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Sustainable finance and ESG: need for guidance and classification

25/08/2020

Sustainability issues are covered by an extensive array of dedicated conventions, norms and standards that straddle the international, national and local levels. They are increasingly embedded in rules and regulation targeted at companies, investors and financial institutions such as banks.

Also, there are already a number of guidelines and frameworks that have been established by various bodies in an attempt to harmonise definitions of sustainable ESG-led finance and investments. 

Classification and certification: the assessment of ESG performance

The demand for classification has been driven by institutional investors seeking evermore data on the companies they invest in. This includes not only large pension funds and asset managers – many of which have been assessing the ESG performance of companies held in their equity portfolios for some time now – but increasingly fixed income investors too. 

There is a growing acceptance among many investors that there could be varying types of “light green” to “dark green” sustainable investments to consider in the future. For instance, in China banks are already issuing green bonds against brown coal refinancing, which may not appear to be “green”, but is deemed sustainable by investors and lenders as it helps to improve social conditions by generating employment. 

Ultimately, it may not be possible to have a one-size-fits-all classification and certification system. The market could potentially end up with different league tables and benchmarks linked to specific key performance indicators or other parameters.

However, it is certain that, as more companies, lenders, institutions and governmental bodies worldwide pursue sustainable investments, there will be increasing amounts of data and evidence that can be cross-shared and used to inform and to enhance the harmonisation and certification process. 

The broader international regulatory framework

While there is no binding regulatory framework or incentive scheme for sustainable finance, economic activity that could be classed as sustainable would likely be underpinned by reference to one or more of the following documents, which encompass not only financial sustainability but wider social and inclusivity goals: 

  1. The Paris Agreement 
  2. United Nations Sustainable Development Goals (UNSDGs) 
  3. EU Action Plan for Financing Sustainable Growth
  4. The European Taxonomy Regulation 
  5. Financial Stability Board’s Task Force on Climate related Financial Disclosure
  6. LMA Green Loan Principles 
  7. ICMA Green Bond Principles, Social Bond Principles and Sustainability Bond Principles
  8. Equator Principles

Next, we briefly highlight two frameworks which we believe are giving the best 'Sustainable Finance' guidance for financial institutions at the moment: the LMA Green Loan Principles and the European Taxonomy Regulation. 

The LMA's Green Loan Principles

One of the best-known frameworks for debt finance is the LMA's “Green Loan Principles” (GLPs). It aims to create a high level framework of market standards and guidelines that provides a consistent methodology for use across the green loan market, but also allows individual loan products to retain their flexibility while preserving the integrity of a developing green loan market.

The GLPs are a set of voluntary guidelines issued by the Loan Market Association to aid the development of a market-standard approach to green lending.  The GLPs require specific methodologies to be applied to a green loan. A loan instrument qualifies as a green loan if it is made available exclusively to finance or re-finance, in whole or in part, new and/or existing eligible green projects. 

The European Taxonomy Regulation entered into force on 12 July 2020

Separately, the European Union has introduced its own taxonomy, a unified classification system, on what can be considered an environmentally sustainable economic activity. The EU believes that this is a first and essential step in the efforts to facilitate the channeling of investments into sustainable activities with a view to complying with EU’s commitments under the Paris Climate Change Act.

The Taxonomy is a toolkit for determining which economic activities are environmentally sustainable. The initial plan for the Taxonomy was developed in the context of the European Commission’s 2018 action plan on financing sustainable growth. The plan represents the EU’s strategy for implementing a financial system that supports its broader climate and sustainable development agenda. 

It is expected that financial market participants will be required to complete their first set of disclosures against the Taxonomy, covering activities that substantially contribute to climate change mitigation and/or adaptation, by the 31st of December 2021.

Sustainable finance: trends and tips in brief

The recent entry into force of the Taxonomy Regulation is a clear indicator of the relevance and the speed of the developments in the sustainable finance sector.

As the market is gaining more mature understanding of ESG opportunities and risk weighting, we expect to observe a growth in sustainability data recording both by financial institutions and by companies. The focus on demonstrating that sustainability is integrated into their business will most certainly increase. 

Also, financial institutions and companies will increasingly face the need to communicate industry comparable sustainability performance data to investors.

In this line, we expect stronger supervision on the transparency and effectiveness of ESG products. This means that financial institutions and companies will need to carefully measure, record, and where possible standardise, data in order to facilitate the assessment of ESG impacts. 

Sustainability issues also present market players with the challenge to strike a balance between divergent interests and standpoints. For example: what are the possibilities and the implications for financial institutions, companies and investors to find a right balance between the sustainability risks and the opportunities when making investment decisions? What do external factors, e.g. the COVID-19 pandemic or the climate change, mean for the way in which investors approach new projects and insure themselves against various risks? 

Authors

Anna-Francesca-Mancosu-CMS-NL
Anna Francesca Mancosu
Professional support lawyer
Amsterdam
Etienne Courbois
Counsel
Amsterdam
Picture of Simon Hardonk
Simon Hardonk
Counsel
Utrecht