Busy week on green finance in Brussels and Frankfurt:
- On 6th July the European Commission launched its Strategy for Financing the Transition to a Sustainable Economy and a proposed regulation on European Green Bonds.
- On the 7th the European Central Bank (ECB) concluded its strategy review and proposed some highly significant changes to the way monetary policy instruments are used to manage climate risks.
- On the 12th July, the Platform for Sustainable Finance published a consultation on a Social taxonomy and a Significantly Harmful (SH) activities taxonomy.
New Stage from 2018 Action Plan
The new Strategy’s predecessor, the 2018 Action Plan, mainly focussed on growing green investments aligned to the block’s environmental objectives and addressing the issue of greenwashing, and culminated in last week’s Green Bond Standard proposal.
These new developments together represent a switch in focus to tackling assets which give rise to climate and biodiversity risks.
The Strategy frames the sustainable finance transformation as a major system change that requires action by finance’s numerous backstage actors: regulators, credit rating agencies and index providers to name just some. This strategy updates activities undertaken by these entities, their oversight bodies and associations and the Commission’s response to emerging findings.
Commission recognises the need to leverage all players of the European financial system: From ECB to SMEs and retail investors.
The Strategy supports the efforts of EU supervisory bodies on climate risk disclosure and encourages global co-operation so environmental risks are fairly reflected in the financial statements the company makes to the market.
The Strategy is harsh about the financial system’s current readiness to absorb future carbon risks, reflecting a finding from an interim study by Blackrock Advisory:
“While financial sector entities and supervisors are making efforts to capture climate and environmental factors in risk management systems and prudential capital requirements, progress remains insufficient”
The ECB’s preliminary climate stress test recently revealed high-emitting firms represented 14% of bank balance sheets and 80% of the banking system to be exposed to firms vulnerable to high or increasing physical risk.
To remedy this the Commission will propose amendments to the prudential framework for banks to ensure ESG factors are consistently included in the risk management systems, and to Solvency II to ensure similar action from insurers. This is a welcome development and reflects recommendations that many commentators have been making for some time. The proposed amendments include climate change stress testing.
The Strategy suggests the European Banking Authority (EBA) brings forward its assessment of the prudential treatment of exposures related to assets associated with environmental objectives to 2023. The EBA has recently suggested ESG risks be incorporated into supervisory capital assessments This means that in the near future, there is a distinct possibility that assets identified by stress tests as bearing high climate-related risk will have lower notional value when determining bank capital adequacy.
The possible amendment of the prudential framework and strengthening of supervisors’ roles in assessing climate-related risks would bring climate risk further within the ECB’s and European Supervisory Authorities’ remits. As we have previously discussed, supervisors do not require explicit mandates to tackle climate-related risks but such amendments would validate assessments that climate change’s threat to financial stability requires action from central banks – as seen with the remit statement for the Bank of England’s monetary and financial policy committees to support the net-zero transition.
Preferential green capital requirements are on the horizon for EU mortgages.
The Commission will consult the EBA on supporting tools for green retail loans and mortgages to promote their uptake by 2022. The Hungarian central bank offers an example of how this might be done, having offered preferential capital requirements to banks against balance sheet exposure to energy-efficient housing loans since 2019 and recently expanding this to include renewable energy loans and corporate green bond exposures.
The Renewed Strategy prioritises Transition, this should target the ‘hard-to-abate’ sectors
One of the four pillars of the Strategy is Financing Transition.
The Strategy recognises that there is a need to support financing not only of green activities but also of interim activities to enable transition plans – a move away from a low-hanging fruit mentality to tackling those parts of the economy which are yet to decarbonise.
The Strategy states that the Commission will consider recognising and supporting activities that support transition ‘primarily in the energy sector’.
Given that renewable energy technologies are already well established and developed in Europe, we would argue that transition funding should be channelled towards those activities where a shift from high-carbon to low-carbon models is most urgent: green hydrogen, steel, cement etc.
Gas remains an outlier
Inclusion of natural gas as a transitional activity in the complementary Taxonomy delegated act is both at odds with the IEA’s recent Net-Zero report on achieving the Paris Agreement, and will distract from greater funding needs.
While the Strategy states that a complementary taxonomy could cover nuclear energy and natural gas as transitional activity, an inclusion that has generated significant concern, there is no indication that such activities would be labelled green. While no thresholds are discussed, the Strategy does suggest a sunset clause for transitional activities.
Proposal for an extended taxonomy to support economic transition
The Platform for Sustainable Finance is consulting on Significantly Harmful and No Significant Impact (SH&NSI) extensions to the Taxonomy. The intention is to provide a positive label for investments to move activities out of significantly harmful performance and to extend the use of the taxonomy to a wider range of low impact activities.
The Platform believes that an extended taxonomy, with additional categories of activities and performance levels, can help improve clarity in financial markets regarding different environmental performance levels and different levels of environmental impact, to make transition finance available more widely, whilst not diluting incentives to ‘go green’.
These extensions would aid in supporting the urgent transition to a low-carbon, climate-resilient and more sustainable economy, as laid out in the EU Green Deal.
While the Platform acknowledges the challenges associated with taxonomy extension, it considers the balance of evidence to be that sustainable finance initiatives to date have not significantly increased transition finance nor driven sufficiently ambitious environmental transitions. This suggests a possible need for extension.
The first report on the SH&NSI Taxonomy considers the rationale for such a taxonomy, outlines a framework for an extension, defines both SH and NSI activities and provides a list of recommendations.
The Social Taxonomy is also taking shape
The Commission has always recognised the social dimension in its sustainable finance considerations alongside the environment. The need for investment in the social field specifically to achieve the sustainable development goals (SDGs) is widely recognised as is the need for businesses to ensure respect for human rights, as envisaged by the UN Guiding Principles on Business and Human Rights.
There is increasing evidence that investors see social investments as an important investment consideration and opportunity just as they acknowledge risks of not considering social factors. Consequently, guidance on what constitutes a social investment is as badly needed as that for environmental investments.
The first report on the social taxonomy considers the pros and cons of a social taxonomy, defining social objectives, conceptual considerations, governance and identifying two potential routes for the inclusion of social objectives within the green taxonomy.
The proposed European Green Bond Standard aims for a ‘gold standard’ on green bonds
Strong regulatory support for standards will help accelerate the market. The proposed Green Bond Standard regulation will enable high-quality green bond market development and, by bringing in regulatory oversight, reduce the risk of greenwashing.
The obligations on issuers echo those of other international standards such as our own Climate Bonds Standards. Given the EU’s ongoing work to internationalise green finance flows, the label would also be available to non-EU issuers.
The proposed Standard includes strict transparency requirements including third-party external review, annual post-issuance reporting and allocation requirements. It adopts ICMA’s Green Bond Principles and mirrors the governance framework of the Climate Bonds Standard v3.
Whither goest market-neutrality?
In its Strategy Review, the ECB Governing Council acknowledges that climate change and the energy transition have profound implications for price stability which need to be reflected throughout ECB’s operations. The strategy sets out a timetable on how change will be incorporated across monetary policy, disclosures, risk assessment, collateral frameworks and corporate sector asset purchases.
Within monetary policy, asset eligibility for corporate sector asset purchases will depend on issuer alignment with the EU’s Paris Agreement legislation. Collateral valuation will be adjusted to reflect climate-related risks and both programmes will require issuer disclosure. If strong enough, these measures will result in a tilting of collateral and asset purchases away from high-emitting sectors towards greener bonds and firms.
There is a tantalising hint that the market neutrality straitjacket may soon become a thing of the past, with assessments of alternative market allocations and benchmarks to come in 2022. We look forward to these developments and hope they align monetary policy eligibility with EU net-zero targets.
The European Commission and ECB are recognising the need for systemic change
This Strategy demonstrates that the Commission is embracing the need to green all aspects of the economy, mainstreaming climate and biodiversity in the EU budget and developing a green budgeting reference framework to support member states who want to redirect the national budget towards green priorities.
For example, in February Italy’s Ministry for the Environment was remodelled as the Ecological Transmission Ministry, taking on energy policy responsibilities previously split across ministries and establishing transition as a government priority.
This need for systemic change is also reflected in the announcement that the Commission will assess risks of ecosystem degradation and biodiversity and natural resource losses and accelerate its engagement with industry on biodiversity and natural capital accounting.
The Commission and ECB are also recognising the power of fiscal and monetary policy cooperation, pledging to cooperate on system-level sustainability risk management while the ECB’s climate action plan has been developed in line with EU disclosure policies.
We welcome these announcements not only for their ambition but also for their comprehensive coverage of European financial policymaking.
EU Action has set a new baseline: Measures to address climate change and promote sustainable finance
Of course there’s more to be done, and arguments with Member States about practical steps are still a big issue; for example, the inclusion of agriculture in the Taxonomy has been delayed as those arguments rage.
But these developments are likely to lead to a realignment of EU policy and financial systems towards transition; exactly what’s needed.
Addressing climate change is an enormous challenge and undertaking, albeit one with huge opportunity as capital is deployed in vast scale to necessary solutions.
With the announcements of the past week, the EU has in essence taken a big step to forging a partnership with European capital to address climate change and sustainability.
This is essential.
That step has to be followed up by related shifts in urban, industrial and infrastructure planning, in agricultural and land use policy; and by support for such changes in developing countries around the world. Leadership.
The deals that flow from such change will fill out the portfolios of EU investors, banks and corporations for many years to come.
‘Til next time
Thursday, July 29th, Webinar ‘The Climate Policy Acceleration - Impacts for Investors.’