What is behind the European Commission’s latest push on sustainable finance?
Laurence Caron-Habib: The European Commission (EC) has been interested in sustainable finance for some time and now views it as a major priority. After the 2015 United Nations Climate Change Conference – known as COP 21 – and the Paris Agreement, the EC started to work on a dedicated report and strategy. In March 2018, it published an Action Plan on sustainable investing, with three main priorities:
- Reorienting investment towards sustainable finance
- Fostering disclosure and transparency of sustainability factors, primarily for institutional investors
- Integrating sustainable criteria into investment decisions
Additionally in May, the EC released a legislative package to accelerate the move towards sustainability.
What are the concrete measures from the EC to make real progress?
Florence Fontan: After COP21 the political awareness and willingness to act on climate issues was there. It was clear that significant investment would be needed to achieve the agreed political objectives on climate risks. Given the state of global public finances, the EC, alongside international organisations including the World Bank and the United Nations, realised private investment would be needed.
LCH: Another key concern of the EC is to allow investors to measure how they are allocating capital according to sustainable finance goals. Without it, the EC fears a “green-washing” of products, which is the classification of unsuitable products as environmentally friendly. As a result, another major initiative in the recent EU legislative package is a new taxonomy or classification system, even though it will be quite tricky to reach a consensus across the EU Member States on such a sensitive topic.
Aren’t many long term investors already including ESG factors in their investment processes?
FF: Yes. Many companies and investors have not waited for regulators to get started. But until now, it has been difficult for the industry to agree on common criteria and rules, which makes difficult to truly measure the level of investments.
How have the separate elements of ESG and sustainable investment been approached so far?
FF: Let’s break down the “environmental social and governance” elements of ESG.
Regarding the “E”, investors have made significant progress on the environmental aspect over the last few years. There is indeed a sense of urgency and momentum around the environmental factor, especially after COP21. Significant asset owners (notably major pension funds or sovereign funds) have publicly announced new investment policies integrating environmental criteria, although the data is not always available or complete. As a consequence different investors have developed their own interpretation and calculation.
Given this lack of standardisation and the difficulty of obtaining the relevant data, institutional investors are at different stages of integrating environmental factors in their investment decisions. Generally, an investor’s first step is to adopt an exclusion policy – deciding not to invest in palm oil, for example. They inform their investment manager, who executes the command, based on the best available information.
The second step is often to measure a portfolio’s carbon footprint. To properly account for climate factors, investors need to have a forward-looking approach. Since finding data on companies’ carbon footprint reductions can be difficult, investors need to engage with companies to better understand their strategy. In addition, carbon footprint is just one piece of the environmental consideration. There is also the impact your portfolio has on water security, waste and how certain industries are more susceptible to these risks than others.
And what about the “S” and “G”, ie the social and governance?
LCH: Socially responsible investing is probably the most complex to tackle. To really assess the impact of investing, the whole supply chain must be considered. But it is not always easy to gather the necessary information. The starting point for an investor is to ensure all its suppliers comply with international human rights and working laws. However, this is a very complex issue and there is no clear way to measure the impact. This is one reason why this social aspect is less integrated in investment decision policies yet.
Regarding corporate governance, there are already several regulations around shareholder rights. Many investors have used those regulations to build internal policies and vote at shareholder meetings, particularly on the diversity and independence of the board. There is also a significant amount of information publicly available.
Why are environmental factors so tricky?
FF: The main issue is that the necessary data is not always easily accessible, available or comparable. Due to increasing pressure from investors, NGOs and citizens, companies are publishing more relevant information. However, the lack of agreed standards makes this information difficult to use and to compare across companies. Adding to this problem is the variety of methods available to analyse and measure the environmental impacts. This is where increased standardisation of the calculation models would greatly help. As a consequence, today, only niche players or large institutional investors have invested in dedicated research teams to address this issue.
LCH: Today, around one third of institutional investors can produce detailed reporting on climate change criteria, another third are considering it and the other third is still lagging. For the EC, the best way to achieve this transition is to introduce new measures that will create standards in order to build an effective industry framework.
What are the short-term challenges for the financial sector?
LCH: The difficulty will be agreeing on this taxonomy. Even if there is consensus and strong industry support for this objective and framework, we can already see different interpretations from one Member State or market participant to another.
Is BNP Paribas involved in this standardisation process?
LCH: Yes. BNP Paribas is part of the working group that the EC recently created to discuss the provisions on taxonomy and, more precisely, the implementation measures – called Level Two measures– needed to make it work. Once the major principles are defined and adopted by the European Parliament and Council, they must be implemented and measured in a concrete and specific way.
Once the taxonomy is agreed, is the implementation straightforward?
FF: No. Firstly, the standardisation must not only tackle the data but also the calculation methodologies as well.
Secondly, it will take some time to have access to all relevant information. Companies should be incentivised to publish data and improve transparency on those issues.
Finally in our view, the prudential cost of these new green products should be low to incentivise institutional investors and, notably, insurance companies to invest. Indeed there is a danger that existing “brown” investments may be penalised through additional costs on a risk-weighted basis, instead of promoting the adoption of an approach that would favour investing strategy in“green” products.
How do sustainable investments benefit the Capital Markets Union?
LCH: CMU is about how investments can be reoriented towards the long term. Sustainability and green finance are key to address long-term issues. Formulating an EU classification system should encourage the creation of more products that are built around standardisation. The aim is to make them attractive to all consumers, but especially retail investors, who are a key part of the CMU’s target group.
How can institutional investors start preparing?
FF: Most of our clients have not waited for the EC’s proposals and already have implemented investment policies including ESG criteria. Institutional investors have demonstrated increasing awareness within their own organisations. They are expanding policies to embrace more global sustainability factors using the UN’s Sustainable Development Goals as a benchmark. The challenge for asset owners is to implement those policies and measure progress towards their objectives. Regulatory requirements may develop in the coming years, in particular with respect to increased disclosure. Institutional investors should therefore start building their data set and defining strategic policies in regards to sustainability.
On the asset management side, we see an expansion of sustainable products due to the increasing demand and requirements from asset owners. Here again, asset managers should prepare to increase the transparency of their model and the disclosure of sustainable data on the portfolios they manage.
Over and above the ethical considerations of sustainable finance, there is already an inescapable link between ESG factors, asset performance and financial returns. This is clearer in some markets, asset classes and economic sectors, but increased data transparency will continue to drive this aspect. So, like all risk factors, sustainability will need to be included in long-term investment decisions.
How can BNP Paribas Securities Services help institutional investors?
LCH: We have developed sophisticated ESG reporting tool that can help both asset owners and asset managers. Based on their ESG criteria and the policies they have defined, we can help them work out their risk profile. We look at the portfolio from a range of points of view –sustainability, carbon footprint – and help them integrate ESG criteria. We can also simulate changes in asset allocation to see what impact they would have on the portfolio.
These tools can facilitate their asset allocation decision and also their communication towards their various stakeholders (boards, individual investors, …) enabling them to explain their actions.
What is the key take-away for investors?
FF: Sustainability is a major trend that is here to stay and is becoming mainstream. Institutional investors and asset managers can’t ignore it and will need to embrace it. At BNP Paribas Securities Services, we are fully engaged with our own sustainability journey and are supporting those of our clients. Some clients are more advanced than others, but we are all learning and travelling together. We are developing with our clients the reporting and analysis they require and sharing our experience – from across BNP Paribas, which was recently named the World’s Best Bank for Sustainable Finance – with asset managers as they create the products and services their clients demand.
LCH: We are engaging with regulators to develop standards and taxonomies to improve access to relevant and comparable data. In parallel, we should collectively ensure that regulatory measures are built to incentivize and facilitate investment in “green products” without penalising existing investments from a prudential perspective. Tackling climate change is about managing the transition and we should do the same in terms of our investments.
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To read more
- Three (not so) little letters that have changed the investment landscape forever: E, S and G: here
- Great expectations for ESG: survey
- United Nations
- European Union
- Sustainable finance initiatives
- High Level Expert Group on Sustainable Finance: final report
- Capital Markets Union, November 2014, plan
- Capital Markets Union, mid-term review, 2017
- Action plan on financing sustainable growth, March 2018
- European Commission, Press release “Sustainable finance: Making the financial sector a powerful actor in fighting climate change”
- Markets In Financial Instruments Directive (MiFID II) and Insurance Distribution Directive (IDD) amendments: consultations closed on 21 June 2018.