Building on the 2018 Sustainable Finance Action Plan (SFAP), a renewed sustainable finance strategy is in the making and will provide a roadmap to increase capital flows towards sustainable investment, support actions set out in the European Green Deal and to manage and integrate climate and environmental risks into the financial system. Ahead of the publication, we review the three objectives we see implications for financial institutions from a regulatory point of view.
The objective of the renewed strategy is not fundamentally different from the 2018 SFAP which consisted of ten actions resulting into a far-reaching and expanding regulatory wave. The 2018 SFAP was about establishing the basic conditions 1) to reorient capital flows to a more sustainable economy, 2) mainstream sustainability in risk management and 3) foster transparency. Much has been achieved in last three years. With the upcoming renewed strategy, it may be good to pause for a moment.
Linked to aforementioned three objectives, ten broad actions were defined. Most but not all of these actions require either new regulation or amendments to existing regulations, which needs to be done in a coherent and consistent manner. For instance, several regulations come with disclosure requirements (Taxonomy Regulation, SFDR, ITS on Pillar 3 disclosures, NFRD) which require alignment in terms of both content and timelines for implementation.
The ten actions fulfill in a set of basic conditions to answer for example: what is sustainable? (Taxonomy), which financial products meet this definition of sustainable? (green bond, labels) and how sustainable are companies? (disclosure requirements). In fact, as it is a prerequisite for financial institutions to have relevant ESG related information on corporates, sovereigns and properties to make investment decisions, most effort has been put into establishing a classification system for sustainable activities and disclosure requirements. In addition, by compelling banks and investors to assess and manage ESG-related risks which can have a financial impact, regulators believe they will not be blindsided by for example stranded assets locking-in capital.
As seen in the figure, with most Level 1 Regulation covering different frameworks to fulfill those basic conditions is in place, we move increasingly into the territory of a multitude of Level 2 Regulation covering detailed technical criteria. This leaves us still various fundamental questions to answer. One recent example is whether or not to classify nuclear energy as sustainable (meaning it supports climate change mitigation/adaptation efforts).
The European Commission is about to renew its sustainable finance strategy and as such the SFAP. As basic conditions are being satisfied policymakers are eager to ensure funds are mobilized towards a more sustainable economy. This requires an update to the 2018 SFAP. Responses to the consultation on the renewed strategy have been overall supportive. The consultation indicates there will be focus on three domains.
First, there needs to be a strengthening the foundations for sustainable investment by creating an enabling framework, with appropriate tools and structures. This includes among others disclosures (e.g. NFRD / CSRD), accounting standards, sustainability ratings and labels for green products (e.g. Green bonds). It very much builds on the actions from the 2018 SFAP. In general, there is a call by market participants to regulators to provide uniform definitions, standards and remedy any accounting issues.
It could imply a wait-and-see attitude by the industry. We have seen various private and public-private initiatives to develop standards covering definitions and methodologies, which in itself help to increase our common understanding of sustainable finance. Yet the time has come to converge to one set of standards, which the industry can use to intensify their efforts to reorient capital flows. Latter needs to be market-driven as suggested by the limited support for the government to have a role in developing sustainable-finance oriented exchanges.
Second, climate and environmental risks will need to be fully managed and integrated into financial institutions and the financial system as a whole. Essentially meaning that reducing the exposure to such risks will contribute to 'greening finance'. The initial objective to mainstream sustainability in risk management is evolving. The industry has mixed views on the direction to be taken by regulators. The main discussion points relate to taxonomies, pace of integration and integration of ESG criteria in credit ratings.
Third, there needs to be increasing opportunities to make a positive impact on sustainability for citizens, financial institutions and corporates. This includes among others mobilisation of retail investors, green securitisation, incentive structures and measuring impact. Education is key: financial advisors need to educate retail investors. Barriers to cross-border intra-EU investments need to be removed.
An overarching item appears to be data. There is strong support by market participants to develop a public environmental data space to overcome information asymmetries. Investors and banks tend to be very critical on availability, quality, reliability and comparability of ESG data (e.g. climate related loss and physical risk data) and ratings. Such data is a prerequisite for sound investment and lending decisions and risk management. Not surprisingly, the industry supports EU action in this area – the debate is mostly on the design of such data space.
Sustainable investments need to grow substantially to annually EUR 260 billion by 2030, which explains the strong need for standardisation in definitions, etc. and availability of useful ESG data. Parts of the financial industry is already planning how to integrate ESG considerations into their strategy and risk management. In fact, all European banks under direct ECB supervision are finalising their action plans to meet ECB supervisory expectations. There is not much time to wait until regulation has fully crystallised and all data you would like to have is available. Not if you have committed yourself as an institution to contribute towards the 2030 climate goals from the EU Green Deal.
Industry and regulators should look for ways to accelerate the process and prioritise along the way those (regulatory) initiatives essential for the time-critical climate goals. Strong cooperation among investors, banks, regulators, data providers and rating agencies is needed in order to achieve such acceleration.