The traditional purpose of investment is the generation of good financial returns and investment into sustainable projects and economics activities is no exception. However, sustainability has been often regarded as a “nice to have” variable when it comes to investment decision-making and in some cases one that may bring diminished returns, compared with more short-termistic investment decisions. The reasons for this assessment are numerous but there are two in particular that merit further discussion: on the one hand, risks related to climate change, environmental degradation and social factors have not traditionally been taken into account by economic actors, as they are likely to only materialise over the long-term. On the other hand, the discourse that has been informing economic and financial decision-making, particularly in the years before the 2008 global financial crisis, in many cases focused purely on short-term returns. Particularly the latter is inherently at odds with sustainability, the integration of which would require taking a longer-term view of risks and returns.
For these reasons, Environmental, Social and Governance (ESG) considerations were in the past rather limited to actions and policies as part of Corporate Social Responsibility (CSR) departments in companies and financial institutions. However, investors are increasingly starting to take into account impacts of investments that go beyond shorter-term financial returns, such as when seeking to contribute to healthy communities and a cleaner environment, while aiming to deliver a competitive rate of
Sustainable finance indeed makes sense from a business perspective. For instance, investments in low-carbon energy sources should generate gradually higher returns given an increasing demand for energy and a decrease of oil reserves (Business case for sustainable finance, page 93). Unsustainable conduct on the other hand can be costly. Harmful effects of investments on the environment can result in expensive compensation claims and reputation costs (Handbook on Sustainable Finance Chapter 7, 2018 ; Business case for sustainable finance, chapter 3). Adverse working conditions can lead to higher production costs resulting from injuries at the workplace and strikes (Business case for sustainable finance). Sustainable investments could therefore generate more long-term value for investors in terms of both profits and stock value. A focus on sustainable value creation rather than (short-term) shareholder wealth maximization could allow for the incorporation of all relevant costs and benefits of projects, including their social and environmental
Action Plan on financing sustainable growth
The Commission recognised this when it adopted its Action Plan on Financing Sustainable Growth on 8 March
Key measures include:
– establishing a classification system (“taxonomy”) to build a common understanding of which economic activities can be considered as environmentally sustainable;
– developing quality standards and labels for sustainable financial products which would help develop markets for these products and avoid “green-washing”;
– clarifying asset managers’ and institutional investors’ duties regarding sustainability and improving disclosures towards end-investors;
– incorporating sustainability factors in prudential requirements, if justifiable from a risk perspective, in order to promote investments in sustainable assets while safeguarding financial stability;
– and strengthening companies' transparency on climate-related risks through improved company reporting.
May Package of Sustainable Finance legislative proposals
In the follow-up to its publication, the Commission took important steps to implement the Action Plan in May 2018, notably by proposing four legislative measures. They include:
– a framework for an EU taxonomy for environmentally sustainable activities to facilitate sustainable investments;
– disclosure requirements for institutional investors and asset managers on how they incorporate adverse impacts of investment decisions on sustainability and on how they integrate sustainability risks, such as the effects of natural disasters on the value of investments, in their decision-making process. In addition, market actors who offer financial products that pursue the objective of sustainable investment are required to explain how these objectives are achieved;
– a new category of low-carbon benchmarks, with minimum standards in terms of transparency and the calculation of their carbon footprint, both for Paris-aligned and Climate Transition
– the specification of how ESG considerations and preferences should be integrated in portfolio management and investment advice provided by investment firms and insurance
Up until now, the European co-legislators and the Commission have reached political agreements on low-carbon benchmarks and sustainability-related disclosures of investors. The Commission's proposal on a legal framework for an EU taxonomy is still under discussion by the
EU Taxonomy
From the Commission's perspective, and echoed by Member States and investors, the proposal to establish an EU taxonomy, which stipulates which economic activities are environmentally sustainable, is regarded as the centrepiece for the development of sustainable finance. Such a commonly-used classification system would allow identifying activities that contribute substantially to environmental sustainability and could be the reference point when developing green financial products or green labels.
Furthermore, an EU taxonomy could be used to underpin financial institutions' and companies' disclosure and reporting obligations on climate and environmental activities and risks, and help companies raise private capital to finance their environmentally sustainable (“green”) activities. The EU Taxonomy under development focuses on six environmental
To develop the EU taxonomy, the Commission is drawing on the knowledge of technical experts from a variety of industries and sectors as well as academia and civil society organisations. In June 2018, the Commission set up a dedicated Technical Expert Group (TEG) on sustainable finance for this purpose. The TEG is tasked to deliver by June 2019 a first list of economic activities contributing substantially to climate change mitigation and adaptation objectives (while not significantly harming any of the other environmental objectives). The Commission will consider this technical advice when preparing its delegated acts on the EU taxonomy to be adopted, pending the empowerment from European co-legislators, European Parliament and Council.
The TEG is also helping the Commission to develop other actions of the Action Plan, such as for instance an EU Green Bond
Future of Sustainable Finance
One would hope that in the future every aspect of finance is sustainable. Until then, it is necessary to continue building out different elements within the sustainable finance framework to their full maturity. This could include the further mainstreaming of sustainability risk management in the banking and insurance sectors, as well as continuing to improve data provision around sustainability, such as through company disclosure and sustainability ratings.
In order to access the full potential that financial markets can offer, it will also be necessary to scale up sustainable finance globally. Many jurisdictions around the world have started developing sustainable finance tools to mobilise their financial sectors. This is why the Commission has started engaging with key partners and other jurisdictions to establish a forum of discussion that could contribute to the coordination of national and regional financial services initiatives, embedding sustainability in the financial sector
While the exact contours of these next steps will certainly be affected by the political and economic climate in Europe and beyond, it is clear that sustainability must become a key variable in economic and financial decision-making, in order to deliver long-term value as part of a financial system that fully appreciates environmental and human capital.
