“Sustainable development is a development that meets the need of the present without compromising the ability of future generations to meet their own needs” (Definition by the United Nations).
In 1992, after years of slight and shy awareness on sustainable development, the United Nations Framework Convention on Climate Change held its first summit in Rio de Janeiro. 172 governments attended with one objective: work together, internationally, on development issues that are too big for states to handle in standalone. During this summit, the 3 pillars of sustainable development were presented:
llustration 1: What are 3 pillars of sustainable development?
From the launch of the first “Environment Report” in 1996 by Unilever to the introduction of ESG (Environmental, Social and Governance) principles as requirements in the financial industry by the European Commission in 2018, a large number of initiatives have been undertaken and laws have been voted on and implemented.
Illustration 2 – The long road to sustainability
Also, the last decade’s internet and social media revolution has made information easy to reach to all. All companies’ internal practices, exploitations and financial scandals have been spread worldwide and thus creating a bad buzz around many industries. Sustainability has thus become a priority in many industries and most companies finally agreed that balancing the three pillars will lead to long-term stability.
You may have heard about many sustainable initiatives in oil and gas, fashion, food etc. but not so many in the financial sector. Nevertheless, financial institutions, specifically investment managers, can have a major role and impact on sustainability.
How was sustainability introduced in finance?
Starting 1998, studies started to identify a positive correlation between performance and sustainability, and after the 2008 financial crisis caused by excessive risk taking, regulators required stronger controls on risks and more long-term bias for investments. Also, after many conferences on social responsibility, the launch of the Principles of Responsible Investments (PRI) in 2006 and the adoption of the Sustainable Developments Goals in 2015, financial institutions were more and more encouraged to include non-financial criteria in their investments strategies and processes. The PRI label is delivered by the United Nations to financial institutions who have implemented its 6 principles based on a specific audit performed by an independent company. This label is very renowned and appreciated by investors as it promotes transparency and responsible investor behavior.
Illustration 3 – PRI principles according to the UN
What is sustainable finance and how can financial institutions have an influence on sustainability?
Sustainable finance refers to all types of investments and financial services considering Environmental, Social and Governance (ESG) criteria. ESG should contribute to sustainable development and value creation in economic, social and environmental terms. Sustainable Finance should also increase awareness of and transparency on the risks that may impact the stability of the financial system. These risks should be mitigated through appropriate corporate governance.
Illustration 4 – Key risks to be mitigated by an ESG approach
As important investors, shareholders and creditors, financial institutions can be the main drivers, leaders and partners in pursuing sustainable development. They can influence the economy and launch trends to be followed by all industries.
Regulatory framework and impact on financial institutions
Due to a lack of regulatory framework on this topic, financial institutions have integrated ESG based on
- Their own understanding
- Their links with the investors
- Their definition of clients’ best interests.
We can distinguish four types of investors sorted by maturity levels:
- “Traditional investors”: are driven by financial performance and do not think that ESG should be integrated as additional criteria in the portfolio analysis framework.
- “Modern investors”: will integrate ESG in their performance analysis in order to boost corporate valuations and thus obtain additional returns on their investments.
- “Broader goals investors”: believe ESG factors should be included in the performance analysis of the portfolio. These investors are willing to accept less short-term returns in order to promote long-term investments and well-being of investee companies.
- “Universal investors”: have fully integrated ESG factors in their investments decisions process and have convictions around their social, environmental and governance responsibility.
Except for the PRI that gives a responsible investor label, there is no international standard on what the ESG criteria are, how they should be measured and how to integrate them in finance.
Focus on the European adoption of ESG criteria
In Europe, as in the rest of the world, the integration of ESG criteria was encouraged and very much promoted by NGOs, governments, UN summits etc. Except for disclosure requirements, there was no obligation to take ESG factors into account in investments and performance analysis. The European Commission, following its commitment to social, economic and environmental issues and in order to provide guidelines has:
- Released the “Shareholder Rights Directive II” in June 2017 applicable in June 2019. This directive aims at vivifying corporate governance, enhancing transparency on voting activity and investment strategies and including non-financial criteria in investment decisions processes. It gives requirements to all stakeholders intervening in the investment value chain: from issuing companies, to intermediaries, asset managers and proxy advisors.
- Appointed a “High Level Expert Group” (HLEG) to propose an action plan on the adoption of non-financial factors in the investment strategies, decisions process and monitoring. The action plan that was presented in March 2018 has been agreed on in May 2018. This action plan should lead to a European taxonomy on what can be considered an environmentally sustainable economic activity, a proposal for a regulation on disclosures related to sustainable investments and sustainability and a proposal for a regulation amending the benchmark regulation. The proposed amendment will create a new category of benchmarks including low-carbon and positive carbon impact benchmarks, which will provide investors with better information on the carbon footprint of their investments.
These two initiatives provide guidelines and present very concrete actions to be adopted by financial institutions in order to promote long-termism, transparency and sustainability.
All answers to what it actually means for financial institutions will be answered in Part 2: Regulatory framework and impact on asset managers in Europe of this article.