The European Commission (EC) set out its refreshed vision on how to finance the transition to a sustainable economy with the publication of its strategy in July, building on its 2018 Sustainable Finance Action Plan.
In recent years, the Paris Agreement commitments to limit global warming have increasingly become embedded in public and regulatory policy. With the Covid-19 crisis drawing more attention to the link between biodiversity and ecosystem loss and pandemics, and greater focus on the consequences of environmental issues to the global economy, the need to transition to a sustainable economy is becoming a greater priority.
The financial services industry is key to this transition. Given the enormous cost of implementing the Paris Agreement — estimated to be between $3tn and $5tn per year — the sector has an important role to play in channelling the capital needed towards the transition. And as the financial services sector is so heavily regulated, and has a direct impact on both the real economy and consumers, it provides a useful lever for policy-makers looking to create significant change in a relatively short period of time.
Shifting sustainability to the C-suite
The title of the 2018 action plan led some to overlook the fact that it has a broader ambit than just sustainable financial products. Both the original plan and the new strategy are also concerned with firms’ own transition plans.
In the strategy, the EC commits to a proposal on sustainable corporate governance. This could include mandatory due diligence on environmental and human rights issues across value and supply chains (including for financial services firms), changes to remuneration to incentivise achieving sustainability objectives, and clarifications on directors’ duties and board-level expertise in sustainability.
The EC may introduce a new regulation to improve the reliability, comparability and transparency of ESG ratings
While the sustainable corporate governance proposal may still be inchoate, the requirement to consider sustainability strategy is explicit in the proposed new Corporate Sustainability Reporting Directive. Firms within the scope of the directive (which is currently drafted to include companies with securities listed on EU-regulated markets) would have to report their sustainability targets and what progress is made against them.
The commission will also look at publishing guidance on voluntary pledges by financial institutions to adopt strategic science-based climate and environmental targets.
Expanding the taxonomy framework
The taxonomy was the centrepiece for the original 2018 plan, aiming to establish a common classification framework for what ‘sustainable’ means in order to facilitate more sustainable investment. The current regulation focuses on what activities can be classified as environmentally sustainable, essentially setting out what constitutes as green.
This is set to be expanded. The EC will consider options for recognising intermediate activities — such as those that do not significantly impact the environment —as well as reporting on a “significant harm” taxonomy and a social taxonomy. These are not new concepts; the taxonomy regulation requires the commission to report on the possibilities of each by the end of this year. However, the emphasis the strategy places on the intermediate taxonomy suggests this is the most likely to materialise into a new proposal.
Review of ESG in ratings and research
It is important to note that the taxonomy focuses on economic activities, not entities as a whole. While some financial services firms have in-house environmental, social and governance (ESG) ratings capabilities, others will look to these ratings to help assess the sustainability performance of companies.
In the strategy, the EC indicates that it may introduce a new regulation or other measure to improve the reliability, comparability and transparency of ESG ratings, as well as looking at whether the ESG research market requires regulation.
It will also consider further the role that ESG plays in credit ratings — a topic likely to receive increased focus as various regulators and central banks integrate climate and environmental financial risk into their financial stability monitoring and micro supervision.
Labels and standards
The EC will also look at developing further labels and standards for sustainable products, in addition to the proposed EU green bond standard proposal it published the same day. This could include labels for transition bonds and sustainability-linked bonds, an ESG benchmark label and a framework for financial instruments more generally. Whether these will be voluntary remains to be seen.
These may be accompanied by minimum sustainability criteria for financial products that promote environmental or social characteristics and changes to securities disclosure requirements, as well as potential changes to the supervisory framework of regulators to tackle greenwashing.
The strategy is thin on specifics and timings, but it is likely that the EC will want to press ahead and achieve as much as it can before this presidency ends in 2024, with its eye to the EU’s 2030 emissions reductions target. With other major policy-makers likely to seek to make their mark in this area at COP26 this year as well, sustainability is likely to dominate the agenda for some time to come.
Kelly Sporn is senior policy adviser on sustainability regulation at law firm Allen & Overy.
