Alarm bells should ring for those not supporting the EU on sustainability

This week, the European Parliament published its position on the European Commission’s sustainable finance legislation, and the next stage of negotiations with Member State Governments will begin.
The European Commission’s Action Plan for a greener and cleaner economy “sets out a roadmap to boost the role of finance in achieving a well-performing economy that delivers on environmental and social goals as well”. It is part of a long-term project to rebuild trust in the financial system. The plan recognises that ‘blunt tools’, such as increased capital requirements on banks and insurers, which were deployed to reduce risk in the European financial system, did so at the cost of productive investment. This is a particular concern given that €1.7trn in investment is currently needed to fill the EU’s 2030 climate and energy investment gap.

This next generation of reforms is a call to action for investors to play a more active role in managing risk in the system and to achieve this by putting sustainability at the heart of how the financial system is governed and operates.

They include:

• Amendments to MIFID II to require clients to be consulted on Environmental, Social and Governance (ESG) preferences.
• Regulation requiring investors to disclose how they integrate ESG considerations into their operations.
• Regulation requiring benchmark providers to disclose how ESG benchmarks are constructed and to prepare a new category of low carbon indexes
• Regulation to establish a new sustainability taxonomy.

The aim is to better manage risk in the system by increasing transparency and explicitly redefining notions of value to look beyond short-term financial returns. The legislation calls on investors to consider not only how their investments will perform in the longer-term, but also the role they play in helping or hindering the creation of a sustainable, low carbon economy.

Given that a day doesn’t seem to pass without more news of social unrest and worsening environmental crises, one would imagine any moves to refocus the capital markets and investment industry on sustainable wealth creation for the benefit of current and future generations, would be universally welcomed. However, these refocuses have not been welcomed by all, with some industry commentators having suggested that such proposals are overly gimmicky and will be ineffective in achieving their objectives.I don’t agree.

The MIFID II rule change is being put in place to identify latent demand for sustainable investment products and to help build demand in the market. The regulation to introduce a sustainable taxonomy should also be viewed positively. It is not designed to constrain the sustainable investment universe, rather, it addresses the confusion surrounding what constitutes sustainable economic activity and what does not. Backed by capital relief for ‘deep green’ projects, it should significantly accelerate the reallocation of capital which is needed to deliver the EU’s climate goals by making capital efficient, particularly for banks in order to create green mortgages and loans.

Similarly, the proposed regulation on sustainable and low-carbon benchmarks is not there to constrain capital to only a few already sustainable firms. Rather it is intended to address the information asymmetry between investors and index providers – stimulating debate about index construction and selection, and the quality of ESG data used. This is incredibly important given the rise of passive investing across the globe.

But sustainable taxonomies and benchmarks alone won’t be enough to shift the economy onto a truly sustainable footing. To do this, the investment industry needs to shift from not simply allocating capital, but stewarding that capital to create sustainable businesses and investment outcomes. This can only be achieved through investors engaging with the firms they own to develop sustainable business models, not just products.

The updated Shareholder Rights Directive paves the way for this type of stewardship approach to become the norm in Europe.

What the European Commission is trying to do is both brave and necessary. The legislative proposals themselves should be supported by any financial institutions truly committed to playing an active role in accelerating the shift to a sustainable economy. If such firms are not supportive, this should raise alarm bells among prospective clients seeks sustainable wealth creation products.

Ingrid Holmes is Head of Policy and Advocacy at Hermes Investment

Note: The views and opinions contained herein are those of the authors and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.