By: Jan Willem van Gelder and Michel Riemersma 

On 8 March, the European Commission (EC) published its action plan on financing sustainable growth. The action plan is based on the recommendations of the High-Level Expert Group on Sustainable Finance (HLEG) (established by the European Commission), which published a roadmap towards sustainable finance in the EU. A transition to a sustainable financial system is much needed, and the EC plan includes some useful actions. But as argued in Profundo’s response to HLEG’s public consultation, the action plan should focus more on regulatory and supervisory measures. Leaving the implementation of most policy objectives to a market that is still too much focused on financial short-termism, might not result in the urgently required transition. At least four of the actions could be strengthened.

First, the proposed establishment of an EU sustainability taxonomy is useful, but it is imperative that the taxonomy is based on sustainability in the broadest sense. Although a pressing issue, the proposed initial focus on climate change mitigation ignores other equally essential sustainability themes such as human rights, labour rights, inequality, health and biodiversity. Similar to the comprehensive scope of the UN’s Sustainable Development Goals (SDGs), the EU taxonomy should from the start cover a broad and inclusive sustainability agenda.

This is possible and relevant. The sustainability taxonomy for the financial sector could be modelled after other existing sustainability taxonomies that already exist, such as the Fair Finance Guide. This web-based tool of civil society organisations assesses the responsible investment policies and practices of financial institutions. An increasing body of scientific studies and analyst reports also shows that the financial risks related to these sustainability issues are just as tangible as those related to climate change.

Second, the time horizon of risk management regulation should be expanded to better align with sustainability goals. The European Banking Authority (EBA) could learn from countries like Bangladesh, Brazil or China that have already integrated attention to ESG risks to loan portfolios firmly in their risk management supervision. Caution is advised regarding proposals to use differentiated risk weights (Pillar I of Basel III) to make ‘green lending’ more attractive. Adjusting risk weights for reasons unrelated to financial risks creates the risk of ‘green asset’ bubbles, similar to the carbon bubble.

However, ‘brown-penalising’ risk weights are related to financial risks and should therefore be introduced in EBA’s regulations. The EBA could coordinate a ‘sustainability stress test’ that involves a detailed investigation of corporate loan portfolios and internal risk models used to calculate the capital requirements for such loans. However, the EC will only “explore the feasibility of the inclusion of risks associated with climate and other environmental factors in institutions' risk management policies and the potential calibration of capital requirements of banks as part of the Capital Requirement Regulation and Directive”.

Third, the EU should create a new European public agency that assesses risks and assigns certificates (like differentiated labels for green bonds, sustainability benchmarks and other sustainable assets) to borrowers and financial instruments accordingly. The agency should be a non-commercial entity that is not deeply rooted in a conventional, i.e. unsustainable and short-term, business logic to do justice to the importance of ESG factors. The rating system should reflect the multi-dimensional nature of the SDGs and the proposed EU taxonomy by assigning multi-dimensional scores. Avoiding misuse and greenwashing will require rigorous external monitoring.

Fourth, the general direction of the Capital Markets Union of the EU seems at odds with the goal of creating a more sustainable financial system. Increasing the share of capital market financing, as opposed to bank financing, making capital markets more liquid, and encouraging loan securitisation are the opposite of creating a more patient, long-term financial system. The EC should insist that sustainability issues take precedence in such cases. Furthermore, the European Central Bank should not counteract the transition to a sustainable economy by buying corporate bonds of high-carbon industries in its Corporate Sector Purchase Programme.

To construct a sustainable financial system in the EU, at least four actions of the EC’s plan could be strengthened:

1. the EU taxonomy should be based on sustainability in the broadest sense;
2. the time horizon of risk management regulation should be expanded;
3. the EC should create a new European public agency that assesses risks and assigns certificates to borrowers and financial instruments accordingly; and
4. the EC should insist the policies of the Capital Markets Union and the European Central Bank do no counteract the transition to a sustainable economy.

As the financial market will not by itself shift from short-term to long-term, from brown to green and from unsustainable to sustainable, it is imperative for regulators and supervisory agencies to set up a framework that is monitored and enforced.

For more information or to discuss research opportunities on this topic, please contact: Jan Willem van Gelder jw.vangelder@profundo.nl or Michel Riemersma m.riemersma@profundo.nl.