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.
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.
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.
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.
South Africa’s taxonomy is taking shape
In May 2020, South Africa’s National Treasury published a draft technical paper called “Financing a Sustainable Economy”. The aim of this draft paper was to “unlock access to sustainable finance and stimulating the allocation of capital to support a development-focused and climate-resilient economy”. One of the recommendations within the initial paper was to develop a taxonomy for green, social and sustainable finance initiatives, consistent with international developments.
Accordingly, in June 2021 National Treasury released the Draft Green Finance Taxonomy for public comment. The taxonomy follows similar legislation released in Europe and aims to “help the financial section with clarity in selecting green investments in line with international best practice”. The taxonomy is may also unlock significant investment opportunities. The release of this taxonomy papers will help guide the financial services sector within South Africa and assist institutions in playing their part to achieving the sustainable development goal of effective, accountable, and inclusive institutions.
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.