Sustainable Finance: EU becomes a global leader, but trillions unlikely to shift
Brussels, 8 March 2018 - Finance Watch welcomes the publication of the European Commission’s Action Plan Financing Sustainable Growth. The breadth of issues tackled by the Action Plan undoubtedly makes the EU one of the global leaders in advancing a Sustainable Finance agenda. However, it will fail to deliver on its core objective of “reorienting capital flows towards a more sustainable economy” as it falls short of confronting the key drivers of capital allocation in our financial system.
First and foremost, it avoids the fact that the financialization of our economy over the past three decades, by shifting capital from public to private balance sheets while at the same time deregulating the private sector, has taken away any democratic oversight – let alone sovereignty – over the creation and allocation of credit and capital.
Yet, due to the scale of the challenges, only a direct and effective articulation between such societal objectives (in the form of a robust EU plan to implement Sustainable Development Goals) and the creation and allocation of credit and capital in the financial system (starting with guidelines) leaves us a chance of succeeding.
Benoît Lallemand, Secretary General, said:
“The short-termism of the financial system and the growth of speculative activities over the past three decades have contributed significantly to accelerating environmental degradation, increasing inequalities and weakening social protection standards.
“We should have learned by now what happens when you leave all decisions to markets. Society is left to beg the financial sector to help with the financing of crucial objectives such as the Paris Agreement. The servant has become the master. It is high time we stop shying away from reclaiming democratic sovereignty over finance.”
The European Commission’s Communication on its Action Plan reminds us that “we are increasingly faced with the catastrophic and unpredictable consequences of climate change”, alluding to the fact that our economies are fundamentally unsustainable. But it does not address the root cause of our unsustainable system, i.e. a massive market failure: the negative externalities resulting from economic activity are not priced in.
For fossil fuels alone, the IMF estimates that yearly subsidies (mostly negative externalities not priced in) amount to $ 5 trillion. These subsidies are the reason why the financial sector is not investing in the energy transition. Taxonomies and labels cannot compete with a $ 5 trillion subsidy when it comes to influencing investment decisions. Economic regulation is needed to reorient private capital in the right direction.
Nina Lazic, Research and Advocacy Officer, said:
“The Commission Action Plan is an important step forward and should be delivered with a sense of urgency. Indeed it is only the first step in a transformation of the relationship between finance and the economy. What is needed are adequate public policies which regulate the economic framework in which financial returns are created”.
Failing to remove direct and indirect subsidies to unsustainable activities will also make ineffective the proposals for “mainstreaming sustainability into risk management”. Sustainability risks will only have an impact on investment decisions at scale once they become financial risks.
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The Action Plan lists a number of important actions based on the recently published High-Level Expert Group (HLEG) recommendations:
a) Reorienting capital flows towards a more sustainable economy
1. ESTABLISHING AN EU CLASSIFICATION SYSTEM FOR SUSTAINABLE ACTIVITIES
Establishing an EU taxonomy for sustainable activities, which will give clarity regarding what a sustainable asset is and constitute the basis for most of the initiatives set out in the Action Plan. The EU taxonomy for sustainability should be aligned with the EU investment strategy for a sustainable growth. Positive criteria should be complemented with negative criteria, which would be important for identifying non-sustainable investments as well. If we are to improve market transparency and foster a demand for sustainable assets, a full picture of the market needs to be provided so that investors can make fully informed decisions.
- Point 1 in Finance Watch’s analysis of the HLEG report on Sustainable Finance
- Point 2 in Finance Watch’s blueprint on Sustainable Finance
2. CREATING STANDARDS AND LABELS FOR GREEN FINANCIAL PRODUCTS
Introducing measures aimed at fighting greenwashing, such as establishing EU standards for Green Bonds, are important steps. Two external reviews should be mandatory, one upon issuance and the second for impact monitoring, to ensure that the use of the amount received from bond issuance is consistent with the new EU Green Bond standards.
- Point 5 in Finance Watch’s analysis of the HLEG report on Sustainable Finance
- Question 3 in Finance Watch‘s response to the HLEG questionnaire on sustainable finance
3. FOSTERING INVESTMENT IN SUSTAINABLE PROJECTS
We regret that the European Commission did not follow the HLEG’s recommendation for establishing a Sustainable Infrastructure Europe which would provide strategic advice and expertise and could significantly contribute to supporting the development of sustainable infrastructure projects. In any case, it is important to spur a diversity of financial institutions that finance the transition. Local, long-term lending capacities are missing in certain parts of the EU, they can and should play a significant role in achieving a just and inclusive transition.
- Point 6 in Finance Watch’s analysis of the HLEG report on Sustainable Finance
- Point 4 in Finance Watch’s blueprint on Sustainable Finance
- Question 4 in Finance Watch‘s response to the HLEG questionnaire on sustainable finance
4. INCORPORATING SUSTAINABILITY WHEN PROVIDING FINANCIAL ADVICE
The push from individual depositors and savers is an important driver for the financial system and governments to accelerate the shift to sustainability. They will benefit from better information about and promotion of sustainable finance products.
For investment firms and insurers to take into account sustainability preferences of the clients, we need the highest possible standards for performing suitability assessments to be established in both MIFID II and IDD delegated acts.
- Point 6 in Finance Watch’s blueprint on Sustainable Finance
- Finance Watch response to the ESMA Consultation Paper on suitability requirements guidelines under MiFID II
5. DEVELOPING SUSTAINABILITY BENCHMARKS
The introduction of EU rules on the transparency of benchmarks would be an additional important step in fighting green washing, given that in most of the cases the methodologies applied by index providers in the calculation of ESG benchmarks are not fully transparent. Therefore, any measures that help to improve market transparency and give more confidence to investors is expected to incentivize the demand for sustainable investments.
B) Mainstreaming sustainability into risk management
6. BETTER INTEGRATING SUSTAINABILITY IN RATINGS AND MARKET RESEARCH
Financial institutions including banks should disclose their sustainability exposure and policies, including both risks and opportunities. This non-financial reporting information would then be available to all, including credit rating agencies. They could therefore incorporate the reported exposure into their rating assessment if they deem it appropriate (that is, if the climate exposure is affecting the credit risk on the debt issue in question). This climate exposure reporting requirement will increase awareness at company level and also at investor and stakeholder level, hopefully triggering widespread climate risk mitigation action.
7. CLARIFYING INSTITUTIONAL INVESTORS’ AND ASSET MANAGERS’ DUTIES
Any legal clarification should guarantee that it is the investor’s responsibility to not only consider ESG factors for the purpose of risk adjusted return maximisation, but also to integrate the non-financial preferences of their clients in their investment decisions. The stewardship of investments should be also a fundamental part of the legal duties. Thus, the investors should actively engage with investee companies to make sure that they take into account ESG factors.
- Point 2 in Finance Watch’s analysis of the HLEG report on Sustainable Finance
- Finance Watch’s Consultation response on institutional investors and asset managers' duties regarding sustainability
8. INCORPORATING SUSTAINABILITY IN PRUDENTIAL REQUIREMENTS
The financial system’s instability is a key obstacle to the long term investments that the shift to sustainability requires. Structural reform and an ambitious and binding cap on leverage would reduce bank shareholders’ appetite for speculative risk, directing them towards other operations such as long term lending to the real economy.
The green supporting factor idea puts two legitimate public interest objectives – greener finance and safer banks – in opposition. There are better ways to promote green finance that do not weaken banks. One is to raise risk weights for brown assets, which would strengthen banks and discourage lending for fossil fuel activities. For society, if not for banks, a brown penalising factor is a win-win outcome.
In addition to a brown penalising factor, the Commission could investigate ceilings or quotas on brown credit, carbon taxes, liquidity support and guarantees for green loans, and subsidies to green economy borrowers, among others.
- Point 3 in Finance Watch’s blueprint on Sustainable Finance
- Finance Watch article “A green supporting factor would weaken banks and do little for the environment”
C) Fostering transparency and long-termism
9. STRENGTHENING SUSTAINABILITY DISCLOSURE AND ACCOUNTING RULE-MAKING
The recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) should be endorsed by the EU and made mandatory which is not the case in the proposed Action Plan. Taxonomies and methodologies for reporting should be standardised to allow comparisons and aggregations of reported information. This would give regulators and market supervisors a better view on global market trends, and therefore a better capacity to take corrective action if necessary.
10. FOSTERING SUSTAINABLE CORPORATE GOVERNANCE AND ATTENUATING SHORT-TERMISM IN CAPITAL MARKETS
The Commission’s ambition to align the corporate culture of financial institutions with sustainability and broader society’s interests is very welcome. However, on top of the proposed actions, we recommend that European Supervisory Authorities (ESAs) guidance documents are used to introduce key performance indicators assessing the level to which corporate governance of financial institutions is aligned with sustainability.