The market for “sustainable finance” has grown exponentially over the last few years. The term usually denotes investment approaches that consider environmental, social and governance factors (“ESG”) in portfolio selection and management. Following up on the Paris Agreement of 2016, the European Union has ambitious plans to mobilize private capital for contribution to sustainability concerns such as climate change and pollution.
In January 2018, the EU High-Level Expert Group on Sustainable Finance published its final report. [1] It suggests focusing on common taxonomy and standards, investor duties, transparency of asset managers, governance of companies, and enhanced powers of the European Supervisory Authorities. In March 2018, the European Commission went ahead with an action plan, announcing a number of short and long-term legislative steps that should be taken.
Soon after, in May 2018, the Commission submitted proposals for three distinct regulations on sustainable finance: (1) a taxonomy of assets qualifying as “sustainable”; (2) rules on transparency of institutional investors and asset managers; and (3) carbon benchmarks.
The first proposal establishes a taxonomy that is aimed at improving investment decisions. It lays out uniform criteria for defining whether an “economic activity” is environmentally “sustainable.” Note that the proposal speaks only about economic activities, and does not provide criteria for assessing individual issuers or financial assets, nor does it establish a certificate for sustainability. The Commission proposes four criteria to apply when assessing the degree of environmental sustainability. First, the economic activity has to contribute substantially to one or more of six environmental objectives. Those objectives are climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection of healthy ecosystems. Second, the activity may not significantly harm any of these objectives. Third, the activity must be carried out in compliance with certain minimum safeguards to ensure that worker and labor rights are respected as defined by the International Labour Organization’s declaration on Fundamental Rights and Principles at Work. Lastly, the activity has to conform to technical screening criteria to be defined by the Commission.
The second proposal focuses on institutional investors and asset managers and their investment approaches. They will be required to integrate the ESG factors into their internal strategy, and to inform their clients about this strategy. This includes disclosing policies governing how they integrate sustainability risks into their investment decision-making procedures. Such disclosure extends to the expected impact of sustainability risks on the return of financial products and to the link between compensation and the integration of sustainability risk.
The third proposal takes up the variety of indices currently used as benchmarks for “low carbon.” The wide divergence of these approaches causes significant information asymmetries. The proposal lays down a regulatory framework for harmonized low carbon benchmarks and introduces a distinction between low-carbon and positive carbon impact benchmarks.
All three proposals focus on financial market participants, primarily institutional and asset managers. An earlier European directive on disclosure of non-financial information addresses issuers.[2] The directive requires issuers with more than 500 employees to include a non-financial statement in their management report. This statement covers, among other topics, a description of the policies in relation to ESG factors, the outcome of these policies, and the principal risks related to those matters. Based on a “comply or explain” approach, issuers which do not pursue any policy must provide an explanation.
The focus of the U.S. Securities and Exchange Commission (“SEC”) has so far been on issuers. For five years, the agency has worked on a “Disclosure Effectiveness” project,[3] including a Concept Release on how to modernize Regulation S-K.[4] As part of this project, the SEC has sought input regarding whether ESG factors should be considered material to investors, which would lead to enhanced disclosure obligations by issuers. Disclosure targets are not institutions or asset managers, but registrants in their periodic reports to shareholders. A recent petition to the SEC for a rule making on ESG disclosure[5] has argued forcefully that the SEC has statutory authority to require disclosure of this kind and that ESG information is material to a broad range of investors today.[6] In an effort to reduce the costs of new disclosure mandates, U.S. scholars have pondered a “comply or explain” approach similar to that discussed above,[7] a strategy France has been applying to sustainability reporting for asset managers and institutional investors since 2015.[8]
Conclusion
Comparing these two approaches, the broader goal of raising awareness for sustainability issues can be approached from two very different angles. The approach taken up by the recent EU proposals speaks to institutional investors and asset managers. It requires these actors to disclose their portfolio strategy according to the ESG factors. Using this strategy, the regulator hopes to make for better informed investment decisions by the end beneficiaries of institutional investors – for example, pensioners. If these end beneficiaries base (some of) their investment decisions on ESG factors, the EU proposals hope to set incentives for funds and asset managers, to take ESG factors into account. By contrast, ESG reporting, as discussed by the SEC and addressed in the EU directive of 2014, enlists issuers, shareholders, boards, and management. As both approaches rely on market forces, the ultimate test for their effectiveness will depend on how these markets price sustainability strategies of financial intermediaries and issuers.
Footnotes
[1] High-Level Expert Group on Sustainable Finance Final Report 2018 (PDF: 2.71 MB)
[2] DIRECTIVE 2014/95/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL (PDF: 361 KB)
[3] Disclosure Effectiveness Project
[4] Concept Release: Business and Financial Disclosure Required by Regulation S-K (PDF: 1.8 MB)
[5] Authored by Cynthia Williams and Jill Fish.
[6] Request for rulemaking on environmental, social, and governance (ESG) disclosure (PDF: 649 KB)
[8] LOI no.2015-992 du 17.8.2015 relative à la transition énergétique pour la croissance verte
Dr. Katja Langenbucher is a Professor at Goethe-Universität Frankfurt.
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