What is sustainable finance and what are the consequences for the existing or future governance framework of financial institutions? While the EU’s fight against climate change through changes to regulatory structure is in full swing, the financial services industry is only at the beginning of paradigm shift that will change the way it does business.
Last week, the European Securities and Markets Authority (ESMA) submitted its technical advice to the European Commission on Sustainable Finance. Split into two reports that contain technical advice to the Commission on the integration of sustainability risks and factors, relating to environmental, social and good governance considerations with regards to investment firms and investment funds, into MiFID II, AIFMD, and the UCITS Directive.
It’s the final step of a process that started with the Commission adopting a package of measures on sustainable finance in May 2018 and gave ESMA and its sister agency EIOPA (European Insurance and Occupational Pensions Authority) a mandate to provide technical advice to supplement the initial package of proposals and to assist the Commission on potential amendments to these regulations to accommodate the integration of sustainability risks and sustainability factors.
With the deadline set for 30 April, ESMA delivered the requested advice right in time. In the meantime, the Commission has also published a set of draft rules in with regard to amendments required to MiFID II in January 2019.
What is Sustainable Finance?
Besides the good intentions and the legalese of these documents in mind, the more practical question for financial institutions is how this affects them and why they should care.
Having gone through the various documents and reports, it all starts with a fundamental question: what do the European institutions actually mean by sustainable finance?
When the Commission last year published its Action Plan on Financing Sustainable Growth, it boldly announced its intention to
- reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth;
- assess and manage relevant financial risks stemming from climate change, resource depletion, environmental degradation and social issues; and
- foster transparency and long-termism in financial and economic activity
Though it has its origins in climate finance, the extent of sustainable finance must accordingly be drawn wider to include all aspects of environmental aspects and not limited to climate change alone as well as social and governance objectives.
These intentions did not come out of the sheer goodness of the Commission, but are based on theadoption of the 2016 Paris agreement on climate change and the United Nations 2030 Agenda for Sustainable Development. What this essentially means, became clear to everyone when a group of eight European countries released a joint statement calling for an ambitious strategy to tackle climate change, which makes reference to the EU budget that is currently under negotiation and that envisage at least 25% of the spending to go to projects aimed at fighting against climate change. To put this into perspective, the current budget for 2019 is set at €165.8 billion, so we would be talking about an annual commitment of more than 40 billion euros – a quite substantial sum.
What is interesting though, is the overall excitement and surprise this statement has caused since it reflects the Commission’s message that has been voiced by the VP for Financial Stability, Financial Services and Capital Markets Union Valdis Dombrovskis many times, for instance at a climate summit in New York in September last year and several other times since:
“To meet our Paris targets, Europe needs around €180bn in extra yearly investment over the next decade. We want a quarter of the EU budget to contribute to climate action as of 2021. Yet, public money will not be enough. This is why the EU has proposed hard law to incentivise private capital to flow to green projects. We hope that Europe’s leadership will inspire others to walk next to us. We are at two minutes to midnight. It is our last chance to join forces.”
– Valdis Dombrovskis, Vice-President in charge of Financial Stability, Financial Services and Capital Markets Union
So, the Commission means business and while it remains to be seen if all Member States will get behind it, it seems a given that it will happen in one way or another and some of the draft rules are already out there.
The Impact on Financial Services Compliance
Thus, we should be getting back to the initial question as to how this affects banks and financial institutions and why they should care.
To start with: The focus on sustainable finance is already firmly fixed in the priorities of the European Supervisory authorities. Financial Institutions would therefore be would be well advised to mirror this focus in their strategies as regulatory initiatives will consider these intentions where they can.
Consequently we can identify three core elements financial institutions should be focusing on:
Firstly, to choose a strategic approach and identify what the actual and potential impacts of climate-related risks and opportunities could be to then determine the risk management processes that should be applied.
Secondly, establish how it fits in the existing governance and control framework, set out clear organizational responsibilities for assessment and reporting of respective risks and make amendments where required including adding relevant expertise if necessary.
Thirdly, ensure the correct measuring of results adjusting data sources, methodologies and processes where and when required.
And as fourth point: make sure that all aspects are regularly reviewed and amended to address a changing environment. The story of sustainable finance and its impact on financial services regulation is after all only at its beginning.