Sustainable Finance : A New Framework from the EU

EXECUTIVE SUMMARY

With the adoption of its action plan on sustainable finance, the European Commission is aiming at fostering a transition of economic activities towards a more sustainable model. To achieve this ambitious goal, the Commission is pursuing a number of key objectives, including:

  • Improving the quality and standardization of environmental, social and governance (ESG) policies by supplementing the European Union’s existing Non-Financial Reporting Directive (NFRD) with additional guidelines and the creation and implementation of a sustainability taxonomy for all players in the financial system.
  • Demonstrating the EU’s commitment to the Paris Agreement by including sustainability risk exposure assessment in the fiduciary duty of investment firms, notably asset managers and institutional investors.
  • Eliminating “greenwashing” strategies by requiring increased transparency from ESG funds and ESG indices regarding their strategies, methodologies and data sourcing.
  • Developing EU labels for green financial products so that investors can more easily find products that comply with green or low-carbon criteria.
  • Debuting a “green supporting factor” in the EU prudential rules for banks and insurance companies, which would require the incorporation of climate risks into banks’ risk management policies and support financial institutions that contribute to funding sustainable projects.

The action plan on sustainable finance is a patchwork of EU regulations and recommendations that aim to drive institutional investments towards initiatives that will support the transition of economic activities to more sustainable models. While it imposes stringent disclosure requirements on investment firms and index providers, it employs a more subtle approach regarding issuers by only providing guidelines and a framework to evaluate and report climate-related information. The European Commission’s end goal appears to be to empower institutional investors and index providers to push corporates to adopt a more granular, standardized approach when generating their non-financial reports.

The implementation of this regulatory package will certainly reinforce the EU leadership role in the transition towards a sustainable economy and will potentially set the standard for sustainable investment. It will have a profound impact along the whole investment value chain and will require significant investment from market participants to adapt their operations accordingly:

  • Corporates: The new EU guidelines on reporting climate-related information, while not mandatory, will be a clear supplement to the existing NFRD. In order to follow this framework, companies will have to invest significant time and resources to identify areas of improvement, capture and clean the relevant data, and report this information in a standardized and comparable format. All of this will require the implementation of ad hoc processes and the acquisition of the relevant expertise. Opimas estimates that by 2024, targeted companies will have to invest over €500 million to adopt this new reporting structure.
  • Index and benchmark providers: The disclosure requirements for these market players will become mandatory by January 2022, when they will have to provide full transparency on their ESG indices, notably regarding methodologies and data sourcing, but also follow clear guidelines around the criteria implemented according to the asset classes being included in the index.  These new obligations will push the industry towards a higher quality standard. However, providers will have to acquire industry-specific expertise for both data gathering and methodology creation.
  • Investment firms: The deadline for the implementation of the disclosure requirements for investment firms is January 2021. Investment firms will have to integrate sustainability factors into their risk management practice and report their specific exposure to this risk for each fund they operate. ESG funds will have even greater transparency requirements, providing detailed explanations of their methodology, data sourcing, due diligence process, etc. The inclusion of sustainability risks into the fiduciary duty of investment firms will be a major disruption for the European investment management industry. Adherence to disclosure requirements could have serious bottom line consequences, eroding roughly 2.5% of the industry’s annual profits that accounted for €19 billion in 2018.

Overall, we expect that the adoption of the action plan will require spending of more than €2 billion over the next five years, mostly within the asset management business that will have to invest over €1.6 billion (see Figure 1). This will create a significant opportunity, particularly for ESG data providers and consulting firms.

Figure 1. Sustainable Finance Action Plan to Create €2.1bn Market Opportunity over the Next Five Years 

Source: Opimas

                 

There are also opportunities for sell-side institutions, especially investment banks that are likely to see increasing demand for corporate and analyst access to their detailed non-financial reports and custodian banks that can leverage the data they hold on behalf of clients to help them address their sustainability risk evaluation and disclosure duty.

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