1) The EU failing the sustainable finance challenge
The EU taxonomy still sinking
One of the first measures put forward in the renewed strategy is the broadening and extension of the EU Taxonomy for climate mitigation and adaptation. As announced in its previous communication following the publication of the first set of taxonomy delegated acts in April 2021, and before developing the criteria to cover the remaining objectives of the taxonomy, the Commission plans to brand more activities as sustainable through:
- The inclusion of activities that were not cover by the first delegated acts, among which nuclear energy could be included;
- Additional legislation to support the financing of certain economic activities deemed to contribute to the transition, including fossil gas;
- The examination of options to mobilize finance for activities transitioning on “a credible pathway”.
By planning for fossil gas and nuclear inclusion, the EU Commission has hammered another nail in the coffin of a taxonomy that already welcomed dangerous forest burning. If, unlike gas, the fate of nuclear is not certain, the recent report commissioned by the Commission to its own research committee suggests it will finally enter the taxonomy. Furthermore, propositions to open the taxonomy to activities not yet included but supposedly transitioning raise many questions and could allow for several polluting industries to benefit from the framework.
The failure of the EU to establish a strong science-based taxonomy would be especially problematic for Europe, as the EU Taxonomy will be used as a reference for the proposed EU Green Bond Standard (EUGBS) and used in other European regulations, thus locking in support to polluting activities. But, it would also be a severe blow for the global development of sustainable finance. Indeed, the renewed strategy clearly states the EU’s intent to promote its taxonomy principles at the international level.
Polluting activities still ignored
Much like the 2018 sustainable finance strategy, the renewed strategy emphasizes the scaling up of green finance and puts aside the need to simultaneously scale down harmful activities. The official goal is to build an “inclusive” system aiming at bridging a green investment gap evaluated at “€350 billion additional investment per year over this decade” for GHG reduction objectives in energy systems only, “alongside €130 billion for other environmental goals”.
The EU Commission’s “green” proposals – whether to favor green loans and mortgages, to create new labels and benchmark or to relax capital requirements for green activities – do not clearly contribute to reducing support to high carbon activities. The EU Commission’s choice to pair the renewed strategy with a proposal for a EU green bond standard and to make this proposal a key piece of its “sustainable finance” communication is a clear signal that priority has been given to the development of the “green” finance segment, and not to guide the whole financial system on a sustainable path.
It is worth noting that, if adequately implemented with a clear identification of polluting activities a few measures discussed in the renewed strategy could help mitigate this critical flaw. This is notably the case for establishing minimum sustainability standards for all financial instruments that contribute to the transition, creating a taxonomy for “significantly harmful activities” or ensuring ESG ratings reflect the support given to polluting activities. However, recent taxonomy developments related to the inclusion of gas suggest these measures could define standards so weak that they won’t contribute to overall sustainability and could even permit greenwashing by opening the door to polluting activities such as fossil fuels.
The only feature of the renewed strategy that directly addresses the issue of polluting activities is the Commission’s upcoming report describing the provisions that would be required to cover economic activities that “significantly harm environmental sustainability”. Unfortunately, it seems difficult to envision such a “significantly harmful” taxonomy while fossil fuels still have a place in the EU sustainable taxonomy.
A blind bet on the good will of financial players
Despite evidence that EU financial institutions have continuously failed to align with climate objective, and have even increased their support to fossil fuels, the EU Commission continues to bet on their good will.
A large majority of the measures of the renewed strategy deal with building new non-binding tools (such as benchmarks, taxonomies and labels). The Commission’s flagship EU green bond standard itself will remain voluntary. The few binding measures described pertain to disclosure, stress-testing or – to a lesser extent, later and with high uncertainty – risk integration.
As it is, nothing in the strategy forces financial players to adopt credible transition plans and to redirect final flows from polluting activities to sustainable ones. In that regard, the Commission’s stated objective to “reinforce science-based target setting, disclosure and monitoring of financial sector’s commitments” is critically insufficient and companies should be obliged to set paris-aligned climate targets and transition plans to meet them.
EU hesitation on climate risks
While the renewed strategy addresses the climate risk issue, it falls short of promoting mandatory measures that would mitigate these risks.
When it comes to micro prudential regulation, the only constraints imposed on financial institutions are stress-tests, risk analysis and disclosure. These rather uncontroversial measures are a simple extension of current risk management practices. Furthermore, the efficiency of these measures is limited by:
- The reliance on climate scenarios – such as the ones from the NGFS – that are not aligned with the Paris Agreement and do not consider drastic value loss possibilities – such as “stranded assets”.
- The radical uncertainty that characterizes climate change, making it extremely difficult – if not impossible – to accurately evaluate and assess climate risks.
If several impactful measures are discussed, regarding the adjustment of capital requirements through the CRR/CRD and Solvency, their content remain highly uncertain tied to future additional work. For example, it is not clear that the EBA and EIOPA’s planned assessments of whether specific “prudential treatment of exposures related to assets and activities associated substantially with environmental and/or social objectives would be justified by 2023” will concern activities that impair the transition. Similarly, regarding macro prudential regulation, the Commission’s intent to “broaden systemic risk considerations to other environment-related financial risks, cover non-bank financial intermediaries and assess where environmental exposures are unknown” is welcome but tells us little about the actions envisioned. The Commission’s will to move forward on a “green supporting factor” – a feature strongly supported by the banking lobby – also leads us to question its objectives as “polluting” assets are much more relevant from a risk perspective.
Furthermore, the timeline outlined for these potential risk integration measures is long, even though the riskiness of several activities – such as fossil fuel production – has already been clearly demonstrated. The Commission’s pledge to analyze how risk identified in stress tests will be integrated to macro and micro prudential regulation suggest such changes will not be considered before several years.
In a word, in the absence of strong capital requirement rules the measures put forward by the Commission will remain largely ineffective. The EU Commission should adopt a precautionary approach to climate-related risk and adapt capital requirements to reflect the very high level of risks tied to the most polluting – including fossil fuels – as soon as possible. It cannot wait for climate risks to build up and climate change to deteriorate to act and already has ample information to do so. The proposed update of EU supervisors’ mandate could be used to implement such immediate measures.
The work proposed by the Commission on biodiversity-related risks is welcome but do not contain any measures that would help mitigate those risks and the related environmental harm in the short term. Much like for climate risks, the Commission’s focus on methodologies may delay meaningful action and a precautionary approach to nature-related risks should be followed.
Greenwashing: a call for action
Addressing greenwashing seems to be the only area where the EU Commission recommends immediate action. The renewed strategy contains several measures that could help on that front, like guidelines for voluntary pledges, shareholder rights to better include sustainability issues, a European assessment of national authorities’ work and tools, and minimum sustainability standards for financial products declared as sustainable. Of course, the impact of all these measures will largely depend on their final content, and notably on the fact that they center the end of support to climate destructive activities. Furthermore, several of these measures – including minimum sustainability standards for all alleged “sustainable” products – are still at an exploratory stage.
Perhaps the most powerful tool put forward by the Commission to sanction greenwashing is the one that already exists. The renewed strategy indicates that “National Competent Authorities should make full use of their current legal mandates to address emerging issues and risks in the area of sustainable finance, including greenwashing. Member States may consider changing the legal mandates of National Competent Authorities in order to take into account sustainability-related factors when carrying out their tasks, in line with best practices.” This is a call to action: national supervisors already have the powers to identify and sanction greenwashing, they must make full use of them. If they do not, national governments or the ESA and Commission could adopt significant changes to their mandates.
Today, French financial supervisors follow the voluntary commitments made by French financial players to exit coal but do not sanction the ones that failed to make good on their promise. If the French AMF and ACPR where to follow the Commission’s recommendations, several financial institutions that did not adopt policies to exit coal or did not respect their announcement of reducing support to fossil fuels would be sanctioned.
A new era for fiduciary duty?
The fiduciary duty exists to ensure that those who manage other people’s money act in the interests of beneficiaries (3). The EU Commission intends to clarify its definition for institutional investors, including pension funds.
The Commission could ultimately provide clearer rules that would ensure that the climate and ESG preferences – often referred to as non-financial preferences – of the clients are considered by those who are entrusted with managing their money.
The EIOPA will be tasked to explore the integration of sustainability preferences and environmental goals to several aspects of fiduciary duty (notably the “long term best interest” of the client and the “prudent person” rule). The Commission’s action will largely depend on this assessment and is therefore uncertain at this stage.
Beyond double materiality
The EU’s intent to promote double materiality at the international level is welcome. Double materiality – that require financial institutions to consider both the impact of finance on climate and the risk climate change creates for finance – is a must to avoid finance totally carrying on regardless of dramatic environmental impacts. Apart from pushing double materiality at the Financial Stability Board, the EU should ensure the notion is used in all relevant international financial regulation.
Nonetheless, double materiality alone is far from sufficient. The EU should recognize the previously mentioned radical uncertainty, thus adopting a precautionary approach to climate risks that prioritize climate mitigation to mitigate the related risks. This precautionary approach should be the basis of EU recommendations at the international level, notably when pushing for a “green basel” framework.