Sustainability has a regulatory tailwind in Europe: Brussels is pressing ahead with EU action plan
The action plan presented by the European Commission pursues three core objectives. Firstly, it aims to redirect the flow of capital towards sustainable investments. Secondly, it promotes the integration of sustainability into risk management. This should limit financial risks arising from problems such as climate change, scarcity of resources and social issues. Thirdly, it seeks to promote greater transparency and long-term thinking in financial and economic activities. The plan devised to implement these objectives comprises a total of ten measures:
- Taxonomy – implementing an EU classification system for sustainable activities
- Green bond standard and ecolabel – defining norms and developing a label for environmentally responsible financial products
- Efficiency enhancement – promoting investment in sustainable projects
- Sustainability preference check – including sustainability in financial advice
- Sustainability benchmarks – creating transparency regarding methods and characteristics
- Ratings and market analysis – taking greater account of sustainability
- Sustainability of institutional investors/asset managers – adopting requirements concerning integration and transparency
- Risk management and capital requirements – embedding sustainability in regulatory requirements
- Transparency – strengthening disclosure requirements for sustainability-related information and financial reporting requirements in this area
- Corporate governance and short-termism – promoting sustainable corporate governance and measures to reduce short-term thinking in the capital markets
The EU’s ambitious action plan is fast approaching implementation. On the following pages, we will provide a brief overview of the most important measures and what investors can expect.
Standards for the disclosure of environmental criteria by companies
The proposed harmonised criteria of the taxonomy are designed to help assess whether an economic activity is environmentally sustainable. The taxonomy is being developed in stages. Initially, the focus is on climate protection and adaptation to climate change. Further environmental aspects will be included later on. Expanding the taxonomy to include social aspects is currently being discussed. There is consensus that the taxonomy should also serve as a basis for the future implementation of norms and labels for sustainable financial products.
The taxonomy is a milestone in terms of defining more clearly which economic activities make a positive contribution to combating and adapting to climate change. It provides a much greater level of detail than other green taxonomies in the market, such as the ICMA Green Bond Principles or the detailed UN sustainable development goals (SDGs). This is also reflected in the length of the document (414 pages).
The taxonomy is not, and does not claim to be, a definition of sustainable investment. But it defines which economic activities have a positive impact on climate protection and adaptation to climate change. Commonly used ESG approaches, such as exclusion criteria screening, ESG integration and engagement, are not covered by the scope of the taxonomy on the whole and will remain popular ESG strategies.
In total, the taxonomy report identifies 67 activities relating to the environmental objective of climate change mitigation and nine activities relating to the environmental objective of climate change adaptation. The taxonomy works at a highly granular level of sector-specific activities that range from the composting of biodegradable waste to hydrogen production and passenger transport on inland waterways. Companies’ conformity with the taxonomy is measured by the revenue that they aim to generate from sustainable economic activities. A sustainable economic activity must make a substantial contribution to EU environmental objectives without adversely affecting other EU environmental objectives:
Here is an example from the taxonomy for an activity in the area of low carbon transport and infrastructure.
Infrastructure for low carbon transport – land transport as an activity that facilitates low-emission transport and/or promotes the transition to a carbon-neutral economy
- Principle: The infrastructure must enable a substantial reduction in greenhouse gas emissions.
- Metric: Carbon emissions per passenger kilometre, per tonne-kilometre or per kilometre
- Threshold: Areas in which the construction and operation of infrastructure is classified as positive include:
- Infrastructure required for zero-emission transport (e.g. charging stations for electric vehicles and hydrogen filling stations)
- Infrastructure for pedestrians and cyclists
- Infrastructure for electric rail transport
- Climate change adaptation – consideration of factors such as physical consequences of climate change in infrastructure planning and design
- Sustainable use and protection of water and marine resources – prevention of water pollution during construction and operation
- Transition to a circular economy, waste prevention and recycling – use of recycled and recyclable materials in infrastructure construction and maintenance
- Pollution prevention and control – minimisation of noise and vibration, reduction of dust, noise and environmental pollution during construction and maintenance
- Protection of healthy ecosystems – measures to protect biodiversity (e.g. measures to minimise accidents involving wildlife, avoidance of work during breeding seasons)
So far, only a very limited pool of data on issuers is available for the purpose of assessing the conformity of a portfolio or global index with the taxonomy. Data is not yet available for many criteria of the taxonomy. This means that there is still much to be clarified regarding its use.
New transparency requirements regarding sustainable investments and ESG risks
Brussels is serious about tackling climate change: Regulation (EU) No. 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector – commonly referred to as the Disclosure Regulation – was published in the Official Journal on 9 December 2019 and is scheduled to come into effect on 10 March 2021.
“This Regulation lays down harmonised rules for financial market participants and financial advisers on transparency with regard to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability-related information with respect to financial products.” (Article 1 Disclosure Regulation)
The following are defined as financial market participants: insurance companies, investment firms, developers of pension products, alternative investment fund managers, credit institutions that perform portfolio management services and institutions for occupational retirement provision (IORPs).
The objective of this regulation is to harmonise sustainability-related rules at a European level.
It governs how persons and organisations defined as financial market participants or financial advisors have to publish information about the sustainability of their investment activities and relevant sustainability risks. And it also sets out in some detail what specific information needs to be published.
The following are examples of information that must be disclosed:
- Financial market participants and financial advisors must state on their website whether and how they take account of sustainability risks in their investment decision-making processes and their remuneration policy.
- In addition, financial market participants should identify, evaluate, manage and communicate the adverse effects of their investment decisions on ESG factors. In particular, they should define measures that can mitigate these effects (e.g. compliance with a pertinent corporate governance code).
- A product prospectus should include detailed information on the assessment of sustainability risks and the likely implications these may have on the return generated by the financial product. In cases where sustainability risks do not apply to a financial product, the financial market participant and the financial advisor need to provide an appropriate explanation. These requirements will take effect on 30 December 2022.
- When financial market participants advertise products based on their ESG criteria, they have to specify how these products or their underlying index meet these criteria and what sustainability objectives are being pursued with the product. The methods from the new taxonomy have to be used for these explanations.
- Subsequently, retroactive assessments should be conducted to determine the extent to which these products did, in fact, contribute to the sustainability objectives to which they were assigned. The findings of these assessments should be published as part of the regular reporting cycle.
Sustainability risk refers to events or circumstances in the environmental, social and corporate governance spheres that could have a definite or potential adverse effect on the value of an investment if they occurred.
Sustainability risks are part of established risk categories such as market risk, liquidity risk, counterparty risk and operational risk and can have an impact on the materiality of these risks.
I. Investment advice
If Union Investment provides investment advice in respect of financial instruments, it will recommend financial instruments to the client that have already undergone Union Investment’s research process. The principle of ESG integration is embedded in this process. The term ‘ESG integration’ describes the systematic consideration of sustainability factors in the research process used to assess the issuer of the financial instrument. Sustainability factors include aspects such as environmental protection, social responsibility and treatment of employees, respect for human rights, and combating corruption and bribery. When selecting financial instruments to be offered to the client, the scores assigned to the financial instruments based on the research process are taken into account and presented to the client.
II. Consideration of sustainability risk in investment advice
Union Investment’s sustainability analysts examine material sustainability risks for a particular industry and/or asset class and thus incorporate financially relevant sustainability risks into the traditional fundamental analysis.
The findings from the ESG analysis and the sustainability risk assessment are documented. Union Investment’s investment advisers can access this documentation and use it as a basis for their investment advice.
III. Impact on returns
Taking account of sustainability factors can have a significant influence on the long-term performance of a financial instrument for which investment advice is provided. Issuers with inadequate sustainability standards may be more vulnerable to event risk, reputational risk, regulation risk, litigation risk, and technology risk. These sustainability-related risks can, for example, have implications for the company’s operations, its brand and/or enterprise value and even the continued viability of the business. If such risks materialise, they may have an adverse impact on the valuation of the financial instrument on which advice was provided.
At present, the investment advice provided by Union Investment does not take account of adverse implications of investment decisions on sustainability factors. The availability in the market of the type of data required to identify adverse sustainability implications and assign a weighting to them is not yet sufficient.
Union Investment intends to include the most significant adverse implications of investment decisions on sustainability factors in its investment advice from 30 June 2021.
The remuneration policy is consistent with consideration of sustainability risk. Aspects such as the transparency and appropriateness of the remuneration systems, target-based and performance-oriented remuneration and long-term remuneration components form part of the remuneration policy.
Introduction of ‘low-carbon’ benchmarks
The objective is a harmonised and transparent approach.
The Low Carbon Benchmarks Regulation, which is based on the Financing Sustainable Growth action plan, sets out standardised EU-wide provisions for methods and disclosure requirements in relation to CO2-based benchmarks. The objective is to eliminate the fragmentation of the single market and ensure a high level of investor protection through EU-wide harmonisation.
Benchmarks play a central role in the world of investment. They can be used to create new investment products, define asset allocation strategies and measure performance. The main objective of the Low Carbon Benchmarks Regulation is to implement minimum standards for two different climate-related benchmarks in order to counteract greenwashing and improve transparency and comparability through disclosure requirements. In addition, it aims to implement ESG disclosure requirements for all benchmarks.
To this end, a new category of benchmark has been introduced that, in turn, comprises two types of benchmark: the EU climate transition benchmark and the EU Paris-aligned benchmark. The Low Carbon Benchmarks Regulation also requires information to be published on whether and how ESG factors are taken into account by the underlying method of a benchmark or family of benchmarks.
EU climate transition benchmark (CTB)
This low-carbon benchmark is based on the decarbonisation of a standard benchmark such as an equity index. The underlying shares are selected based on their emissions profile and compared with the shares contained in the standard benchmark. The objective is to use this comparison to compose a portfolio that meets certain minimum standards and is on a trajectory towards decarbonisation.
EU Paris-aligned benchmark (PAB)
This ‘positive carbon footprint’ benchmark ties in with the objective of the Paris agreement to limit global warming to less than two degrees above pre-industrial levels. The selection of the equities contained in the index focuses on companies that achieve carbon emission reductions in excess of their residual CO2 emissions (positive carbon footprint). The underlying idea is that the carbon emissions profile of the resulting portfolio is geared to achieving the goals of the Paris Climate Agreement. The portfolio has to be constructed in compliance with minimum standards and the economic activities of the companies represented in the portfolio must not have a significant negative impact on other environmental, social and corporate governance objectives.