Grafic: EU Commission
13. December 2018
Dr. Ralf Breuer
The year 2018 fueled a lot of optimism into my views on sustainability in the financial industry. Getting started with the EU Action Plan on financing sustainable growth (#SustainableFinanceEU) many factors brought sustainability into the industry’s mainstream. Facing tremendous tail risks from climate the global leaders strongly confirmed this view. The long and hot summer with it’s drought and wildfires strongly built up a broad awareness for the changing climate moving it up on the political agenda. However, since the end of last week the optimism has become muted. And is not because of the lacking progress at the COP24 in Katowice, it is first of all the consultation pack published by the technical expert group (TEG) working on the taxonomy of assets as outlined in the action plan.
Disputable points disputed
The action plan found criticism mainly in two points:
1. Green supporting factor not logical
The EU Commission proposed a green supporting factor, i.e. reduced capital burdens for environmentally friendly assets. This is understandable as it shares the French view and secured a strong support. This was confirmed by President Macron’s personal engagement. From the regulatory point of view, it is rather „brown“ resp. „fossile“ to burden as this imposed tremendous tail risks on the financial industry.
2. The sequence of distribution directives and taxonomy
The commission almost immediately intended to amend the distribution directives for banks (MiFIDII) and insurance companies (IDD) and work out a classification for sustainable assets afterwards. For good reasons some from the industries doubted this sequence and proposed a different order.
Ecology should only be the gateway, not all
The action plan seemed open to all (17) sustainable development goals. Climate risk was a sensible approach as a „hook“ as this secured the support of the supervisory bodies because they see that the financial industry faces tremendous tail risks currently not covered in regulation. In addition, risks from climate change and energy transition have already deeply eaten into portfolios and collatoral pools.
However, the United Nations for good reasons set out 17 sustainable development goals (the „SDGs“) going far beyond ecology. Since 2017 the consensus view on sustainability turned in this – forward looking – direction, away from – historical – ESG criteria. The sustainability ratings will follow this move rather sooner than later.
In sharp contrast to this, the TEG has narrowed it’s terms of reference on environmental factors:
In line with the Commission’s legislative proposals of May 2018, the European Commission has set up a Technical Expert Group on Sustainable Finance (TEG) to assist it in developing;
• an EU classification system – the so-called taxonomy – to determine whether an economic activity is environmentally sustainable;
• an EU Green Bond Standard;
• benchmarks for low-carbon investment strategies; and
• guidance to improve corporate disclosure of climate-related information.
Taxonomy subgroup – Progress report p. 6
Thus, the outlined result will be a narrow one as well:
An EU taxonomy would fill these gaps, as it would inter alia:
create a uniform and harmonised classification system, which determines the activities that
can be regarded as environmentally sustainable for investment purposes across the EU;
address and avoid further market fragmentation and barriers to cross-border capital flows as
currently some Member States apply different taxonomies;
provide all market participants and consumers with a common understanding and a
common language of which economic activities can unambiguously be considered
provide appropriate signals and more certainty to economic actors by creating a common
understanding and single system of classification while avoiding market fragmentation
protect private investors by avoiding risks of green-washing (i.e. preventing that marketing is
used to promote the perception that an organization’s products, aims or policies are
environmentally-friendly when they are in fact not);
provide the basis for further policy action in the area of sustainable finance, including
standards, labels, and any potential changes to prudential rules.
Taxonomy subgroup – Progress report p. 7
The approach to taxonomy would be strongly flawed
1. Why only one goal?
The narrow approach focussing on environmental sustainability will heavily flaw the action plan. While market consensus and reality turned to SDGs and thus looking forward, the consultation pack sticks to ESG, strongly stressing the E for ecology. This stands in a sharp contrast to the strong growth of not climate-related instruments, e.g. at the Luxembourg Exchange LGX, where the number of „social bonds“ is increasing“.
Sustainable Finance should not be „one trick pony“. Climate change is a severe problem of sustainability, but unfortunately by far not the only one. Why should a taxonomy therefore exclude other burning questions like education, hunger, housing, inclusion etc.?
2. Historical ESG can be misleading
It is not straightforward, but also no rocket science to show, that the common historical sustainability benchmarks such as carbon footprint and ESG-Scores can be misleading for investment decisions with impact intentions in the future. The consultation document seems to confirm this outdated view starting with the NACA classification highlighting sectoral emissions (see Taxonomy subgroup – Progress report p. 9f).
The alternative is straightforward
According to a paper of the German sustainability rating agency imug (Wirkungsorientierte Investments zur Erreichung der UN Sustainable Development Goals – Impact investments to achieve the UN Sustainable Development Goals) the industry is on the move away from particular and individual ESG approaches to the SDGs, thus defining „a new normal“.
In some cases this normal is already put into practice, e.g. at the Dutch pension fund PGGM and APG Asset Management. Very impressive is the system of the German development finance agency DEG (KfW Group) which benchmarks the whole portfolio in development finance: We measure development outcome. The group is using a IOOI model (Input, Output, Outcome, Impact) that is also advocated by rating agencies, e.g. vigeo eiris.