Financial and non-financial regulators have an opportunity to promote sustainability and ensure credibility and soundness of sustainable finance markets and investments. The key action that supervisors and regulators should prioritise, having started incorporating climate and environmental issues on their agendas, is achieving consistency of policies amongst themselves. This involves ensuring that companies are not subject to multiple differing disclosure requirements or policies and harmonising policies to best facilitate information exchange.
The regulator could also provide economic actors with advice and capacity building on sustainable finance activities, to encourage and enable action. A specific entity can be set up to deliver this. Capital Markets Malaysia was set up by the Securities Commission, to enhance capital market opportunities. Funded by the Capital Markets Development Fund, capacity building is provided to issuers, investors and intermediaries by centres of excellence, such as the Malaysian Sustainable Finance Initiative, the Sustainable Investment Platform and the Centre for Sustainable Corporations.[i] These centres of excellence also increase awareness and provide a knowledge sharing platform. Capacity building can also be provided to support the development of local expertise in green bond verification and second party opinion provision. This can help kickstart local green bond markets and reduce the cost of obtaining verification.
Establish sustainable finance guidelines
Supervisors can set out GSS bond guidelines and frameworks. These can help standardise the local market which reduces investor due diligence and facilitates transparency efforts. Many green bond guidelines are aligned with the ICMA Green Bond Principles (GBP)[ii] and Climate Bonds Standard.[iii] Aligning guidelines with the GBP, Social Bond Principles (SBP), Sustainable Bond Guidelines (SBG) and Sustainability-Linked Bond Principles (SLBP) will create consistency with international markets and ensure local issuance meets investor expectations. Such guidelines can also be set out for green and sustainability-linked loans (SLLs), drawing on the SLL guidelines.[iv] Guidelines can also help kickstart local green bond markets. The PBOC 2015 guidelines for the issuance of green financial bonds in the interbank bond market were accompanied by the first edition of the Green Bond Endorsed Project Catalogue and led to rapid scaling of Chinese issuance.[v]
Jurisdictions with green bond guidelines already in place can expand their guidelines to also cover social and sustainability issuances. For example, the Moroccan Capital Markets Authority (AMMC) issued its Green Bonds Guidelines in 2016, using the GBP.[vi] In 2018, the Guidelines were amended and AMMC launched the Green, Social and Sustainability Bond Guidelines with support from IFC.[vii]This also illustrates how supervisors can leverage development bank or other expertise to assist with guideline development, overcoming capacity issues that may be present particularly in EM.
Guidelines are also being developed for sustainable sukuk. Sukuks are debt instruments that are compatible with shariah law, they are well-suited for GSS issuance given the overlap between Islamic finance principles and sustainability principles. The Malaysian Securities Commission’s updated Sustainable and Responsible Investment (SRI)-linked Sukuk Framework builds on guidelines first issued in 2014.[viii] The Framework is also linked to a grant scheme covering up to 90% of external review costs. This is applicable to all sukuk issued under the SRI Sukuk Framework or bonds issued under the ASEAN Green, Social and Sustainability Bond Standards.[ix] This demonstrates how frameworks can facilitate implementation of grant and incentive schemes.
To ensure development of robust and usable guidelines, regulators could facilitate a series of pilot green bond issuances through state-owned enterprises. These could provide a test ground to identify operational issues and risks of issuance and develop appropriate structures.
Ensure transparency on climate and environmental impacts
Financial regulators are increasingly establishing climate disclosure requirements on financial institutions. While these do present a large administrative burden for FIs, disclosure is a valuable tool to assess alignment with a 1.5°C pathway, encourage FI action to decarbonise their activities, and to enable enforcement of targets and phaseout dates. For example, the Swiss Financial Market Supervisory Authority mandated the largest banks and insurers to disclose climate risks based on the TCFD recommendations from 2022. This includes the financial risk that a company incurs as a result of climate-related activities and the impact of the company's business activities on the climate and the environment (double materiality).[x] Double materiality is essential to all disclosure regimes as it ensures a comprehensive understanding of the climate risks incurred by an investment. It is also embedded in the European Commission’s sustainability reporting regime.
The European Commission’s Sustainable Finance Disclosure Regulation (SFDR) applies to all financial market participants, requiring entity and product level disclosure on sustainability risks and principal adverse impacts. The sustainability reporting regime also includes Taxonomy Regulation disclosures on turnover, capital expenditure, and operating expenditure from products or activities associated with Taxonomy.[xi]
Corporate disclosure requirements will help shift corporate investment to green and enable financial disclosure and inform climate-related risk assessments and stress tests. For example, the EU Corporate Sustainability Reporting Directive (CSRD) is expected to apply from 2023 and will require large and listed European companies to publish audited sustainability data. It increases the number of firms obliged to report sustainability data from 11,700 under the Non-Financial Reporting Directive (NFRD) to more than 49,000, covering three quarters of all EU-based companies.[xii] This ensures that companies are reporting the information required by investors and FIs, although SMEs will report according to simpler standards than large companies. The reporting standards also include indicators that correspond to those applied to FIs.
Regulators can also introduce nature-related disclosure requirements, following the recommendations of the Taskforce on Nature-Related Financial Disclosures (TNFD). These follow the structure of TCFD recommendations, aiming for double materiality in disclosures of nature-related risks and opportunities. TNFD disclosures will encourage actors to address vulnerabilities and adverse impacts. [xiii] In 2021 France’s climate-related risks reporting requirements for financial investors were extended to biodiversity-related risks. While challenges remain with data access, this will increase awareness and enable management of nature-related risks.[xiv]
Disclosure regulations present a high administrative burden for FIs and companies. Therefore, a clear roadmap for disclosure requirements ensures companies have time to prepare for disclosure. Roadmaps can introduce voluntary before mandatory disclosure. The UK Sustainability Disclosure Requirements will gradually apply to corporates, asset managers and owners, and investment products.[xv] This ensures coherency of disclosure data which can then inform more interventionist policies. China’s Guidelines for Environmental Information Disclosure by Financial Institutions, issued by PBOC, were piloted in its green finance innovation zones.[xvi]
Guidance from supervisors is key to minimise compliance costs and to ensure meaningfulness and comparability of disclosed data. For example, guidance from the Dutch supervisor prompted some sustainable funds to reclassify their funds (dark green to light green) under SFDR, given the regulator’s stricter disclosure demands for dark green funds.[xvii]
Regulators can standardise key metrics that need to be disclosed, establishing tools for data capture. To reduce the burden of data collection, they can also capture data at a national level and ensure data is easily available to investors. For example, the European Single Access Point (ESAP) will provide centralised and digital access to sustainability-related information disclosed by European companies.[xviii]
Many financial institutions will likely be disclosing in several jurisdictions. Therefore, as with taxonomies, it is important to improve international alignment of disclosure requirements. This can reduce the burden of disclosure, likely improving quality of disclosed information.
Require and assess transition plans
Credible company transition plans are crucial to ensuring transition finance flows are aligned with 1.5°C, see Figure 8. An immediate step is to require investors and corporates to publish transition plans. For example, UK and EU sustainability disclosure requirements include net zero transition plans.[xix] This can be accompanied by guidance for plan construction. The regulator can then introduce risk tools for long-term assessment of transition plans and their impact on exposure. Basing these on robust standards such as the Climate Bonds transition and entity criteria will ensure credibility and speed of transition.[xx]
Transition plan assessment criteria and detailed requirements can ensure strength of these plans. For example the OECD Guidance on Transition Finance recommends consideration of other non-climate sustainability impacts.[xxi] These can also inform eligibility for subsidies and preferential treatment. For example, the ECB’s corporate bond tilt is based on issuer-specific climate scores, which are partially based on ambition of climate targets.[xxii] Similar schemes could be based on credibility of transition plan assessments. These assessments would not only prompt companies to transition their activities, they also ensure that funds are available for hard-to-abate transition.
Support sustainable financial innovation
Regulators can support green and sustainable financial innovation. Financial innovation has been limited following the GFC. However, it could overcome several financing challenges of the net zero transition, such as long-term investment horizons and uncertainty. Regulators are establishing so-called regulatory sandboxes that allow financial products to be tested in a controlled environment, exempt from compliance with regulatory requirements. Complying with such regulatory framework is the biggest barrier to entry for financial services providers. Once these are tested, and if successful, they shall be launched onto the market and required to comply with the regulatory framework in place. The UK’s Financial Conduct Authority promotes innovation in finance to support the transition to net zero through its Green Fintech Challenge and Digital Sandbox.[xxiii]
Green securitisation is an important instrument to increase green financing. Securitization involves the aggregation and packaging of small loans into a larger debt product to reach institutional investors’ minimum bond sizes. This enables banks to move those assets off their balance sheet and originate more loans within their capital requirements. Regulators can establish standards for loan contracts, installation processes, operations and management. This creates consistency, which improves the ability of packaging loans into securities.
Green covered bonds provide an opportunity to increase transparency to underlying green assets, and provide a bridge between bonds with entity recourse and pure asset-backed securities, where bondholders are reliant solely on the performance of a defined pool of assets.[xxiv] In most countries where covered bonds are issued, legislation has been created to define stringent requirements that a bank needs to meet in order to be licensed to issue covered bonds, as well as the core concepts applied in structuring covered bonds. Including green assets, e.g. renewable energy and low-carbon transport assets, as eligible assets in covered bond legislation would boost green bond issuance.
Encourage climate action by all market participants
Regulators will play a crucial strategic role to encourage action by individual financial institutions. The regulator, alongside the MoF and CB can help inform FIs of their role in transition and encourage them to fulfil their potential. This is crucial as bank lending provides much of the early-stage financing of infrastructure projects. Encouraging lenders to engage with their clients and green their lending will help build up the green project pipeline. For example, banks could set up a Green Revolving Credit Facility or issue green commercial paper to pre-finance projects that will then be financed by green bonds.[xxv]
Financial market regulations can be updated to include climate change considerations to ensure that retail clients’ environmental preferences are taken into account when purchasing financial products (including pensions, investments and insurance) and that financial institutions’ product offering matches these preferences. The French regulator found that despite strong retail investor interest in sustainability, only 17% reported holding at least one related investment.[xxvi] Therefore, retail investor disclosure rules at product level must be amended to make sure that sustainability preferences of consumers are taken into account in the financial advice and marketing of products.[xxvii]
The European Securities and Markets Authority (ESMA) is partly responsible for drafting technical norms for integrating sustainability preferences. This requires firms to collect information from clients on their sustainability preferences, identify the products that fulfil these preferences, and provide staff with appropriate training. It has also released proposed amendments to its Suitability Guidelines to outline how it expects sustainability considerations to be built in to the suitability process.[xxviii] The US Securities and Exchange Commission has proposed norms to enhance disclosures about ESG investment practices.[xxix] It aims to review its 2001 “names rule”, which requires funds to invest 80% of their assets in the investments suggested by their name, to adapt it more specifically to ESG investing[xxx]
Regulatory KPIs can be established that nudge financial institutions to allocate their capital towards green or transition activities through capital regulations. These measures do not put stability of the financial system at risk if designed carefully and allow for non-discriminatory nature of the incentive (i.e., if all financial institutions in a given jurisdiction have an opportunity to take advantage of this measure). It is very important to set KPIs for financial institutions and development banks in alignment with science-based green taxonomies. Vague KPIs, aligned, for example, the SDGs, may be too vague and inefficient in terms of decarbonisation.
Regulators can embed climate risk considerations into senior leadership requirements, integrating responsibility for climate risk into board accountability. For example, in the UK, bank and insurer board and leadership teams are required to have climate oversight. The regulator cited liability risk as a climate-related risk, particularly for insurance companies.[xxxi] This is the risk of legal action being taken against financial institutions or companies whose activities negatively impact the environment, or who fail to protect their clients from climate-related risks. Such cases have more than doubled since 2015 to over 2000.[xxxii]
[ii] ICMA, 2021, Green Bond Principles: Voluntary Process Guidelines for Issuing Green Bonds, https://www.icmagroup.org/sustainable-finance/the-principles-guidelines-and-handbooks/green-bond-principles-gbp/
[v] Climate Bonds Initiative, 2022. China Green Bond Market Report 2021, https://www.climatebonds.net/resources/reports/china-green-bond-market-r...
[vi] AMMC, 2016, Green Bond Guidelines, https://www.ammc.ma/sites/default/files/AMMC%20BROCHURE%20VGB.pdf
[xv] HM Treasury, 2021, Greening Finance: A Roadmap to Sustainable Investing, https://www.gov.uk/government/publications/greening-finance-a-roadmap-to-sustainable-investing
[xvi] PBOC, 2021, Guidelines for Environmental Information Disclosure by Financial Institutions, https://www.chinadevelopmentbrief.org/wp-content/uploads/2021/08/Guidelines-for-financial-institutions-environmental-information-disclosure.pdf
[xix] HM Treasury, 2021, Greening Finance: A Roadmap to Sustainable Investing, https://www.gov.uk/government/publications/greening-finance-a-roadmap-to-sustainable-investing
[xxv] Climate Bonds Initiative, 2022. Discussion Paper: Certification of Short-Term Debt Instruments, https://www.climatebonds.net/files/reports/cbi_shorttermdebt_22_01d_1.pdf
[xxxii] Setzer J. and Higham C., 2022. Global Trends in Climate Change Litigation: 2022 Snapshot, https://www.lse.ac.uk/granthaminstitute/publication/global-trends-in-cli...