How the EU’s green finance ambitions could revolutionise fund management

Such ambitions cost serious money. According to the Intergovernmental Panel on Climate Change, limiting global temperature rise will require spending $7 trillion in energy, buildings, transport and water annually over the next 15 years.

The Commission does not have that kind of money to hand. Its Sustainable Finance Action Plan aims to help channel private investment into efforts to protect the environment and the climate, with a three-pronged approach to legislation. The first two elements have already received political approval from the European Parliament and EU member states.

Integrating ESG measures into investment

A new regulation sets out how asset managers and other market participants must integrate environmental, social responsibility and governance risks into their investment processes, and introduces uniform rules on how they should report the sustainability or otherwise of the companies and projects in which they invest.

More transparent information should help end-investors in their decision-making, including planned EU low-carbon benchmarks designed to enable them to measure adherence to the union’s climate transition goals and the targets of the Paris Agreement, and judge how investments can benefit the planet and its inhabitants as well as delivering returns.

But it may be the third element that has the biggest impact on Europe’s fund industry in the coming years. The EU’s proposed ‘taxonomy’ – classification – of sustainable economic activities is intended to remedy what is currently a glaring gap in the conception of green finance. There is currently no recognised definition of what constitutes green investment, or a system for comparing the environmental qualities of different investments and activities.

So the EU’s planned classification system should be a boon to both retail and institutional investors, and play an important role in stamping out greenwashing – dressing up as environment-friendly investments that in fact offer little or no benefits. But it will also lead to substantial changes in how asset managers think and invest.

Adherence to environmental objectives

The taxonomy element has yet to be fully completed. The Commission, European Parliament members and national governments are still hoping to reach agreement on its final form by the end of this year, but are still arguing about the details.

It has already been settled that to qualify as green, investments will have to contribute to at least one of six EU environment objectives: climate change mitigation, climate change adaptation, sustainable use of water and marine resources, the circular economy, preventing pollution, and the health of the ecosystem. They must also demonstrate that they are not detrimental to any of the other objectives, and that they comply with social responsibility and governance safeguards.

Knowing what counts as green should benefit fund managers who already have an ESG element within their investment process. As Brenda Kramer of the giant Dutch pension scheme PGGM argues, ESG investors can use the taxonomy to engage with existing or potential investment targets to nudge them toward compliance in their activities.

National regulators are taking action too. The Bank of England, De Nederlandsche Bank and other central banks have been warning the institutions they oversee about climate change risk, its measurement and reporting. Securities and investment products entailing higher climate change risk may be shunned by investors, raising capital costs for industries based on extraction and carbon release.

Giving teeth to divestment campaigns

Fund groups and their managers may increasingly shy away from investments such as oil company stocks and coal-fired power stations as the measured risks start to outweigh potential returns – and perhaps even before that. The Unfriend Coal movement could develop real teeth if such sectors are labelled as not just as damaging to the climate, but vulnerable to substantial financial liability.

The risks to be considered are complex, interlocking and at times apparently contradictory. A gas production facility may be considered green if carbon capture can curb its emissions, but a catastrophic accident at the plant could devastate local communities and the environment.

Social responsibility issues can weigh heavily on companies that depend greatly on a wholesome brand image – witness the discomfort experienced by Apple in the face of damaging evidence about labour practices at its Chinese component suppliers, or of fashion brands whose manufacturers have been found to depend on child labour in conditions tantamount to slavery.

In today’s world, businesses risk not only boycotts by consumers and divestment by institutions and individuals, but also the threat of lawsuits from investors claiming that losses due to declining share prices were down to negligence on the part of companies and their managers. Flouting ESG standards can risk not just a loss of public face but a downward economic and financial spiral into bankruptcy.

Cross-border influence

As is often the case with EU legislation, its impact may reach far beyond Europe’s borders. With the problem of vague and woolly definitions in green finance a global issue, other countries may well embrace European standards as their own. And bond and equities markets are truly global; a sell-off in one country can quickly spread around the globe.

Companies will do well to be on their guard. The power of EU rule-making has been illustrated with the General Data Protection Regulation, which impacts companies all over the world (and has been adopted as a template by the state of California). It’s not utopian to imagine that the Commission’s planned rulebook – itself just the start of EU efforts to start driving progress toward climate change prevention goals – could begin a switch from ESG investment being demand-led to supply-led.

It’s certainly is not hard to imagine an investment world where only investments compliant to the EU’s sustainability standards are acceptable to managers, investors and regulators alike. By then ESG will not have just gone mainstream, it may be the only game in town.