Standards, labels and credit ratings are tools for sustainable finance, but handle with care

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.

Sign up for a free trial to Responsible Investor

The European financial system is moving towards sustainable practices at a pace that resembles a race to the top. This is, of course, a good thing, but at the same time many are wondering about the rules of the game. What kind of decisions will be rewarded in future, and what might be the next ‘diesel-gate’ – a product or technology that proves to be old-fashioned and disliked by majority of investors in the long run? Predictability and credibility is in demand.
The European Commission established a High Level Expert Group to distinguish best efforts that accelerate the development of sustainable European financial markets. It has been greatly motivating for me to take part in drafting our recommendations, which include also legislative proposals. One of the first recommendations that we propose is to create a taxonomy for sustainability in financial markets. Our group considers European standards, labels and ratings as tools for potentially matching financial assets with sustainable targets.
Creating common standards and labels helps investors to understand what companies are doing, and bring trust towards ‘green’ objectives. At the same time, however, we need to recognise that these are two fundamentally different concepts: a standard sets out minimum requirements for an action, while a label means proof of fulfilment of a criteria.
A standard is much more flexible for a company, especially if the minimum requirements are reasonably principle-based and leave room for manoeuvre. A label necessitates a reporting and auditing scheme, which imposes another layer to a company’s administrative costs. Understanding the pros and cons of both these frameworks is required when we want to address the need to mainstream sustainable finance.
Reforming credit rating methodologies has also been suggested as a way to integrate sustainability considerations to a company’s perceived value. If sustainability in a company’s business model would affect its debt price, it would create a strong incentive to align actions with sustainability. On the other hand, both ratings and labels look to the past, so there remains a need for an investor to ensure that a company continues to operate according to sustainable business models throughout the investment’s duration.
To become an integral part of financial markets, sustainable practices need companies that drive the development and help set the bar high. The most substantial effects are brought about by all the others that follow, though.To mainstream sustainability, we need to ensure that there are diverse and easy-to-grasp first steps available for companies of all sizes. The approach should be similar to a company’s listing process; requirements grow along with the company.
The best way to steer finance towards sustainable assets is to reform markets in a way that incentivises companies to do so. There is no silver bullet, and if taken to excess, each of the above-mentioned measures can act as an impediment rather than a stepping stone for mainstreaming sustainability. Too strict requirements will create a niche, not mainstream. Through rightly-adjusted standards we can help companies, big and small, to design their strategies so that sustainability will be taken as an integral part, not an add-on, in their operations.
‘Responsible’ labelled products are sometimes used to phase out other kinds of investments, but for a smooth transition to happen, simple divestments aren’t the solution. Rather, companies’ top management needs to redesign their business operations, and financial institutions as owners, investors, lenders and asset managers can help them to do just that – not by abandoning them, but by steering them towards a new course and strategy.

The approach should be similar to a company’s listing process; requirements grow along with the company.

Fintechs providing loan and payment services are spreading in Europe as a consequence of the Payment Services Directive II. These days, companies have access to money, and traditional financial institutions have to face increasing competition. But long-established financial companies have a competitive advantage in their knowledge about market and business operations. If they make use of this resource, they can help the companies in which they invest to adjust to the new business environment and create opportunities out of sustainability demands.
Compromise between ambitious sustainability standards, labels and ratings and their usage to reach a critical mass won’t be easy to find, but should nevertheless be our first priority. Inaction is more expensive in the long run. The good thing is that if we don’t get everything perfect at once, the definitions and framework can be improved over time.

Esko Kivisaari is the Deputy Managing Director of Finance Finland, formerly the Federation of Finnish Financial Services. He is also Chair of the Insurance Committee for the Actuarial Association of Europe and Vice-Chair of the Pensions and Employee Benefits Committee at the International Actuarial Association.

To give feedback on the group’s interim report, published in July, see here.