General | Regulatory
Written by Nicky Heber
Apr 5, 2022
Sustainability matters. The topic has become omnipresent in our everyday lives and has also been reshaping the financial industry over the last years. The demand from both retail and institutional investors for sustainable investments has been increasing tremendously. This transformation is politically desirable and reinforced by legislation. While multiple countries have anchored the importance of sustainability in their national legislation, the European Green Deal has set the foundation for considerable new regulations for the financial industry. To deliver the ambitious targets laid out in the deal, European regulators have been eager to help direct the flow of money towards financing the transition to a sustainable economy.
Managing Regulatory Challenges
The main regulatory changes comprise the EU Taxonomy, the Sustainable Finance Disclosure Regulation, changes to MiFID II and the European Green Bond Standard (for more information visit our website). All these initiatives target different aspects but are partially overlapping and reference each other.
The EU has set out rules in the EU Taxonomy classifying business activities as sustainable, and companies are required to publish information on how and to what extend their activities are taxonomy-aligned. Respectively, banks are now obliged to report their green assets as a share of the total assets. The Green Asset Ratio is intended as to give an easy-to-understand snapshot of the Taxonomy alignment of a banks’ portfolio. Furthermore, as a push to further enhance transparency, the Sustainable Finance Disclosure Regulation requires asset managers and other financial markets participants to disclose how and to what extend ESG factors are integrated at entity and product level (mostly for funds). ESG refers to environmental, social and governance criteria as a measure for sustainability. But this poses a problem: the underlying criteria from the EU Taxonomy and SFDR are only partially aligned and under the SFDR regime also social and governance factors are considered when assessing sustainability.
According to the upcoming changes in the MiFID II legislation, investment advisors are now obliged to ask the client if and to what extent they want to invest in financial instruments that take into account sustainably factors. Again, there is the problem of how sustainability is defined and what criteria are considered. The client can choose among three different methods how sustainability preferences should be taken into account.
The upcoming legislation introducing the European Green Bond Standard will set new standards for green bonds as these will only finance projects that are EU Taxonomy aligned. This framework also applies the classification established in the EU Taxonomy; however, banks are required to collect data on a project level and perform a multi-step alignment assessment of projects. Especially, when it comes to refinancing of loans, this information is will be difficult to obtain.
It becomes evident that additional costs are associated with the mentioned legislation resulting mainly from research, the adaption of processes for investing, distributing and reporting and especially from the sourcing of relevant data. In this early stage, most financial institutions are rather cautiously starting with rudimentary and manual solutions like spreadsheets classifying their instruments or calculating their green asset ratios.
According to our experience, obtaining the specific and relevant ESG data, which are a central element for all the mentioned laws, poses a great challenge as the criteria for sustainable investments are only partially aligned throughout the legislation: For example, a fund declared as sustainable under SFDR might not be eligible for a client expressing the wish to invest sustainably. Furthermore, the data has to be obtained on project, asset, company and portfolio level. Hence, predefined ESG labels have very limited applicability and it is crucial to fully understand the respective indicators and have access to the underlying data reflected in a sustainability assessment. For many assets, financial institutions are still lacking sustainability related data and, despite external sourcing or collaboration with competitors, many financial institutions face substantial data gaps. This might lead to the inability to identify all green assets and to underestimated green asset ratios. However, we expect that this problem will be resolved in the future as reporting standards for sustainability data will improve.
Integration of sustainability aspects in product and risk management
While legislation might seem burdensome, growth opportunities can be seized and costs associated with sustainability risks can be lowered when sustainability aspects are integrated in the investment and also in the lending process.
More and more, sustainability risks are not just a statement on the balance sheet but require an active management. Let’s take for example CO2 emissions. As of now, this is a key criterion in current legislation. Apart from that, public scrutiny and steadily increasing costs due taxes on CO2 emissions or CO2 certificates, pressure companies to transform their operations towards carbon neutrality. Consequently, CO2 emissions should not be regarded as a tick the box approach for legislation or a feel-good factor in investment decisions. The risk associated with a high emission operating model poses a real threat to certain sectors and companies. Hence, just like any other risks, exposure to CO2 emissions need to be actively controlled and reflected in the product offering. For that, asset managers and banks need to understand what aspects of sustainability are impacting the business models of their customers. We will likely observe similar developments with water usage, waste production and other greenhouse gas emissions. Operating non-sustainably will become costlier and companies will look to banks as partners who are willing to help finance their transition towards net zero emissions. Hence, quantifying these risks and opportunities, understanding their dynamics and impacts on individual sectors and companies will become a key challenge for risk, portfolio and product management. For example, credit lending institutions accounting for default risks due to sustainability related issues can incentivise their clients to invest in sustainable technology because this lowers the risks and at the same time contributes to the bank’s sustainability rating. In the same way, asset managers can also reduce and diversify the sustainability risk for their clients. Financial institutions need to understand the rapidly changing client demand and adjust their product offering along with increasing the transparency related to ESG performance. Again, the key element is dependable and sufficiently granular data.
Financial institutions need to understand how data is obtained, measured and assessed. It is not sufficient to rely on predefined sustainability ratings which can be found in abundance on the market for ESG data, as these often take into account an arbitrary number of criteria, adjusted ratings or can sometimes be found to have filled in missing data gaps. Data providers often provide aggregated data, data sets with missing data points for several criteria or no data at all for smaller companies. This calls for a strong ESG data strategy and framework together with IT solutions that support efficient sourcing and management of sustainable related data. We at LPA understand the difficulties when identifying and interpreting relevant data and have been observing that financial institutions struggle in particular with the integration of sustainable related data throughout the value chain. Players in the financial industry are often struggling to frame their data strategy regarding their dependency on third parties, the resources they want to allocate on ESG data management and the way data is integrated into processes.
Sourcing suitable data with modern technology
To provide reliable ESG data on a project level, one of our collaboration partners has designed a platform where physical impact data is collected and sustainability risks can be assessed. With the help of IoT, satellites and drones, ESG risks and performance can be assessed for individual projects. This is an example of how the financial industry can ensure enhanced transparency and risk management. The platform also supports the portfolio management itself identifying sustainable assets in compliance with the legal requirements in the EU and other regions. Hence, it provides a comprehensive solution to adapt portfolio management processes to the above-mentioned different criteria imposed by various legislative requirements.
Sustainability is more than a tick in the box
As of now, the industry finds itself in an orientation phase: Some market participants have started with the implementation of new processes to comply with regulatory requirements as their top priority. This is reasonable because regulations provide clear guidelines and little room for uncertainty. The downside, however, is that initiatives are highly decentral, de-linked and only little business-oriented.
Some institutions understand the importance of the ESG transition for their clients. However, these institutions sometimes lack the understanding of how they can take advantage of the transition for their own business model and how they can to leverage growth and revenue opportunities.
Therefore, we emphasise on the importance of a sustainability strategy that yields future growth opportunities. At this relatively early stage, we give the following recommendations:
Following this strategy, banks can ensure that they have covered the topic on a strategic and operational level given what we know today. We can also predict that this is not a one-off topic, and regulation and market dynamics will intensify over the next years. Banks should aim for an advanced strategic approach that can be adjusted according to changed organisational or technical requirements.
About the authors
Kristina Siebold is a senior consultant at LPA and advises our clients on all aspects of regulation and ESG. For her, one of the most exciting topics is ESG data.
Nicky Heber is director at LPA and is responsible for our ESG offering.
Nicky Heber has over 10 years of consulting experience in the European Capital Markets sector, ranging from banks to clearing houses and asset managers. He is SME for implementing European regulatory requirements in the context of ESG.
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