Sustainable Finance – a trend to stay

Sustainable finance, according to the European Commission (EC), refers to the process of taking account of environmental and social considerations in investment decision-making, leading to increased investments in longer-term and sustainable activities. To reach its goals, the EU will need to channel private sector investment into green and more sustainable businesses, projects and technologies.
There is thus little doubt that the EU's sustainable finance agenda, as enshrined in its 2018 Sustainable Finance Action Plan, will remain a top priority in 2020+ that will not only impact the financial sector, but will also re-shape the environment for the real economy.

The EU's sustainable finance agenda rests on the following key areas which are expected to spur legislative and policy development in 2020:

1. Re-directing capital towards a more sustainable economy;
2. Increasing transparency to incentivise long-term investments; and
3. Integrating sustainability in risk management practices.

Re-directing capital towards a more sustainable economy
Definitions for sustainability used in the market vary widely. Thus, developing a unified EU classification system ('taxonomy') is at the core of the EC's action plan:

• The regulation establishing taxonomy aims to bring about a shared understanding of what constitutes sustainability, and thus aims to create more consistent labels and standards across the EU for sustainable investments. The taxonomy, which is built on the existing NACE industry classification, is expected to build a classification determining the environmental sustainability of a particular investment by defining 'environmentally sustainable economic activities'. To qualify as green, an investment needs to contribute to at least one of the six high level policy objectives (e.g. climate change adaptation, pollution prevention etc.), must not cause significant harm to other objectives and must comply with both minimum social safeguards and certain technical screening criteria developed with the advice of a technical expert group (TEG) which will form the basis of the delegated acts needed to implement the taxonomy.
• The taxonomy is expected to feed into further legislative initiatives such as
  • establishing an EU standard for the issuance of green bonds as bonds seeking accreditation under the proposed green bond standard will need to be taxonomy compliant;
  • introducing a prudential supporting factor for sustainable investments in the form of lower regulatory capital charges for banks and insurances;
  • proposing two low-carbon benchmarks to provide investors with better information on the carbon footprint of their investments to assist investors in identifying and pursuing low carbon investment strategies and in reducing greenwashing; and
  • integrating sustainability factors and risks in credit ratings, which may ultimately lead to amending the credit rating agencies regulation.

Increased transparency and incentives to long-term investments
In addition, the EU aims to encourage greater ESG integration through enhanced transparency and reporting obligations:

• The disclosure regulation will require providers of financial products and advisors such as investment firms or fund managers to make certain website and pre-contractual disclosures, including e.g. how they integrate sustainability considerations in their investment decision-making processes and remuneration policies.
• The non-financial reporting directive will require listed corporates, insurers and banks with more than 500 employees to disclose diversity and non-financial information related to environmental, social, employee and human rights aspects as part of their management or annual report. The EC has developed metrics and provides guidance for climate-related disclosures.

We expect that these disclosure requirements - while hopefully delivering tangible investor benefit – may be adding additional cost to investment products and potentially raise cost of funding for companies.

Integration of sustainability in risk management practices
Finally, while the market for sustainability ratings and research is gaining increasing importance in aiding buy-side investment decision making, there are no uniform standards as to scoring methodologies and independence of sustainability ratings yet, all of which the EC will be exploring further in 2020.
Other initiatives include incorporation of ESG factors in stress tests for financial institutions, policy discussions around incorporation of sustainability in board strategies ("sustainable corporate governance") or diligence requirements on companies across the supply chain.

Action points for corporates
Sustainable finance is a trend that is meant to stay. Corporates are well advised to put ESG topics high up on their board agenda early on. In particular, they should

• engage proactively in stakeholder debate to get the taxonomy and its application right, as this will impact their sources and costs of funding;
• familiarise themselves with the taxonomy to see how their activities are perceived by asset managers and investors and provide reporting in a form that will allow checking against the taxonomy's technical screening criteria;
• critically review their culture, values and strategy to examine whether these sit well in the current ESG focused environment;
• develop a robust ESG strategy, identify any related ESG risks and seek expert guidance where needed;
• identify ESG related opportunities and bring these up proactively when engaging in investor dialogue.