Monday 06/04/2020

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Publication of the final HLEG report: mixed feelings

Responsible Investment Strategist

The long-awaited final report of the High Level Expert Group on Sustainable Finance, which helped the European Commission with its strategy to foster sustainable finances, was made public on 29 January 2018.

The main associations for environmental protection have recognised it as ambitious. Indeed, several recommendations aim to trigger a minor revolution in the financial industry, which certain investors are viewing less than positively.

Europe as a model for responsible and sustainable finance

The final report is the corollary of the intermediate report published last summer. Although some criticise it for its lack of new content versus its previous version, it is nonetheless a major report, for various reasons:

  • Firstly, it provides a systematic view of the urgent changes which are required for a financial industry at the service of energy transition, taking into account a scenario in which global warming is limited to 2°C.
  • In addition, it is the result of the work of an expert committee which depends directly on the highest governance institutions of the European Commission. This committee gathers together highly qualified experts with various training, expertise and nationalities, in order to represent the various stakeholders, including civil society and investors.
  • Finally, when looking at each recommendation individually, it may look as if they are already known and not particularly revolutionary. However, looking at the report as a whole, and putting it into perspective, it is an ambitious and powerful roadmap.

Four dimensions for an outstanding report

The recommendations revolve around four major dimensions:

  • Priority dimensions: these aim to identify the most pressing action points.
  • Transversal recommendations: these tackle structural issues.
  • Recommendations inherent to the various actors: they address each individual profile of the protagonists of the financial industry, being investors, banks, investment banks, consultants, capital markets and financial hubs, as well as rating agencies and extra-financial rating agencies.
  • Recommendations in terms of social and environmental sustainability: these are increasingly geared towards inherently social or environmental themes, such as earth and marine resources.

Without going into detail, the priority recommendations mainly include:
1. The fiduciary obligation of investors to acknowledge that environmental, social and governance criteria are key to management;
2. The adoption of a taxonomy of sustainable investments, that is to say related to the development and implementation of official sustainability standards on the European level;
3. Ensuring that the corporate culture of the financial industry is perfectly aligned with a long-term vision;
4. The financial support of sustainable infrastructure.

“One size does not fit all”

These various recommendations have received a rather mixed welcome.

Three major associations representing major institutional investors, namely PensionsEurope, the pan-European association of pension funds, Aba, the German association of pension funds and finally the pension federation in the Netherlands, are refusing some rules and measures imposed by a law regarding the issue of responsible investment. Cultural differences and values which are inherent to each activity sector and its pension fund must be decided freely by the pension fund itself. Evoking the principle of “One size does not fit all”, they are opposed to any regulation obliging the implementation of values to the detriment of their own primary duties: ensuring the payment of the pensions promised to their employees.

The WWF NGO, on the other hand, welcomes the work of the high-level working group, in particular:

  • the obligatory climate reporting by 2020
  • ensuring that sustainability challenges are the legal responsibility of investors
  • the obligatory consultation of individuals regarding their ESG investment preferences
  • the integration of the climate scenario in the indices used by the financial products.

Challenges and next steps

The European Commission is very determined to implement its responsible and sustainable finance strategy. To that end, it is surrounding itself by experts with various backgrounds and profiles, in order to increase its credibility among the various stakeholders.

It is committed to a well-defined and concrete action plan, and has respected the deadlines so far. Moreover, it has to come up with an action plan based on the recommendations of the final report by 7 March.

Of course, the challenge lies in the power of the measures it will recommend in its action plan, as well as the tool used for the transposition into national legislation (Directive, Regulation, Decision, etc.).

Doubtlessly, institutional investors have the right to worry about the prescriptive measures the European Commission may adopt, if they essentially result in reporting and disclosure obligations in the name of the sacred commitment and transparency. Although the taxonomy of sustainable approaches is definitely required to clarify market practices and to protect investors, obtaining a label or certification of specific standards may rapidly result in a business to which the various market players do not have equal access.

Indeed, the role of a pension fund is to ensure the payment of pensions to its associated members in all market conditions; the environmental, social and governance criteria having to be taken into account under all market circumstances. However, is it really realistic to ask the opinion of each associated member regarding his or her ESG preferences, knowing that for one person, nuclear energy for instance will be completely incompatible with a sustainable and responsible vision, while for another, the use of coal will be considered unacceptable?

Unique and exclusive financing

Then, there are reasons for concern about investments which are all channelled into the same direction. It is important to finance the energy transition. On the other hand, the unique and exclusive financing of an economic model, which is opposed to the current one, entails major risks to economic and social sustainability. There is a great sense of urgency with regard to climate change, and the measures that are taken must correspond to this. However, climate change may not be an isolated topic, and cannot be disconnected from the other major challenges, above all on the social front.

There’s no doubt that the associations of pension funds are correct to monitor the report of the high-level expert group closely. The latter, just like the recommendations of the Task Force on Climate-related Financial Disclosures to which it has often referred, may be a paradigm shift in the way people have looked at investing so far.

A real advance

That is with no doubt the reason for the enthusiasm among environmental groups such as the WWF. The integration of the climate scenario in the indices used by the financial products should constitute a real advance. And indeed, that’s also where the challenge for tomorrow lies. On the one hand, there has been a strong appetite for index funds and passive management in recent years, with these indices attracting massive investments as a result. On the other, they currently do not integrate or hardly integrate the major challenges of climate change, and underestimate their real economic and material impact.

So the European Commission faces the considerable challenge of striking that difficult balance between on the one hand the pressing need for standardisation of a sector which has evolved from an investment niche to a sector addressing urgent environmental challenges which should be adopted on a massive scale, and on the other hand the unwanted effects of regulation which is too stringent and inflexible. This risks leading to a system of procedures, red tape and reporting of all kinds, which only have a very limited measurable positive impact on our environment. By way of a reminder, we will have to find close to 180 billion euros annually to finance the European sustainable development programme up to 2030!

The window of opportunity is wide open to continue to finance a more responsible financial industry which is at the service of economic activity. However, it also entails many pitfalls of which the European Commission must be aware at all times.