The European Commission has held a detailed public consultation to inform its work on the upcoming Renewed Sustainable Finance Strategy. This package will shape the debate on sustainable finance in Europe for the years to come. You can download the Finance Watch’s response, or read its summary hereunder:
Finance Watch’s nine priorities for Europe’s Renewed Sustainable Finance Strategy
1 Clarifying what sustainable is, and what it is not
In parallel to finishing the classification of environmentally sustainable economic activities (i.e. the Green taxonomy), the EU is contemplating defining and classifying economic activities that significantly contribute to climate change, biodiversity loss, and other environmental issues. Finance Watch thinks that creating a brown taxonomy (Q82) could make it easier for private and public institutions to respectively stop investing and stop subsidising activities that are not in line with the Paris agreement and the Convention on Biological Diversity, among other objectives (Q82.1., 82.2.).
2 Using taxonomies to incentivise green and disincentivize brown
Finance Watch supports the Commission’s commitment to explore how the EU Taxonomy can be used by the public sector (Q70). While the EU green and (future) brown taxonomies could primarily help to classify and report on green/brown public expenditures and investments, it could also become cornerstones for specific policy mechanisms aimed at incentivizing green and disincentivizing brown investments: Taxonomies could then be used to calibrate specific public support mechanisms (Q70.1) (e.g. tax deduction for companies with a certain threshold of taxonomy-compliant activities). It could also be used to calibrate green public procurement, therefore increasing the demand for taxonomy-aligned goods and services (Q71.1).
3 Unlocking the pipeline of sustainable projects
While numerous barriers explain the lack of sound sustainable projects to invest in, the most important one is the lack of appropriate long-term incentives (Q60). In a world where overexploiting nature is done at low/zero cost, unsustainable activities will remain more profitable than sustainable ones. Policymakers must shift profitability away from unsustainable activities. This can be achieved through economic instruments (e.g. environmental taxes, carbon pricing) which should, whenever possible, be built on the EU taxonomy – as discussed in our recently published “Nature’s Return“.
The second is the excessive risk perception (Q60) and it can be overcome with the help of well-designed blended finance mechanisms. This agenda of derisking necessary sustainable investments is already well advanced through InvestEU, but questions remain on the amounts of funding available and on their additionality.
Finally, there is a lack of public funding for necessary sustainable projects that do not have sufficient revenue streams (Q60) – e.g. most conservation projects. This can’t be solved by changing economic incentives or the flow of ESG information. Policymakers must create a policy framework that ensures sufficient public funding for these.
4 Ensuring a better access to reliable information on companies’ sustainability
Financial professionals can’t take the sustainable dimensions into account in the absence of information on the sustainability of the economic activities that they finance. The ongoing review of the corporate non-financial reporting framework (i.e. NFRD and EU ESG standards) is expected to finally bring comparability on the impacts, risks and dependencies of a broader scope of companies towards the environment.
But how and where these “non-financial” informations are disclosed is not neutral. Finance Watch therefore supports the creation of an open data platform (Q14-14.1) reflecting EU standards, and whose access should be made free of cost, or at a very low price.
A next step would be for the EU to ensure appropriate regulation and supervision of ESG ratings agencies and data providers (Q21-21.1), particularly for potential conflicts of interests and reliability of the data. While an improved non-financial reporting framework will do a lot in improving consistency and reliability of ESG ratings, diversity of sources will remain important. We are therefore concerned about the level of concentration in the market for ESG ratings and data (Q17).
5 Clarifying financial products’ ability to impact the sustainability of the economy
The ongoing process of creating an ecolabel for financial products and green bond standards should be complemented by labels and minimum standards for sustainably denominated investment funds (Q28) as this market is characterised by a wide dispersion of meanings, definitions and standards. While minimum standards are simpler and cheaper to adopt than labels, both are needed.
While we welcome the creation of European green labels and standards, we can’t elude a simple fact: not all financial products are equally able to finance a sustainable economy. For this reason, Finance Watch is calling for the creation of a taxonomy of financial products and financial practices (Q52-53). This taxonomy would define under which conditions a financial product, or practice, can be said to positively impact the sustainability of the economy, and would classify them accordingly.
6 Tackling adverse social and environmental impacts of company’s own operation and supply chains
The creation of a harmonized EU framework for supply chain due diligence (Q47) would have a strong impact on the identification and mitigation of some negative social and environmental impacts in a company’s own operations and supply chains. While it should apply to all companies (Q48) if environmental and human rights issues are to be tackled effectively, SMEs should benefit from lighter minimum requirements (Q48.1).
7 Addressing short termism and reducing environmental risks by tackling harmful financial practices
The ESAs have made a series of proposals to tackle short-termism (Q38) imposed on companies by the financial systems – such as defining clear objectives on portfolio turn-over ratios and holdings periods for institutional investors. More fundamentally, financially induced short-termism has its roots in widespread financial practices such as “benchmarking” (Q39) which is itself the mother of a detrimental practice: passive investing.
Passive investing is in contradiction with the development of sustainable finance (Q45, 45.1) as, by construction, passively managed portfolios replicate indices mimicking today’s unsustainable economic world. Furthermore, it is structurally short-term biased, having developed hyper liquid instruments (e.g. ETFs) that gives the possibility to ride short-term profits from an unsustainable world with the possibility of exiting the market before it collapses.
The EU should act to address passive investing’s negative impacts (Q45.1), notably (1) by encouraging member states regulators to stop requiring funds to benchmark themselves and (2) by prohibiting these practices and related products to be marketed as sustainable, green or Paris-aligned.
8 Resisting lobbyist argument: funding the transition does not require to reduce capital requirement
Since the start of the Sustainable Finance agenda, banks are advocating in favor of a reduction of their capital requirement to incentivize them to lend to green projects – the so-called “green supporting factor” or “sustainability supporting factor”.
While the objective of prudential regulation is to foster financial stability, and not to serve as an economic-policy tool (Q68.1), this call from banks is fallacious: we live in a world of abundant liquidity where sound green projects face no difficulty to attract capital or to obtain a loan (Q89.1). Furthermore, the idea of introducing such a “supporting factor” based on the EU green taxonomy would be particularly harmful as the taxonomy is not a risk classification of assets, but a sustainability classification of economic activities.
In contrast to this false good idea, there is an absolute necessity to tackle the link between climate change and financial instability.
9 Breaking the climate-finance doom loop
While there is no contestation of the fact that climate change will trigger financial risks through the channels of physical and transition risks, Finance Watch wants to highlight the existence of another channel of financial risks: disruption risks (Q84). We define disruption risk as the fact that climate change will disrupt human societies, which will disrupt the world economy, which will disrupt the financial system.
While the occurrence of these risks is as certain as their quantification is impossible to realise, there is meanwhile a need to better incorporate ESG risks into prudential regulation (Q88).
Fossil fuel (defined as coal, oil, natural gas, bituminous and shale gas) is the source of CO2 emission and, as such, is both the source of macro-prudential risks (i.e. disruption risks due to the exhaustion of our carbon budget) and of micro-prudential risks (i.e. stranded assets). Fossil fuel should therefore warrant a more risk-sensitive treatment in banking prudential regulation (Q88.1) – as described in our recently published “Breaking the climate-finance doom loop“.