How to understand the EU’s growing rulebook on sustainable investing

In the last few years, new words have been invading our everyday vocabulary. We have gone from “climate change” and “green economy” to the more specialised “sustainability” and “integration” and the utterly bizarre “principal adverse impact” and “taxonomy”. What is happening?

There is new sustainability regulation coming from the EU which affects asset managers, companies, investment advisers and many others in financial markets.

At the bottom of it lies the fact that climate change is getting harder to ignore. Policymakers have realised that tackling it and all its consequences will take a lot of effort.

The EU’s “call to arms” came in the form of the EU Green Deal, according to which the EU should introduce an elaborate framework of policies and new regulations in order to achieve net zero emissions by 2050. A very long list of things need to change in the real economy such as: how we build houses, how we travel from A to B, how the things we buy in the supermarket are packaged, where the energy for cooking and heating comes from, how long our smartphone batteries last and so on.

The initial investment required to deliver all this is estimated to be about €2.6 trillion by 2030. Approximately half of it will come from various public sources such as the EU budget. The other half is expected to come from private investment, which is what the regulation driven by EU Sustainable Finance Action Plan is supposed to deliver.

Although quite elaborate in its structure, the plan has one ultimate objective - to shift investment towards more sustainable projects and businesses so that we transition to a low-carbon economy faster.

There are many obstacles that stand in the way such as market fragmentation, unclear labelling for investment products with sustainability features, insufficient company disclosures to assess sustainability etc. Every bit of regulation connected to the Sustainable Finance Action Plan is trying to remove or overcome these obstacles. This includes:

• Having a common language on what is sustainable and what is not (Taxonomy Regulation)
• Companies reporting the corresponding sustainability information in their accounts (Non-Financial Reporting Directive)
• Having clear investment disclosures on sustainability both at the firm and product level (Sustainable Finance Disclosures Regulation
• Financial advisers having an explicit discussion with clients on their sustainability preferences (amended Markets in Financial Instruments Directive II suitability rules)

The full list of new regulations is much longer than what we have identified above. This is because, to achieve its very ambitious objective, the regulation should touch upon every single part of the investment chain: asset owners, asset managers, advisers, credit rating providers, benchmark providers and so on.

To understand how this is supposed to work, we can look at it from an information flow perspective.

First, companies report on their activities and flag the extent to which these are sustainable as per the new regulation. Then institutional investors (asset managers, pension funds and insurers) can take this information, use it to allocate money and, in parallel, report on how they approach sustainability in their business and whether their products have sustainability features.

Then advisers can look at which investment fund, pension, or insurance provider has incorporated sustainability into its investment approach and which products are environmentally sustainable. They can then recommend those to end-investors with a preference for sustainability.

And, the final link in the chain, end-investors will be able to see from all disclosures which providers and which of their products are sustainable and/or follow adviser recommendations to buy into these products.

Our paper explores in more detail both the regulation coming out from the Sustainable Finance Action Plan and who along the investment chain is supposed to do what.

Saying that this is a learning process for everyone involved would be an understatement.

The million dollar question of course is whether this will work and help the EU deliver its ambition. As with everything in life, it depends. We identify three risks:

1. Forgetting that investing comes before sustainable investing. As we have written in the past, most people need solutions to real life problems and, right now, they don’t see investing as part of the solution but rather as a nice-to-have. If we fail in developing a framework that creates an investor culture more broadly, then there is little chance that sustainable investing will really get off the ground, at least for retail investors.
2. Following a “too narrow size fits no one” approach. Regulatory standards that are too prescriptive could result in the sustainability bar being placed too high for anyone to reach, or in rules that are not dynamic enough to respond to what is a very rapidly moving area of study and research.
3. Developing different standards across borders. Since climate change is a global problem, the response to it should be global too. If the effort is not aligned across borders, we could end up with fragmented regulation. This would defeat the purpose of creating one strong, liquid sustainable investment market.

With careful planning and cooperation across industries and borders these risks can be addressed. One thing is for sure: there is still a lot to do. If the last couple of years have been about shaping the new regulatory landscape, the next couple of years will mainly be about implementing all the changes. Some along the investment chain will have to be nudged more than others but the goal is for everyone to improve. These are the first steps in the right direction for what is ultimately going to be a long journey towards a more sustainable future.

Our full paper is available below as a PDF.