This article is one in a series of thought leadership pieces written for Responsible Investor by members of the European Commission’s High Level Expert Group on Sustainable Finance. To see other HLEG coverage, see here, or to comment, visit our discussion page.
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France’s now famous Article 173 of the Law on Energy Transition and Green Growth requires investors to disclose how they factor ESG criteria and carbon-related aspects into their investment policies. In July, the release of the TCFD final recommendations and of HLEG’s interim report, in addition to the US withdrawal from the Paris Agreement have opened the question of the implementation of such regulation for the financial sector at the European level. A pan-European Article 173 is seen by many as the ‘holy grail’ of climate finance policymaking and our fourth early recommendation in the interim report sets out the idea that “disclosure by firms and financial institutions of material information on sustainability issues should be further strengthened”. Article 173 is quoted in the report as the example to build upon for financial institutions.
The French example is a good start but has not demonstrated yet its real impact to enable better informed choices and pave the way to driving investments towards more sustainable patterns.
Is article 173 really a holy grail, though? With one year of experiment and the release in June of the first reporting by investors and asset managers, best practices are starting to emerge and first lessons can be learned from the French experiment. The answer depends on where you start, in the sense that ESG and climate disclosure is not the end of the road but rather the indispensable prerequisite for a new organisation of the financial system, and which real utility highly depends on the way it is implemented. The French example is a good start but has not demonstrated yet its real impact to enable better informed choices and pave the way to driving investments towards more sustainable patterns.The devil hides in the details… of implementation. Not only do we need a pan-European article 173, but we need a demanding pan-European article 173, that will help release the useful information that investors need to follow a 2 degrees investment path, and that could therefore become a competitive advantage to the European financial industry and companies. The French experiment has enabled us to identify a few issues that we need to tackle if we want a European Article 173 to be successful.
First of all, the ambition and the objectives pursued. The necessity of climate disclosure for the financial sector encompasses different needs for information from various stakeholders dealing with various types of risks. The devil is in the detail… hence in methodologies. Opting for one disclosure methodology or another will give a different meaning and level of impact to the concept of decarbonisation.
A restrictive meaning – and impact – is to minimise the levels of induced carbon emissions of portfolios and help financial regulators to assess the risks of stranded assets to protect the stability of the financial system. Disclosure of Scope 1 and Scope 2 – direct and indirect emissions – will provide information on part of the climate transition and legal risks associated with an asset invested or financed by equity, bonds or loans. This will protect the financial system from the impact of the transition in the short term, but it will have no effect on earmarking capital flows towards climate-oriented opportunities and preventing the medium- and long-term risks associated with the physical damage of climate change – which may have a much higher impact on our economies and on the financial system than transition risks and stranded assets. Climate disclosure should therefore also help invest in assets that contribute to decarbonising our economies over the long term at a global level. This means assessing the impact of supply chains but also the carbon-efficiency of products and business models through Scope 3 and avoided emissions. This is the guarantee that such regulation will really contribute to provide the information necessary to the economic impulse towards a clean economy.
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In this regard, Article 173 is a good start, but not enough and only one piece of the coherent EU sustainable finance regulation architecture that we need. A strong and meaningful European label for sustainable finance products based on an EU public taxonomy of sustainable assets is for instance another major element of this framework. This will help investors to rapidly identify what products to invest in if they want to support the energy and ecological transition and to limit the risk of ‘green washing’. Like for the food industry, not only do we need to understand the ingredients of a product, but also to have a guarantee that those claiming to be organic actually respect a certain number of criteria. The French public SRI label and the TEEC (the green label backed by the French environment ministry) have paved the way for the articulation of a coherent EU framework. We need to build on these examples, although we need to go much further, as demonstrated by fellow HLEG member Anne-Catherine Husson-Traore.
A European Article 173 should require not only investors, but also index providers, for example, to disclose how their products are compatible with a 2°C transition path.
Secondly, the comprehensiveness of the scope of application of climate disclosure is another key element – for the financial industry, but also for European companies. A major part of investment is passive, and harmful to our fight against change – Mirova recently assessed in a study that investing in mainstream indexes is tantamount to investing in a +4°C to +5°C scenario. A European Article 173 should require not only investors, but also index providers, for example, to disclose how their products are compatible with a 2°C transition path. This will not be harmful to Europe’s competitiveness – on the contrary: the dynamic for the transition is so strong that even the US federal decision to leave the Paris Agreement has not hampered the world dynamic, and looks more like the last resistance of the old world than a serious barrier. Companies and financial players disclosing their level of compatibility with a 2°C path will be the winners. First, because they will disclose information that will generate investors’ trust much more than if they don’t. Second, because this will encourage players who are not yet involved in the new transition economy to rapidly evolve beyond cosmetic changes, and to adapt their business models to the new energy equation.However, this will not be without social dislocations. Beyond disclosure, the true challenge of climate and ESG information is the social acceptability of a major shift in capital allocation, as recently recalled by Nick Robins. He said: “The social consequences and the net positive prospect of our zero-carbon future does not mean the employment implications of the transition can be brushed aside (…). If these are poorly managed, then the transition itself will be dented, economic performance knocked and investment returns undermined”. As for any major economic transition, the role of the public sector, but also the role of investors, will be crucial; but at a much greater scale than in the previous economic transitions. Because of these disruptions, the European public sector could be tempted to limit to its minimum the ambition of climate finance policies, the scope of a pan-European Article 173, and the demands for standards and labels for financial products claiming to be responsible. The risk of such prudence would be to kill in the egg the chance for the EU to become the leading financial center for sustainability. Let’s not be shy. We do need to guarantee the social acceptability of the transition, not so much for the financial sector – which will on the contrary benefit in the end from more transparency demands – but for the regions and the activities that may be progressively and rapidly disinvested, and above all, for the people that will undergo the consequences of these disruptions. The climate finance policy challenge should also serve to reconcile finance with the social challenge of our dislocated European societies. Let’s be ambitious. Let’s fully tackle both challenges, let’s develop innovative tools that will also build on the strength of the financial industry to bring territorial coherence in our investments. This is the condition for our collective success.
Philippe Zaouati is CEO of French asset manager Mirova, which manages €6.5bn, all in responsible investment strategies. He is also Chair of Finance for Tomorrow, a new initiative from French regulators and financial bodies to promote the Paris Agreement and the SDGs within France and globally.
To give feedback on the group’s interim report, published in July, see here.