HLEG. A sustainability test for the regulatory process: a good start

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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One of HLEG’s early recommendations (number five) was to require the EU to develop and undertake a sustainability test of its policies and regulations. More concretely, it wants the European Commission to subject its EU legislative proposals for financial services to a sustainability impact assessment describing the environmental, social and governance (ESG) impacts. The goal of the impact assessment is to include sustainability at the beginning of the EU regulatory chain. Given the long-ignored link between the financial sector and climate, as well as other environmental and social impacts, well-researched impact analysis will better clarify how legislation and regulation is stimulating EU finance to be supportive of environmental and social sustainability – especially where this is prevented by current market dynamics and market failures.

What could be the tools for providing insight on how EU financial legislation affects social and environmental sustainability, let alone promoting it?

Well-researched impact analysis will better clarify how legislation and regulation is stimulating EU finance to be supportive of environmental and social sustainability

Note that the Commission has the sole mandate to initiate and review EU financial legislation (Directives or Regulations) and present it for further decision-making to the European Parliament and the European Council of Finance Ministers (ECOFIN). When presenting such legislation, it has the obligation to publish the related impact assessment report. These reports have long had a social and environmental impact subchapter. The problem is that the Commission stated in these sub-chapters – mostly in one or two sentences – that there were no such impacts of financial legislative proposals, even if the financial crisis had shown serious social and economic impacts which had prompted the new financial laws. Since 2015, the Commission’s Better Regulation methodology has been accompanied by a useful Better Regulation Toolbox tools are clear indicators for assessing social and environmental impacts of potential legislation, such as:

• Tool #28 -Fundamental rights & human rights
• Tool #29 -Employment, working conditions, income distribution, social protection & inclusion
• Tool #32 -Consumers
• Tool #33 -Territorial impacts
• Tool #34 -Developing countries
• Tool #35 – Resource efficiency

Nevertheless, after 2015, the impact assessments of the financial legislation have continued to ignore these tools, and have lacked of a serious methodology to understand these social and environmental impacts. So far, the different consultation procedures have not been able to improve the impact reports. The development of the methodology for social and environmental impact assessment of finance will need new research and an analytical framework that goes beyond the traditional evaluations. Such an approach was also needed when DG Trade initiated Sustainable Impact Assessments (SIAs) for future trade agreements, which were a change from traditional impact assessments that had a business, economic and legal perspective.

The SIAs explored how environmental impacts should distinguish between, amongst others, climate change, biodiversity, natural resources, water and pollution. This analysis could be applied to financial legislation: for instance, that which facilitates more lending or investment, like the recent EU law on securitization, and the new legislative proposal on personal pension funds (PEPPs). Such new legislation might result in more indirect investments in companies and projects operating in fossil fuels, mining and processing of natural resources, agriculture, and consumer goods, etc.; or in renewables, recycling and innovative sustainable products. The way the EU law includes ESG aspects will play a role in investment choices.

The social aspect includes impacts on employment and income among different groups, as well as labour rights and human rights, inclusion and discrimination. For instance, proposals for private pension funds may provide direct income for the asset class management sector, but pensioners’ future income will depend on the vagaries of interest rates and financial markets – even if the pension funds are well managed. Civil society organisations from around the world have illustrated with many case studies how financiers (banks, investors) contribute or facilitate companies, projects and activities that harm human rights (unhealthy work, land grabbing) and the environment (exacerbating climate change through fossil fuel industries or deforestation).

The Commission urgently needs to develop a sustainability impact assessment methodology, since it indicated it was willing to take the HLEG interim report into account. New legislative initiatives are in the pipeline, such as the review of the three European Supervisory Authorities (ESAs): one for banking (EBA), one for the financial markets (ESMA) and one for insurance and pensions (EIOPA). These ESAs are also responsible for drafting technical standards or guidance on EU financial laws. Experience over recent years has shown that their technical standards and guidance can have a great influence on how EU financial laws are implemented, and therefore what their impact is on the economy and stakeholders, including on social and environmental aspects. The ESAs will need to do a sustainability test of their technical standards and other guidance instruments.

Recent legislation such as occupational retirement provisions (IORP II, 2016) and the proposed pan-European pension fund product (PEPP) stipulates that investors should cover ESG risks (IORP II, Art 25) or disclose whether they take ESG factors into account (PEPP, Art. 27, 29). A sustainability test of the upcoming review of the ESA legislation should ensure that ESAs can duly propose technical standards and guidelines to implement these laws, within the current mandate or with a new mandate if need be (see also ‘early recommendation’ number seven in HLEG’s interim report).

The ultimate test however, will be for the financial industry itself to assess whether EU legislation around sustainable impact assessments, and ESG considerations integrated into EU law, will have a positive impact on the ground. Case studies by civil society organisations and researchers, including SOMO, have experienced that effectiveness of these kind of ESG criteria is not easy to assess: often negative impacts on the ground are exposed only after careful cooperation with local or domestic organisations, for example. Research in financial databases are used to detect the linkages between particular companies and their financiers (often different forms of loans and different investor types from numerous jurisdictions).Institutional investors with shares in large international companies may not be provided with detailed information about companies that belong, directly or indirectly – sometimes through tax havens – to these companies. This means that assessing the real impact will be more costly than current standardised practices and on-screen financial figures; and even more than paying for extra analysis by responsible investment rating agencies that do not do on-site visits. Within the financial chain, from issuer or borrower to the ultimate investor or lender, the costs of these impact assessments will have to be internalised. Such on-the-ground impact assessments will enable the financial sector to become more viable and profitable over the long term.

The ESAs will need to do a sustainability test of their technical standards and other guidance instruments.

The Commission’s improved impact assessments should be done with due resources, consider the experiences of earlier reports and that of the financial industry, and be based on implementation studies. They should clarify what kind of legislation (e.g. promoting passive investment or supporting the financing of small innovative sustainability initiatives) is the most suitable in order to stimulate – and if needed, enforce – sustainable finance. They should also provide guidance on what kind of requirements within the legislation is needed: for example, only requiring disclosure of whether ESG factors have been taken into account, or requiring particular ESG measurements and opportunities of what is being financed.

Myriam Vander Stichele is a Senior Researcher at the Centre for Research on Multinational Corporations (SOMO), a Dutch-based not-for-profit.

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