Building Bridges to the Future
Sustainable finance policy and regulation need better alignment mechanisms, argues Judson Berkey
By Judson Berkey.
Nothing is more powerful than an idea whose time has come. Not actually found in any of Victor Hugo’s works, this quote is an apt description of sustainable finance. While still short of the incremental $5-7 trillion per year necessary to achieve the UN Sustainable Development Goals (SDGs), according to the Institute of International Finance assets under management in ESG funds were USD 2.5 trillion in mid-2021, up from $400 billion in 2015 and the stock of sustainable debt issuance was $2.9 trillion by mid-2021, up from $200 billion in 2015. This growth is a testament to the shared objectives around the Paris Agreement and the SDGs. Although there is still much to do, finance is starting to flow to support the transition to a more sustainable economy.
The growth of sustainable finance has been matched by growth in sustainable finance policy and regulation. That idea has arrived on different timelines in different jurisdictions creating potential for fragmentation. Europe was first out of the gate with its comprehensive 10 point Sustainable Finance Action Plan in 2018. To date this has developed into an impressive 1049 page rulebook across the Taxonomy, Disclosure, and Benchmark Regulations and ECB and EBA guides on risk management and disclosure alone. This is starting to rival the 1626 page Basel Framework. The difference is that the Basel Committee took 45 years to develop its rules while the EU has taken 4 years since first sustainable finance proposals.
Other countries, while not developing at the same pace as Europe, have also started to put in place their regulatory frameworks. The most recent example is the announcement of the UK Green Finance Roadmap. Thus, it is too much to expect full alignment of sustainable finance regulation. But there are still areas where this is possible and we should learn lessons from the past. In the aftermath of the global financial crisis, there was a strong desire by regulators to align around a single framework. As a result today we have a well-regulated derivatives market, systemically important banks with credible recovery and resolution plans and substantially stronger capital and liquidity regimes. We need to learn from this and continue to foster alignment around a global framework for sustainability finance with a focus on three key areas: transition, climate scenario analysis, and disclosure.
First, there is still potential to align on the concept of transition. We will only achieve the Paris Agreement if we transition all sectors. While technologies largely exist to de-carbonize, there are lock-in challenges as well as difficulties to scale solutions given the need to have supporting systems e.g. charging stations for electric vehicles or battery storage for renewable energy. This makes it critical to align real economy and financial policies around clear government statements about phase out dates for technologies such as internal combustion engine vehicles or fossil fuel power and heating. The same is true of broader environmental needs where policy signals are key to success.
A mechanism to support this effort can be Taxonomies. These make a clear statement of what the end goal is for a sustainable economy. However, on their own, they do not necessarily give the timing or pace of the pathways for a given industry to transition and, within an industry, for a given company to complete its evolution. They also try to create a new measurement system focused on greenness whereas companies have been working on better disclosures of carbon emissions for years already.
A focus on transition naturally leads to a focus on companies. It may be easier to build a governance, monitoring and reporting framework around companies than activities given that we already have well established company reporting frameworks today. Transition is a nuanced and multifactor discussion not easily boiled down into a single measure of greenness at a point in time.
There are concepts being developed for how to guide transitions and assess company commitments to transitions. Clear rules for the governance, disclosure, and measurement of transitions are critical and would give the financial sector further confidence when investing in companies in transition. This is why we welcome collaborative efforts such as the recently announced Transition Pathway Initiative Global Climate Transition Center, due to be launched in early 2022. There are also interesting regulatory frameworks to consider such as the Japan FSA work on transition guidelines.
Ultimately we need regulatory alignment that supports transition and innovation by ensuring assumptions are consistent, disclosures are comprehensive, and firms live up to commitments while aligning with region and country specific pathways. This has already started with the recent update of the TCFD guidance to include transition plans and TCFD becoming a regulatory requirement in jurisdictions such as the UK, Switzerland, and Singapore, among others.
Such an approach would give countries another option to the implementation of detailed Taxonomies, given the significant data requirements to make them work. For example, investment managers will need almost 250,000 data points on Taxonomy alignment and Adverse Impact for the average fund and a typical bank will need more than 1 million data points from its corporate counterparties to make their required EU disclosures. Most of those data points do not even exist yet. Thus, it will be a multi-year process to implement the EU Taxonomy in the most sophisticated ESG market in the world. Other countries may not have the luxury of taking such an approach. A focus on transitions and alignment would be a faster road that has the further benefit of leveraging market-based approaches.
Second, we need global alignment in the emerging climate risk scenario analysis exercises. They build on established financial stress tests but adapt them to the timeframes (30 years vs 3-5), data needs (e.g. forward looking scenarios), and objectives relevant for climate change. The exercises run by ACPR and PRA show how collaboration between authorities and private sector can develop actionable insights. Several public officials from the PRA and FED have also helpfully distinguished these scenario analysis exercises from what we know as financial stress tests today and the ECB has indicated that its 2022 test will not have direct capital implications. Continuing these efforts every few years, perhaps in regulatory sandboxes, would be helpful to the market. Through work at the Institute of International Finance, the financial industry has developed proposals on how to further align such exercises and ensure they continue to be learning exercises that support climate transitions.
A third topic that may be open for at least partial alignment is on disclosure both for investment products and companies. The current market based standards from International Capital Markets Association and Loan Marketing Association for disclosure have worked well for the professional market with few if any instances of greenwashing. Thus, they should be relied upon for that market. The retail market may be different though and the fast relabeling of many funds to meet the European SFDR categories may raise cause for concern. However, actions by the HK SFC, MAS, SEC, and Swiss FINMA show that active review and enforcement based on existing norms can keep the market honest. Detailed product disclosure requirements and templates are certainly one way to ensure comparability. However, it would be helpful to consider market standards to clearly identify product types (e.g. as proposed by IIF, UK IA, and ICI) as well as efforts to improve investment strategy disclosure (e.g. current exposure draft on product disclosure by CFA Institute) before rushing to regulate a de novo regime.
When it comes to corporate disclosure we can and should build on market efforts. The emerging work to develop an IFRS Sustainability Standards Board (SSB) climate standard is a great example of how the power of an idea can bring together what seemed to be diametrically opposed voluntary standards. Global investors / banks need to be able to take a global view and international standards that offer consistent disclosures are the best way to achieve this. We welcome the example of the UK pre-commitment to modify its TCFD disclosure proposal to align with an IFRS standard. The recent prototype published by the EU EFRAG also very helpfully based many of its proposed disclosure items on TCFD and other market efforts while adding aspects of the EU double materiality approach to disclosure. The world manages with two financial accounting standards (IFRS and GAAP). It can do so again if some jurisdictions wish to push through international standards to establish new floors of their own. The only condition should be that standards are not applied extraterritorially and there is an equivalence or mutual recognition regime developed.
There is one quote that definitely can be attributed to Victor Hugo. At the 1849 Paris Peace Conference he suggested that major countries could soon be “stretching out their hands across the sea, exchanging their products, their arts, their works of genius, clearing up the globe, making deserts fruitful, ameliorating creation under the eyes of the Creator, and joining together, to reap the well-being of all” The vision of building bridges to the future is something that should inspire the current G20, FSB, IFRS, and international standard setter efforts. The private financial sector will gladly roll up its sleeves to help make this a reality.