The United Nations’ Sustainable Development Goal 16 (SDG 16) is about peace, justice and strong institutions. In line with that, regulators can use their powers to build effective, accountable and inclusive organisations capable of meeting and maintaining sustainability standards.

The financial services sector can play a vital part in helping reach this goal because financial institutions can have a huge positive impact through the role of capital distribution, whether this is raising finance, lending money or making investment decisions.

In this article, I will talk about how EU and UK financial services regulators are responding to this responsibility.  It's important to remember though that this is a global goal, which requires a global effort.

In the past few years, there's been a vast push from governments and regulators towards using the force of financial services to create a more sustainable economy. 

A key driver of this has been the EU Sustainable Finance Action Plan which was adopted by the European Commission in March 2018. The plan has three main objectives:

  • To reorient capital flows towards sustainable investment, in order to achieve sustainable and inclusive growth
  • To manage financial risks stemming from climate change, environmental degradation and social issues, and
  • To foster transparency and long-termism in financial and economic activity.
We discuss some of the tools created to enact this plan below:

1. Avoiding ‘greenwashing’: the EU taxonomy

The EU taxonomy is a unified classification system on what can be considered environmentally sustainable economic activities. It sets out six environmental objectives, and for an economic activity to be considered an environmentally sustainable activity, it must:
 

  • Contribute substantially to one or more of the environmental objectives (or directly enable other activities to make a substantial contribution to one or more of them)
  • Do no significant harm to any of the other environmental objectives.
It must also comply with certain technical screening criteria and be carried out with certain safeguards.
 
The taxonomy creates a common standard for firms and investors alike, making it easier to identify what activities are truly sustainable and reduce the possibility of ‘greenwashing’. 
 
‘Greenwashing’ refers to the exaggeration of the environmentally responsible credentials of a product or service, particularly in its marketing and communication, when in reality it is untrue.
 
 

2. Providing consistent information: SFDR

The Sustainable Finance Disclosure Regulations (SFDR), which came into effect in the EU on 10 March 2021, aims to reduce information asymmetries related to:
 

  • The integration of sustainability risks
  • The consideration of adverse sustainability impacts
  • The promotion of environmental or social characteristics as well as sustainable investment.
Firms now have to publically disclose information on how they integrate the consideration of principal adverse impacts1 (PAI) of investment decisions on sustainability factors into their due diligence processes, how they prioritise PAIs, and how they integrate sustainability risks into their investment decision-making, advice and remuneration policies.
 
The SFDR will improve the quality and availability of information on firms’ practices with regard to the consideration of sustainability risk. This way, investors can easily assess and compare this information.
 
 

3. Taking clients’ sustainability preferences into account: MiFID II amendments

The proposed amendments to the Markets in Financial Instruments Directive (MiFID) II suitability requirements will require firms to integrate environmental, social and governance (ESG) considerations into both portfolio management and how investment advice is given. This will be done by asking clients about their sustainability preferences and considering this as part of the suitability assessment.

Firms will also need to include the consideration of sustainability risk as part of their internal systems and controls, and risk management policies and procedures. They will need to consider any potential conflicts of interest which could arise from the distribution of sustainable investments and also make sure that when they include ESG considerations into advice and management services, it won't lead to greenwashing.

The proposed amendments to MiFID II will embed the consideration of sustainability factors into all aspects of a firm’s practices and ensure that they demonstrate to clients how their preferences are being met or, importantly, where they are not.

 

How this plays in the UK post-Brexit

While the above mechanisms were not onshored into UK legislation following Brexit, the UK Government has been clear that it intends to at least match the ambition of the EU Sustainable Action Plan.

In 2019, the UK Government published its Green Finance Strategy which aims to align private sector financial flows with clean, environmentally sustainable and resilient growth, and to strengthen the competitiveness of the UK financial services sector. In November 2020 HM Treasury published a roadmap setting out an indicative path towards mandatory climate-related disclosures across the UK economy aligned with the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD).

As recently as March 2021, HM Treasury wrote to the Financial Conduct Authority (FCA) giving its recommendations on how the latter should advance its objectives based on the government’s economic policy. As part of these recommendations, the FCA has been asked to formally integrate the goal of moving to a net-zero economy in the UK by 2050, into the way it regulates.

The FCA recently implemented requirements for premium listed issuers that align with the recommendations of the TCFD, and is looking to consult by mid-2021 on proposals for TCFD-aligned disclosures by asset managers, life insurers and FCA-regulated pension providers. The FCA is also in the process of developing guiding principles to help firms with ESG product design and disclosure.

It’s clear that ESG and sustainable finance are areas of high regulatory focus. Firms will need to demonstrate not only how they integrate the consideration of sustainability factors into their practices but also that they are meeting their clients’ needs in the process.

1 Principal adverse sustainability impacts are defined as the impacts of investment decisions and advice that result in negative effects on sustainability factors i.e. environmental, social and employment matters, respect for human rights, anti-corruption and anti-bribery matters.

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