Issue #6
EU Sustainable Finance Regulation Framework
Back from a hot summer and MIFID II ESG amendments have come into effect. And it gets me thinking: Are individual ESG preferences what we need? And how fickle might they be?
But before losing myself in conjectures, maybe this is a good time to write a quick overview of EU Sustainable Finance regulations and put them into context. Indeed, I have mentioned the need for these regulations since my first letter and even if I often point out their limits and why we should strive to do better in our practices, they are setting a welcome minimum by making disclosures and practices mandatory.
Context
The EU Sustainable Finance regulations are part of a larger plan: the European Green Deal. The goal is to decouple economic growth from the use of resources and reach net-zero emissions by 2050. The first step is to reduce greenhouse gas emissions by 55% by 2030 (vs 1990). Considering the fact that economic growth has always involved burning more energy, the size of the European Union and the ongoing war in Ukraine, this goal is extremely ambitious! It requires aligning actions in many areas: industry, transport, agriculture, environment, energy, etc.
In this context, the Sustainable Finance Action Plan was presented in 2018, with three main objectives: 1) Reorienting capital flows towards a more sustainable economy, 2) Mainstreaming sustainability into risk management and 3) Fostering transparency and long-termism. We could detail the ten actions according to these objectives, but I would only be paraphrasing the European Commission’s publication.
Instead, I prefer to categorise these actions and related regulations as 1) those fostering awareness and 2) those fostering alignment.
Awareness
A major part of the plan requires nudging us, individuals and the institutions we represent, to change our decision making processes. For that, the weapon of choice is information. The idea is that once a decision maker knows something, that knowledge will be taken into account in the decision process.
So the first action mentioned in the plan and one of its main pillars is the establishment of a classification system for sustainable activities: the EU Taxonomy.
Activities are evaluated with six objectives: climate change adaptation, climate change mitigation, biodiversity, circular economy, pollution and water and marine resources. For example, an activity could be the rehabilitation and restoration of forests for which a series of technical screening criteria is defined, like the period used for the climate benefit analysis: 30 years. In addition, the activity should comply with minimum social safeguards and do no significant harm (DNSH) and, here again, a series of criteria is defined, like the controlled use of pesticides to prevent pollution in our forest rehabilitation example.
As of today, a small half of economic activities are covered, but they represent over 80% of greenhouse gas emissions. And only the first two objectives have been published: climate change adaptation and mitigation. With other activities to be added, the next four environmental objectives and a social taxonomy to come, this is work in progress. Already, nuclear and gas have been temporarily added with a lot of noise and complaints. But as I have mentioned in a previous letter, my view is that we need politicians onboard even if that requires some adjustments.
As for the interpretation of the Taxonomy, it is important to distinguish between eligibility and alignment. The first only means that an activity is covered by the regulation; the second that the activity is aligned with the technical criteria, and that emissions are below a given threshold. Companies will need to publish alignment in terms of revenues, capital expenditure and operational expenditure. This can help understand who is moving in the right direction as revenues of a company may not yet reflect sustainable activities while capital expenditure could indicate a brighter future; for example, that could be the case of an oil company investing in green energy.
Let’s mention that, from a practical point of view, implementing the EU Taxonomy can be very complex, especially for large players with legacy systems. Not only does the data need to be produced and collected efficiently, but it is classified by activities and not by companies and sectors as most financial systems are today… However, these profound changes are also a great opportunity to overhaul corporate strategies and make investment and IT processes more efficient.
These are exciting challenges for which data is key! Data that can be turned into information and become knowledge.
Which leads us to the main producers of that data: corporates, and to the second brick in our regulatory framework: the Corporate Sustainability Reporting Directive, or CSRD. This was published last year to replace and expand upon the Non-Financial Reporting Directive (NFRD) which came into force in 2014. The change in name clarifies the purpose: “non-financial” means “sustainability”.
Obviously, there is more than just a new name. The CSRD will apply to many more companies, approximatively 50 000 (from around 12 000 previously), as the thresholds have been lowered. All listed companies and private entities fulfilling two of the three following criteria must comply: 1) total assets of 20 M€ or more, 2) net revenues of 40 M€ or more and 3) 250 employees or more.
Also, audit becomes mandatory and the content of the required reporting is expanded: it will need to comply with the European Sustainability Reporting Standards (ESRS) being developed by the European Financial Reporting Advisory Group (EFRAG). Logically, it will include Taxonomy alignment and data needed by the financial sector to comply with the Sustainable Finance Disclosure Regulation, or SFDR.
To close our informational / awareness loop, the financial sector is required to comply with SFDR and its disclosure templates. In a nutshell, the EU Taxonomy and CSRD enable financial institutions to comply with SFDR, thus increase transparency and, hopefully, reorient capital flows towards a more sustainable economy. And as risk managers will use this newly available data, in an ideal world, all these sustainability disclosures would suffice to reach the three goals of the Sustainable Finance Action Plan already mentioned.
Alignment
But an ideal world only exists in theory. Our world is one of realities where incentives are often needed to motivate the desired outcomes.
The Benchmark Regulation sets rules to ensure the accuracy and integrity of financial benchmarks, or indices. As many low-carbon benchmarks were popping up with various degrees of climate ambitions, this regulation was amended in 2019 to introduce two “Climate Benchmarks”: the EU Climate Transition Benchmark and the EU Paris-Aligned Benchmark. Two may still be one too many… but one must recognise that not everybody can have the same level of ambition. Without entering into the details of how these benchmarks are constructed, the first brings the resulting benchmark portfolio on a decarbonisation trajectory whereas the second is much more stringent, with resulting benchmark portfolio’s carbon emissions in line with the Paris Climate Agreement target to limit the global temperature rise to 1.5C° compared to pre-industrial levels.
These Climate Benchmarks should make it easy for investors to compare the alignment of their portfolios with global warming scenarios.
Similarly, the EU Green Bond Standard aims at making bonds easier to assess and compare. As a voluntary standard, it is similar to a label “proving” that the proceeds of the bond are allocated by the issuer in alignment with the EU Taxonomy, i.e. they are contributing to one or more of the environmental objectives, doing no significant harm, etc. In addition, full transparency and disclosures are required as well as an external review. In theory, issuers will make up for these added costs as the framework should facilitate green bond issuances.
Aside from the corporates and financial institutions, we also have end-investors. MIFID II was design to reinforce their protection (and increase market efficiency) with one key element being that banks and asset managers need to ask their customers about their financial objectives.
Since earlier this month they also have to question their customers sustainability preferences! And then check the adequacy of their product offering…
This could be a big change and I suspect few institutions are ready as it means both an evolution of marketing with new customer segmentations and a serious update of financial product offerings with a clear integration of sustainability objectives and the necessary governance. It is no surprise that legal departments look like they are taking over product development.
Fickle preferences?
Back to my initial, more philosophical question: is aligning financial product offering to individual ESG preferences enough? i.e. do these preferences represent what the world needs in terms of sustainability? And will these preferences be stable enough to integrate them into structurally sound investment policies? Obviously, only time will tell.
But I hypothesise that individual preferences will not automatically lead to a sustainable world. Usually, individuals want more: more power, more ego, more pleasure, more holidays, more friends, more things… you get the idea. A sustainable world is one of drastic limitations where we consume much less and work much more (to replace energy hungry machines). Not a very good selling proposition!
On stability, I worry about our limited knowledge and psychology. How many of us would have imbedded the risk of a pandemic in our ESG preferences in 2019? How many of us will think global warming and droughts are the main problem today, after all the summer heat waves we went through? And in six months, how will we answer the questionnaires when insufficient food supplies start to hurt?
Here, devil will really be in the details and I am curious to see how ESG questionnaires evolve in the coming months and years.
Should we dive further?
This overview of the Sustainable Finance Regulation Framework is obviously far from being exhaustive. I did not cover financial institutions prudential rules like the Green Asset Ratio (also dependent on the EU Taxonomy). I did not cover the coordination with international initiatives, nor reporting standards, nor European national legislations that may go further in their requirements, like the “article 29 de la loi énergie-climat” in France. I did not cover the way these regulations are evaluated and updated. I did not cover the European Green Deal Investment Plan or the InvestEU Programme. And, just for the fun, we could dive much deeper into the psychology and design of “nudges”…
However, this letter is still meant to stimulate a conversation. Please share your comments, ideas or questions!
As usual, this letter, originally published on LinkedIn, is meant to open a discussion: join it here.
Lenny Kessler