EU sustainable finance rules: clarity and muddle
The European Commission launched on Tuesday a second big wave of regulation that will soon be controlling more aspects of sustainable finance more tightly. There is a tendency to think anything with the word “sustainable” attached to it is good. But capital markets specialists must ask themselves: will the regulations be helpful?
It has been 60 years since the environmental movement began, 40 since global warming became widely known about, 15 since the Principles for Responsible Investment were created and 14 since the first green bond. Yet capital markets are still financing an unsustainable economy, in which rampant greenhouse gas emissions are accelerating climate change.
The major difference compared with 40 years ago is not that the economy has become cleaner. Global emissions are still rising; plastic and chemical pollution are intensifying; extinctions are rising. It is that now the damage is harder to ignore.
There was little enough excuse for burying one’s head in the sand in the 1980s. Now it seems evidence of insanity.
The EU wants to tackle this by legislating markets into better behaviour. Its new package includes at least 30 measures.
Some have already been long in preparation and are fully formed, such as the EU Green Bond Standard. Some are in their infancy, such as the Green Asset Ratio for banks. Others are embryonic, like expanding the Taxonomy to cover more parts of the economy in transition, as well as social issues.
A mere three years ago, investing responsibly or sustainably was an unregulated activity, in which market participants could freely follow their own best ideas and ways of understanding the problem. Already in the EU it is now highly regulated — it is going to become much more so.
The EC often justifies its interventions by claiming that it needs to prevent greenwashing, though it is not clear that there is an epidemic of this. The crucial question is whether regulating finance can force it to steer the economy on to the sharply divergent path that leads to sustainability.
A common argument in financial circles is that decision makers — institutional investors, banks, central banks — do not have enough information to make sustainable choices.
This is, for the most part, rubbish. It is perfectly clear what is an oil company, what is a fossil fuel-fired power station, who makes plastics.
Companies in heavy industrial sectors such as cement, chemicals, shipping and manufacturing have been disclosing large amounts of environmental information for years if not decades. Investors can use this to distinguish between them, and if they want more details, can ask for them. It is very easy to distinguish a company that is willing to provide more information from one that refuses.
Why, then, does finance keep backing pollution? The answer lies in the way the finance industry is set up and incentivised, and how its role in society is defined.
Financial firms are designed to make money for savers. They are necessarily attracted to short term profits. Money now is better than money later: it can be reinvested to increase returns. Liquid capital markets, which allow investors to get out of bad bets, also encourage investors to tolerate long or medium term risk in search of immediate returns.
The tragedy of the horizons is not Romeo and Juliet — a tragedy of ignorance — but more like Faust, where greed overpowers knowledge of the inevitable.
The situation is complicated by the division of labour in investing. Money flows through a chain of intermediaries, so the ultimate beneficiary is only one of several making a decision as to what to invest in.
Those in the chain, who work in financial markets, are making their money now, with which to retire and give their children a start in life. If investments they make cause harm in future decades, they will not be held accountable.
What matters to them is short term performance reviews. These have been made more constricting by the science of benchmarking. Judging asset managers against their peers means forcing them into strict categories and incentivising them not to stray from the mainstream. This usually means buying whatever shares or bonds exist. No wonder the economy doesn’t change very fast.
Being biased towards optimism about the future and against making short term sacrifices is not unique to financial markets — it is inherent to being human.
But faced with environmental destruction and social evils, how can society break that habit?
There is no one answer — and that is the point. Plurality is the best medicine. Consciousness of the need for sustainability has grown through multiple channels — ordinary people protesting, organised activists, writers, journalists, politicians, civil servants, business people, trade bodies, international organisations — and investors and bankers.
Many of these were apparently powerless to begin with and have faced opposition, sometimes brutal, sometimes more subtle.
Freedom to speak — even if this had to be fought for — and access to information gave their voices force. Each group informs, awakens and encourages others.
Enlightened individuals willing to face reality, seek justice and break the consensus can crop up anywhere. They must be given the space and wherewithal to have influence.
One reason for sustainable finance to exist is to be one of these voices — for finance to play its part, like other actors, in making society better.
But in financial markets, there is an alarming lack of voice. Companies talk plenty, but they have such a huge information advantage that they can guide the conversation in service of their own ends. It is difficult for other stakeholders to challenge them in detail on the really important issues, rather than the company’s chosen talking points.
Investors are mostly silent, exchanging views with companies behind closed doors, and with developed market government bond issuers not at all.
The rash of new investor sustainability alliances and collective engagements in the past few years is a refreshing change.
The main spokespeople for investors are analysts at investment banks, who often seem eager to please corporate management. More importantly, their job is defined narrowly as predicting share price performance.
The credit rating agencies and some buy and sell side research firms enjoy independence, a public platform, an imperfect but decent set of incentives — they have to get things right for investors or their credibility would suffer — and the time and resources to conduct research and express themselves methodically. But they, too, tend to stick close to received opinion.
That is as good as it gets. The conversations between asset managers, pension funds, the consultants who advise fund trustees, and the ultimate savers — ordinary people — are so infrequent, stilted and generalised that most discussion of sustainability is about principles and methods, rather than specific investment choices.
When banks act as lenders, the investment chain is much shorter — ironically, since capital markets claim to be “disintermediated” — but the depositor or bank bond investor who puts up the capital in the first place has minimal say in how the bank uses its money.
The reason sustainability does not advance through this thicket is not that information does not exist — and nor can it be put down entirely to greed. It is that information is concentrated in a few places, while decision making is decentralised.
An individual pension saver has to make an effort to find out what funds her or his money is in. There will be a general description of the fund’s approach, including to sustainability, and perhaps the top 10 holdings can be identified. But there is no real way for investors to know if their money is being invested in a manner they would approve of.
This fuzziness has some benefits. Investors are protected from following their instincts and rashly blowing their money. No intermediary is fully responsible either, if something goes wrong. But it means that communicating investment preferences is like shouting through a tube stuffed with pillows marked ‘consensus’.
Under these arrangements, finance is unlikely to be a dynamic champion for the economic transformation we need. Perhaps it can never do much better.
But for the sake of getting every shoulder to the wheel of transition, it is worth trying to tackle the central problem: responsibility is split between five players, most of them ill informed, and each of whom defers to the others and therefore does not even exercise its own share of responsibility fully.
The EU regulations should be judged on whether they contribute to the solution of that problem.
In that light, some elements of the new package are impressive, even remarkable. The EC is strongly emphasising “double materiality”. This fairly new term means taking account not only of how environmental and social factors could affect investment performance, but also of the outward results of investments on the environment and society. Stripped of fancy language, this means exercising moral responsibility.
Double materiality had got into the Sustainable Finance Disclosure Regulation, part of the first regulation package, with the support of NGOs and against the warnings of some investor lobbyists. That the Commission is driving home its support for the concept is highly significant. Now supervisors will require this approach in the risk management systems of all financial players, including banks and pension funds. Ducking responsibility will get harder.
Valuable, too, are corporate and fund disclosure rules — though there is still scope for these to be diluted in implementation. But imagine if every company and fund published its Scope 1, 2 and 3 carbon emissions per unit of revenue, in a uniform way.
Given this one set of facts, investors — even individual savers — could see how cleanly or dirtily their investments were making money.
Combine that with the growing duties for financial firms to consider their clients’ sustainability preferences — one of the most promising but longest delayed parts of the 2018 Sustainable Finance Action Plan — and you begin to see how finance could wake from its slumber.
Introduce an app — such as is envisaged by the World Benchmarking Alliance — that ranks companies against sector peers and funds against each other. Then ask investors which quartiles they are willing to invest in. A simple question, which could have powerful results.
Other regulations are more likely to stir up confusion than bring clarity. Sadly, the Taxonomy, which has taken up so many millions of person hours, is in this category.
The original intention — creating a common language to compare the greenness of investments — had merit. But the creators should have stuck to defining the metrics that should be used to compare projects or assets.
By trying to establish a standard of sustainability across all the multifarious aspects of economic life, the Taxonomy has stumbled into a quagmire.
Parts of the rules are useful guides for investors, but they will always at best be limping behind reality. At worst, they could get in the way of investors and governments moving fast to adapt to changing circumstances.
Already its first chapters have blessed biofuels — an environmental disaster masquerading as green. This is the worst case of greenwashing in the history of sustainable finance, and it has been actively encouraged by regulation. Nuclear wants in and natural gas hasn’t given up hope either. Meanwhile, the Taxonomy does not distinguish between Exxon Mobil and a media company.
EU regulations can be valuable — even powerful — where they liberate and empower people by giving them better information, along with the right, and the duty, to make choices.
Rules that try to make choices for people, by simplifying things into pre-set bands and standards, disempower market actors, discourage the application of intelligence to the problems we face, and could even put sustainability at risk.