Green Deal puts the action into the Action Plan

The European Union’s Sustainable Finance Action Plan is changing the legal and cultural environment of capital markets. It is bringing excitement — but also fear. It aims at systemic change, but has many opt-outs. And just when the Plan is getting going, another one arrives — the European Green Deal. As Jon Hay reports, that may be the one the market really needs.

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In 2015, in the run-up to the Paris Agreement, the CEOs of six European oil majors wrote to governments and the United Nations. They begged them to introduce carbon pricing and promised to help. “For us to do more, we need governments across the world to provide us with clear, stable, long term, ambitious policy frameworks,” they wrote.

In that sentence, they encapsulated the longing of thousands of leaders in business and finance. For years, they have been running ahead of governments in their willingness to tackle climate change. The private sector has not been blameless — far from it — but in their public pronouncements, businesspeople have been much more ready to confront the reality of global warming and call for strong action to deal with it.

They also realise no company or investor can solve these issues alone. Pollution has been created by the whole of society — all must contribute to remedying it.

Economic actors have therefore been afflicted by a sense of helplessness. They want to get on with fighting climate change, but are paralysed, because the economy is still structured to promote it. Only politicians have the power to change that, and they have not acted.

At last, thanks to the rising tide of hurricanes, droughts and fires, and the forthright voices of young protesters, the public conversation has changed. From being a rare item in the news, climate change is now rarely out of it. 

SRIPoliticians are finding their tongues. Nearly 1,000 governments have declared a climate emergency, including France, Canada, Argentina and the cities of New York and Los Angeles. Twelve countries have legislated targets to reach net zero carbon emissions — the most ambitious being Finland, aiming for 2035, and Norway, for 2030.

In Europe, the most important force is the European Union. It, too, is set to crank up its action on climate change. When Ursula von der Leyen, the former German defence minister, sought the approval of the European Parliament in July to become president of the European Commission, she set out her policy programme for the next five years in a 20 page document.

Her top priority is a European Green Deal, which she pledged to propose during her first 100 days in office — between November this year and February next. Its centrepiece will be introducing legislation to make Europe “the first climate-neutral continent” by 2050.

The prayers of business and finance over many years — that governments would set the direction for the low carbon transition, so that markets could get on with implementing and financing it — look finally to have been answered.

For the sustainable finance movement, this is not the first intervention by the EU.


Renewing the system

Immediately before it began to live up to its own responsibilities, the Union set about teaching the financial sector how to do the same.

For the last 18 months, investors, banks and companies have been watching the legislative evolution of its Sustainable Finance Action Plan — some 10 initiatives billed as a “comprehensive strategy” to “build a financial system that supports sustainable growth”.

“This development of integrating sustainability into financial markets is picking up speed, and there are various reasons for it,” says Maarten Biermans, head of sustainable markets at Rabobank in Utrecht. “Not least, the increasing acknowledgement that change needs to happen, that it needs to be financed, and that inaction will lead to unacceptable financial risks.”SRI

At the moment, the Action Plan is rather like a colony of large, many-limbed insects, all different, which are going through the phases of their life cycles. Market participants are pleased to see them, but can still only observe them from a distance. It is too early to tell what they will look like when fully grown, still less how they will behave.

After years when financial markets had tried to make themselves more sustainable, by developing the justifications and techniques for taking environmental and social issues into account, the SFAP was designed to accelerate that process, by spreading best practice from the vanguard to the mass of the market and clearing away barriers of ignorance and opacity.

Now, von der Leyen has said she will put forward a new “strategy for green financing”, though no detail is available yet.

Nevertheless, specialists believe it is highly likely that the Action Plan pushed by the last Commission will keep moving ahead. 


Two wins

The Plan has had some successes already, though all the new primary legislation has been pulled and pummelled into different shapes by conservative and progressive forces.

The first law to reach political agreement, in February, concerns investment benchmarks such as equity and bond indices. To prevent greenwashing, with investors being offered ethical and sustainable indices of limited value, the Benchmarks Regulation creates two official labels index providers can use if they want. Both were improved from vaguer versions in earlier drafts.

‘Paris-aligned benchmarks’ will list companies whose emissions reductions are on track for only 1.5C of global warming; and ‘climate transition benchmarks’ will gather firms that are off track, but have committed to getting to Paris compliance.

While these labels are voluntary and only apply to specifically green benchmarks, all indices with market capitalisations of over $50bn will have to publish some kind of statement in the small print, saying how well aligned they are with Paris. 

That may give investors some sticks to poke the providers with — and more importantly, may help the ultimate savers see that most of their money is invested in ways that will lead to climate destruction.

A few weeks later, in March, after an all night session, came agreement on the Sustainability Disclosure Regulation — hailed by one responsible investment campaigner as “a great victory”.

SRIThe Commission had originally intended the Disclosure Regulation just to make investors, especially those marketing environmental, social and governance funds, be more explicit to customers about the financial risks to their portfolios from ESG issues.

But the finished law enshrines two more radical principles. Investors should also consider effects in the opposite direction: what the impacts of their investments could be on the environment and society in the outside world. And they have a duty to perform due diligence on their investments, to ensure they get these risk assessments right.

Investors do not have to follow the rule — it is on a comply or explain basis — but it will eventually be mandatory for big firms. 

Precisely what disclosures are required will be defined by market regulators in technical standards next year.

That investors should care what effects their investment choices have on others seems at once obvious common sense and dangerously new — a measure of how divorced the culture of the financial markets has become from ordinary morality. 

But considering outward-facing impact is inherent in any approach to investing that strives to help meet the Paris Agreement commitments. This cultural change is necessary for sustainability.


Ruling on sustainability

The third chunk of legislation introduced in 2018 has not been completed. It is the one many in financial markets — especially green bond enthusiasts — see as most important. This is the Taxonomy of Sustainable Economic Activities. 

Its most ardent and idealistic supporters see the Taxonomy as a translation tool, enabling market actors with different views on what is green to understand what each other mean. 

To most of the market, it is a catalogue of what is officially deemed sustainable. Though no one will be obliged to follow the Taxonomy, it is already regarded as a document of immense power.

Companies considering issuing green bonds, for example, are fearful that they may not be able to prove they meet all the requirements — such as to “not significantly harm” any of the Taxonomy’s six environmental objectives.

SRIThis is partly because another plank of the SFAP, the EU Green Bond Standard, a voluntary badge of quality for issuers, will take its definition of green from the Taxonomy.

The process for creating the Taxonomy has a curious, two-level structure. The Commission has appointed a Technical Expert Group of sustainable finance practitioners, plus a very few environmental experts, to write detailed rules on what is sustainable. 

In June it produced its first draft — running to 414 pages — of the first stage, covering climate change mitigation and adaptation. Sections for the other four objectives — water, the circular economy, pollution and ecosystems — will come later.

“We think in general the work of the TEG is robust, it’s largely science-based. However, we have concerns on specific issues like bioenergy,” says Sébastien Godinot, economist in the European policy office of WWF in Brussels. “Very likely, the definition of green will be more restrictive than what is used currently by financial institutions.”

But at the political level, it has still not been decided what kind of Taxonomy there will be. This will be thrashed out during the autumn, when the Finnish presidency of the Council wants to reach agreement, first among member states, and then with the Commission and Parliament.


Tangles and wrangles

The Commission originally proposed a one layer Taxonomy. It would include any activity that “contributed substantially” to any of the six environmental objectives, without “causing significant harm” to any of the others.

But that, many argue, is just “a dark green niche Taxonomy”. It clarifies for investors what is really green. But because it does not cover most of the economy, it cannot help those parts transition.

In the Council, France has pushed hard for a broader Taxonomy with five bands: dark green, light green, neutral or not very climate-relevant, potentially harmful and very harmful. 

“Unfortunately it seems the French proposal is not getting traction,” says Godinot. “What is getting traction is something much less ambitious, which the TEG has proposed — to have three categories: green as initially planned, and also transition activities and enabling activities.”

Transition activities would be the best technologies in industries like steel and cement, where there is no low carbon option yet, but great improvements can be made. Enabling activities would include making windfarm components. 

“But this is only a small part of a big picture,” says Godinot. “It covers only a few sectors — for example, all the unsustainable activities are not covered at all. What is climate-irrelevant is put in the same box with what is unhelpful, which is a missed opportunity.”

Tom Jess, policy adviser in Brussels at E3G, the environmental thinktank, agrees in theory that the more all-encompassing the Taxonomy, the better. But he argues that, taking into account the time available, the second option favoured by the TEG is the best and likeliest outcome.

This is not the only battle to be fought. Much of the SFAP — including the Disclosure Regulation — applies to all investors. Not the Taxonomy. Only financial players marketing products as sustainable are encouraged to use it.

“All the mainstream funds have to disclose nothing, because the bulk of money is not in green finance,” says Godinot. He fears the Council might even weaken the Taxonomy’s applicability further, by introducing a long grace period.


Big guns

Some observers believe the real potential of the Taxonomy does not lie with green bonds or securities markets at all. 

It could be used as a guide for the EU budget. If “public money is not invested outside the Taxonomy,” Jess argues, “it would send a big signal of what you need to do to get to net zero. You are starting to get to the point where it changes the economy.”

Biermans believes the ‘green supporting factor’ — a lower capital charge for banks holding green assets — is likely to be introduced. The Taxonomy is the obvious criterion.

The price advantages of green bonds and loans are slight, he argues. But “if you are talking about game changers, influencing the cost of capital for green assets will inevitably create larger flows going into it,” he says, adding that it must be done “diligently and with some caution — a solar park is not inherently less risky than a cookie factory”.

Central banks could tilt the playing field in favour of green assets. Christine Lagarde, soon to lead the European Central Bank, said in August: “As soon as [the] Taxonomy is agreed, the ECB will need to assess whether and how it can apply it” to its Asset Purchase Programme. 

“The worry about the Taxonomy is that people will use it to stifle progress,” says Biermans. “When I hear Anglo-Saxon lawyers talking about it, they are talking about the exact dots and commas, and not the intention. If you want to have a Taxonomy that is as precise as a biological taxonomy, it will not work. Trying to have an all-encompassing definition of sustainability has never succeeded. It is not the object people should strive for.”

Partly because the Taxonomy is untried, Jess is a big advocate of the Platform on Sustainable Finance that will come with it. “Establishing the Platform is a really key action that needs to be done immediately,” he says. “It will have two main tasks. One is to update the Taxonomy going forward, based on technology, etc. The second is to monitor progress on the Sustainable Finance agenda, how it is affecting capital flows, and to advise on other policies, to overcome some of the gaps.”

The SFAP is a remarkably thorough and far-reaching set of measures. But it has its idiosyncrasies — notably the Taxonomy. And each piece is going to end up — depending on the political battle of influence — at a different point on a scale between ‘missed opportunity’ and ‘game changer’.


Form before substance

The Action Plan’s main limitation, however, is that it acts only on the mechanisms of the financial market. 

The remit of the EC’s High Level Expert Group, whose report in January 2018 formed the basis of the Action Plan, steered it away from making the most important demands: that governments set rational climate policies and work out how to raise large amounts of money to pay for them.

The Action Plan de-emphasised this further, by not taking up the HLEG’s recommendation to establish a new entity, Sustainable Infrastructure Europe, to remedy the main bottlenecks in sustainable investment: the poor and disjointed efforts of countries to develop national investment plans and green infrastructure projects.

The Commission preferred to use existing organs — the European Fund for Strategic Investments and the European Investment Advisory Hub (now both part of InvestEU).

Overall, the SFAP is like giving the old jalopy of the financial markets a thorough refit and makeover, with gleaming new parts and interior — but not putting any fuel in the tank.


The real Deal?

While the Action Plan is being enacted, von der Leyen has arrived with a new raft of policies — the Green Deal.

This remains just a sketch — a list of good intentions on little more than the back of an envelope. But what intentions. 

True greens will say she has not gone far enough; 2050 is too late to reach carbon neutrality. But her Deal goes far further than Europe, or any other major economy, has gone before.

The Green Deal attacks the main issues head on: where should the economy go and how is it going to get there? It would set the 2050 climate-neutral target in law and increase the existing 2030 target of a 40% emissions cut to at least 50%.

“Carbon emissions must have a price,” von der Leyen declares. “Every person and every sector will have to contribute.” The six oil CEOs may finally get what they asked for.

Shipping will join the EU Emissions Trading System, which covers high-emitting industries, and airlines will gradually lose their free allowances.

A Carbon Border Tax will penalise carbon emissions made offshore — a bold move likely to provoke international opposition. A new industrial strategy will make the economy “future-ready”, with Europe “a world leader in circular economy and clean technologies”.

Von der Leyen emphasises the just transition — the idea that cleaning up the economy must not leave behind communities reliant on sunset industries. Existing regional Cohesion Funds and a new Just Transition Fund will support those most affected.

She wants a European Climate Pact — a set of pledges to motivate citizens through the transition.

Only after all that does von der Leyen mention a €1tr Sustainable Europe Investment Plan over the next decade. This is where her Strategy for Green Financing comes in, though no detail is given, except that part of the European Investment Bank will become Europe’s climate bank. She wants to at least double the 25% share of EIB financing that is already for climate purposes.

Other aspects of the environment are not ignored. New strategies are planned on biodiversity, sustainable food, cutting pollution and single use plastics.

Godinot argues biodiversity is just as important as climate. “They have to work together if we want to achieve net zero,” he says. “One of the key parts is thriving ecosystems, stopping deforestation. We are lagging behind on climate change and much worse on biodiversity.”

All this on the environment is just the first of six chapters of von der Leyen’s plan — others include ‘An economy that works for people’ and ‘A Europe fit for the digital age’.

Of course there is a risk that so much cannot be achieved in practice. Von der Leyen is being radical on so many fronts, from an EU unemployment benefit reinsurance scheme to minimum wage requirements, that she is bound to encounter opposition. As cutting carbon emissions begins to really bite, sticking to ambitious climate targets will involve much more painful decisions.

But for the first time ever, European capital markets have something like a realistic attitude to climate change from the public sector to work with. There will be a long term target and a commitment from government to bring it about.

If citizens get behind it, and with a huge dose of luck, it might work. The sustainable economy would then no longer be a theoretical notion, but another word for the future economy. Carbon, properly priced, is just a cost. 

Might the special discipline of sustainable finance, and its new regulatory paraphernalia of disclosure and Taxonomy, soon be obsolete? It’s something to hope for.