The emergence of EU sustainable finance policy is a product of a new world reality characterized by increasingly degrading environmental and social conditions on one hand,[1] and deeper awareness of the substantial damage to people and property that flows from these phenomena on the other.[2] Sustainable finance policy provides critical solutions to these serious problems by improving the management of sustainability risk faced by companies and financial markets, as well as promoting sustainable investment in markets characterised by transparency and long-termism in decision-making.[3] In this brief article, I will outline the objectives of the EU policy on sustainable finance and provide an overview of recent reforms sponsored by the European Commission (“Commission”) in this policy area.
The management of sustainability risk is a key objective of EU sustainable finance policy. The most evident source of sustainability risk has been climate-related phenomena, especially climate change and global warming.[4] Problems originated by bushfires, ice melting and consequent rising sea levels, floods in agricultural land and urban areas, draughts, hurricanes, and the gradual change in weather patterns, among other events, have been observed with greater frequency and are now widely reported.[5] These events have become a serious concern to people and businesses.[6] They are affecting lives on the planet and properties in detrimental ways, such as damaging plants and animal ecosystems, food and water supplies, housing stock, and other basic infrastructure in towns and cities.[7] Damage to businesses trickles down to falling values of corporate assets and weaker financial performance.[8] In this context, sustainable finance aims to integrate sustainability risk in financial decision-making and strategy while making sure that market participants act to better manage this risk (recognizing the fact that sustainability risk is a financial risk).[9]
Sustainable finance also aims to accelerate the allocation of investment capital to projects and companies that show sustainability goals. At the centre of this allocative mechanism are both responsible investors (who prefer to invest in ways that improve the environment or society) and mainstream investors (who embrace sustainability to the extent that it yields maximum returns). In recent years, the demand for sustainable investment assets has skyrocketed. Globally, the value of such assets has surged fom nearly USD 22.9 trillion in 2016 to USD 35.3 trillion in 2020.[10] Similar upward trends have been observed in the European markets.[11] The development of vigorous markets for sustainable investment products may ultimately transform the role of the financial sector in Europe with asset managers, banks and other financial participants expected to play a central role.
It is within this policy framework that the Commission has sought financial market participants in Europe to integrate environmental, social and governance factors in their business models, services and products. Unsurprisingly, such integration has proved fraught with obstacles, such as how to identify and measure sustainability risk, or how to determine and account for the sustainability properties in business activities or financial instruments. The problem of greenwashing in sustainable investment products, for example, has represented one of the thorniest challenges for policymakers and clearly illustrates the perils confronted by sustainable investors.
In the financial sector context, greenwashing occurs when financial intermediaries advertise or sell “financial products as environmentally friendly, when in fact basic environmental standards have not been met.”[12] As explained by the Chair of the European Securities and Markets Authority (“ESMA”), greenwashing conduct encompasses:
a wide variety of practices that range from mis-labelling to mis-representation and mis-selling of financial products. As the number of products that claim to be linked to the sustainability performance of firms increases, driven by market demand, we need to be careful to ensure that investors do not end up buying products which are marketed as sustainable when in reality they are not.[13]
The problem of greenwashing has been reported widely in the business media.[14] In the asset management industry, for example, there are concerns regarding the opaque composition of investment funds branded as “sustainable.”[15] The Financial Times reported that “many of the funds that use the ESG label … are not as sustainable as they first appear. Several popular ESG funds, for example, invest in the world’s largest carbon emitters.”[16]
Since combating greenwashing is far from a one-off exercise, sustainable finance policies have produced critical legal instruments to tackle greenwashing systematically, namely the EU Taxonomy Regulation[17] and the Sustainable Finance Disclosure Regulation (“SFDR”).[18] The EU Taxonomy Regulation sets up a classification system of environmentally sustainable activities. It also imposes disclosure obligations on companies and financial market participations to report the extent to which their activities and financial products align with the taxonomy.[19] The SFDR imposes sustainability-related disclosure obligations on financial market participants. It has been clear to the Commission that new markets for sustainable investment products must not harm the EU internal market or dampen investor protection standards. Moreover, the Commission has also taken measures to secure market transparency. It became apparent early on in the reform process that problems in sustainability information disclosure can strongly undermine the policy of fostering sustainability in finance.
Without sufficient quality data, it is difficult, if not unfeasible, to adequately manage sustainability risks and adequately identify sustainability properties and impact.[20] The critical value of sustainability-related information has been rightfully upheld by the Commission in its Action Plan, which has proposed, among other measures, the overhaul of the current regime governing corporate non-financial information reporting.[21] The current EU rules based on the Non-Financial Reporting Directive (“NFRD”)[22] have proved insufficient to deliver expected outcomes and will soon be fully replaced by a new legal framework for corporate sustainability reporting enshrined in the Corporate Sustainability Reporting Directive (“draft CSRD”), which will create a regime of mandatory and audited non-financial information reporting.[23]
The above-mentioned legal reforms have been undertaken with the purpose of building the institutional and policy architecture needed to promote sustainable finance in Europe. This is an ongoing process, which has already achieved important progress. However, as argued in my recent article, the reform process has been moving at a breakneck speed, creating an urgent need to identify and reflect on the current state of the law in this area. Reforms undertaken have been numerous, complex, and fast-paced. They have proved difficult to grasp and contextualize, while amplifying the intricacies of an already highly sophisticated EU legal and regulatory regime. To meet this need, my article outlines and examines recent sustainability-related reforms in the area of (1) information disclosure obligations—including the SFDR,[24] the EU Taxonomy Regulation,[25] and the draft CSRD;[26] and (2) EU financial services law, with a focus on the Markets in Financial Instruments Directive (“MIFID II”).[27] In addition, a brief overview of the evolving prudent person rule contained in the Institutions for Occupational Retirement Provision Directive (“IORP II Directive”) is also offered, as this rule is relevant to the discussion on sustainability and investments in the context of pension funds.[28]
Final considerations are offered at the end of the article about the shortcomings – largely challenges of implementation – that EU sustainable finance policy faces, as reforms start to confront and shape the reality of business practices. To mention a few, challenges of implementation afflicting the EU Taxonomy Regulation includes how market participants will adequately evaluate and report on the Key Performance Indicators (Turnover, CapEX and OpEX).[29] Moreover, although the design of the taxonomy has been praised for its science-based standards, a recent proposal sponsored by the Commission has included gas and nuclear power projects in the list of climate-friendly energy sources.[30] These newly proposed sources of energy have proved controversial because, as opponents have argued, the inclusion of such sources waters down the otherwise strict environmental standards initially set by the Commission.[31] Further complexities will inexorably arise in the near future from the advent of the EU social taxonomy,[32] because conceptualising and measuring social impact is very difficult.[33]
The new rules mandating sustainability information disclosures, namely the CSRD, the SFDR and the EU Taxonomy Regulation, will deliver more and higher quality non-financial information. Despite these advantages, the implementation of all these information disclosure rules is expected to be a complex process that must be monitored closely. Reporting the principal adverse impact (“PAI”) on sustainability factors of a firm or product is likely to be costly and burdensome to financial market participants (“FMPs”). The SFDR requires that FMPs and investment advisors fill out mandatory reporting templates on PAI, which are composed of multiple quantitative and qualitative indicators.[34]Restricted availability of data on environmental and social impact, as well as poor quality of available measurements and metrics will certainly remain a concern, at least in the short term, as the new rules start to be implemented.[35]Amendments to MiFID II rules will bring additional challenges to investment firms, such as the numerous changes in internal compliance systems that these firms will be required to undertake in order to integrate sustainability into suitability requirements and product approval processes.[36]
Strong external shocks have also disrupted the otherwise rapid progress of sustainable finance reforms. Evidently, the Ukraine war has powerfully altered Europe’s strategic considerations and policy prioritisation at least in the short term. Even at this difficult juncture, however, one must keep in mind that the problem of climate change and global warming continue to worsen at an alarming pace, as do social problems exacerbated by successive events including Covid-19, conflict-related migration, price inflationary pressures, and lower economic growth.
Felix Mezzanotte is an Assistant Professor of Law at the Trinity College Dublin.
This post is adapted from their paper, “Recent Law Reforms in EU Sustainable Finance: Regulating Sustainability Risk and Sustainable Investments,” available on SSRN and forthcoming in the American University Business Law Review.
The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.
[1] EU Commission, “Strategy for Financing the Transition to a Sustainable Economy,” Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, Strasbourg, COM/2021/390 final, 6 July 2021, p1 (“The EU also aims to strengthen its resilience to climate change, to reverse biodiversity loss and the broader degradation of the environment and to leave nobody behind in the process”).
[2] Financial Stability Board (FSB), “The implications of climate change for Financial Stability,” 23 November 2020. The FSB is an international body that monitors and makes recommendations about the global financial system whose members include representatives of central banks, ministries of finance and international financial organizations, <https://www.fsb.org/about/organisation-and-governance/members-of-the-financial-stability-board/> (accessed on 9 December 2021). Also, Network for Greening the Financial System (NGFS) “A call for action Climate change as a source of financial risk” Final Report (April 2019) (hereinafter “NGFS 2019”); Network for Greening the Financial System (NGFS) “Overview of Environmental Risk Analysis by Financial Institutions” Technical Document (September 2020) (hereinafter “NGFS 2020”). The NGFS is an association composed largely of central banks and financial regulators, <https://www.ngfs.net/en/about-us/membership> (accessed on 9 December 2021).
[3] EU Commission, “Action Plan: Financing Sustainable Growth” Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions (Brussels, 8 March 2018 COM (2018) 97) 2 (hereinafter “EU Action Plan”).
[4] FSB (n 2) 4; Task Force on Climate-Related Financial Disclosures (TCFD), “Recommendations of the Task Force on Climate-related Financial Disclosures,” Final Report, June 2017, 5-8.
[5] For example, Financial Times, ‘Extreme weather blows out catastrophe insurance losses to $40bn’ (by Ian Smith) 12 August 2021; Financial Times, ‘ECB stress test reveals economic impact of climate change’ (by Martin Arnold) 18 March 2021; Wall Street Journal, ‘Fed’s Brainard: Climate Change Already Affecting Economy, Financial System’ (by Michael S Derby) 18 February 2021.
[6] An authoritative report in relation to the impact of climate change is the IPCC, “Climate Change 2021: The Physical Science Basis. Contribution of Working Group I to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [Masson-Delmotte, V., P. Zhai, A. Pirani, S. L. Connors, C. Péan, S. Berger, N. Caud, Y. Chen, L. Goldfarb, M. I. Gomis, M. Huang, K. Leitzell, E. Lonnoy, J.B.R. Matthews, T. K. Maycock, T. Waterfield, O. Yelekçi, R. Yu and B. Zhou (eds.)]. Cambridge University Press, 2021. For comments on the economic impact of climate change see, Financial Times, “Extreme weather blows out catastrophe insurance losses to $40bn” (by Ian Smith) 12 August 2021; Financial Times, “ECB stress test reveals economic impact of climate change” (by Martin Arnold) 18 March 2021; Wall Street Journal, “Fed”s Brainard: Climate Change Already Affecting Economy, Financial System” (by Michael S Derby) 18 February 2021. “Overall, worldwide economic costs from natural disasters have exceeded the 30-year average of USD 140 billion per annum in 7 of the last 10 years”; NGFS 2019 (n 3)13 (citing Munich Reinsurance Company (2019), “Natural Catastrophe Review 2018” Geo Risks Research, NatCatSERVICE).
[7] Ibid, IPCC.
[9] FSB (n 2) 4.
[10] Global Sustainable Investment Alliance, “Global Sustainable Investment Review 2020”, 9 (hereinafter “GSIR”) (covering sustainable investment assets in Europe, the United Stated, Canada, Australia, New Zealand, and Japan).
[11] Ibid.
[12] Regulation (EU) 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 (EU) 2019/2088 (OJ L 198, 22.6.2020) recital 11 (hereinafter “EU Taxonomy Regulation”).
[13] European Securities and Markets Authority (ESMA), “Sustainable financial markets: translating changing risks and investor preferences into regulatory action”, European Financial Forum 2020, Dublin (Speech by Steven Maijoor, Chair European Securities and Markets Authority) 12 February 2020, ESMA32-67-642.
[14] For example, Wall Street Journal, “You Want to Invest Responsibly. Wall Street Smells Opportunity” (by Jason Zweig), 16 April 2021.
[15] Wall Street Journal, “Fund Managers Brace for Europe’s New Anti-Greenwashing Rules” written by Dieter Holger and Fabiana Negrin Ochoa) 5 March 2021. Greenwashing concerns in the banking industry have been reported widely as in the Financial Times, “Global banks” $750bn in fossil fuels finance conflicts with green pledges” (by Billy Nauman and Stephen Morris) 24 March 2021 (citing statements made by Climate Action 100+ investor group).
[16] Financial Times, “Greenwashing in finance: Europe’s push to police ESG investing” (by Attracta Moony) 10 March 2021 (quoting Marcus Björksten manager of Fondita Sustainable Europe fund). Also, R Schwegler, B Ehmann and A Kohli, “Sustainability Funds Hardly Direct Capital Towards Sustainability: A Statistical Evaluation of Sustainability Funds in Switzerland and Luxembourg” INFRAS (Commissioned by Greenpeace Switzerland and Luxembourg) 03 May 2021 (finding that sustainable investment strategies used in investment funds are failing to channel private funds to sustainable activities).
[17] Footnote no. 13 above.
[18] Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector (OJ L 317, 9.12.2019) (hereinafter “SFDR”).
[19] Footnote no. 13 above, article 8.
[20] Proposal for a Directive of the European Parliament and of the Council amending Directive 2013/34/EU, Directive 2004/109/EC, Directive 2006/43/EC and Regulation (EU) No 537/2014, as regards corporate sustainability reporting, Brussels, 21.4.2021 COM (2021) 189 final 2021/0104 (COD) (hereinafter “Draft CSRD”), recitals 11-14.
[21] EU Action Plan (n 3) s 1.3 and s 4.
[22] Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups (OJ. L 330/1), art 1(1) (inserting art 19a (1) in the Accounting Directive2013/34/EU) (hereinafter “NFRD”).
[23] Draft CSRD (n 21) (The draft CSRD amends four EU legislative instruments: the Accounting Directive (2013/34/EU); the Transparency Directive (2004/109/EC); the Audit Directive (2006/43/EC); and the Audit Regulation (537/2014)).
[24] (n 19).
[25] (n 13).
[26] (n 21).
[27] Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU [2014] OJ L173/349, article 24(1) (hereinafter “MiFID II”). Other important sources in relation to the MiFID II regime includes: Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012 (hereinafter “MiFIR”); Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive [2017] OJ L87/1 (hereinafter “MiFID II DR”).
[28] Directive (EU) 2016/2341 of the European Parliament and of the European Council of 14 December 2016 on the activities and supervision of institutions for occupational retirement provision (IORPs) (OJ L 354/37 of 23.12.2016), article 19(1) (hereinafter “IORP II Directive”). Following the publication of the IORP II Directive in the Official Journal of the European Union, Member States had 24 months to transpose this Directive into national law.
[29] Commission Delegated Regulation (EU) C(2021) 4987 final, 6 July 2021, supplementing Regulation (EU) 2020/852 of the European Parliament and of the Council by specifying the content and presentation of information to be disclosed by undertakings subject to Articles 19a or 29a of Directive 2013/34/EU concerning environmentally sustainable economic activities, and specifying the methodology to comply with that disclosure obligation.
[30] Commission Delegate Regulation C(2022) 631/3 amending Delegated Regulation (EU) 2021/2139 as regards economic activities in certain energy sectors and Delegated Regulation (EU) 2021/2178 as regards specific public disclosures for those economic activities (02 February 2022), https://ec.europa.eu/info/publications/220202-sustainable-finance-taxonomy-complementary-climate-delegated-act_en (accessed on 17 February 2022). This new draft delegated act has included in the EU taxonomy classification gas and nuclear energy projects as transitional activities, covered by art. 10(2) of the Taxonomy Regulation (n 10). The Commission has explained that “[t]hese are activities that cannot yet be replaced by technologically and economically feasible low-carbon alternatives, but do contribute to climate change mitigation and with the potential to play a major role in the transition to a climate-neutral economy, in line with EU climate goals and commitments, and subject to strict conditions, without crowding out investment in renewables.” European Commission, “Questions and Answers on the EU Taxonomy Complementary Climate Delegated Act covering certain nuclear and gas activities” 02 February 2022, https://ec.europa.eu/commission/presscorner/detail/en/QANDA_22_712 (accessed on 17 February 2022).
[31] For instance, the Irish Times reported that ‘the EU Financial Services Commissioner with responsibility for the taxonomy file, Mairead McGuinness, repeated this week that the proposal was based on best scientific advice. Four member states have accused the Commission of departing from scientific evidence, and Austria and Luxembourg have threatened to sue, with the possible backing of Denmark.’ The Irish Times, ‘Inclusion of gas and nuclear in EU taxonomy not necessary – Eamon Ryan’ 5 Feb 2022 (by Kevin O’Sullivan, Environment and Science Editor); The Guardian, ‘EU includes gas and nuclear in guidebook for “green” investments’ 22 February 2022 (by Jennifer Rankin).
[32] Current policy work on the EU social taxonomy is being undertaken by the EU Platform on Sustainable Finance, technical workgroup no.4 on social taxonomy, https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/overview-sustainable-finance/platform-sustainable-finance_en#subgroups (accessed on 31 October 2021).
[33] See generally, L Corvo, L Pastore, A Manti and D Iannaci, “Mapping Social Impact Assessment Models: A Literature Overview for a Future Research Agenda” Sustainability 2021, 13, 4750; I E Lisi “Determinants and Performance Effects of Social Performance Measurement Systems” J Bus Ethics (2018) 152:225–251; J Reisman, V Olazabal and S Hoffman “Putting the “Impact” in Impact Investing: The Rising Demand for Data and Evidence of Social Outcomes” American Journal of Evaluation, 2018, Vol. 39(3) 389-395; A Ebrahimi and V Kasturi Rangan, “A Framework for Measuring the Scale and Scope of Social Performance” University of California, Berkeley, Vol. 56, No. 3, Spring 2014, 118.
[34] Draft Regulatory Standards, ESAs, “Final Report on draft Regulatory Technical Standards” JC 2021 03, 02 Feb 2021.
[35] For instance, an evaluation of the current conditions for compliance with the Principal Adverse Impact Reported under the SFDR by the investment fund industry in Ireland has been produced by the Irish Funds Industry Association, Irish Funds, “Principal Adverse Impacts Reporting: Practical insights for the next stage of SFDR implementation” (August 2021).
[36] A survey identifying shortcomings in the implementation of product governance rules has been conducted by CFA Institute without, however, including sustainability issues, CFA Institute, “The Brave New World of Product Governance in the EU Asset Management Industry: How MiFID II and PRIIPs have modified the rules of the game for manufacturers and distributors” May 2020.
