Social expectations on business and finance are changing rapidly. It is too early to say where the process will end up, but it could be at least as profound as what started in the early 1980s and led to our current economic and financial model. A fundamental question is whether the desire to profit from business and financial activity needs to be balanced by – and channelled towards – environmental and social objectives to sustain life worth living into the foreseeable future. The concern is therefore existential. The answer from a growing chorus, whether at the level of the UN, the G20, the OECD, national and regional governments, NGOs or electorates – and indeed many in the business and financial communities in private and increasingly in public – is ‘yes’.
The EU Commission’s Action Plan on Financing Sustainable Growth should be seen in this context. It addresses how to get the financial sector to operate as a key driver for sustainable business activity. In particular, it aims to:
- reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth;
- manage financial risks stemming from climate change, resource depletion, environmental degradation and social issues; and
- foster transparency and long-termism in financial and economic activity.
What would this mean in practice for the business community? We highlight three impacts below.
First, more funding for business activities deemed sustainable and less or higher cost for those that are not.
The EU has pledged to make at least 20 per cent of its budget directly climate-relevant. This is partly to help close the yearly investment gap of €180bn to achieve EU climate and energy targets by 2030, and partly to increase the EU’s competitiveness in a global economy that is rapidly embracing clean technologies.
However, the attempt in the action plan to nudge private sector financing and investment towards sustainable business is probably more significant in terms of the amount of funding that could be reallocated. And the Commission will help to identify what is ‘sustainable’ by taking the innovative step of creating an EU classification system or ‘taxonomy’ for sustainable activities, focusing initially on climate change and the environment. This will fall to a new EU expert group on sustainable finance which will assist the Commission, but in due course it may be overseen by an entirely new public-private governance ‘platform’. Once developed, other reform measures will be benchmarked to the taxonomy classifications. Some of the more significant potential financial sector nudges include the following.
- Making clear that institutional investors and asset managers are legally obliged to integrate sustainability factors into investment allocation, and that those giving investment advice must also take account of sustainability preferences. Institutional investors and asset managers are likely to be required to disclose what steps they take.
- Amending the Credit Rating Agency Regulation to mandate the integration of sustainability factors into assessments, potentially penalising unsustainable behaviour particularly where it could affect medium to long-term value. The Commission has also asked the European Securities and Markets Authority to include sustainability information in its guidelines on disclosure for credit agencies and is going to undertake a wider study on sustainability ratings and research by Q2 2019.
- Using the Benchmark Regulation to strengthen the quality of sustainability benchmarks as a means of highlighting strong and poor performance.
- Developing EU ‘green bond’ standards and potentially introducing a sustainability labelling regime for investment products.
- An invitation to each of the European financial services supervisory authorities (covering banking, investment and insurance) to undertake their own work to identify how sustainability factors can be more fully incorporated into the financial services regulatory regime.
Finally, the Commission also wants further development in the way public funding vehicles to support private investment or co-investment in sustainable projects, especially sustainable infrastructure. Action in this area would include advice and capacity building to generate a greater number of new investible projects.
Secondly, greater transparency.
For these measures to work, greater transparency is needed from businesses on their approach to sustainability. This will influence the capital allocation process directly. However, it will also feed into credit ratings and investment research, affecting allocation indirectly. The Commission is proposing to revisit the EU regime for disclosure of so-called ‘non-financial information’ to ensure that it achieves this. Among other things, any changes would be aligned with Financial Stability Board work on climate-related financial disclosures. These proposals are congruent with growing demands from asset managers, increasingly aware of the long-term implications of today’s (in)action, for more clarity from companies about how they will address long-term risks. Accounting standards are also to receive attention to assess the impact they could have on long-term investment with the possibility of the EU introducing an over-ride for international accounting standards where they are considered incompatible with the European public good.
Thirdly, there will be greater focus on long-term corporate value creation with legal duties to match.
Reflecting similar statements by leading companies (Unilever) and asset managers (BlackRock and Vanguard), the Commission is keen to address the issue of ‘chronic short-termism’ which is preventing the medium to long-term transition to a sustainable economy. This may involve a requirement for companies to develop and disclose a sustainability strategy with measurable targets, a redefinition of the duties of directors to ensure they act in company’s long term interests and the development of steps to address undue short-term pressure from capital markets on corporations.
As for timing, the Commission does not give the impression of wanting to wait around. The timetable for the EU’s obligations under the climate change framework set by the 2015 Paris Agreement is tight, and the needs identified by the UN Sustainable Development Goals pressing. But in any event, its term expires on 31 October 2019 and it is likely to want to have consulted on and made many of these changes by then.
Beyond the action plan. Greater policy certainty?
The action plan is not everything. The final report of the Commission’s high-level expert group on sustainable finance, from which much of the action plan originated, contains a series of wider proposals, some of which would drive greater certainty on the policy direction for public sector action on climate and sustainability. This is likely to be important for investment to flow towards a low-carbon economy and businesses and investors would certainly welcome a reduction in the volatility of low-carbon investments which could result. Watch this space.