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Leave no company behind: Europe's sustainability revolution

EU action on sustainable finance is welcome, but a tick-box exercise must not take the place of truly deep engagement by capital markets

The European Union (EU) has been working to refocus today’s short-termist capital markets on investments that create wealth in a long-term, sustainable way. The project was launched through the Sustainable Finance Action Plan in March 2018, and the EU has since outlined initiatives about the following areas:

ESG disclosures

The EU is proposing new disclosure requirements for institutional investors so that their clients can see what procedures are used to assess environmental, social and governance (ESG) risks when making investments on their behalf. There will be stricter requirements on investments that are explicitly sold as being sustainable to ensure they are true to label.

In our view, these proposals have the greatest potential to shift capital markets towards long-term sustainability and are not in any way unreasonable. Investment firms that value sustainability should have no objections.

Because sustainability runs through our investment processes, Hermes already satisfies many of the disclosure requirements proposed by the EU and we cannot see any major implementation challenges.

Integrating ESG into MiFID II

The EU is proposing to amend its MiFID II directive, which among many other outcomes has improved financial advice and investment processes across the industry, to force firms to always gauge their clients’ ESG preferences.

Some industry bodies have objected to this proposal, largely because it would come before the other measures are implemented, but we believe such objections misunderstand the aim of the proposal. A growing number of investors, notably but not limited to millennials, are seeking sustainable investment opportunities[1]. However, while new products are emerging onto the market, levels of penetration remain low. For retail investors there are related concerns about whether the claims made by sustainable or ESG-focused funds match their impact[2].

This inadequate provision of ESG options must be addressed. Giving clients the opportunity to express their desire to invest sustainably would provide further evidence of demand.

Sustainable benchmarks

Because many investors around the world now invest passively – simply tracking market indices – the popularity of these vehicles can be a powerful tool used to shift capital in certain directions.

The EU is proposing new indices, such as low-carbon gauges for companies with below-average carbon emissions, and positive-carbon-impact indices for firms whose operations reduce emissions overall.

However, the number of companies that would qualify for inclusion in these indices today would likely be low. Furthermore, companies aiming to reduce their emissions in earnest, but would not yet qualify for these indices, could lose access to capital and much-needed engagement from ESG-conscious investors.

Another unintended consequence could be that investors in these indices might be led to believe there is no need to engage with the underlying companies, given their low-carbon credentials, and there overlook other sustainability challenges.

Sustainable taxonomy

One of the EU’s most interesting and controversial aims is for the creation of a single classification system, or taxonomy, for sustainability.

This would stipulate specific activities that could qualify as environmentally (and eventually, we hope, socially) sustainable, leading to common EU standards for the screening of investments and preventing firms from claiming to be sustainable unless they meet clear criteria.

We advocate that the EU begins this project by creating a clear gold standard for a green taxonomy, taking a science-based approach to classifying sustainable activities.

For example, assets that are not sustainable, such as securities issued by natural-gas producers, would not be classified as being sustainable unless using, for example, carbon capture and storage technology to operate in a net-zero carbon world.

Beyond a taxonomy: an EU stewardship standard

Central to Hermes’ investment approach is that deep, constructive engagement with the companies you invest in is crucial to safeguarding our futures and delivering strong, long-term risk-adjusted performance to investors in the long term.

We welcome the EU’s focus on sustainability, and in making it easier for investors to take ESG risks more seriously, measures such as taxonomies and indices are helpful – but we encourage the EU to go further.

It is essential that companies that do not fit the sustainability taxonomy, or qualify for entry into sustainable indices, still be guided in the right direction by capital markets. We therefore propose that the EU should work towards a standardised framework for good stewardship.

Building upon the Shareholder Rights Directive II, this should provide clear expectations on how to consider sustainably in analysing all assets – not just those that fall within the taxonomy.

Only then can the progressive goals of the EU’s initiative truly be delivered.

[1] For information, see the following:

[2] See “Financing a sustainable economy,” published by High-Level Expert Group on Sustainable Finance, a Secretariat of the European Commission, in July 2017. It states: “Many people, when asked, say that they do not want to exploit their fellow citizens or the planet in an unsustainable way. But fiduciaries currently tend to ignore these interests, and few beneficiaries are asked about their preferences at the time of investing. This leads to capital allocation that exacerbates market failures and undermines society’s collective interests and, over time, the economy itself.”

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