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New EU sustainable finance paradigm

The new EU sustainable finance paradigm

Almost a decade on from the global financial crisis, the European Commission last March showed its resolve to become a global sustainable finance leader by unveiling its Action Plan: Financing Sustainable Growth. The plan anticipates concrete action and proposes major regulatory changes to enable the transition to a low carbon economy and the maintenance of a stable financial system.

Although the roadmap has ramifications for the whole investment chain, it is asset managers that are pivotal here, investing clients capital and providing equity and debt financing, while wielding enormous influence over corporate governance and business practice. Those with highly-developed sustainable investment processes and an offering that resonates with the preferences of responsible asset owners will likely gain competitive advantage over their peers.

The European Commission's Action Plan aims to1:

  1. Reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth;
  2. Manage financial risks stemming from climate change, resource depletion, environmental degradation and social issues; and
  3. Foster transparency and long-termism in financial and economic activity

The EU addresses asset managers in several ways. Notably, as an essential step in the efforts to channel investments into sustainable activities, it proposes the establishment of a taxonomy for sustainable investments and products, which would gradually create a unified classification system. Furthermore, regulation will likely introduce disclosure obligations on how both asset managers and institutional investors integrate environmental, social and governance (ESG) factors into their risk processes.

KPMG professionals have several key recommendations for clients that want to prepare for the EU's forthcoming regulatory changes, and gain advantage in the new sustainable finance paradigm.

Firstly, to get ahead of the curve, asset managers must analyze current and future ESG expectations of institutional investors and ask how likely regulatory developments may shape the markets. It is time to review business strategy in order to ensure that ESG is integrated in vision, business strategy and strategic targets.

Secondly, it is important to be realistic about expectations; making an informed decision on the level of ambition so that both direction and targets are clear. It is important to understand your current state in terms of insight, capacity and mindset on ESG, so that the gap between the current and targeted states is clearer.

Finally, define governance of responsible investment, define the principles and policies you need and integrate ESG in all key business processes so that theory becomes practice across asset classes, mandates and value chain.

The move to a sustainable financial system in Europe is all part of a bigger, global trend and smart Europe-based asset managers who invest or manage assets responsibly may find ample opportunities in other regions of the world. For example, Chinese asset managers are rapidly signing up to the UN Principles for Responsible Investment (UN-PRI) and a group of banks from all continents are cooperating on building up principles for responsible banking.

Sitting at the very top of the investment eco-system, yet having a symbiotic relationship with asset managers, asset owners should also integrate ESG into their investment policies, governance and processes. They must be prepared to disclose how they manage ESG risk and consider the ESG expectations of their beneficiaries. Importantly, they should look into measuring the impact of their investment activities on the return-risk ratio and on society.

Impact investing - investing in companies, organizations, and funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return - is becoming increasingly important for both asset owners and asset managers. Credible measurement and reporting of impacts needs good frameworks, good data and skilled people. Funds focusing on the Sustainable Development Goals or thematic investments are examples. There is also interest in measuring how funds and investment portfolios reduce negative externalities.

Linked to this is the interest in quantifying the financial impact of ESG. For instance, how does responsible investment impact return-risk ratio? Academic research and meta-studies show that responsible investment, at the least, does not impair return-risk ratio; indeed, several studies actually show that considering ESG has a positive effect on return-risk ratio.

Sustainable investment finance is here to stay. That is good news for the stability of the financial system and a sustainable future for people and planet. It is also good news for those asset managers and institutional investors who have already started their journey of responsible investment, since they will enjoy competitive advantage over their less prepared peers.

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