Lecture 8: A Theoretical and Regulatory Framework for Sustainable Finance (Part 2) PDF

Lecture 8 A theoretical and regulatory framework for sustainable finance (part 2)...

Lecture 8 A theoretical and regulatory framework for sustainable finance (part 2) Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be LEIF Master Programme attributed in any way to the European Commission.  Agenda Problem definition – Structural shift in our economy – How finance has looked at the issue so far – Market failures (e.g. greenwashing) Designing a regulatory response – Sustainable Finance Action Plan (key elements and rationales) – Key regulatory strategies © Valiante Diego - 2  Problem definition © Valiante Diego - 3  The most debated one - Climate change risks Source: 2021 IPCC Report © Valiante Diego - 4  Consequences of inaction are already here a. In the last two decades, annual weather-related disasters worldwide rose by 83% compared to the previous 20 years. b. In the last 10 years, economic losses from extreme weather worldwide have reached a new top ($145 billion in 2019 and 10-year moving average is at $212 billion in 2019). – In 1995, economic losses (10 year MA) were less than half c. Close to 50% of the exposure of Euro area banks to risk is directly or indirectly linked to (transition) risks stemming from climate change (ESRB) – Credit losses could reach up to 10% of total assets d. Lower supply of insurance products against effects of an increase of global temperatures (physical risks) – Unless climate adaptation plan in place… © Valiante Diego - 5  But sustainability is not just about climate change Sustainable finance looks at how finance (investing and lending) interacts with environmental, Social and Governance (ESG) factors ESG factors have been around for few decades now, when it comes to portfolio investment, but they (as then identified) were unable to steer investments towards more sustainable activities. © Valiante Diego - 6  The goals are ambitious (investment needs) © Valiante Diego - 7  The law and economics of the climate change crisis ”Our economic models were developed in an empty world with an abundance of goods and services produced by nature” (Daley and Farley 2011 in Schoenmaker and Schramade 2019) Joan Robinson called it “The second crisis of economic theory” (1972) → i.e. the failure to look into composition of economic growth (e.g. inequality or sustainability), which was left only to the political sphere – The first crisis was brought about by the Keynesian Revolution, which argued about the possibility by governments to boost economic growth via aggregate demand (before it was thought that only markets could do so). – This preoccupation for growth was not accompanied by a similar concern about its composition or structure (so, leading to a second crisis). As a result of this failure, the only way to address this concern has been left for decades to Pigouvian solutions. © Valiante Diego - 8  Market vs Pigouvian solutions? The Pigouvian approach via national environmental laws has failed so far. Why? 1. The social marginal cost is hard to measure (e.g. direct and indirect costs of GHG emissions or costs of income inequality and so on) The example of the factory’s chimney is a textbook example, but the reality of how pollution kills is murkier. 2. There are other factors that make an approach only based on internalisation of costs hard to succeed: Legal factors (e.g. limited liability companies) Political factors (e.g. protection of ‘national champions’ by sovereign States or political ideologies) The result is that the internalisation of cost is taking too long and the human kind is facing existential threats. – Pigou’s solution remained confined to specific areas (well identified pollution cases) and was an ex-post expensive solution that can have significant collateral damages, as Coase pointed out. © Valiante Diego - 9  Market vs Pigouvian solutions? Markets have, however, also failed to properly price sustainability risks, mainly due to: – Insufficient non-financial disclosure and scientific evidence – High search costs for investors – ‘Systemic’ switching costs and inertia What can be done public intervention and Pigouvian solutions (e.g. Pigouvian taxes)? Making these business activities more costly to run (e.g. carbon border tax in the EU, emission trading schemes), so complementing ‘pure’ Pigouvian solutions with more market-based solutions. – Private initiative that can lead to internalisation of cost via negotiations (i.e. removing adverse selection affecting carbon pricing and other unsustainable economic activities). 1. Disclosure and risk signalling to make pricing mechanisms more efficient 2. Remove subsidies and other market distortions © Valiante Diego - 10  ‘Greenwashing’ risk as a key transaction cost “The value of global assets applying environmental, social and governance data to drive investment decisions has almost doubled over four years, and more than tripled over eight years, to $40.5 trillion in 2020.” “A report of the research said active strategies represent the majority of ESG- related assets under management, at 75% in the U.S. and 82% in Europe.” (both quotes from Pension&Investments) This tells us that markets are failing to correctly identify and price sustainability risks. ‘Greenwashing’ is widespread. There are many definitions of ‘greenwashing’. The term has been first coined by the environmentalist Jay Westervelt in 1986 (when discussing practices of the hospitality industry about the reuse of towels). → (Vieira de Freitas Netto et al. 2020) There are two kinds of greenwashing: a. Selective disclosure behaviour. “the act of misleading consumers regarding the environmental practices of a company or the environmental performance and the positive communication about environmental performance” (Terrachoice 2010) → e.g. fossil fuel companies communicating about their renewable energy business b. Decoupling behaviour. Symbolic actions, “which tend to deflect attention to minor issues or lead to create ‘green talk’ through statements aimed at satisfying stakeholder requirements in terms of sustainability but without any concrete action”. (Siano et al. 2017) → e.g. towel reuse in luxury hotel industry © Valiante Diego - 11  The design of a sustainable finance framework (regulatory response) © Valiante Diego - 12  European Commission Action Plan Launched in March 2018 and reviewed in July 2021 1. Reorienting capital towards more sustainable activities 1 Establish an EU classification system for sustainability activities: Taxonomy 2 Create standards and labels for green financial products 3 Foster investment in sustainable projects 4 Incorporate sustainability in providing investment advice 5 Develop sustainability benchmarks 2. Mainstreaming sustainability in risk management 6 Better integrate sustainability in ratings and market research 7 Clarify institutional investors' and asset managers' duties 8 Incorporate sustainability in prudential requirements & banks’ risk management 3. Foster transparency & long-termism 9 Strengthen sustainability disclosure and accounting rule-making 10 ↑sustainable corporate governance and ↓ short-termism in capital markets © Valiante Diego - 13  EU Taxonomy Regulation (Regulation (EU) 2020/852) The EU taxonomy is a classification system, establishing a list of environmentally sustainable economic activities (GREEN LIST). The Commission defines it as “a living document that will be added to over time and updated as necessary.” The Taxonomy Regulation establishes six environmental objectives 1. Climate change mitigation (1 January 2022) Process of holding the increase in the global average temperature to well below 2 °C above pre-industrial levels (efforts to limit it to 1.5 °C) 2. Climate change adaptation (1 January 2022) The process of adjustment to actual and expected climate change and its impacts 3. The sustainable use and protection of water and marine resources (1 January 2023) 4. The transition to a circular economy (incl. waste prevention and recycling) 5. Pollution prevention and control (emissions of pollutants in the air, water or land) 6. The protection and restoration of biodiversity and ecosystems (1 January 2023) Different means can be required for an activity to make a substantial contribution to each objective. © Valiante Diego - 14  EU Taxonomy Regulation (Regulation (EU) 2020/852) 4 overarching conditions that an economic activity has to meet in order to qualify as environmentally sustainable. 1. Contributes substantially to one or more of the environmental objectives 2. Does not significantly harm (DNSH principle) any of the environmental objectives 3. Is carried out in compliance with minimum safeguards (e.g. fundamental rights protection) 4. Complies with technical screening criteria (defined by the Commission via delegated acts) to determine point 1 and 2 The Regulation also requires pre-contractual disclosure for financial products that portrays themselves as ‘sustainable investments’ or ‘promote environmental and social characteristics’ in relation to: – The environmental objectives the underlying investments contribute to. – To what extent these underlying investments are in economic activities meeting the 4 conditions above (% of overall business) © Valiante Diego - 15  An example of use of the EU taxonomy for the RRF Funds under the post-Covid19 Recovery and Resilience Facility (RRF) had been tied to the DNSH principle. No measure (i.e., no reform and no investment) included in a Member State’s Recovery and Resilience Plan (RRP) should lead to significant harm to any of the six environmental objectives within the meaning of Article 17 of the Taxonomy Regulation – For instance, measures promoting greater electrification (e.g. industry, transport and buildings) are considered compatible with the DNSH assessment for the climate change mitigation objective, provided they are accompanied by increased renewables generation capacity DNSH on every single measure. It needs to consider the life cycle of the activity that results from the measure. Simplified procedure only for measures that: a. have no or an insignificant foreseeable impact on one of the six environmental objectives, or b. are tracked as 100% supporting one of the six environmental objectives (according to the methodology in Annex IIA of the RRF Regulation), or c. ‘contribute substantially’, pursuant to the Taxonomy Regulation, to one of the six environmental objectives. © Valiante Diego - 16  EU Taxonomy is a key building block Principles to identify sustainable economic activities vs less sustainable ones 1. Working towards more sustainable business (e.g. CO2 emissions) 2. Not significantly harm other objectives of sustainability 3. Minimum social and governance safeguards. © Valiante Diego - 17  Coupled with four key actions on disclosure 1. Financial institutions and institutional investors’ duties and disclosure → amendments to a list of delegated regulations (under existing legislations) – Objective: Integration of sustainability factors in the investment strategy, risk management, product selection and governance a. ESG preferences as part of the target market definition if the product explicitly targets investors with a preference for ‘sustainable’ finance b. Clients should be presented with the sustainability risks in their portfolios c. Investment firms providing financial advice and individual portfolio management should carry out a mandatory assessment of sustainability preferences of their clients. – These investment firms should take these sustainability preferences into account in the selection process of the financial products that are offered to these clients. © Valiante Diego - 18  2. Sustainable Finance Disclosure Regulation (SFDR; Regulation (EU) 2019/2088) SFDR Regulation is an additional legal act to: 1. Lay down sustainability disclosure obligations for manufacturers of financial products and financial advisers toward end-investors. General policies on IF and HOW they integrate sustainability risks in their decision-making process (also in pre-contractual disclosure) in most financial products (article 6) 2. Set out disclosure obligations as regards adverse impacts on sustainability matters at entity and financial products levels. It also introduces specific additional pre-contractual disclosure for two types of products: 1. Article 8 financial products promoting environmental and/or social characteristics (i.e. on how these characteristics are met), provided that the companies in the portfolio follow good governance practices. 2. Article 9 financial products targeting ’sustainable investment’ as their objective and an index is designated as ‘reference benchmark’ (i.e. how the designated index is aligned with the ’sustainable’ objective). © Valiante Diego - 19 © Valiante Diego - 20  The Non-Financial Reporting Directive (NFRD) The Non-Financial Reporting Directive, NFRD (Directive 2014/95/EU) amends the Accounting Directive 2013/31/EU) – NFRD only applies to ‘large public-interest entities’ (>500 employees; around 11,700 companies in the EU) The NFRD introduced a requirement for companies to report both on how sustainability issues affect their performance, position and development (the ‘outside-in’ perspective), and on their impact on people and the environment (the ‘inside-out’ perspective). This was defined by the Commission (2019 Guidelines) as the ‘double materiality’ principle. – But not detailed requirements on how to implement it (some guidelines in 2017 and 2019, but they are not mandatory) Materiality is a socio-economic and political, rather than a technical, phenomenon (Carpenter et al., 1994; Lai et al., 2017), which shapes a broader societal understanding of sustainable development through corporate communication (Brown and Dillard, 2014; Puroila and Mäkelä, 2019). © Valiante Diego - 21  3. Corporate Sustainability Reporting Directive Proposal (April 2021) – Amendments of the NFRD 1. Clarifies that companies must report information necessary to understand how sustainability matters affect them, and information necessary to understand the impact they have on people and the environment (under the ‘double materiality’ principle). 2. Extends the scope to all large companies and all companies listed on regulated markets (except listed micro-enterprises) 3. Requires the audit (assurance) of reported information 4. Introduces more detailed reporting requirements, and a requirement to report according to mandatory EU sustainability reporting standards 5. Requires companies to digitally ‘tag’ the reported information, so it is machine readable and feeds into the European single access point envisaged in the capital markets union action plan © Valiante Diego - 22  …and 4. An action on benchmarks 4. Low carbon benchmarks and sustainability-related disclosures for benchmarks (Regulation (EU) 2019/2089) – Generally, two types of indexes out there, that are often subject to high greenwashing risks: 1. pure-play indexes that focus on renewable energy, clean technology, and/or environmental services and 2. “decarbonized” indexes (or “green beta” indexes), whose basic construction principle is to take a standard benchmark, such as the S&P 500 or NASDAQ 100, and remove or underweight the companies with relatively high carbon footprints – The Regulation creates two types of benchmarks (with specific requirements): 1. EU Climate transition BMs (benchmark portfolio on a ‘decarbonisation trajectory’ towards alignment with Paris agreement; must be ‘measurable, science-based and time- bound’) 2. EU Paris-aligned BMs (benchmark portfolio’s carbon emissions are aligned with the objectives of the Paris Agreement) – Benchmarks providers, more broadly, will have to disclose how their methodology takes into account ESG factors © Valiante Diego - 23  OBJECTIVES Definitions Sustainability Indicators factors (risk assessment) TOOLS Enforcement Transparency Disclosures and Taxonomy Fiduciary duty Benchmarks Sustainability Low carbon strategy (product) benchmarks Definitions & metrics © Valiante Diego - 24  Other regulatory interventions being considered (for info) Natural capital accounting Green bond standards and other eco-labelling of financial products Pigouvian taxes (carbon border pricing tax etc) © Valiante Diego - 25  A complex interaction © Valiante Diego - 26  Recommended readings Optional readings – J. Robinson (1972), The Second Crisis of Economic Theory, Richard T. Ely Lecture, https://www.jstor.org/stable/1821517 – Schoenmaker and Schramade, Principles of Sustainable Finance, 2019 – Regulation 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation 2019/2088, OJ L 198, 22.6.2020. (Taxonomy Regulation) – IPCC (2021), AR6 Climate Change 2021, The Physical Science Basis https://www.ipcc.ch/report/ar6/wg1/#Regional © Valiante Diego – 27  Diego Valiante LEIF Master Programme [email protected] www.unibo.it