were that the financial markets lacked transparency, long-termism and suitable sustainability metrics, as well as appropriate regulation. These insights, together with the final report of the High-Level Expert Group on Sustainable Finance, formed the basis for the EU Action Plan on Sustainable Finance.
Currently, the EU is working on the concretization of the Action Plan, with the support of the EU Technical Expert Group on Sustainable Finance (EU TEG). This means that selected actions (among the ten suggested actions for sustainable growth) are being transformed into legislative proposals at the EU level and for future national level regulation. The ten actions and the respective legislative proposals include the development of a European taxonomy on sustainable activities, low carbon benchmarks and the development of labels and standards, such as the green bond standard and ecolabels. This means that financial institutions will also need to take sustainability into account in their strategies, in their risk management related to investments and business, as well as in their reporting. Companies of a certain size across all sectors are being guided to report on their approach to climate issues in addition to the more conventional corporate responsibility topics.
On 18 June, the EU shed more light on these when it published its supplement on reporting climate-related information (part of the non-binding reporting guidelines). On the same day, the EU TEG published its reports on taxonomy, the green bond standard and low carbon benchmarks.
Why should one pay attention to these? First, we must recognize that the term “sustainable finance” relates not only to financial sector actors. The EU sustainable finance package has wider implications, in that corporates – especially those listed companies in sectors that play a key role in climate change mitigation and adaptation – will want to know how their investors and financiers see and analyze them; if one cannot manage to convince investors that the company is “investable”, in cases where taxonomy has a role, this can result in a higher cost of capital.
The EU sustainable finance package has wider implications, in that corporates – especially those listed companies in sectors that play a key role in climate change mitigation and adaptation – will want to know how their investors and financiers see and analyze them.
Moreover, although taxonomy is “only” a tool for classifying sustainable activities, its power lies in the related infrastructure. The rest of the forthcoming tools supported by the EU TEG, i.e. the green bond standard, low carbon benchmarks and guidance for climate reporting, will also make use of it.
Until now, the EU TEG taxonomy development has dealt with the following sectors:
These sectors have been selected due to their key role in climate change mitigation and adaptation. Later on, more sectors are likely to be covered. In order to be taxonomy-eligible, an economic activity must contribute substantially to at least one of the six environmental objectives and do no significant harm to the others. In addition, minimum social safeguards should be met.
So the key takeaway for investors (asset owners, asset managers, insurance companies and banks) is that the taxonomy will provide an additional tool for analyzing investment targets. ESG (Environmental, Social and Governance) reporting to clients will also benefit.
For those companies that are covered by the taxonomy sectors, the key takeaways will include understanding the market demand, checking one’s own entity’s position within the taxonomy, making the most of it as a competitive tool, and responding to market needs.
With respect to the debt market, the Green Bond Standard (GBS) also aims to make use of taxonomy. Investors/financiers and companies issuing green bonds will have a motive to study the contents of both reports. Consequently, the GBS will have the potential to upgrade the quality of the bonds from the environmental perspective, as its criteria are clearly stricter than those currently used in the market. What is also new, is the proposal to create market incentives for green bond market growth and to have a centralized accreditation scheme for pre- and post-issuance verification, as well as for impact verification. For the issuers, this is likely to ease the selection of verification products. Why so? The current range on the market is very diverse with verification products ranging from second opinions to assurance. Again, also beneficial for investors/financiers is the more robust quality of their sustainable products.
Consequently, the GBS will have the potential to upgrade the quality of the bonds from the environmental perspective, as its criteria are clearly stricter than those currently used in the market.
Similar benefits can be mentioned in the context of low-carbon benchmarks, which help to better understand how far one’s own investments may contribute to meeting the Paris targets or decarbonization. The Paris-aligned benchmark (EU PAB) is branded for advocates of the +1.5°C scenario, whereas the Climate Transition Benchmark (EU CTB) is branded for investors such as pension funds that need to sufficiently diversify and protect their assets. This may be a great tool for its users – and also for companies that are included in the benchmarks, given that the homework has been done when it comes to climate action and reporting on it.
Finally, what’s new in reporting? If one already reports on corporate sustainability, which translates into “ESG” in investors’ and financiers’ language, a lot has already been done. It is important, however, to review reporting on climate, as much of the stakeholder interest will be focused on that. The guidance and suggested indicators combine the reporting requirements of the Non-Financial Reporting Directive (NFRD) and those of the Task Force on Climate-related Financial Disclosures (TCFD). So there are no new topics to report on, as all are in one package. Have you already quantified how climate change-related financial opportunities and risks will impact your company? And how can your company impact climate change?
Whereas asset managers have the Principles for Responsible Investment, bankers will soon have the Principles for Responsible Banking, which are being developed out of the two frameworks mentioned above.
In the making under the UNEP FI by 28 major banks representing USD $17 trillion in assets, these principles will shape the future of this industry by aligning banking efforts with societal goals, establishing a global benchmark for sustainable banking while increasing transparency and accountability.
So far, six principles have emerged:
The final version of these principles will be available in September 2019.
In the meantime, banks and other institutions can show their support by publicly endorsing them: besides the obvious reputational benefits, such a statement followed by concrete shifts in business practice will ensure that banks are keeping up with the regulatory changes that are most definitely coming. In this way, they can get ahead of compliance and financial risks. As with other areas of regulation, the “wait and see” attitude will not be optimal!