Expert View: Will more transparency green the financial markets?

March 2022

By Jan Willem van Gelder

The European Union now promotes sustainability reporting with several directives, as it hopes that investors will act as agents of change. But more transparency requirements alone will not  sufficiently stimulate companies and investors to collaborate on drastically needed sustainability transitions.

For the European Union, improving the availability of Non-Financial Information (NFI), also known as Sustainability Reporting, is an important cornerstone of its Green Deal. The EU wants listed companies to publish data about all kinds of sustainability topics: environment, human rights, labour standards, corruption, etc. The EU hopes that this information will stimulate investors to choose the shares and bonds of companies that have a better sustainability performance. Fearing to lose the interest of investors, companies would then be encouraged to become greener.

With this aim, the EU has issued the Sustainable Finance Disclosure Regulation in March 2021, which requires banks and investors to report how they deal with sustainability topics. Based on the new Corporate Sustainability Reporting Directive (CSRD), large and listed companies will be soon required to improve their sustainability reporting. These two directives are complemented by the EU Taxonomy which clarifies which products and technologies can be seen as “sustainable”. Companies are expected to report on the progress they make in adopting such sustainable products and technologies, enabling investors to make an informed decision on which companies they want to invest in and/or engage with.

Agents of change
Investors could in theory be powerful agents of change, by allocating available capital in a more sustainable way. But will more sustainability reporting convince them to take up this responsibility? Recently, I discussed this question in two roundtables with board members of big Dutch companies organised by the AFM, the Dutch supervisor of financial markets. An initial study by AFM was not very encouraging: after analysing reports of shareholder meetings and investor calls of Dutch listed companies, the AFM concluded that the companies do not provide much non-financial information and that investors hardly ask for it. AFM’s conclusion: both sides of the market should put more effort into reporting and using NFI.

While AFM’s intention to “green” the financial markets is laudable, this focus on non-financial information is not sufficient to reach that objective - for three reasons. First: we are forgetting a step when most companies are still not transparent on simple financial information, such as break-downs of revenues, profits and investments by products and technologies, as well as by country (who is doing what in Russia, for instance). And too often corporate reporting on sustainability issues is not reliable. Tata Steel in the Netherlands, for instance, for years underreported its harmful emissions by a factor of 5 to even thousand, according to recent independent measurements.

To avoid such greenwashing, the EU Taxonomy aims to offer clear, science-based guidance to the markets on which products and technologies account as sustainable. Companies’ reporting on their level of “Taxonomy-compliance” can then be audited. The idea is promising, but the recent, politically motivated inclusion of natural gas and nuclear energy in the Taxonomy undermines its credibility. And it makes you fear the worst for the upcoming discussions on human rights and labour standards in the Taxonomy.

Drastic transitions needed
Secondly, this focus on transparency creates extra reporting obligations for listed companies that do not motivate them. The sustainability discussion should not be about reporting, it should be about the drastic transitions which are needed in all economic sectors to deal with climate change, inequality, pollution, and resource depletion. Inevitably all companies, in all economic sectors, will have to change their products, production processes and/or business models. So, the question for any company is: what role do you want to play in addressing these global challenges? Demanding companies to publish loads of indicators will only drain their energy away from finding answers to this fundamental question.

Thirdly, it is not a lack of sustainability information that is preventing investors from putting sustainability considerations at the core of their investment decisions. For investors willing to invest time and resources, there is already a wealth of information available.

The real obstacle is that investors are spreading their capital over thousands of companies and are gaining returns from trading stocks. Financial regulators and supervisors, like AFM, carry responsibility for this. The dominant perspective on risk management in the investment sector, which is made mandatory by various financial regulations, is to spread investments across various geographies and as many sectors as possible. This makes it hardly possible for investors to understand the business models and sustainability challenges of all the thousands of companies across the globe they are investing in.

Apart from some forerunners, the average investor excludes one or two companies over sustainability concerns and engages with another handful - completely insufficient in relation to the number of companies in their portfolios. The embarrassing news that 300 investment funds which were marketed as “responsible” had invested US$ 8.3 billion in the Russian economy just before the horrible attack on Ukraine started, therefore hardly comes as a surprise.

Short term gains
Other financial regulations force institutional investors to optimize their financial returns on the short-term, on penalty of having to lower the pensions of their members. This pushes investors, also supposedly long-term investors like pension funds, to focus on short-term gains by trading stocks on a daily basis. The average investment portfolio, including those of pension funds, will be completely renewed within two years. As a result, sustainability risks still only play a marginal role for most investors, as they bet they can exit their positions when things really get hot.

To address this problem, the AFM and other financial regulators and supervisors should fundamentally restructure their regulation of the financial markets. Investors should be incentivized to invest for the long-term - let’s say the coming decades - in a much smaller number of companies which they know thoroughly. As committed stakeholders, they should travel with their investee companies on their transition journeys, and together invest in the new products and technologies needed to tackle various social and environmental challenges. Without addressing the present flaws in the regulation of financial markets, more transparency alone will not offer sufficient incentive for investors to take up their responsibility as agents of change.

(Photo: Miha Rekar on Unsplash)

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