There has never been a more ambitious and comprehensive package of measures in the area of sustainable finance than what we find in the European Action Plan, argues Helena Viñes Fiestas, deputy Head of Sustainability and member of the European Commission’s Technical Expert Group on Sustainable Finance. The unprecedented roadmap, published in March 2018 by the European Commission, puts forth 10 specific action points intended to make European financial markets more sustainable and climate-resilient.
The European Action Plan has three distinct aspects: its scope, its goals and its governance. The strategy covers all key players along the financial value chain, and compels each to integrate sustainability in their activities. The package goes beyond aiming to make the system more transparent, better governed, less short-term oriented and more sustainable. It plants the seeds to harvest significant private sector capital towards achieving global emissions reductions goals.
A final noteworthy point is that the Action Plan is a key element of the Capital Markets Union to be rolled out during 2019 and 2020. The Directorate-General (DG) for Financial Stability, Financial Services and Capital Markets Union (DG FISMA) – the equivalent of the Treasury – leads the work, in collaboration with the DG Environment and DG Climate. Sustainability has made it into mainstream financial regulation and strategy.
The European roadmap towards sustainable financing has three formal objectives.
Objective 1: Reorient capital flows towards more sustainable technologies and businesses
Europe has set itself ambitious targets on climate change for 2030 to fulfil its commitments under the Paris Climate Agreement. Indeed, if negotiations during 2019 are successful, it is expected that the EU will work towards being carbon neutral by 2050. To meet its targets, the EU needs EUR 180 billion per year of additional investment, which cannot be achieved without the active participation of the financial sector. This is why it is important not only to ensure that mainstream investments minimise their environmental impact and integrate climate-related risks, but that they also re-allocate capital towards ‘green’ investments.
Given the divergences between and within countries, financial institutions and industrial players as to what ‘green’ investments really are, re-orientating capital towards such a currently blurred goal would be difficult. This is why the first step is to develop a common language and understanding of what activities are truly environmentally sustainable. The EU taxonomy or classification system will be science-based and built as much as possible on existing standards, market practices and regulations.
The taxonomy will provide a list of economic activities that are considered environmentally sustainable. It will establish the base for the development of EU standards and labels for green financial products (action point 2 of the plan), for sustainability benchmarks (action point 5) and for the selection of projects, particularly in infrastructure, for which the Commission will prioritise funding (action point 3).
Companies selling financial products marketed as ‘green’ or sustainable will have to report how they relate to the taxonomy. For a classic ‘green’ equity fund this will translate into the percentage of the fund that is invested in taxonomy-compliant activities.
By the end of 2019 we will have a climate taxonomy that will then be extended to cover other environmental objectives. And although the legal text does not commit the EU to a social taxonomy, the expectation is that, once the green classification has been completed, the development of a social classification will start, most likely in January 2021.
Objective 2: Mainstreaming sustainability into risk management
The imminent legislative proposal for a regulation on disclosures relating to sustainable investments and sustainability risks and amending Directive (EU) 2016/2341 aims to clarify institutional investors’ and asset managers’ fiduciaries duties. The law will explicitly require institutional investors and asset managers to integrate sustainability factors in their investment decision-making process and increase transparency on how they incorporate them, in particular their exposure to sustainability risks (action point 7 of the plan).
This will also apply to credit rating agencies and research providers. The Commission will examine the merits of amending the Credit Rating Agency Regulation to explicitly mandate the integration of ESG factors into agencies’ assessments (action point 6). It will also explore the feasibility of including risks associated with climate-related factors in institutions’ risk management policies, and the potential calibration of banks’ capital requirements as part of the Capital Requirement Regulation and Directive (action point 8).
Financial advisors will be similarly affected. The Markets in Financial Instruments Directive (MiFID II) and the Insurance Distribution Directive (IDD) will be amended to include sustainability preferences in the suitability assessment as part of the obligation of investment firms and insurance distributors to offer ‘suitable’ products to meet their clients’ needs (action point 4). Systematically asking clients about their sustainability preferences could be a real game-changer. It will certainly require financial advisors and intermediaries to be educated on sustainability and Environmental, Social and Governance (ESG) products. Yet it could boost the retail market in future years, not least because by 2025, millennials will form 75% of the labour force and a sizeable majority regard sustainability as a key consideration when investing.
Objective 3: Foster transparency and long-termism in financial and economic activity
The Commission will set clear requirements for significantly improving transparency and strengthening accounting rule-making across the financial value chain, as well as improving corporate disclosure regarding climate-related and other ESG factors.
However, the key question is how much capital can be re-orientated towards a more sustainable economy when negative externalities are priced in to little or no extent and short-termism remains the modus operandi of many financial players.
As part of our sustainable investment philosophy at BNP Paribas Asset Management, we recognise that sustainability is imperfectly understood, under-researched and mispriced. And while we are convinced that ESG integration helps us achieve better risk-adjusted returns, the lack of common standards and data creates multiple market inefficiencies and makes the task more difficult. This is why we are investing significantly in understanding, researching and measuring ESG risks and opportunities.
The European Action Plan aims to foster sustainable corporate governance and, very importantly, reduce short-termism in capital markets (action 10 of the plan). Its approach will likely include reviewing issues such as asset managers’ portfolio turnover and equity holding periods, and could also require corporate boards to develop and disclose a sustainability strategy, including appropriate due diligence throughout the supply chain, and measurable sustainability targets.
Adequate pricing of sustainability factors is an arduous task and a long-term objective that is not within the scope of the current Action Plan, but will be pursued within other policies and initiatives e.g. carbon markets and carbon taxes. The Commission acknowledges the need for these measures to be complemented by further concrete actions in other areas.
The Action Plan sets a precedent for sustainable finance reforms globally, firmly establishing Europe as the global leader. Its intention is to make the financial system a catalyst for the transition to a low-carbon, climate-resilient and circular economy; while making it much more transparent, and environmentally and socially conscious. We applaud those aims, and are pleased to be able to contribute to the work at hand.
LEGISLATIVE PROCESS AND TIMELINE
The European Commission presented the three legislative proposals related to the European Action Plan that it has so far developed:
- on the establishment of a framework to facilitate sustainable investment (‘taxonomy’)
- on disclosures relating to sustainable investments and sustainable risks: the text proposes to integrate of ESG factors in investment and advisory processes (‘disclosure’)
- on amending benchmark regulation. The proposed amendment will create a new category of benchmarks comprising low carbon and positive carbon impact benchmarks (‘benchmarks’).
Next steps before 18 April
‘Disclosure’ and ‘benchmarks’ are in the final phase before approval by the three decision-making EU bodies: the European Parliament, the Council of the European Union (representing the member states), and the European Commission.
‘Disclosure’ faces differences between the parliament and the council over its scope – the products whose ESG factors must be disclosed to investors – and over the definition of sustainability risk (financial risk only, or financial risk plus the risks to the environment and society).
At the time of writing, and taking into consideration how the negotiations are going, it seems reasonable to expect that the ‘benchmarks’ regulation will be the first to be approved. Next is ‘disclosure’, even if this will require concessions from the parliament and the council.
The text faces serious difficulties. Few believe that an agreement can be reached before 18 April, when the last session of the outgoing parliament will be held. It looks likely that this proposal will be debated by the next parliament and commission.
 The author is a member of the European Commission’s Technical Expert Group on sustainable finance (TEG), which was set up to assist the EC in developing an EU classification system – the ‘taxonomy’ – to determine whether an economic activity is environmentally sustainable; an EU Green Bond Standard; benchmarks for low-carbon investment strategies; and guidance to improve corporate disclosure of climate-related information. Regular updates of the work of the TEG can be found at https://ec.europa.eu/info/publications/sustainable-finance-technical-expert-group_en
 According to a recent Morgan Stanley survey, 84% of millennials cite investing with a focus on ESG impact as a central goal, Sustainable Signals: The Individual Investor Perspective,” Morgan Stanley