Recommendations signal a major shift for Europe’s financial system through both legislative and non-legislative changes.
By Paul A. Davies and Aaron E. Franklin
The European Commission (EC) has revealed its action plan for mobilizing the financial system to encourage a “greener and cleaner economy.” The plan, which was released on 8 March, states that it aims to facilitate the following, in conjunction with the Paris Agreement and the EU’s sustainable development agenda: i) improvements in the financial system’s contributions to sustainable and inclusive growth, and ii) stronger financial stability by incorporating environmental, social, and governance (ESG) factors into investment decision-making. The inescapable takeaway is that the EC strongly encourages a more active regulatory role in the sustainable investments market, through both legislative and non-legislative changes.
Such an approach would represent a major shift. Regulation has been light touch over the past decade as sustainable investment products have expanded rapidly, with green bonds acting as a standard bearer for a wide-ranging and long-term shift in investor preferences. Investors have demanded bonds and other investments with sustainability credentials; and bond issuers have responded accordingly. In particular, issuers have been eager to emphasize their commitment to sustainability and to access investors with sustainability preferences. Whether a bond qualifies as a green bond has been a matter of market acceptance and public comment. So far, green bond issuers have not needed to assess compatibility with national or European rules.
A more active regulatory role may offer long-term benefits for the sustainable investment market. This may, for instance, foster consistency and reliability in the green bond market by providing issuers and investors with bright line rules on what can be called a green bond without legal risk. A more active regulatory role should also concentrate resources in this market, as well as improve market players’ awareness and capacity.
In the short term, however, market participants would be well advised to stay laser focused on the EU’s potential interventions. Condensing the wide variety of opinions on the meaning of sustainability into legal rules will involve compromise and not everyone will agree with the outcomes. Bright line rules exclude as much as they include and market participants will need to be careful to adhere to them.
The Action Plan
- Establish an EU classification system for sustainable activities: This will help ensure a common language among member states, and define what is, legally speaking, sustainable.
- Create standards and labels for green financial products: This will ensure that investors can rely on the certainty of the green label.
- Foster investment in sustainable projects: The EC plans to provide more technical assistance and play a larger advisory role in the form of grants, as well as the European Funds for Strategic Investment and the European Investment Advisory Hub.
- Require sustainability be incorporated in financial advice: The EC announced potential regulatory changes that would require certain financial institutions to assess the suitability of investment products for the investor’s sustainability preferences.
- Develop sustainability benchmarks: This will help investors measure the performance of their investments, and then choose how to allocate their assets.
- Better integrate sustainability in ratings and market research: The EC will encourage credit rating agencies to fully integrate sustainability and long-term risks.
- Clarify institutional investors’ and asset managers’ duties: Although EU law imposes a fiduciary duty on institutional investors and asset managers, how this applies to sustainability is not sufficiently clear or consistent across sectors. The EC will put forward proposals on the duties of institutional investors and asset managers regarding sustainability to ensure they consider appropriate ESG issues in their investment decision process and are more transparent towards their clients.
- Incorporate sustainability in prudential requirements: The EC indicated it may potentially add a supporting factor relating to the sustainability of a financial institution’s assets.
- Strengthen sustainability disclosure and accounting rule-making: The EC announced a plan to review accounting standards to avoid directly or indirectly discouraging sustainable and long-term investments.
- Foster sustainable corporate governance and attenuate short-termism in capital markets: The EC will consult with all relevant stakeholders to assess whether corporate boards should be required to develop and disclose a sustainability strategy, and whether directors’ duties to act in the company’s long-term interest require clarification.
Latham will continue to monitor and report on the EC’s next steps.
This post was prepared with the assistance of Olivia Featherstone in the London office of Latham & Watkins.
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