On 8th March, the European Commission laid out its plans to achieve sustainable growth, manage financial risks and foster transparency in markets. Here’s what you need to know.
The problem
- Europe has to close a funding gap of €180 billion a year.
- Close to 50% of the Euro area banks to risk is directly or indirectly linked to risks stemming from climate change.
- There is a lack of clarity among investors on what constitutes a sustainable investment.
The solution
Corporate transparency on sustainability issues is a prerequisite to enable financial market actors to properly assess the long-term value creation of companies and their management of sustainability risks.
EU taxonomy and labels for sustainable financial products
Before we can take any significant steps, we need to understand and be clear about what is (and what is not) 'sustainable'.
Agreeing on a universal definition of sustainability and breaking this down into individual activities is a highly complex task that will undoubtedly take many years. We believe that it is nonetheless an important task to bring more meaning and, importantly, rigour to the sustainability dimensions of activities. Recognising the extent of this work, the Commission will undertake a step-by-step approach, starting with a taxonomy on climate change mitigation and adaptation and some environmental activities. The commission will set up a technical expert group on sustainable finance do develop this taxonomy and it will also table a legislative proposal in the next few months to implement this into the European legislative framework.
Once the taxonomy is developed, the expert group will use these to develop labels for sustainable financial products to build more trust and enable easier access for investors seeking those products. This will result in an EU green bond standard by Q2 2019, which the Commission will use to specify the content of the prospectus for green bond issuances to provide potential investors with additional information.
Fiduciary duty
Several pieces of EU legislation require institutional investors and asset managers to act in the best interest of their beneficiaries. However, this is widely understood to be a duty to generate maximum returns, rather than to take wider sustainability matters into consideration and ensure that the money invested does not degrade the world in which these beneficiaries live. There is also growing evidence that taking sustainability matters into consideration in capital allocation decisions creates a more complete picture of the risk/return profile of financial products.
The commission will, therefore, table a legislative proposal to clarify investor and asset manager duties in relation to sustainability considerations by Q2 2018. To our knowledge, this will be the first legislation of its kind, which might significantly alter the way investments are made in Europe.
Disclosure
The Commission has rightly set the scene by highlighting that "Corporate reporting on sustainability issues enables investors and stakeholders to assess companies' long-term value creation and their sustainability risk exposure." Disclosure is therefore in many ways the bedrock of sustainable finance, which allows capital to be allocated for its most efficient use.
The EU Directive on the disclosure of non-financial information (NFI) requires large public entities to disclose material information on key environmental, social and governance aspects. While this directive has set a minimum threshold in Europe on reporting, its requirements have allowed for significant flexibility in the way information is reported. We will be assessing the effectiveness of this flexible approach this year by reviewing the annual reports of 10 companies from each European Member State.
In the meantime, the Commission has recognised that, while it is important to allow companies to communicate the unique aspects of their business, it is also important to have a level of standardisation in place to ensure that the resulting information is suitable for comparative analysis by investors. The commission is, therefore, launching a fitness check of EU corporate reporting legislation, including the NFI Directive, to assess whether these are fit for purpose. The first step of this process began before the publishing of the Action Plan with an overall consultation on the state of corporate reporting in Europe. You can read our response to this consultation here.
To address the issue of inconsistency of information, the Commission will also update its non-binding guidelines on non-financial information to integrate the recommendations of the Task Force on Climate-related Financial Disclosures and the climate-related metrics developed under the new classification system.
While the guidelines serve as useful additional information, they are by definition non-binding. To ensure that the EU corporate reporting framework is in fact fit for purpose, we strongly believe that the NFI Directive needs to evolve. This should start by the integration of the TCFD recommendations, followed by clearer natural capital reporting requirements, in order to ensure that the resulting information is fit for investor decision-making.
Accounting
In addition to the shortcomings of conventional reporting practice, the commission has also rightly highlighted that financial accounting practices may not always be compatible with sustainable finance. The Commission’s plan highlights International Financial Reporting Standard (IFRS) 9, which covers financial instruments as a standard that may discourage sustainable investment activities.
The solution to this comes from the European Financial Reporting Advisory Group (EFRAG), which is tasked ensuring that European views are properly considered in the IASB standard-setting process and in related international debates. EFRAG also provides advice to the European Commission on whether newly issued or revised IFRS meet the criteria of the EU legislative framework, namely the IAS regulation.
The commission will set up a European Corporate Reporting Lab, modelled after the UK Financial Reporting Council’s Corporate Reporting Lab. This will promote innovation and development in corporate reporting practice, such as environmental accounting and the TCFD recommendations in particular. EFRAG has also been requested to assess the impact of IFRS on sustainable investment.
CDSB has a long history of demonstrating how existing IFRSs could be used to report on climate change in order to bring more consistency and alignment to this type of information. In fact, our new report “Uncharted waters” goes into depth about:
- IFRS 7 “Financial Instruments: Disclosures”;
- IFRS 19 “Financial Instruments”;
- IFRS 15 “Revenue from Contracts with Customers”;
- IFRS 17 “Insurance Contracts”;
- IAS 36 “Impairment of Assets”; and
- IAS 37 “Provisions, contingent liabilities and contingent assets”.
Financial reporting standards are important in the implementation of a sustainable financial system because they govern the way most of a company’s annual report is presented and they are accepted across Europe and most other jurisdictions globally. They are the de-facto reporting standard and they are trusted by both the preparers and the users of the information. In addition, by using the same standard as for financial information, it becomes inherently interconnected and relatable. We will be sure to share this research with the Commission and EFRAG.
Beyond Europe
One of the most encouraging parts of the Commission’s action plan was at the very back of the report:
“The Commission will promote discussions on this Action Plan in existing fora, such as the Financial Stability Board, the G20, the G7, the United Nations and the International Organisation of Securities and Exchanges Commission (IOSCO).”
This sentence is very important, because in times of political turbulence internationally, we need leadership to make progress on a truly global issue. We are pleased to hear that the European Union is eager to lead and we will continue to support their work.
The Commission will report on the implementation of this Action Plan in 2019.