Laying the Foundations for Sustainable Finance in Europe

Sustainable finance may help “green” European and Global economies. (Art by iStock/marchmeena29)

Responding to a perceived lack of global leadership, the European Commission announced its “Action Plan: Financing Sustainable Growth” in March 2018. The plan recognizes a global need to direct more capital toward environmental and social goals, and promises to encourage the financial industry to operate in a way that benefits the planet and society. The commission released the plan just two months after the publication of extensive recommendations by the High Level Expert Group (HLEG) on Sustainable Finance, a group that advises the commission on how to steer public and private capital toward sustainable investments, and identifies steps European institutions should take to protect the financial system from environmental risks. The Action Plan seems largely motivated by the need to combat climate change, and acknowledges both that there is a need to standardize definitions of “sustainability” and that the financial industry needs to use investment—including investment by private sector institutions derived from our insurance, pensions, and savings—to build a “greener” economy.

This work has, to some degree, flown under the radar, but social innovators should take heed. Given that the commission is eager to largely finalize the plan before electoral season in April, there is only a small window of time for consultation and feedback. Yet there is much at stake. The ambition of the HLEG recommendations to mainstream sustainable finance throughout Europe, the apparent political will illustrated by the commission’s swiftness of response, and involvement at the highest levels (including by the Governor of the Bank of England Mark Carney) mean the Action Plan will likely impact how investors in Europe and beyond think, work, and actually invest. Indeed, the commission has the global economy in sight. At a keynote lecture at the University of Oxford in November 2018, Olivier Guersent, director general of the department overseeing the Action Plan (the Directorate-General for Financial Stability, Financial Services and Capital Markets Union) said that Japan’s largest pension fund has already publicly stated it will refer to the commission’s sustainability classifications.

Five Action Plan Activities

The Commission will undertake a number of actions in accordance with the plan; the following are the most concrete at this stage.

1. Establish a European Union (EU) classification system or “sustainability taxonomy.” Perhaps most significantly, the commission is currently producing a unified EU classification system of environmentally and socially sustainable activities that will effectively define “sustainable” and identify areas where investment can make the largest impact. This would establish a clear and common understanding about what sustainability means in Europe; act as a reference in attracting capital, and launching products and services; and help direct flows to sustainable activities.

2. Establish standards and EU labels for green financial products. EU labels would help investors more easily identify products that comply with criteria such as low carbon, just as the EU organic and Eco labels have helped guide consumers toward sustainable products. The commission is also exploring EU labels for sustainable financial products to increase protection for consumers against greenwashing by having a pan-European standard against which to verify them.

3. Consider measures to clarify sustainability duties. Through the plan, the commission will clarify what asset managers and institutional investors must do to take sustainability into account during the investment process. Currently, these duties are not always clear or consistent.

4. Strengthen companies’ reporting on environmental, social and governance (ESG) policies. The commission is strengthening reporting requirements, with an eye to ensuring that end-investors and market participants get the information they need to consider sustainability in their decisions. Intended effects include harmonizing practices throughout the European Union, generating more comparable information, and building ESG risks into financial modelling more systematically. The commission hopes that this will spark competition and incentivize institutions to adopt higher ESG standards.

5. Consider incorporating sustainability into capital requirements. Current EU financial rules do not discriminate between “green” investments and “brown” investments (those potentially associated with unsustainable practices). The commission is exploring the feasibility of a “green supporting factor,” or a lowering of capital requirements for green investments, in line with EU prudential rules, which require that firms have adequate resources to remain financially viable.

Through these and subsidiary activities, the action plan aims to:

1. Re-orient capital toward sustainable investment, to achieve sustainable and inclusive economic growth in Europe and beyond
2. Manage financial risks stemming from climate change, natural disasters, environmental degradation, and social issues
3. Foster transparency and long-termism in finance and economic activity

Those working in sustainability and social impact will no doubt surmise the extreme complexity of the plan. The classification system alone—beyond the technical complexity of categorizing activities, which frequently straddle the sustainable and unsustainable—will require the reconciliation of divergent views. Many French people, for example, consider nuclear power low carbon and hence “green”; others argue nuclear is not sustainable, due to the long half-life of the radioactive waste it produces. The good news is that there may be an opportunity to scrutinize and intervene on the latest round of consultations.

Five Things to Look Out For

Amid this flurry of activity, social innovators should pay particular attention to the following, all of which have the potential to impact innovation globally.

1. Implications for front-runners and innovators. Increased reporting requirements and differing definitions of sustainability might unfairly over-burden the sometimes-smaller institutions leading the way on sustainable finance and ESG. Uniform standards could also straight-jacket innovators.

2. Longer-term governance structures. A platform of experts from the public and private sectors will advise the commission, but—given the project’s magnitude, complexity, and technical detail, and the need for the classification system to evolve over time—it remains to be seen whether the small number of staff assigned to do the work will be sufficient. Clearly, the nature of longer-term governance structures, which still appear uncertain, will have a lasting impact on how sustainable finance and sustainability more generally take shape in Europe.

3. Mainstreaming sustainable finance. The HLEG recommends mainstreaming sustainable investment throughout Europe, starting with European institutions’ investment arms. But while the commission has earmarked at least 40 percent of the European Fund for Strategic Investment’s infrastructural financing to support climate action—a potent signal of the commission’s intent—mainstreaming sustainable finance throughout Europe will require that both the commission and the wider financial industry make even more tangible commitments.

4. Moving from E to S and G. The commission may heed the radical recommendations of the HLEG, and use the work to define sustainable investment as a stepping stone toward addressing social and governance issues through investment. Practitioners who work on sustainability and social impact should keep an eye on developments.

5. Setting a global standard. From the beginning, the HLEG cast its recommendations as potentially global standards. In the Action Plan, the commission states it will encourage sustainable investments in partner countries such as Africa by leveraging 44 billion Euro (approximately $49.83 billion) of investments, through the EU External Investment Plan, by 2020. It would tap into these investments from both public and private sources through the European Fund for Sustainable Development. Whether this is the first or the last step will depend on how deeply regulators and financial markets allow sustainable finance to take root in Europe itself.

Leaders within the sustainability and social impact fields will likely have additional concerns about the commission’s work, given its potential consequences. A number of scenarios might play out, and the results of the next European elections in May will sway the direction. Nevertheless, in the next couple of months, innovators have a chance to make constructive recommendations. The commission’s Action Plan gives sustainable finance a foothold in the large European financial markets, and offers an important opportunity to direct investment toward stemming climate change and other challenges—but the devil remains in the details.

Editor's note: February 14, 2019 | Point four of section one and point two of section two have been adjusted to improve clarity.

Read more stories by Anna Sakurai.