Future financial footprints: Europe takes next steps on sustainable legs Federated Hermes Limited

In December 2016 the European Union (EU) opened the sustainable finance conversation with a loud statement, assembling a group of 20 “senior experts from civil society, the finance sector, academia” and other institutions to steer the debate.

The so-called HLEG was charged with a serious mission; to scope out “the scale and dimensions of the challenges and opportunities that sustainable finance presents”.

But HLEG was also asked to recommend “a comprehensive programme of reforms” to set the EU financial system onto a more sustainable footing. Just over 12 months later, the EU Commission incorporated the final HLEG proposals into its ‘Action Plan for Financing Sustainable Growth’ that laid out several priority times for the agenda including:

establishing an EU sustainability taxonomy, starting with climate mitigation and adaptation, to define areas where investments are needed most;
clarifying investor duties to extend the time horizons of investment and bring greater focus on environmental, social and governance (ESG) factors into investment decisions;
upgrading disclosures to make sustainability opportunities and risks transparent; and,
enabling retail investors to invest in sustainable finance opportunities.

The HLEG wish-list goes further to cover goals such as creating official EU sustainability standards for financial assets and creating the conditions for a sustainable infrastructure plan for Europe.

Importantly, the HLEG proposals and ensuing EU action plan are aimed at improving access to sustainable investment rather than adding more complexity and regulatory burdens to the financial industry. The EU Action Plan also goes well beyond merely heaping new rules on investment institutions with a much more ambitious target of embedding sustainability into the fabric of finance and business across the region.

Now nearly three years since the EU Commission put its sustainability plan into action – and amid a second tranche of proposed reforms for the 2020-25 period – in a five-part blog series (see below), we review the journey to date and map out the most promising routes ahead to reach the HLEG destinations.

Over the last four years, the EU has talked-the-talk – now it’s time to walk the walk.

Part 1. Early strides: A for attitude, E for execution

The EU Commission along with other key European institutions, including the European Supervisory Authorities (ESA), has made a herculean effort since 2018 to implement the first phase of the HLEG recommendations.

For example, the process so far has led to a new EU taxonomy, adjustments to the Insurance Distribution Directive (IDD) and Markets in Financial Instruments Directive (MiFID) to introduce sustainability-focused suitability tests and progress in reforming the Non-Financial Reporting Directive (NFRD).

These initiatives have created more consistency around how sustainability is defined and disclosed to investors and broader society. Another HLEG-related rule now requires index providers to disclose how they incorporate (or not) alignment with the Paris Agreement on climate change into the development benchmarks – a critical component of portfolio construction and investment performance attribution.

Elsewhere, the overarching (Level 1) requirements of the Sustainability-related Financial Disclosure Regulation (SFDR) regime have encouraged more comprehensive integration of ESG factors into investment processes and even remuneration practices of asset managers and many other regulated financial firms.

In spite of these early positive moves, however, we have identified three broad areas of concern about the current status of the EU sustainability program and its trajectory.

First, the reforms rest on a disappointingly narrow definition of sustainability that highlights simple exclusionary approaches to investment instead of the more considered ‘stewardship’ approach of leading asset management firms.

Stewardship means “the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society”. We believe only stewardship of investment assets, combined with government and corporate policies, can deliver the kind of action we need to meet the major challenges facing the world, such as those outlined in the UN Sustainable Development Goals (SDGs) and the Paris Agreement on climate change.

If society is to address issues like climate change and inequality, then whole companies and industries need to change – and rapidly: the strongest tool investors have to drive this change is to use ownership rights to engage.

We suggest the EU sustainability program needs to set minimum expectations for stewardship – covering actual engagement and impact reporting, for instance – that require a higher degree of governance from financial supervisors. The EU could significantly improve the coming round of its sustainability action plan by introducing a new region-wide ‘Stewardship Code’, building on global best-practice foundations established under the Shareholder Rights Directive II.

Second, the overly prescriptive draft Level 2 Regulatory Technical Standards (RTS) set under the SFDR are not fit-for-purpose: as they stand the proposed rules won’t achieve the changes in investment behaviour envisaged by the high-level legislation – and indeed the HLEG itself.

In particular, the ‘principle adverse impact’ (PAI) reporting requirements of the RTS offer the worst of both worlds, proving too prescriptive in some respects and not nearly detailed enough in others.

The RTS and PAI indicators, as currently drafted, leave little scope for investment managers to set out how they identify key PAIs but more importantly, perhaps how they are working to mitigate them through engagement or advocacy. Instead of a nuanced set of standards designed to encourage and highlight real-world improvements through a more holistic approach to understanding ESG factors of relevance to the long-term value of investments, the current proposed approach is more akin to a box-ticking exercise.

Again, we would prefer a more principles-based approach to the SFDR that allows scope for sustainability practices to evolve and recognises the importance of using ESG integration to inform stewardship and advocacy practices at firms.

The RTS proposals also need to align with the newly developed EU taxonomy to enhance clarity and consistency across the whole regime. Fortunately, under a revised timetable the RTS rules won’t take effect now most likely until January 2022, allowing time to resolve the flaws and misalignments we have highlighted.

And finally, the EU must address taxonomy and timing inconsistencies throughout its sustainability action plan that threaten to undermine the effectiveness of the proposals.The SFDR (which regulates the users of the information) and the NFRD (which regulates the providers of the information) need to be linked through common use of the EU taxonomy, which should underpin reporting expectations. Without this confusion and potential delays to implementing the action plan properly are risked.

As explained above, the RTS start-date has already been pushed out but we expect the ESAs working with the European Commission will have to extend other reporting deadlines to ensure a smooth, logical transition to the new sustainability regulatory environment.

Part 2. What's in a name: that which we call a green bond

A rose, according to Shakespeare, “by any other name would smell as sweet”. Nice poetry, of course, but his loose attitude to labelling would spell chaos if adopted in the real world.

Names hold meaning and power, especially now, perhaps, in the blossoming field of sustainable investment where products are more abstract than roses and come without scent.

Prior to the EU taxonomy being developed (a cornerstone goal of the Action Plan for Financing Sustainable Growth in 2018), ‘sustainability’ was bandied about the investment industry with little regard for consistency or collective understanding.

The new naming convention sets out some guiding principles that define ‘sustainable’ investments as those that:

make a substantive contribution to one of the six target environmental objectives (climate mitigation and adaptation activities; protection of water and marine resources; transition to a circular economy; pollution prevention and control; and protection and restoration of biodiversity and ecosystems);
do no significant harm (DNSH) to the other five environmental objectives, where relevant; and,
meet minimum safeguards (eg, OECD Guidelines on Multinational Enterprises and the UN Guiding Principles on Business and Human Rights).

The taxonomy as proposed by the EU Technical Expert Group is a fine piece of work, produced on the basis of a highly informed but also consultative process¹. Currently, the programme focuses only on sustainable climate mitigation and adaptation activities, but the scope should grow as the task of expanding the taxonomy is taken up by the 50-strong Platform on Sustainable Finance, created in October 2020.

With the rules now in force under regulations introduced in July 2020, the EU taxonomy could be the key to unlocking a core HLEG goal – opening up sustainable finance opportunities to a wider range of retail investors through a new Ecolabel for financial products. The taxonomy – if implemented properly as part of the Sustainability-related Financial Disclosure Regulation roll out – should also improve and standardise investor disclosure on sustainability factors – both at the firm and at the product level.

We are already seeing the EU taxonomy in action through the current consultation on EU ‘Green Bond’ standards. The EU Commission is due to decide on the final form of the Green Bond protocols before the end of 2020. Although the standards are likely to remain voluntary for the time-being, bonds that don’t meet green taxonomy rules should clearly be known by other names.

Part 3. Letters of the law: how SFDR makes ESG disclosure real

As explained earlier, the SFDR – or Sustainability-related Financial Disclosure Regulation – emerged out of the HLEG recommendation designed to clarify “investor duties to extend the time horizons of investment and bring greater focus on environmental, social and governance (ESG) factors into investment decisions”.

Following a European agreement in November 2019, all firms will have to disclose at the entity level whether they take sustainability and adverse impacts into account in their decision-making processes from March 10, 2021. Pre-contractual disclosures must also be made on whether and how products integrate sustainability risks into investment decisions and the likely impacts of such risks on financial returns plus, by December 2022, whether and how a financial product considers adverse impacts. There are additional disclosures for ESG and sustainable investment funds.

In general, we support the Level 1 SFDR requirements, which will provide a window for investors to see how investment managers and indeed other regulated firms consider sustainability risks and opportunities within their investment and lending processes.

Such improved ESG disclosure should better communicate to investors how such sustainability issues are considered – including both how their potential impact on financial outcomes is taken into account by investment managers as well as how investment managers consider any material impacts on society and the environment from investment decisions made. Furthermore, the extra disclosure obligations for investment products labelled as ESG or sustainable could both improve the quality of information available to investors and reduce the dubious marketing practices known as ‘greenwashing’.

But in spite of these positive features of the SFDR, the Level 2 requirements – delayed in implementation most likely until January 2022 – of the regime fall short of best practices, relying again on prescriptive language that risks encouraging boilerplate reporting from many investment firms rather than what was intended: proper engagement of firms with the sustainability challenge. We will discuss this issue – and potential remedies – in future posts.

Part 4. Above and beyond: somewhere over the benchmark

The EU Commission has taken the HLEG proposals on investment benchmark reforms and run further with them. In its original recommendations, HLEG set out to ensure index providers offered benchmarks that are consistent with long-term investing strategies and that encourage – or at least do not impede – that allocation of capital towards green or sustainable investments.

Tellingly, the EU has gone further, bringing in a raft of investment benchmark regulations due to take effect in stages over the next couple of years.

As of the second quarter of 2020, index providers have already been required to disclose whether or how they integrate ESG factors into their benchmark construction process.

And from 31 December 2021, providers will have to explain how their methodologies align with the Paris Climate Agreement objectives for all benchmarks, except currency and interest rate indices.

In perhaps an even more substantial move, all index firms will also have to create at least one Paris-aligned climate transition benchmark for EU investors by January 2022.

Finally, starting in the final quarter of 2022, the Commission plans to review the minimum standards for EU climate transition and Paris-aligned benchmarks to ensure the respective underlying index assets comply with the sustainable investment framework in force across the region.

The HLEG proposals and ensuing EU regulations have underscored the current mis-match between investment benchmark structures and the Paris Agreement on climate change. But while the new index rules adjust the dial a little towards ESG, the vast majority of the investment universe remains outside the sustainability circle.

As discussed elsewhere in this paper, we believe there is still much work to be done in mapping out how investors can lead change through corporate engagement and asset stewardship.

Part 5. Suits you: why sustainable products could be cut to client ESG measures

The EU floated two proposals in June 2020 that could have far-reaching consequences for how financial firms engage with clients on ESG issues.

If adopted, governing legislation for both the Markets in Financial Instruments Directive (MiFID) and Insurance Distribution Directive (IDD) will be amended to include serious sustainability clauses.

Among other changes, the MiFID proposals require investment firms to seek information from clients about their ESG preferences while also disclosing how the company incorporates sustainability factors. The mooted rules further stipulate that investment advice must take account of client ESG preferences as well as financial objectives. Under the MiFID plan, product suitability assessments would have to incorporate client sustainability preferences.

Meanwhile, the IDD amendments will embed sustainability risk factors into insurer (including reinsurer) processes across the board. For example, the rules will require insurance firms to include appropriate ESG-related issues into their governance structures, solvency assessments, risk-management systems and remuneration policies.

Also, the IDD changes introduce sustainability risks into the prudent person principle in a move that will see ESG factors included in insurance product oversight, governance processes for insurance distributors and into conduct codes covering advice on insurance-based investment products.

The MiFID and IDD proposals do represent steps in the right direction but – as with our general concerns about the EU sustainability program – they also run the risk of promoting exclusion-based products at the expense of the positive, outcome-based alternative approaches that stand a better chance of driving real progress in sustainability through engagement and stewardship.