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Beate Born, Executive Director at UBSSustainability, ESG, Climate Change, Carbon Neutral, SDGs and CSR are all expressions we hear and read day in day out in our professional and private lives and it is easy to attribute this media saturation to it just being the next fad, the next big thing to talk about like Brexit, the US elections, Covid or any other recent big news story. This is not an article voicing an opinion on the necessity of climate action (even though I certainly have a strong view on it). It is an article on how the climate change and sustainability willimpact the regulatory environment of the financial services industry. The next paragraphs give an overview over the purpose of the regulatory regime and the regulations it entails.
Global Agreements leading to Financial Services Regulations in the EU
In 2015, 189 nations signed the Paris Climate Agreement and 193 Nations to committed tothe 17 Sustainable Development Goals (SDGs) at the UN 2030 Agenda meeting. Since then the EU Commission has published the Action Plan on Financing Sustainable Growth in 2018 which triggered several amendments to existing conduct and prudential regulations as well asa whole suite of newly created ESG-only regulations specifically for financial services.
Why the sudden focus on financial services? According to the World Bank, USD 2-7 trillion are needed to reach the 17 Sustainable Development Goals (SDGs) by 2030and only USD 150-160 billion are currently available in Official Development Assistance (AOD). It has become clear that this considerable funding gap can only be closed by private sector funds – by shifting assets to sustainable investments (for comparison: the 10 biggest private banks manage approximately USD 11.5 trillion).
After years of hoping that market self-regulation would happen organically, the EU regulator has decided to step in and accelerate the process which brings it to the forefront of regulators triggering policy interventions.
The spirit of the regulation
While not even a regulator is keen on telling people what they can and cannot invest in, there are certain hurdles and incentives that can be created with policy tools. As with MifIDII after the crash of the financial markets in 2007, the ESG regime sets a clear focus on transparency and reporting, trusting that the investor will make the right decision when given the right information. That sustainable investments are currently on the profitable side is a nice supporting factor, of course.
The transparency approach is coupled with the principle of dual materiality. That means, that across the board of the investment process issuers, asset managers and investment advisors are now obligated to have assessed the risk sustainability poses to the investment (financial materiality) as well as the risk the investment poses to the planet (environmental materiality). This assessment is to be made public or at least transparent to the investor and investment community. This, of course, has implications on the real economy where the original ESG data must come from to assess financial instruments.
The regulations
The EU has passed the following ESG focused regulations applicable to financial services institutions (some disclosure requirements apply to non-financial firms as well):
1) EU Sustainability Disclosure Regulation (SDR) requiring the disclosure of ESG risk assessments, adverse ESG impacts and ESG credentials for products and the investment process
2) EU Climate Benchmark Regulation introducing two new mandatory climate benchmarks to be provided by benchmark administrators
3) Second Shareholder Rights Directive (SDR II) tackling corporate governance and shareholder value topics
4) Non-financial Reporting Directive (NFRD) requiring large companies and financials services providers to publicly report on ESG matters in a non-or consolidated financial statement
The EU Ecolabel Regulation for Financial products defining rules for ecolabel qualification of financial products is in the making and the Green Bond / Green Finance Standard is not a regulation, but a guideline.
Additionally, there have been amendments to a suite of conduct regulations focused on ESG integration into the investment and advice process(PRIIPS, MiFIDII, UCITS, AIFMD and IDD) as well as to prudential regulations (ESAD, IFR, CRD, CRR II, IPD).
The EU taxonomy regulation
The EU taxonomy regulationis supposed to sit at the heart of the above mentioned. It establishes a classification system to define “economic activities” that may be classified as “environmentally sustainable,” to enable the identification of “environmentally sustainable investments”. Some might argue that it has the potential to disrupt the current corporate reporting eco-system that is mostly based on voluntary disclosure standards such as TCFD, SASB, GRI, CDP and CDSB since the taxonomy metrics used in the technical screening criteria are not fully aligned with the voluntary standards. The revision of the NFRD will shed some light on the future of the ESG data reporting landscape in the EU.
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