What is Sustainable Finance?
Sustainability is currently becoming the most pressing topic of our own and our children’s generation. This results from the fact-that the humanity, to a great extent, lives at the expense of the earth and shall thus destroy its own habitat in the foreseeable future.
Sustainability in this context means the quality of not being harmful to the environment or depleting natural resources, and thereby supporting long-term ecological, social and governmental balance.
This is why the European Commission started the Sustainable Finance initiative. The idea behind this initiative is that the financial service sector, as important global economic player, must make an appropriate contribution to sustainability.
The transformation to a more sustainable economy requires enormous investments (e.g. in energy production or waste management). The financial sector, as an intersection for capital allocation, is to play a major role in promoting sustainability and sustainable management. At the same time, the management of ecological and social risk factors becomes increasingly a prerequisite for a resilient company and, therefore, a factor of utmost importance for the financial system as a whole. However, traditional investment criteria may not adequately cover these risks because of the long-term character of the environment, resources or climate change impacts. For example, financial service providers should, in their loan portfolios, adopt new lending criteria related to long-term risks. It is essential for all banks and financial service providers to address the strategic and organisational implications of this regulatory and socio-economic change at an early stage.
The scope of Sustainable Finance is broad, including environmental, social and governance objectives - the so-called ESG factors. Sustainable Finance thus comprises not only environmental protection but, above all, questions of whether a company will continue its operation in the upcoming years and will generate lasting profits. This includes, for example, dealing with employees in a sustainable manner and building incentive systems to promote the behaviour in line with the sustainability strategy.
What is the state of public perception and how does the financial sector develop?
In general, the requirements of Sustainable Finance are not only driven by the political factors and policymakers. In fact, there is a huge pressure from the customer side as well. Requests for “green” financial products are ever more numerous, as are the refusals to invest in companies which are, from the customers‘ perspective, not in line with the new sustainability demands. Consequently, the financial service providers are not only under a growing pressure from their investors and rating agencies to implement adequate measures for sustainable management and behaviour, but are also facing new competitors, which heavily target sustainability as their major business case pillar.
Opportunities for institutions exist primarily in the introduction of new products, e.g. green bonds, and the improvement of reputation or brand. At the same time, the long-term business risk can be reduced by keeping an eye on the sustainability factor.
What is the EU Commission proposing?
The EU Commission has recognised the importance of sustainability for the financial services sector.
By regulating the allocation of equity capital (e.g. by providing guidelines for investment advice) and of debt capital (e.g. by providing guidelines for the calculation of risk-weighted assets), the EU Commission wants to influence the incentives in the financial sector and thus, indirectly, the real economy.
For example, the financing of a coal-fired power plant by debt capital could be made more difficult by a higher risk weight of this loan in the bank’s loan book or the financing with equity could be more costly with a higher risk rating or a sell recommendation of operator’s stock. For those who are in favour of the sustainability initiative this procedure takes into account the “true” risks of such an investment. On the other hand, some financial market participants criticise the fact that banking regulation is now being misused to implement a political agenda and is unnecessarily interfering with free-market pricing.
The EU Commission has set up several working groups such as the High-Level Expert Group on Sustainable Finance (HLEG) or the Technical Expert Group on Sustainable Finance (TEG). These working groups have initially (in particular ?) published an action plan and, recently, a comprehensive taxonomy. The taxonomy contains criteria, objectives and methods on how sustainable business practices can be classified in a standardised and transparent way in the future. The corresponding classification report shall offer, to the affected companies and investors, the opportunity to analyze the implications of the new taxonomy for their businesses and products. Furthermore, there are already first draft regulations changing single aspects of financial market regulation to promote sustainable financing.
What are the current official publications on Sustainable Finance?
The EU Commission and its working groups have published several publications. We divided them into the following topics:
- Sustainable Finance Framework: These publications set out uniform criteria for determining whether an economic activity is environmentally sustainable. They further set out a process involving a multi-stakeholder platform to establish a unified EU classification system based on a set of specific criteria for determining which economic activities are considered sustainable (Taxonomy).
- Disclosures relating to sustainable investments and risks: Investment firms and insurance intermediaries should consider ESG a value driver adding worth to the advice which the insurance intermediaries are required to provide to investors, as it ensures that the investors will receive the relevant Information. Furthermore, to help investors compare the carbon footprint of investments, the publications introduce new categories of low carbon and positive carbon impact benchmarks.
- Low carbon and positive carbon impact benchmarks: To help investors compare the carbon footprint of investments, the publications introduce new categories of low carbon and positive carbon impact benchmarks.
- MiFID II related updates: These publications aim at integrating ESG considerations into the investment and advisory process in a consistent manner across sectors by amending MiFID II.
- IDD related updates: Customer’s ESG preferences should be taken into account by insurance intermediaries and insurance undertakings when assessing the suitability of insurance-based investment products.
- Green bond standard: These publication describe a voluntary, non-legislative EU Green Bond Standard to enhance the effectiveness, transparency, comparability and credibility of the green bond market and to encourage the market participants to issue and invest in EU green bonds.
Additionally, the EU and its working groups have published several publications as preliminary work, especially the EU Action Plan on Sustainable Finance.
What does this mean for banks and financial service providers?
The changing customer preferences, the EU Sustainable Finance Initiative and the initial reactions of the banking industry influence all domains of a financial services provider.
Sustainable Finance affects the entire value chain of a financial product, i.e. it raises fundamental questions at the top management level as well as at the sales level and all internal units:
- At the management level, for example, a sustainability strategy must be developed and the effects of this strategy for the reputation should be analysed.
- At the risk management level, the lending and compliance risks should be assessed and, if necessary, new specifications have to be prepared.
- At the sales level, new product opportunities, the impact of new benchmarks and changes in customer demand should be taken into account.
- Sustainable Finance also affects the IT department, which must collect and process new data (e.g. product parameters based on taxonomy) but also look for possibilities to reduce resource consumption (e.g. by means of automation).
What should be done now?
The Sustainable Finance Initiative poses significant strategic and operational challenges to financial service providers. Since the first regulatory drafts are already published and many more will follow in this and the next years, financial service providers should start analyzing possible effects of current publications on their companies in general, and their business models, in particular. Furthermore, they should keep themselves constantly informed about the latest developments.
How can RegHub support you?
New publications on Sustainable Finance are regularly published. RegHub can help you identify the latest official Sustainable Finance publications and assess whether they are relevant to your business. You can work together with colleagues and other experts on these publications to derive concrete actions within your company. Thus you can be sure that you will always be informed about the latest regulatory developments. With RegHub you can react early and gain a competitive advantage.