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SRI

People power in finance could help quest for sustainability

The long growth of responsible investing has happened in a voluntary way, with practices and standards defined by the market. Now, the European Union is taking the controls, with an Action Plan containing a host of measures. It is a leap forward towards sustainability, but more will be needed to get all the way there. Jon Hay reports.

“So, sir, how much do you care about the environment? Very much, quite a lot, slightly or not at all?”

The next time you go and see your financial adviser or bank manager, she may ask you questions like that. Maybe not next time, because as yet no one in the financial world has a clue how to do this dialogue. But, sooner or later, it will be a legal requirement in the EU for financial intermediaries to ask clients what their preferences are, when it comes to environmental, social and governance factors.

The absurdity of the way the question is phrased above makes it clear just how difficult this rule is going to be to implement — and the huge risks of it going awry.

Nevertheless, the radicalism of this reform is clear. For the first time, customers will have to be offered ethical choices as a core part of making investment choices. If lots of them pick progressive options, the industry will have to supply products to match.

If, say, 25% of people said they did not want to invest in fossil fuels, the consequences for the economy could be profound.

But in reality, financial advisers are unlikely to sit down for a free-ranging chat to explore each customer’s preferences on animal welfare and genetically modified foods.

Some kind of standardised approach is likely to be developed, to make the process manageable and protect service providers from complaints if customers are dissatisfied.

Will that consensus allow the fresh dynamism of savers’ directly expressed wishes to infuse the market? Or will customers be offered a rigid set of bland choices, to make the industry’s life easier, stifling any real change?

The answer to that question may be a big determinant of whether the European Commission can achieve its ambition, with the far-reaching Action Plan adopted in March, of creating a system capable of ‘Financing Sustainable Growth’.

Having taken a long time to engage in this issue, the EC has accelerated, anxious to honour the pledge in the Paris Agreement of 2015 to “make finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development”.

“It will be a massive challenge for our industry,” says Arnold Fohler, head of debt capital markets at DZ Bank in Frankfurt. “We bankers do not seem to have taken as much notice of it so far as its impact requires. It’s an ambitious plan, but it also has opportunities for our industry in it.”

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Including ESG in investor consultations is just one of the Plan’s extremely broad package of measures, to be enacted over the next few years. 

Sustainability is to be incorporated into the following aspects of finance: investors’ duties, corporate reporting, ratings, research, indices, prudential regulation and policymaking. Authorities will also investigate whether to reform accounting, bank capital, insurance capital and corporate governance. 

An EU classification system for sustainable activities (the Taxonomy) will be created, as will standards for green bonds and possibly an Ecolabel for other financial products such as funds. And efforts will be made to stimulate sustainable infrastructure projects.

Duty-bound to think ahead

Sustainable finance advocates are pleased with the policy, though political hurdles still lie ahead, especially with a new European Parliament and Commission to take office next year.

Some of the simplest reforms may turn out most powerful — such as enshrining in law that an investor’s fiduciary duty to its clients, far from forbidding consideration of ESG issues, requires this.

“The proposal to clarify that ESG issues should be taken account of where they are financially material is helpful,” says Patrick Arber, senior analyst, global public policy, at Aviva in London. “It seems like common sense, but the way the current legislation is interpreted leaves some room for excluding them.”

The combined effect of this and other requirements, such as that investors report on how they take account of sustainability factors, arguably amount to making ESG investing mandatory. Julia Linares, sustainable investment officer at WWF in Brussels, argues the Commission should have been bolder and just flatly made it obligatory.

As higher demand for sustainable investments flows through a financial industry more responsive to customers, other reforms will help “create an infrastructure to satisfy and direct some of that new demand”, says Arber. “Having a clear Taxonomy, and a set of approved low carbon index benchmarks, will be helpful for investors and pension fund fiduciaries to show they are meeting their clients’ requirements.”

But the Taxonomy has its critics, who argue it risks being cumbersome and slow to implement, duplicating other work and choking innovation by imposing a single view.

“It is extraordinary and not smart that they are trying to do it all over again,” says Hans Biemans, head of sustainable markets at ING in Amsterdam. He points to the global System for Environmental-Economic Accounting used by many statistics offices to measure the output of the green economy, and already legally required in the EU. “If the EU introduces a new regulatory scheme for sustainable finance, the classification must be exactly the same as, or very similar to, the system already in place.”

However, if it is well done “the Taxonomy is a very important step forward,” says Linares. “ESG has already been included in some legislation [such as IORP II for pension funds] but it was not defined, so it was open to interpretation. The Taxonomy is the first step of having a definition, which is very important to avoid greenwashing.”

Tough questions

If investors find the Taxonomy a useful guide to what is green, they will still need to observe and measure real activities, to know if they meet standards.

“I think what will help most is not the classification, and also not incentives, but the transparency and disclosure requirements,” says Biemans. “The big effect of disclosure requirements is that people start to think.”

As French funds already must under Article 173 of the Energy Transition Law, investors will have to disclose how they consider sustainability. That will force companies they invest in to explain how green they are.

“The challenge to the finance industry is that it will require us to collect much more precise data on which to base our lending decisions — to differentiate whether loan A is more sustainable than loan B,” says Fohler. “We may need to know how to measure a loan in how it contributes to supporting the Paris Agreement.”

Having collected all this extra knowledge, will banks and investors be allowed to make their own choices about what to do with it? “I don’t expect direct political pressure on banks to lend more sustainably, but there might be moral pressure,” says Fohler. “Banks’ managements will be forced to have a better developed view than now on where to position a bank as regards the greenness of activities.”

The much-discussed green supporting factor — a regulatory capital discount for green assets — has been deferred for further consideration.

Shedding light

Parts of what the EU plan will bring about are already being done, piecemeal, on a voluntary basis. The WWF runs a study on the 100 largest asset owners (pension funds and insurance companies), which own about half the institutional assets in Europe and ultimately call the shots in financial markets. 

The research gauges whether their investments are aligned with a 2°C economy, using predictions of how technologies need to be phased in and out if 2°C is to be hit. The model evaluates public companies’ readiness, including their existing assets and future capex plans.

Last year 29 asset owners let their results be published. Only one, Danish pension fund PKA, still had too much equity exposure to coal mining, and several have cut this out altogether. But on coal power, 10 are still misaligned, and on renewables, 13. And these 29 are likely to be the saints among asset owners.

“Some asset owners are taking action, but definitely more needs to be done,” says Jan Vandermosten, a WWF policy officer who works on the study. “Basically they are investing in line with benchmarks and trying to represent the economy. But asset owners should understand that the Paris Agreement is there and they run risks if they continue to invest in line with the economic direction of travel.”

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This is the kind of transparency towards which EU policy is driving. It cuts between layers in the capital markets, connecting industrial companies, asset managers, pension funds, individual savers, civil society and government. 

All get access to more information, not only on their own exposures, but on how those compare with market rivals.

Reality bites

However important it is to green the financial system, it is also in some ways an easy option for governments, compared with tackling environmental problems head on — for example, legislating to reduce fossil fuel use. They are doing that, but too slowly and gently. 

Making the finance system sustainable is partly about making it more alert to policy signals in the real economy. Ironically, even if investors do listen more carefully, those signals are fairly weak.

“Even if everything in the EU Action Plan comes to pass, there is still a lot to do with pricing externalities, like putting an effective price on carbon,” says Arber. “That would massively influence investment decisions. They will be somewhat influenced by the Action Plan but for a wholesale movement they would need to be coupled with changes in the real economy to make sure the price of assets reflected their true costs. That’s the missing angle that these policies don’t address.”

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