Sustainable Finance: Converging Responsible Finance, ESG, Ethical Finance and Green Finance to deliver real impact.
As published by the Responsible Finance and Investment Foundation (RFI) on 10th July 2018: Climate change and sustainability are not terms commonly associated with financial services. That is set to change following the release of the EU High Level Expert Group (HLEG) report on Sustainable Finance.
The report, published in January, and the subsequent action plan on ‘Financing Sustainable Growth’, issued in March, demonstrate the huge opportunity for convergence of the ESG, SRI, Green Finance and Ethical Finance sectors under the new umbrella of ‘Sustainable Finance’.
The HLEG Action Plan also provides an opportunity for Ireland to lead the way in making a critical impact in areas such as climate change, achievement of the United Nations’ Sustainable Development Goals (SDGs), and especially in developing a sustainable and responsible financial system.
The HLEG was established by the European Commission under the umbrella of its Capital Markets Union (CMU) programme to provide recommendations on how to better integrate sustainability in the EU’s financial policy framework, protect the stability of the financial system and mobilise capital from private resources to finance sustainable investments.
The report is to become a focal point for financial services and investment policy in the EU as part of a master plan to adopt and embed green and sustainable principles across all aspects of its activities and legislative functions. But why is this necessary, and why now?
- CO2 emissions must be reduced by 40% by 2030 in order to meet Paris Agreement climate change goals.
- The UN 2030 Agenda signed by 193 countries globally set 17 sustainable development goals (SDGs) to be achieved by 2030.
- EU targets on energy and climate policy require €11.2 trillion of investment between 2021 and 2030, creating a massive annual investment gap of €180 billion.
- Ireland alone faces fines of between €3 billion and €6 billion between 2020 and 2030 for non-compliance with Paris targets.
It has now been recognised that these critical objectives can only be met by:
- mobilising private finance,
- encouraging energy-efficient investment,
- moving away from short-term investment objectives through regulation,
- improving corporate and financial disclosure,
- recognising climate and other environmental risks by companies, and
- implementing systemic change in the way the financial services industry and EU operate and legislate.
The Paris Climate Agreement, sets out a commitment to align financial flows with a pathway towards low carbon and climate resilient development. Signed by 195 countries in 2015, the first ever universal, global climate deal to stem climate change and limit global warming to below 2O C.
The UN 2030 Agenda, is a framework of 17 sustainable development goals (SDG’s) to prepare for a sustainable future re-targeting poverty, hunger, health, education, climate change, energy, gender equality, water, sanitation, environment and social justice
A recent report surveyed 59 global banks in 2017 and found that whilst encouraging progress had been made since an earlier report in 2015 to align with the Paris Agreement, that still not enough was being done by banks. Although a number of banks in Europe have made commitments to support TCFD implementation of recommendations in their upcoming annual reports for shareholders to monitor and assess compliance and steps being taken. The report found many European banks still have exposures to climate related liabilities and risks, exposures to fossil fuels (RBS recently announced restrictions to its’ lending policies for companies involved in coal and project specific finance in mining, power and oil & gas sectors)
The G20 Task Force on Climate-related Financial Disclosures (TCFD) agreed a global framework in 2012 for financial institutions to report climate related risks for each country to progress their roadmap for green/sustainable finance.
What are the proposals and what sectors are covered?
The EU proposal for regulation published on 24 May, 2018, focusses initially on three strands:
a) Standards, establishing a common language (taxonomy) and green labels (sustainability standards);
b) Disclosures, by asset managers and institutional investors taking account of sustainability in the investment process, and by insurance companies and investment firms advising clients on sustainability. This will include amendments to the MiFID II and Insurance Distribution Directive requiring ESG considerations to be included in advice offered by investment firms;
c) Reporting, by incorporating sustainability in prudential requirements for banks and insurance companies, recalibrating capital requirements for sustainable investments (provided they are justified from a risk perspective, e.g. green mortgages), and in corporate reporting by revising guidelines on non-financial information to align with the TCFD.
The Action Plan will provide further impetus and momentum to the ESG, SRI and Ethical Finance sectors, which were already becoming mainstream. The required capital to close the investment gap offers a huge opportunity to ‘scale’ these sectors and deliver a ‘new normal’ when it comes to financing investment, projects and lending.
Green Finance is the financing of investments that provide environmental benefits in the context of environmentally sustainable development or more broadly any financial instrument which results in a positive change for the environment and society over the long term.
The Green Bond market doubled in both 2016 and 2017, reaching $81 billion and $155 billion, respectively. In addition to green bonds, green finance can take the form of climate bonds; investment in climate change projects such as renewable energy, infrastructure projects, and energy-efficiency projects; and ‘green loans’. The sector has potential to deliver huge growth and impact as demonstrated by the investment gap and the challenges of climate control.
Green Finance is one of the key targets of the Irish government’s IFS 2020 strategy to establish Ireland as a Green Finance Hub.
ESG is the practice of having regard to environmental, social and governance factors in decision making and financial transactions. It looks at the current business practices of a company and uses these to measure a company’s risk based on environmental stewardship, corporate governance and social practices. ESG factors have become common, with the use of SRI and ESG criteria in screening of stocks by investment managers in part due to shareholder pressure for companies to integrate sustainable practices into their operations, such as the avoidance of investments in armaments, tobacco industries, or companies/industries that use child labour. Sustainable and responsible finance principles overlap with ESG factors in determining risk and return and protecting the long-term interests of beneficiaries and the wider financial system.
In 2016, over $22 trillion of assets were managed under responsible investment strategies, an increase of 25% from the previous year. This was driven by recognition that good governance is systemically important, by climate change mitigation initiatives, by the adoption of disclosure reporting by over 250 of the largest companies under the Global Reporting Initiative, and by the Principles for Responsible Investment.
Sustainable Finance is a relatively modern concept and involves the provision of finance to investments taking into account ESG considerations. There is a focus on awareness and transparency, on the risks which may have an impact on the sustainability of the financial system, and in the position of risk mitigants through governance or other measures.
Part of the objective of the EU plan is to establish what will qualify as ‘sustainable’ or ‘green’ and the development of a taxonomy and standards to support this.
Ethical finance and faith-based finance such as Islamic finance are ideally adaptable to sustainable and green investment and have significant potential to be a strong source of financing for the achievement of SDGs. Islamic finance focuses on risk-sharing, real economic activity, and governance principles which encourage financial inclusion and restrict involvement in socially detrimental activities. Islamic finance in particular has a lot in common with SDGs, impact investment and responsible finance.
These value-based investment structures have a moral purpose, and recognise that investors must earn acceptable returns but also create positive social or environmental value or impact. Part of the principles of Islamic finance is the fundamental requirement that finance must be linked with the real economy, trade and production such that debt should not be able to grow beyond real resources. This is achieved through its emphasis on equity and partnership, and sales-based and lease-based financing instruments.
Islamic finance is intended to function as a means for promoting productive activities and not to be used for speculation or as an end in itself. Its principles are closely aligned to the SDGs and in a broad sense are an expression of the objectives of Shariah teachings, including alms giving (zakah, one of the five pillars of Islam) to eradicate poverty and target hunger; and endowments (waqf) for the reduction of poverty, hunger and the provision of health or education services.
The Islamic finance market is predicted to exceed USD$3.8 trillion by 2022, with the market concentrated in the Middle East and Asia. The European market is a relatively untapped opportunity for the growth of Islamic finance. With many Islamic investors actively seeking attractive compliant investments combined with the requirement for Islamic financial institutions to hold highly rated, high-quality liquid assets (HQLA) as part of their regulatory and liquidity requirements, green finance and investments are an ideal asset class with the capacity to meet both the investment return, and regulatory and Shariah requirements.
There are numerous examples of Islamic finance being utilised for ‘Green’ or infrastructure projects internationally through the issue of sukuk (Islamic bonds). The Irish Stock Exchange (now Euronext Dublin) has listed $34.68 billion worth of sukuk, ranking second internationally behind only Nasdaq Dubai.
Opportunities for Ireland
Sustainable and green finance forms a key strategic priority in Ireland’s International Financial Services strategy, the IFS 2020. Sustainable Nation Ireland is the national platform tasked with implementation of the IFS action plan across a range of areas, including the development of Europe’s first dedicated Climate Finance Accelerator, offering a certificate in Green Finance, and the establishment of a low carbon investment fund for the expansion of Irish clean tech SMEs.
Sustainable finance is naturally complementary to Ireland’s existing expertise and reputation for highly rated international financial services.
Euronext Dublin is already the exchange of choice for many leading international listings of debt, and the development of European Green Bond standards will fuel further growth, with €6 billion in green bonds already listed on the exchange.
Euronext’s reputation for sukuk listings, coupled with the measures enacted in the Finance Act 2010 to facilitate equivalent taxation treatment for Shariah-compliant transactions, make Ireland an ideal jurisdiction to structure Shariah-compliant sustainable transactions.
The HLEG Action Plan represents a pivotal point for the responsible finance sector. It creates an opportunity for Ireland to lead the way in delivering real global impact in critical areas such as climate change, achievement of SDGs, and most of all sustainable development, sustainable growth, and a sustainable and responsible financial system.