Climate change is a global challenge that has the potential to transform the world economy. The financial services sector is in a key position to respond to this challenge and support the transition to a low-carbon society. This is why the EU has made sustainable finance a central pillar in its 2018 EU Green Deal, with many of the legislative proposals focused on fostering green investments and aligning the financial sector with the EU’s environmental objectives.

As recognised by EU Institutions, the financial sector can guide the shift towards a more sustainable economy, by directing investments and capital flows to assets and economic activities that have a positive impact on sustainability. This result is being pursued through legislation that encourages investments in economic activities and entities that are sustainable or committed to sustainability.

The starting point has been defining a shared vocabulary for sustainability concepts (such as the ESG acronym), as well as finding out the general features that make economic activities environmentally sustainable . With this as a starting point, and also with a view to tackling greenwashing practices, financial institutions have been required to improve their communication on sustainability. This includes providing clients and stakeholders with detailed information and reports on the sustainability of their investment strategies and their financial products. They have also been required to consider sustainability topics in their services, as well as in the context of their risk management and capital management activities.

Despite the above, there are still many challenges ahead for legislators and financial institutions, which can have a significant impact on the economy and financial markets.

Progress so far: how the EU Green Deal and other laws have boosted sustainable finance

With the first legislative initiatives on sustainable finance (such as SFDR and Taxonomy Regulation), sustainability has become one of the most relevant and trending topics in the space of financial investments. This has led all players to pay increasing attention to non-financial issues when defining their investments and long-term strategies and providing information to the market on these issues.

Important results have been obtained in driving the real economy towards a more sustainable approach, as well as in increasing the flows of investments into sustainable activities.

In the EU market from 2020 onwards, the share of financial products with sustainability features (products that are classified as article 8 or article 9 products in accordance with SFDR) has continuously increased. The flow of investments in these products has constantly outperformed investments in products with no sustainability features. At the same time, inclusion of minimum sustainability elements in financial products and investments is becoming more and more common.

Financial institutions and investors, therefore, in the new legal framework, have demonstrated their intention to contribute to challenges arising from climate change and sustainability through their investment activity.

Challenges: how to define and measure sustainability in the financial sector

Despite these positive results, there’s still a lot of work left to do to boost the role of the financial sector in the shift towards a sustainable economy. Legislation on sustainable finance is constantly evolving and redefining its principles.

The identification of sustainable investments is a first step. The approach adopted so far by legislation, apart from criteria for environmentally sustainable activities provided by Taxonomy Regulation in EU, is based on general principles which leave space for different interpretations and diverging approaches.

This can lead to uncertainties that limit the financial sector’s capacity when it comes to becoming a driver towards a sustainable future. Therefore, we need more detailed guidance for the identification of sustainable investments. This will have an impact on economic activities, which will have to consider any new criteria to be classed as sustainable.

The definition of sustainable investment strategies is another key step. So far, the focus has been on investing in economic activities and sectors that are already inherently sustainable. But to achieve our ESG goals and keep the economy going, we also need the financial sector and any upcoming legislation to also support the decarbonisation of sectors that are traditionally considered not sustainable.

Financing is also crucial. How sustainable an entity or company is can affect the terms and conditions of their financing. This can be a driver for positive change, but it could also have a significant impact on the real economy and the risks that credit institutions face.

The path ahead

To achieve all the sustainable goals, the financial sector and financial institutions need reliable data on the sustainability features of companies, to determine how sustainable they are. In this respect, a crucial role will be played by new disclosure requirements coming from legislation on non-financial reporting (like the CSRD), as well as by new technologies developed to record and analyse the data.

There are still many challenges to face in the field of sustainability for the financial sector, due to the constantly evolving legislation and economic context. It is essential for financial institutions to analyse the impacts of upcoming regulatory developments and plan ahead how they will approach this. They also need to have their own internal policies and procedures to make their organisation, activities and services/products more sustainable for their clients.