Sustainable finance: regulatory intervention on the horizon

In this latest banking reform updater, we discuss initiatives to embed sustainable finance principles in the fabric of financial institutions. In doing so, we consider global initiatives such as the Financial Stability Board (FSB) Taskforce on Climate-Related Financial Disclosures, and examples of leadership such as the Sustainable Banking Network and the European Commission’s Action Plan on financing sustainable growth. Although banks and other financial institutions may already be implementing sustainable finance standards on a voluntary basis, in this article we examine the trend towards increased legislation and regulation in this area.

The objective of sustainable finance is broadly to achieve economic growth whilst reducing environmental impact, minimising waste, and reducing greenhouse gas emissions. This objective builds on global political commitments such as those made under the Paris Agreement¹ and the UN Sustainable Development Goals². Although sustainable finance has its origins in climate finance (referred to under the Paris Agreement as finance to fund activities that reduce greenhouse gas emissions or help society adapt to the impact of climate change³), the scope of sustainable finance is broader, encompassing wider environmental, social, and governance (ESG) objectives.

The expected transition to a lower-carbon economy is estimated to require around US$1 trillion of investments a year for the foreseeable future. Financial institutions therefore have an important role to play in promoting sustainable development and re-orientating the global economy towards more sustainable investments.

In parallel, the management of environmental and social risk factors is increasingly recognised as a requirement for a resilient financial system. The longer-term nature of environmental, resource or climate change related risks means that traditional investment criteria may not adequately cover this exposure.

As a result, initiatives are increasing at the international, regional, national and corporate level, to promote sustainable finance. Whilst initiatives vary, in general these propose a framework to assist financial institutions in changing their governance and risk management functions, so as to incorporate ESG and climate change objectives into decision making. These initiatives also often seek to provide greater transparency for investors, developing a framework for risk disclosure and enabling benchmarking of sustainable finance policies across different organisations and markets.

Consensus is growing that there is a link between stability and sustainability. Research is being undertaken internationally including under the UN Environment Programme Inquiry into the Design of a Sustainable Financial System and the G20’s Sustainable Finance Study Group.

In recognition of the near and longer term risks and opportunities posed by climate change and the transition to a low carbon economy, at the request of the G20, the Financial Stability Board established a Task Force on Climate-related Financial Disclosure (TCFD), which presented its findings in June 2017⁴. The TCFD recommendations apply to financial-sector organizations, including banks, insurance companies, asset managers, and asset owners and relate to four key areas:

• Governance - who should be responsible for assessing and reporting on climate-related risks and opportunities
• Strategy – what the actual and potential impacts of climate-related risks and opportunities are
• Risk Management – what processes are used to address these
• Metrics and Targets – what data sources and methodologies are used to measure this.

Although this is a voluntary framework, already, we are seeing the TCFD recommendations influence policy and practice at every level.

The European Union (EU) has pledged to take leadership in sustainable finance, in order to fulfil EU commitments under the Paris Agreement. In March 2018, following publication of the Final report of the High-Level Expert Group on Sustainable Finance, the European Commission adopted an Action Plan on Financing Sustainable Growth⁵. We summarise below some of the actions which the Commission propose:

• Taxonomies: To propose legislation in Q2 2018 to develop a taxonomy for climate change, environmentally and socially sustainable activities which will provide a legal basis for using this classification system across different areas (e.g. standards, labels, green-supporting factor for prudential requirements, sustainability benchmarks). Development of taxonomies will be led by an expert group in H1 2019
• Labelling: Specifying, by Q2 2019, of the content of the prospectus for green bond issuances, under the Prospectus Directive. The Commission will also explore an EU wide-standard for green bonds as well as a labelling framework for certain financial products based on the harmonised sustainability taxonomy
• Advice: Amending the Markets in Financial Instruments Directive II and Insurance Distribution Directive delegated acts in Q2 2018 to ensure that sustainability preferences are taken into account when assessing a client’s needs
• Sustainability benchmarks: In Q2 2018, adopting delegated acts under the Benchmarks Regulation to allow users to better assess the quality of sustainability benchmarks and, subject to its impact assessment, put forward an initiative for harmonising benchmarks comprising low-carbon issuers
• Credit ratings: Exploring the merits of amending the Credit Rating Agency Regulation to require sustainability factors to be taken into account in credit rating assessments
• Fiduciary duties: Subject to its impact assessment, making a legislative proposal to clarify institutional investors' and asset managers' duties in relation to sustainability considerations by Q2 2018
• Risk management: Exploring the feasibility of including risks associated with climate and other environmental factors in institutions' risk management policies with the potential to adjust capital requirements of banks under the Capital Requirement Regulation and Directive. Similarly the European Insurance and Occupational Pensions Authority will be invited to provide an opinion on the impact of prudential rules for insurance companies on sustainable investments, with a particular focus on climate change mitigation
• Disclosure: A number of actions relate to sustainability disclosure. The Commission will assess the fitness for purpose of the current legislative framework including the Directive on disclosure of Non-Financial Information and will assess the impact of new or revised accounting standards on sustainable investments. In Q2 2019 the Commission intends to revise the guidelines on non-financial information to provide a methodology for disclosure of climate-related information, in line with TCFD and the EU’s climate-related metrics developed under the EU classification system (mentioned above). Environmental and social factors will be added subsequently.

The European Parliament is similarly preparing its position. In April 2018, the European Parliament’s Committee on Economic and Monetary Affairs voted to adopt a draft report on sustainable finance⁶. The draft report, which will be voted on in plenary session in May 2018, calls on Member States to evaluate their public investment needs to ensure that the EU is on track to meet its climate change goals, as well as calling for legislative intervention in establishing credible green taxonomies and for the integration of sustainable finance criteria into all legislation related to the financial sector.

Emerging markets are also showing leadership in this area. However, in absence of a supra-national framework like the EU, the Sustainable Banking Network (SBN) has emerged to promote collaboration in developing best practice, disclosure and effective benchmarking of sustainable finance initiatives. Supported by the International Finance Corporation (IFC), the SBN is a voluntary community of financial sector regulatory agencies and banking associations from emerging markets committed to advancing sustainable finance in line with international good practice⁷. SBN members are reported to represent US$ 42.6 trillion in banking assets, accounting for more than 85 percent of the total banking assets in emerging markets⁸.

The SBN’s latest Global Progress Report (GPR), published in February 2018, highlights the progress made by 15 member countries towards the adoption of sustainable finance principles and policies. The measurement framework assesses the design of national strategies against three pillars: i) environmental and social (E&S) risk management; ii) the expansion of financial flows to green projects and iii) the implementation and enforcement mechanisms relating to these.

In relation to E&S risk management policy, the GPR found that existing policies often applied to project and corporate finance, but more rarely extended to asset management or stock exchanges. None of the policies aligned with the countries’ climate change policies, instead more generally referring to international E&S standards such as the Equator Principles or IFC Performance Standards. Although the monitoring of standards was required at a project level, at a portfolio level, fewer than half of the policies reviewed required analysis of portfolio related risks, which are a key tool in “stress testing” the overall quality and safety of financial assets. Whilst most policies required financial institutions to report on E&S risk management, requirements varied in terms of content, control and disclosure requirements. The GPR notes that the TCFD will provide a useful global reference point for climate risk reporting in future.

In relation to initiatives to encourage green finance flows, the GPR found there was little homogeneity amongst these. Green bond guidelines had been adopted in some countries but generally other asset classes or financial products, such as insurance or retail banking, were rarely addressed. Significant gaps were identified in the requirements to define green finance and related concepts and the monitoring of green investments. In relation to implementation, the GPR found that most SBN countries had started their national initiatives with a focus on awareness raising, capacity building and multi-stakeholder engagement. In some cases (China and Indonesia), policies cover the whole of the financial system. Almost all SBN members cited capacity as a major constraint and will be critical to participation by financial institutions.

The convergence of international action to tackle issues of sustainable development and climate change on one hand, and recognition of the role which sustainability plays in a resilient financial system, on the other hand, is beginning to change the way in which financial institutions assess, manage and report ESG-related risks and opportunities. Whilst, in some cases, organisations and markets are already implementing voluntary measures, greater regulatory intervention is on the horizon. Increasingly, regulators are reviewing policies and looking to embed sustainability into the regulatory framework.

The EU appears ready to take a lead with proposals for legislation as part of the Commission’s Action Plan on Financing Sustainable Growth. As global consensus grows, other countries may follow suit, spurred on by initiatives such as the SBN. Banks and other financial institutions may wish to prepare for greater regulatory intervention, by auditing their product labels, risk management practices and disclosure methodologies.