Clear regulation for sustainable finance

Scratch beneath the surface, and so-called green investments often reveal to be contributing to environmentally harmful activities. With voluntary pledges shown wanting, governments and regulators must urgently mandate for better transparency and accountability in sustainable investing

ClimateGlobal

Coal-fired power plant, Raichur, India. The recent sale of Sembcorp's Indian coal power plants has highlighted distortions in the green bond market. The deal enabled Sembcorp to avoid higher coupon rates on its sustainability-linked debt, despite the fact that it would continue to finance the plants for the next 15 years. ©iStock

The realm of global sustainable finance is experiencing unprecedented growth, boasting a staggering USD 1.8 trillion in cumulative issuances of labeled bonds. A substantial transformation is evident, with sustainability-related financial products now commanding a formidable USD 35.3 trillion, claiming a 36% share of all professionally managed assets (according to the Global Sustainable Investment Alliance’s 2020 review).

However, beneath this impressive façade lies a pressing question: are we genuinely reflecting the essence of sustainable investments? The industry, shaped in part by voluntary initiatives, often spearheaded by the industry itself, has undoubtedly made strides. Yet, a closer look reveals a potential pitfall – a subtle misrepresentation of green bonds and funds. Some bonds bear the label while directing proceeds to emissions-reducing endeavors for refineries, inadvertently extending the economic lifespan of fossil-fuel-based assets and perpetuating emissions.

Amid the surge of financial products flaunting their environmentally friendly credentials (by, for example, pledging to exclude fossil fuels), a disconcerting trend emerges upon closer inspection. The touted commitment to eschew coal production often unravels through subtle loopholes, such as setting exclusion benchmarks at 10% of revenues from coal. The catch? Many of today’s major coal producers generate less than this threshold from coal, casting doubt on the sincerity of these ostensibly green investments. This nuanced play on criteria highlights the challenge investors face in deciphering genuine environmental commitments amid the complex landscape of sustainable finance.

The statistics remain elusive, but a non-negligible amount of these bonds and products may be funneling funds into ventures that are far from sustainable. This raises doubts about the authenticity of our commitment to green finance and emphasizes the crucial need for transparency and accountability in the pursuit of authentically sustainable investments.

Sorting the green from the grey

Since March 2018, Europe has been spearheading the transformation of sustainable finance with its groundbreaking sustainable finance regulatory package. This places a pivotal focus on establishing a taxonomy to categorize sustainable economic activities.

The EU taxonomy serves as a definitive guide, akin to a dictionary, identifying sustainable economic activities under specific conditions. To earn the green label, an activity must genuinely contribute to one of six environmental objectives without causing significant harm to others. Companies must disclose in their annual reports the share of revenue derived from taxonomy-aligned activities and the portion of their capital expenditure allocated to activities meeting the criteria, expanding those activities, or achieving taxonomy compliance. While the former (revenue) sheds light on the environmental sustainability of a company’s activities, the latter (expenditure) provides investors with a window into the company’s strategic direction and future path.

This reporting extends to investors, who must use the taxonomy as a universal tool to gauge the greenness of their portfolios, promoting consistent measurement across all environmentally marketed financial products. At the financial product level, the taxonomy is complemented by additional disclosure requirements related to information on broader environmental, social, and corporate governance (ESG). It also serves as the foundation for the EU green bond standard, striving to eliminate greenwashing in the green bond market by setting itself as the benchmark.

Albeit in its early stages and still evolving, the taxonomy is already making an impact, as revealed by first-year reporting. Major European companies such as those on the STOXX Europe 600 index are averaging around 23% for capital expenditure, 24% for operational expenditure, and 17% for revenues. While revenue alignment is anticipated to be low, there is a notable surge in capital expenditure alignment, especially in high-emission sectors, indicating that some companies are really investing in transitioning to more sustainable business models. 

For example, the utilities sector reports a substantial 70% average aligned capital expenditure compared with 40% aligned revenue, highlighting noteworthy investments in transitioning power generation to near net zero. The taxonomy, beyond transparency and accountability, serves as a catalyst for increased investment in environmentally sustainable activities, actively redirecting capital to bridge crucial investment gaps and propel Europe toward a sustainable economy.

While the EU and China have been frontrunners in developing sustainable finance taxonomies, the concept is enjoying widespread success and proliferation. Dubbed “taxomania,” more than 40 taxonomies have either been developed or are in the making – for example, in the UK, ASEAN (Association of Southeast Asian Nations), Canada, South Africa, South Korea, Chile, Columbia, and India, to name a few.

Reporting standards: completing the picture

The evolving taxonomies serve as a valuable tool to gauge the environmental sustainability of activities and assets at a granular level. However, to holistically evaluate companies, even on environmental issues alone, entity-level disclosures are imperative. While taxonomies operate at the activity and asset level, they lack the breadth needed for a complete overview of a company’s overall environmental sustainability performance. Other essential considerations include the governance of climate change within a company. Additionally, recognizing the significance of social and governance aspects is imperative for a holistic evaluation.

The solution lies in mandatory and standardized sustainability reporting standards. In the EU, the forthcoming but already adopted European Sustainability Regulatory Standards (ESRS) will require companies to disclose information on sustainability performance, policies, risks, and targets, covering a wide array of ESG topics.

These standards include specific requirements for reporting on climate matters, such as transition plans. Transition plans emerge as a key focal point in assessing a company’s commitment to achieving net-zero objectives.

Many, though not all, of the new requirements align with recommendations from the UN High-Level Expert Group (HLEG) report ‘Integrity Matters’. The HLEG was established to develop stronger and clearer standards for net-zero emissions pledges by non-state entities to put an end to greenwashing, and its report addresses key areas of environmental integrity, credibility, accountability, and the role of governments. The alignment of the ESRS requirements with the HLEG report emphasizes the integration of transition plans with overall business strategy, financial planning, capital expenditures, and taxonomy alignment.

Despite commendable net-zero pledges from various entities, challenges persist. Only one-third of major, publicly traded businesses have committed to net zero, leaving gaps, particularly among private and state-owned enterprises. Many pledges lack substance and standardized reporting, raising concerns of greenwashing.

To address this, the UN HLEG stressed the importance of annual progress reporting and independent, third-party verification for transition plans and progress reporting. The new EU standards propose moving from limited to reasonable assurance in a few years, placing climate reporting on a par with financial reporting.

Finance is of course global and often operating across borders. The newly issued International Sustainability Standards Board (ISSB) Standards create a worldwide framework for sustainability-related disclosures, particularly focusing on climate-related financial information. While a notable step toward harmonization, there is a need for continued reinforcement, especially in areas like transition plans. Therefore, standards such as the ESRS play a crucial role in raising the bar and ensuring comprehensive benchmarks.

A global approach

The current taxonomy landscape though remains fragmented. An increased international coherence in sustainability standards and sustainable finance taxonomies could help reduce market fragmentation and accelerate the flow of global capital to sustainable finance.

Many taxonomies are developed under governmental auspices, primarily focusing on climate mitigation. Some extend to cover climate adaptation, while the European taxonomy addresses the entire environmental spectrum. However, there is untapped potential for future extensions to incorporate social taxonomies. This expansion could seamlessly align with the Sustainable Development Goals, encompassing both social and environmental dimensions. Such a holistic approach, attuned to local goals and needs, would markedly contribute to advancing sustainability within specific regional contexts.

Currently, the EU stands out as the only jurisdiction where the taxonomy is complemented by mandatory reporting at both corporate and financial product levels. The ISSB could play a pivotal role by developing revenue and capital expenditure taxonomy-reporting indicators for companies in other jurisdictions. This would empower companies to adhere to and report against their respective national or regional taxonomies, promoting consistency and comparability in sustainability reporting.

The International Platform on Sustainable Finance, jointly chaired by China and the European Commission, serves as a catalyst for global collaboration among authorities from 20 jurisdictions, representing more than half of the world’s population and greenhouse gas emissions, to advance sustainable finance. It aims to identify common elements among global green taxonomies to enhance comparability. While recognizing the indispensable role of jurisdictional taxonomies in reflecting local context and goals, a global framework facilitates consistent sustainability benchmarking. Equivalence mechanisms and metric mapping address challenges in translating standards across jurisdictions. Harmonizing key environmental metrics globally is pivotal for achieving a unified understanding in sustainability reporting frameworks.

Stricter, clearer regulation

The critical challenge of greenwashing within financial markets remains a significant obstacle to urgently decarbonizing credit and investment portfolios. It hinders the redirection of capital toward genuinely sustainable investments, undermining global efforts to combat climate change. While voluntary initiatives from civil society, industry, and multi-stakeholder groups have made strides, the time has come for regulators and policymakers worldwide to address greenwashing definitively. This involves establishing robust regulatory frameworks that guide the transition to sustainable business models and facilitate access to capital for transformation.

Furthermore, there is a need to enhance the quality of net-zero pledges and transition plans, holding corporates accountable. Realistically, voluntary processes may not suffice, necessitating credible transition plans, aligned progress reporting, and taxonomy-compliant capex. As countries move toward regulating net zero, regulators, starting with high-impact emitters, should mainstream net-zero reporting and set standards for transition plans in line with the UN HLEG recommendations, transitioning from reporting to behavioral regulation.

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