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Sustainability: Understanding the Regulatory Trend

Sustainable finance and corporate responsibility have become strategic topics for financial institutions as clients’ expectations are increasingly shifting towards green and sustainable products.

As a result, key players in the financial industry are incrementally enhancing their offerings and commitments related to sustainable finance.

For example, year after year records are being broken when it comes to the number of green bonds and green loans issued. Moreover, the number of institutions committed to the Principles for Responsible Investment and the Principles for Responsible Banking keeps increasing.

The regulatory landscape

One of the main triggers for this shift is regulatory action. According to ECOFACT Policy Outlook data, the number of regulatory actions tripled between 2016 and 2019. A similar level of regulatory activity, according to the Institute of International Finance, can only be found in the regulatory wave that followed the 2008 global financial crisis.

Without any doubt, the publication of the EU Commission’s Action Plan: Financing Sustainable Growth (EU Action Plan on Sustainable Finance) created even more attention. Since its launch in 2018, the EU Action Plan on Sustainable Finance has inspired financial regulators all over the globe to pursue similar regulatory action.

The EU Action Plan on Sustainable Finance has led to the most complex, overarching regulatory initiatives in the field of sustainable finance and corporate responsibility in the world to date. The EU sustainable finance regulations, in particular the EU Sustainable Finance Disclosures Regulation (Regulation (EU) 2019/2088 on Sustainability-Related Disclosures in the Financial Services Sector), have impacted all key frameworks regulating financial markets, such as MiFID II, IDD, and Solvency II.

The EU Sustainability Taxonomy Regulation (Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment) has impacted not only financial institutions, but also large companies as it introduced amendments to the EU Non-Financial Reporting Directive (NFRD).

Moreover, the regulation creating the framework for the EU Climate Transition Benchmarks and the EU Paris-aligned Benchmarks encourages the use of and reliance on global standards such as those of the Financial Stability Board’s Taskforce on Climate-related Financial Disclosures (TCFD).

What is sustainable finance?

Sustainable finance has several definitions. One of the most commonly adopted is the one proposed by the G20 Sustainable Finance Study Group, which says:

Sustainable finance can be broadly understood as financing as well as related institutional and market arrangements that contribute to the achievement of strong, sustainable, balanced and inclusive growth, through supporting directly and indirectly the framework of the Sustainable Development Goals (SDGs). A proper framework for sustainable finance development may also improve the stability and efficiency of the financial markets by adequately addressing risks as well as market failures such as externalities.

What is corporate responsibility?

As with sustainable finance, there is no commonly accepted definition of corporate (social) responsibility. In 2011, the EU Commission proposed the following definition: “the responsibility of enterprises for their impacts on society”. This means that:

Respect for applicable legislation, and for collective agreements between social partners, is a prerequisite for meeting that responsibility. To fully meet their corporate social responsibility, enterprises should have in place a process to integrate social, environmental, ethical, human rights and consumer concerns into their business operations and core strategy in close collaboration with their stakeholders, with the aim of:

  • maximizing the creation of shared value for their owners/shareholders and for their other stakeholders and society at large;
  • identifying, preventing and mitigating their possible adverse impacts

Corporate responsibility

In addition to the sustainable finance regulatory wave, corporate responsibility topics, such as environmental and human rights, due diligence, and diversity, have been at the top of the regulatory agenda.

For example, modern slavery laws have been put in place in Australia, Brazil, California, and the United Kingdom. In addition, environmental and human rights due diligence have been made mandatory in France with the Duty of Vigilance Law.

In the process of discussing and adopting similar laws on due diligence it is possible to identify countries like Germany and Switzerland, but also the EU which has announced its intention to issue regulation in this area.

Do you know what needs to be done?

As a consequence of this intense regulatory movement, what was deemed to be best practice yesterday—such as the integration of sustainability issues into investment decision-making processes—has now become the baseline regulatory expectation for access to the market. Financial institutions must not only be aware of their sustainability risks and adverse impacts but must actively work to minimize them.

Financial institutions must understand what needs to be done and find practical solutions to address complex concepts such as sustainability risk and principal adverse impacts—and this is currently expected to be accomplished using ESG data that rarely meet the requirements of financial regulations.

ECOFACT assists senior managers and decision-makers in focusing on key action items by prioritizing them. We have an in-depth understanding of what needs to be done to implement regulatory requirements pertaining to sustainable finance and corporate responsibility.

What are sustainability risks?

According to the Regulation (EU) 2019/2088 on sustainability‐related disclosures in the financial services sector, sustainability risks are defined as environmental, social, or governance (ESG) events or conditions that, if they occur, could cause an actual or a potential material negative impact on the value of the investment.

What are sustainability impacts?

An event or condition related to environmental, social, and employee matters, respect for human rights, anti‐corruption, and anti‐bribery matters that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment.

What are adverse impacts?

Negative impacts on sustainability factors (i.e. environmental, social, and employee matters, respect for human rights, anti‐corruption, and anti‐bribery matters) resulting from investments.

For example, certain investments might contribute to the violation of indigenous peoples’ rights and/or the maintenance of discriminatory practices within corporate structures. These impacts might not necessarily be converted into a sustainability risk—have a material negative impact on the value of the investment—because the risk evaluation focuses on how rightsholders and the environment are affected. Note that the concept of adverse impacts is closely aligned with how risk is used in the OECD Due Diligence Guidance for Responsible Business Conduct. In the words of the OECD, assessing “adverse impacts […] is an outward-facing approach to risk,” focusing on assessing the likelihood of adverse impacts on people, the environment, and society that an enterprise may cause—and not about risk for the investor or the financial institution itself.

The time to act is now!

To successfully adjust their practices to these new regulatory expectations, financial institutions are compelled by regulators to act regardless of the fact that different jurisdictions are adopting different approaches.

On top of this complexity, the implementation deadlines are often short, especially when considering the far-reaching impacts these regulations have on financial institutions’ products and processes.

We have unique expertise when it comes to establishing policies and processes to address sustainable finance and corporate responsibility topics in the context of financial institutions’ operations.

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Did you know?

Key EU regulatory frameworks in the area of sustainable finance

EU Sustainable Finance Disclosures Regulation (Regulation (EU) 2019/2088 on Sustainability-Related Disclosures in the Financial Services Sector) lays down harmonized rules on:

  • the transparency expectations investors have to abide by when integrating sustainability risks;
  • the consideration of sustainability-related adverse impacts in their processes;
  • and content requirements for sustainability-related information of financial products.

 
 

 

EU Non-Financial Reporting Directive (Directive 2014/95/EU on the Disclosure of Non-Financial and Diversity Information by Certain Large Undertakings and Groups) requires large companies to report on non-financial and diversity information related to environmental, social, and governance (ESG) issues:

  • all EU member states have transposed the directive into national law;
  • as part of its Action Plan on Sustainable Finance, the EU Commission published Guidelines on Reporting Climate-related Information which aim to improve disclosure of climate-related information;
  • and it has been amended by the EU Sustainability Taxonomy Regulation.

EU Climate Transition Benchmarks and the EU Paris-aligned Benchmarks (Regulation (EU) 2019/2089 on EU Climate Transition Benchmarks, EU Paris-aligned benchmarks and sustainability-related disclosures for benchmarks) introduces two benchmarks to help investors compare the carbon footprint of investments:

  • Climate-transition benchmarks (EU CTB);
  • and Paris-aligned benchmarks (EU PAB).

The adoption of these benchmarks is voluntary. However, labelling a portfolio as following either the EU CTB or EU PAB triggers disclosure obligations.

 

 

EU Sustainability Taxonomy Regulation (Regulation (EU) 2020/852 on the Establishment of a Framework to Facilitate Sustainable Investment) is instrumental in enabling the EU to become climate neutral by 2050. It creates a unified classification system to define environmentally sustainable economic activities related to:

  • climate change mitigation;
  • climate change adaptation;
  • sustainable use and protection of water and marine resources;
  • transition to a circular economy;
  • pollution prevention and control;
  • and protect and restore biodiversity and ecosystems.

Read more on our Blog

October 23, 2020

Green Bonds: An Overview of the Current Frameworks

October 7, 2020

Mandatory Environmental and Human Rights Due Diligence: An Overview

August 28, 2020

ESG Disclosures in EU Regulation: Impact for non-EU market players

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