Europe sets stage for ESG reform

The financial system is operating unsustainably, perpetuating or ignoring environmental and social problems. The continued financing of excessive greenhouse gas emissions and worsening economic inequality, for example, threaten to further divide the financial system from the interests of the users and beneficiaries it is designed to serve.

Now, however, a groundbreaking report offers a genuine framework for solutions.

The final report of the High-Level Expert Group on Sustainable Finance, from the European Commission, represents a systematic view of the urgent changes needed to make Europe’s capital markets sustainable for the long term. It builds on more than a decade of market experience and practice on sustainability, and is further informed by responses from European citizens, the financial and non-financial sectors and public authorities.

The HLEG’s report is different from previous efforts in a number of ways. First, its initiation, backing and support come from the highest levels of European Commission policymaking. Second, the HLEG is led by, and comprises, European investors – each with their own ideas, clients and investment style. Together, they have set out the sustainable investment challenge and the solutions we need to implement. Expect policy change to follow the report’s publication; announcements of intent on market supervision and investors’ duties have already been made.

Given what we face, each recommendation in the report may seem modest in isolation; clarifying investor duties, publishing a taxonomy for sustainable investment, and supporting sustainable infrastructure, for example. These are not new ideas, nor are they radical. But, in aggregate, they represent reforms that can realign capital markets to better serve financial system users and beneficiaries for the long term. These reforms will ensure that investment and financial activity are no longer agnostic to sustainability issues and, instead, make a net positive contribution to sustainability goals.

The report sends a clear message that acknowledging ESG factors is a critical component of investor duties, which are essential to investment processes. This puts down a marker for the whole world showing how to contribute to a more sustainable global financial system that is equitable for all and recognises the significance of ESG incorporation.

Effective oversight

The HLEG points to “considerable evidence” that individual investors are increasingly expecting their providers to consider long-term sustainability issues, as the industry’s demand for clarification around investor duties grows. Indeed, the misinterpretation of investor duties has previously been identified by signatories to the Principles for Responsible Investment (PRI) as a top barrier to ESG incorporation.

While we have seen a surge in much-needed regulation related to sustainability and responsible finance in recent years, they are still widely perceived as voluntary, with unclear objectives. Such regulations are also often detached from other crucial aspects of broader financial regulation, and lacking in the oversight they need to be effective.

Although investor duties are codified in European financial services edicts, such as Markets in Financial Instruments Directive II and the Alternative Investment Fund Managers Directive, the HLEG report cautions that they “do not factor in sustainability to the level required”. It also notes that the Undertakings for the Collective Investment of Transferable Securities regulatory framework contains “no explicit mention” of ESG issues, nor does it address the need to disclose information about how such issues are considered in the investment process.

Echoing the HLEG report, the PRI strongly encourages pension trustees and other clients of investment consultants to ask that ESG issues and their probable effects on risk and return be included in the advice for which they pay. Our recently launched Investment Consultant Services Review found that, despite “pockets of excellence”, ESG considerations still are not a standard part of the advice many investment consultants offer.

Other recommendations the report makes cite the need to: link the duties of investors to the horizons and sustainability preferences of the individuals and institutions they serve; develop and implement official European sustainability standards and labels, starting with green bonds; and better align corporate culture in the financial sector with a long-term outlook.

Next steps

Promoting high standards of competence on ESG issues, including awareness, training and ensuring that they are part of management’s continuing professional development, will serve as a vital catalyst to help realign the financial system with the long-term interests of beneficiaries and clients. As the HLEG points out, we also need robust backing from international standard-setting bodies, including having groups such as the Organisation for Economic Co-operation and Development clarify that investor duties should incorporate sustainability issues.

Buoyed by growing awareness that ESG factors do influence market and portfolio returns, the PRI enthusiastically welcomes HLEG members’ determination that the group’s work effects substantial change in many areas of financial policy.

Their recommendations point to an enormous window of opportunity to pave the way for a series of reforms that will transform Europe’s approach to sustainability and, ultimately, ensure that the global financial system is in the best position to support the environment and society for years to come. It is essential to earn returns for beneficiaries and members, and to make a net positive contribution to sustainability goals. The financial system can and must align its activities with pressing issues, including those related to climate change, reducing economic inequality and ensuring that new technologies are connected to – and not siloed from – the real economy.

We are confident that the HLEG’s report represents the start of a new chapter in European and global sustainable finance.

Nathan Fabian is the director of policy and research at the Principles for Responsible Investment and participated in the High-Level Expert Group as an observer.