A confused definition of sustainable investment has spoiled it in its entirety: Stan Dupre on the EU Action Plan

Responsible Investor’s latest instalment of The EU Action Plan: What Matters To Me

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This is the fourth in RI’s ‘The EU Action Plan: What Matters To Me’ series, providing insights from market experts on the implications of the EU Action Plan on Sustainable Finance. Today, 2° Investing Initiative’s Stan Dupre warns that the current proposals for an Ecolabel for Financial Products could undermine the integrity of the market.

In April, the European Commission’s Joint Research Centre launched a consultation on draft criteria for an EU Ecolabel for Financial Products. Today, 2° Investing Initiative, a member of the Ecolabel ad-hoc working group, released its paper Impact Washing Gets a Free Ride, discussing the topic.

STARS ALIGNING

With its Action Plan on Financing Sustainable Growth, the European Commission has set itself the ambitious goal of “reorienting capital flows toward sustainable investment.”

A financial product exclusively invested in brown activities can deliver environmental impact

Good news: retail investors, who collectively own more than 40% of financial assets in Europe, appear to be perfect allies! As demonstrated in surveys and academic research, a large majority of retail investors are concerned about sustainability and want to leverage their power as shareholders and investors to generate positive change in the real economy.
In parallel, major asset owners, asset managers and banks are pursuing environmental impact-related objectives by participating in collective actions such as Climate Action 100+, the Katowice Pledge, and the UNEP Responsible Banking Principles, as well as by developing “impact investment” products.
The evolution of regulation at the EU level, including the integration of sustainability concerns into financial advice, the introduction of sustainability-related disclosure requirements for financial institutions, and the development of the Ecolabel for Financial Products, appears to support this trend. The stated goal of the Ecolabel scheme is to help consumers identify products that deliver scientifically-measurable environmental impacts, with the ultimate objective of reaching a market share of 10-20% for labelled products. In other words, the EU Ecolabel is intended to enable retail investors to find financial products matching their impact-related expectations and to support the emergence of these products on the mass market.
Unfortunately, the nitty gritty of European policymaking on this issue is not as bright as the stars suggest…

CONFUSING INVESTMENT IMPACT WITH INVESTEE IMPACT

The core issue identified in our paper can be summarised by the contradiction between the following statements:

  • “Financial products or investments in themselves cannot be green. Greenness is derived from the uses to which they are being put in underlying assets or activities.”
  • (i) “The green impact of investment into specialist green companies is difficult to evaluate.” (ii) “Basing a green finance definition only on ‘what’ is financed neglects other mechanisms (e.g. information exchange, shareholder activism) through which investment products might exert influence on the environmental impact of the companies in which they are invested.”In the context of the documents from which they are extracted:
  • The first statement assumes that investing in a financial product exposed to green economic activities boosts these activities and/or enhances their environmental impact even when this is not the goal of the investment strategy and there is no evidence to suggest that the investment delivers any change. It also assumes that, for investors, increasing their exposure to green activities is the only way to generate environmental impact;
  • The second statement suggests that the environmental impact of a financial product is not as simple as that: it states that the environmental performance of an investment strategy is distinct from the ‘greenness’ of a portfolio’s “underlying assets or activities.”

Unfortunately, the nitty gritty of European policy-making on this issue is not as bright as the stars suggest

On one hand, an investor can buy stocks or bonds from companies with green activities without changing anything, simply because a shortage of investors is not necessarily the obstacle to their development of the first place. Take the example of bonds issued by a state-owned railway company. The company’s ability to increase investment in high speed train lines – the green activity – is limited by several factors, including a cap on public debt. Clearly, the company is not prevented from increasing investment just because investors are unwilling to purchase their bonds. Thus, an approach that aims at closing the climate finance gap by financing entities that already enjoy access to financial markets is contradictory and likely ineffective.

On the other hand, investors exposed to brown activities can use their voting rights or other means of influence to push brown companies toward greener capital expenditure and practices. A financial product exclusively invested in brown activities can therefore deliver environmental impact. Take the example of a real estate fund that purchases old buildings with low energy efficiency, invests in their green refurbishment and subsequently sells the assets. Increasing investment in this fund contributes to energy savings even though, at any given time, most assets in the fund will have low environmental performance. The financial product is “green” while the underlying assets are “brown.”

By trying to oversimplify a complex reality to deliver quick reforms, the Commission may end up violating its own rules.

Both statements are taken from documents produced by the European Commission. The second comes from a 2017 study by DG Environment, Defining Green in the Context of Green Finance, while the first is drawn from the Technical Report on the Ecolabel for Financial Products, produced two years later by the Joint Research Centre (JRC).
Unfortunately, the Technical Report contradicts the conclusions of the earlier study, which is a telling illustration of the Commission’s current approach to designing the Ecolabel for financial products.
Based on 2°ii’s research, the JRC’s approach is technically inconsistent and legally contradicts the Ecolabel Regulation, in which “environmental performance means the result of a manufacturer’s management of those characteristics of a product that cause environmental impact”. By trying to oversimplify a complex reality to deliver quick reforms, the Commission may end up violating its own rules.

THE APPARENT STRATEGY: CREATING A GREEN ASSET BUBBLE

The Draft Ecolabel focuses exclusively on environmentally-themed funds, which represent about 0.1% of today’s market. Based on the Draft Criteria, the Ecolabel eligible investment universe is composed of about 200 listed companies with environment-related activities, representing 1% of the global investible universe.

The confused definition of “sustainable investment” that lies at the core of the Draft Ecolabel has spoiled the Commission’s Sustainable Finance Regulatory Package in its entirety

Thus, the Ecolabel’s strategy appears to be to inflate this micro-niche artificially to a 10-20% market share by promoting environmentally-themed funds to the two-thirds of retail clients interested in the environmental impact of their investment products.

As a result, these retail investors would be sold products that:

  • Are not associated with a guarantee of environmental impact, and
  • Expose them to a potential asset bubble.

Although the Commission’s Ecolabel is unlikely to be enough of a success to generate a real bubble, it is reasonable to expect that its implementation will support mis-selling of products and to generate unfair competition for genuine impact investment products.

“SUSTAINABLE INVESTMENTDEFINITION: THE ROTTEN APPLE HAS SPOILED THE BARREL

Furthermore, the confused definition of “sustainable investment” that lies at the core of the Draft Ecolabel has spoiled the Commission’s Sustainable Finance Regulatory Package in its entirety. A confusion of the environmental impact of investment in financial products and the impact of investment in underlying activities (i.e. capital expenditure of companies and other entities in the portfolio) has spread across all key regulations of the Package: the taxonomy, the regulation on disclosures, and – more critically – the reform of financial advisors’ obligations.As a result, environmentally-themed funds will not only become the sole category of financial products officially associated with environmental benefits, but, given the proposed integration of sustainability concerns into financial advice (MIFID and IDD Delegated Acts), will also become the only suitable choice for recommendation by financial advisors to clients with “environmental preferences”. This disregards the fact that consumer surveys do not point to environmentally-themed funds, and contradicts the aim of MIFID and IDD to understand what clients want, instead of selling a one-size-fits-all product.
Lastly, by pushing a dogmatic approach as opposed to an evidence-based one, the EU is creating a precedent that has the potential to undermine the integrity of the broader sustainable finance agenda in Europe and globally.
2°ii’s paper recommends an alternate approach to the development of the Ecolabel that centres on implementing an Environmental Management System to design and execute the investment strategy. The approach can be adapted from the European Eco-Management and Audit Scheme (EMAS), and builds on the key principles of impact investing—intention, additionality and measurement. It is technically and legally consistent with existing rules on the Ecolabel and consumer protection.

The EU is creating a precedent that has the potential to undermine the integrity of the broader sustainable finance agenda

We believe the next steps in the development of the Ecolabel will be a litmus test for understanding whether the Commission’s approach to sustainable finance will effectively contribute to the environmental policy goals of the EU, or instead undermine them by legalising ‘impact-washing’ by asset managers. While this conclusion may appear dramatic, it effectively summarises the concerns associated with 2°ii’s findings.

Stan Dupre is the founder and CEO of 2° Investing Initiative, a think tank and the main beneficiary of European research funding on sustainable finance. He was a member of the European Commission’s High Level Expert Group on sustainable finance.