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Europe needs a more ambitious sustainable finance strategy

Sustainable finance

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Finance Watch statement commenting on the European Commission ‘Strategy for Financing the Transition to a Sustainable Economy‘ released on 6 July 2021.

Europe’s citizens expect more.

From a clear leader three years ago, the EU is moving to the middle of the pack on sustainable finance. Actions outlined in the strategy fall short on ambition. If pursued as tabled, Europe may miss the deadline set for its climate goals.

This strategy misses on many fronts, including a chance to integrate sustainability into prudential rules and the need for a sea change in corporate behaviour to put the economy on the path to sustainability. The Commission approach runs counter to its own acknowledgment for Europe needing to take “unprecedented efforts to mitigate climate change, rebuild natural capital and strengthen resilience and wider social capital.”

The core strategy aim should tackle without delay much-needed integration of sustainability into corporate governance, including through mandatory sustainability targets and transition pathways, and prudential treatment of sustainability-related financial risks. EU lawmakers wield the necessary tools and mandate to act. A looming climate emergency requires Europe to be bold, impactful and take immediate actions. Achievable solutions exist. Finance Watch offers many, including ideas to incorporate climate risks into the capital requirements rules for insurance companies.

Transparency: More needed

On transparency, the EU taxonomy must be extended to include social goals and harmful and no significant impact economic activities to accelerate the transition to an inclusive, just and sustainable economy. “Greenwashing” must be defined and financial products and instruments accessed according to their ability to effectively allocate capital for sustainable projects.

Supervisors will not be able to do their job properly unless they refer to a set of common ESG standards to assess against products and financial products. Setting up an EU Green Bonds Standard makes sense, but many will question whether creating voluntary standards and labels matches the urgency of the looming climate and environmental storm. On another front, developing digital technologies, albeit to support sustainable finance, is not as such a game-changer.

Risk-based approach: Withstanding climate change risks

Proposed measures to boost financial sector resilience to sustainability risks completely ignore regulatory capital requirements – the major prudential tool to ensure solvency of financial institutions. Paradoxically, and correctly, the strategy recognises that “unsustainable investments are increasingly likely to become stranded”, but stops short of reflecting this fact in the prudential capital requirements rules. This inaction turns a blind eye to evidence around stranded-asset risk in the fossil fuel industry, and to the recent International Energy Agency (IEA) report calling for all new investments in fossil fuels to stop immediately. Such an approach goes against the precautionary principle of the Treaty on the Functioning of the European Union.

In the absence of solid capital requirements rules, expect extremely low effectiveness of the proposed measures to tackle climate-related financial risks, such as institutions´ internal risk management, supervisory review, disclosures and stress testing. Measures on stress testing are an empty statement given that there is, and there can be, no such thing as climate change-related stress tests. Climate “pilot exercises” and “scenario analyses” will not result in any prudential actions given the radical uncertainty of climate events which render quantitative modelling unable to lead to meaningful conclusions.

It is also highly regretful that the European Commission is ceding to the intense pressure of the financial lobby and asking EBA and EIOPA to move ahead on the preparation of a green supporting factor, which is a completely unnecessary tool. It is also a dangerous one, as it uses prudential regulation for what it should not be – an economic policy tool – as opposed to what it is meant to be – a risk-based tool.

It would be useful for strategy proposals to review the macroprudential tools for banks and incorporate ESG considerations into credit ratings. Credit ratings should ensure that climate-related risks include stranded assets risk even when debt obligations have a near- term maturity, failing which systemic risk will continue being fed by the tragedy of the horizons and therefore ignored. Importantly, the macroprudential review would need to also include insurance companies.

Corporate governance: Transformational change needed

The financial sector remains front and centre in the strategy, marginalising the need for a change in corporate behaviour to put the economy on the path to sustainability.

Scientists increasingly warn of the urgent need for transformational change on processes and behaviours at all levels: individual, communities, business, institutions and governments. Yet the forthcoming initiative on sustainable corporate governance, the target of heavy lobbying during the last weeks and months and already delayed, is severely underplayed in the strategy.

To ensure that the Union delivers on its climate and environmental commitments, EU policy makers must adjust the corporate governance framework to integrate a set of incentives and obligations for companies to pursue sustainability.

Companies should be obliged to set sustainability targets, including transition and decarbonisation plans to meet those targets. The strategy refers to a guidance to support voluntary pledges as well as to the disclosure obligations brought in the proposal for a Corporate Sustainability Reporting Directive, but experience shows that voluntary initiatives fall short. Disclosure requirements alone will not work unless underpinned by a clear obligation for companies and investors to set the targets and transition pathways. To build-in the most impactful behavioural incentives, half of variable remuneration given to directors should be aligned with corporate sustainability targets.

Transparency: Good start but more needs to be done

The Commission’s next steps outlined in the strategy look promising, in particular the importance given to double materiality, but certain actions are missing and some could go further or faster.

EU taxonomy: Little commitment has been made towards widening the EU taxonomy to include social objectives as well as harmful and no significant impact economic activities, despite being important actions to spur the transition towards a sustainable and inclusive economy.

ESG data, ratings and research: There is clear intention to improve the availability, integrity and transparency of ESG market research and ratings. However, we call for action over further analysis. The 2018 Action Plan addressed this and the Commission study conclusions are clear.

Double materiality: Prominence given to the concept of double materiality merits support. It recognises the importance of the systematic consideration and integration of both “outside-in” financial materiality and “inside-out” socio-environmental materiality in financial risk assessment and decision-making processes. Double materiality is as relevant for the real economy as it is for the financial sector, and its principles must form the basis of all financial and economic rules, including the forthcoming proposal on sustainable corporate governance. This will be all the more important given that a number of non-EU reporting standards, including those promoted by the Task Force on Climate-related Financial Disclosures, operate on the sole consideration of financial materiality.

Greenwashing, labels and standards: Supervisors have an important role to play in the fight against greenwashing. They need the necessary powers and tools to that end and the initiatives going in that direction deserve support. However, their actions will show little, if any, impact without defining what constitutes greenwashing. The absence of a commonly agreed set of ESG standards for financial products also limits their muscle. To address the shortfall, standards need to include an assessment of financial instruments against their ability to effectively fund the real economy and its transition to sustainability.

Thierry Philipponnat, Finance Watch’s Head of Research and Advocacy, said:

“The renewed sustainable finance strategy communicated by the European Commission pays lip service to sustainability objectives, but on many fronts it does not give itself the means of reaching its proclaimed ambition. This is particularly obvious on the question of sustainability-related risks where the actions proposed are tantamount to casting a plaster on a wooden leg absent the integration of those risks into capital requirements rules.

“Transparency and mainstreaming sustainability in finance are important, but they form no substitute for real action to change corporate behaviour and improve corporate accountability.”

Finance Watch Secretary General Benoît Lallemand added:

“Under Article 191 of the Treaty on the Functioning of the European Union (TFEU), EU leaders have a duty to preserve, protect and improve the quality of the environment, and in particular to combat climate change. By setting the right ambitions but failing to take appropriate action, in particular when it comes to sustainable corporate governance and sustainability-related risks, the Strategy for Financing the Transition to a Sustainable Economy proposed by the European Commission is a glaring violation of Article 191 TFEU.”

For more information, contact James Pieper, Finance Watch, on +32 496 51 72 70 or at james.pieper@finance-watch.org.

Notes to editor:

Background on the Strategy for Financing the Transition to a Sustainable Economy

Communicated by the European Commission on 6 July, the strategy builds on the 2018 Commission Action Plan on financing sustainable growth which put in place the building blocks for the EU sustainable finance agenda. Via the strategy, the Commission reaffirms its commitment to deliver on the remaining actions stemming from the 2018 Action Plan and unveils new and follow up actions bearing in mind EU sustainability goals have evolved while the global context has changed since 2018.

The strategy identifies four main areas where additional actions are needed for the financial system to fully support the transition towards sustainability:

  • Financing the path to sustainability. This strategy provides the tools and policies to enable all economic actors across the economy to finance their transition plans, to reach climate and broader environmental goals.
  • Inclusiveness. The strategy caters to the needs of;and provides large-scale opportunities for citizens and small and medium-sized enterprises (SMEs) to further access to sustainable finance.
  • Financial sector double materiality. This strategy sets out how the financial sector itself needs to change to meet Green Deal targets, while also becoming more resilient and combatting greenwashing.
  • Global. This strategy lays out how to foster and promote an international consensus for an ambitious global sustainable finance agenda.

In July 2020, Finance Watch responded to the Commission consultation on the Renewed Sustainable Finance Strategy putting forward its recommendations for the direction of travel and next actions needed.

Finance Watch Report: Breaking the climate-finance doom loop

Finance Watch published in June 2020 a report showing how banking prudential regulation can tackle the link between climate change and financial instability. The report calls for immediate regulatory action to end the climate-finance doom loop, in which fossil fuel finance enables climate change, and climate change threatens financial stability in unpredictable ways. An upcoming report by Finance Watch will address the link between climate change and financial instability in the insurance sector.

Finance Watch legislative proposals: Incorporating climate-related financial risk into Pillar I capital requirements

Finance Watch published in May 2021 proposals for changes to the minimum regulatory capital requirements for banks’ and insurance companies’ exposures to fossil fuels via amendments to the CRR and Solvency II. The amendments were sent in May 2021 to EU policymakers in an open letter. The amendments suggest increased capital charges for fossil fuel assets to reflect the associated climate-related risks. The Finance Watch capital charges proposals differentiate between existing fossil fuel resources and new resources to take account of the different risk profiles of both.

Finance Watch work on Sustainable Corporate Governance

Finance Watch responded in February 2021 to the Commission consultation on sustainable corporate governance, calling on EU policy makers to adjust the corporate governance framework to integrate a set of incentives and obligations for companies to pursue sustainability. An ambitious EU legal framework is needed to require companies to integrate sustainability considerations within corporate strategies, business models, decision-making and oversight. These recommendations were reflected in a joint-NGO policy briefing published in June 2021, showing a unified vision on how to better embed sustainability into corporate governance in the context of the forthcoming European Commission initiative.

Finance Watch work on improving corporate and financial industry transparency

Finance Watch advocates for improved sustainability-related disclosures of corporates – financial and non-financial – and financial products. In June 2020, Finance Watch responded to the Commission consultation on the revision of the non-financial reporting directive (NFRD). In April 2021, Finance Watch reacted to the Commission sustainable finance package, including a proposal for a Corporate Sustainability Reporting Directive, revising the Non-Finance Reporting Directive. Finance Watch views were echoed in a joint NGOs’ statement published later that month.

Finance Watch actively participates in shaping the EU Taxonomy as a member of the Platform on Sustainable Finance and responses to various consultation:

  • Dec 2021: Response to the ESMA consultation on Art 8 Taxonomy-related disclosures
  • Dec 2021: Feedback on the draft Delegated Acts on climate mitigation & adaptation (EU Taxonomy)
  • Jan 2021: Response to EIOPA consultation on Taxonomy Regulation Article 8 disclosures
  • May 2021: Response to the ESAs consultation on EU taxonomy-related sustainability product-level disclosures
  • June 2021: Response on the Draft Delegated Act on Art. 8 of the Taxonomy Regulation

About Finance Watch

Finance Watch is an independently funded public interest association dedicated to making finance work for the good of society. Its mission is to strengthen the voice of society in the reform of financial regulation by conducting advocacy and presenting public interest arguments to lawmakers and the public. Finance Watch’s members include consumer groups, housing associations, trade unions, NGOs, financial experts, academics and other civil society groups that collectively represent a large number of European citizens. Finance Watch’s founding principles state that finance is essential for society in bringing capital to productive use in a transparent and sustainable manner, but that the legitimate pursuit of private interests by the financial industry should not be conducted to the detriment of society.

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