Sustainable Finance in Europe: Corporate Governance, Financial Stability and Financial Markets 3030718336, 9783030718336

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EBI STUDIES IN BANKING AND CAPITAL MARKETS LAW

Sustainable Finance in Europe Corporate Governance, Financial Stability and Financial Markets Edited by Danny Busch · Guido Ferrarini Seraina Grünewald

EBI Studies in Banking and Capital Markets Law

Series Editors (all members of the EBI Academic Board)

Danny Busch, Financial Law Centre (FLC), Radboud University Nijmegen, Nijmegen, The Netherlands Christos V. Gortsos, National and Kapodistrian University of Athens, Athens, Greece Antonella Sciarrone Alibrandi, Università Cattolica del Sacro Cuore, Milan, Italy

Editorial Board (all members of the EBI Academic Board)

Dariusz Adamski, University of Wroclaw Filippo Annunziata, Bocconi University Jens-Hinrich Binder, University of Tübingen William Blair, Queen Mary University of London Concetta Brescia Morra, University of Roma Tre Blanaid Clarke, Trinity College Dublin, Law School Veerle Colaert, KU Leuven University Guido Ferrarini, University of Genoa Seraina Grünewald, Radboud University Nijmegen Christos Hadjiemmanuil, University of Piraeus Bart Joosen, Free University Amsterdam Marco Lamandini, University of Bologna Rosa Lastra, Queen Mary University of London Edgar Löw, Frankfurt School of Finance & Management Luis Morais, University of Lisbon, Law School Peter O. Mülbert, University of Mainz David Ramos Muñoz, University Carlos III of Madrid Andre Prüm, University of Luxembourg Juana Pulgar Ezquerra, Complutense University of Madrid Georg Ringe, University of Hamburg Rolf Sethe, University of Zürich Michele Siri, University of Genoa Eddy Wymeersch, University of Ghent

The European Banking Institute The European Banking Institute based in Frankfurt is an international centre for banking studies resulting from the joint venture of Europe’s preeminent academic institutions which have decided to share and coordinate their commitments and structure their research activities in order to provide the highest quality legal, economic and accounting studies in the field of banking regulation, banking supervision and banking resolution in Europe. The European Banking Institute is structured to promote the dialogue between scholars, regulators, supervisors, industry representatives and advisors in relation to issues concerning the regulation and supervision of financial institutions and financial markets from a legal, economic and any other related viewpoint. As of May 2021, the Academic Members of the European Banking Institute are the following: Universiteit van Amsterdam, University of Antwerp, University of Piraeus, Alma Mater Studiorum—Università di Bologna, Universität Bonn, Academia de Studii Economice din Bucures, ti (ASE), Trinity College Dublin, University of Edinburgh, Goethe-Universität, Universiteit Gent, University of Helsinki, Universiteit Leiden, KU Leuven University, Universidade Católica Portuguesa, Universidade de Lisboa, University of Ljubljana, Queen Mary University of London, Université du Luxembourg, Universidad Autónoma Madrid, Universidad Carlos III de Madrid, Universidad Complutense, Madrid, Johannes Gutenberg University Mainz, University of Malta, Università Cattolica del Sacro Cuore, University of Cyprus, Radboud Universiteit, BI Norwegian Business School, Université Panthéon - Sorbonne (Paris 1), Université Panthéon-Assas (Paris 2), University of Stockholm, University of Tartu, University of Vienna, University of Wrocław, Universität Zürich. Supervisory Board of the European Banking Institute: Thomas Gstaedtner, President of the Supervisory Board of the European Banking Institute Enrico Leone, Chancellor of the European Banking Institute European Banking Institute e.V. TechQuartier (POLLUX), Platz der Einheit 2 60327 Frankfurt am Main, Germany Website: www.ebi-europa.eu

More information about this series at http://www.palgrave.com/gp/series/16681

Danny Busch · Guido Ferrarini · Seraina Grünewald Editors

Sustainable Finance in Europe Corporate Governance, Financial Stability and Financial Markets

Editors Danny Busch Financial Law Centre (FLC) Radboud University Nijmegen Nijmegen, The Netherlands

Guido Ferrarini Department of Law University of Genoa Genoa, Italy

Seraina Grünewald Financial Law Centre (FLC) Radboud University Nijmegen Nijmegen, The Netherlands

ISSN 2730-9088 ISSN 2730-9096 (electronic) EBI Studies in Banking and Capital Markets Law ISBN 978-3-030-71833-6 ISBN 978-3-030-71834-3 (eBook) https://doi.org/10.1007/978-3-030-71834-3 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover credit: Teekid/gettyimages This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Series Editors’ Preface

The European Union (EU) has set ambitious climate-related and environmental goals. In this respect, and according to the recent (2018) European Commission’s Action Plan on Financing Sustainable Growth, the financial sector should play a key role in this ‘green’ transition by bringing together supply and demand for ‘green’ capital, supporting thus sustainable finance. The aim of this book on Sustainable Finance in Europe is to collect views of expert academics and practitioners on the latest regulatory developments in sustainable finance in the EU. The volume deliberately includes a wide range of cutting-edge aspects. Although it mainly focuses on the green transition and environmental sustainability, it also addresses social and governance issues, i.e. all so-called ESG issues. The individual contributions deploy different methods of analysis, including theoretical contributions on the status quo of macro-financial research, as well as law and economics approaches, encouraging thus interdisciplinary readership. The book chapters are grouped in a thematic way, covering the following areas: (i) General Aspects, including the impact of the current COVID-19 crisis on the sustainability agenda (Part I); (ii) Sustainable Finance and Corporate Governance (Part II); (iii) Sustainable Finance and Systemic Risk (Part III); and (iv) Sustainable Finance and Financial Markets (Part IV). Some of the chapters included in this book are based on presentations made at the 2020 Global Annual Conference of the European Banking v

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SERIES EDITORS’ PREFACE

Institute (EBI), which took place in Frankfurt on 20 & 21 February. The conference was jointly organised with the Goethe University, the Institute for Monetary and Financial Stability (IMFS) and benefited from the kind support of the Foundation Project Capital Markets Union. The book serves as the first volume in the newly established EBI Book Series on Banking and Capital Markets Law. Danny Busch Christos V. Gortsos Antonella Sciarrone Alibrandi

Contents

Part I General Aspects 3

1

Sustainable Finance in Europe: Setting the Scene Danny Busch, Guido Ferrarini, and Seraina Grünewald

2

The European Commission’s Sustainable Finance Action Plan and Other International Initiatives Danny Busch, Guido Ferrarini, and Arthur van den Hurk

19

Sustainable Digital Finance and the Pursuit of Environmental Sustainability Marco Dell’Erba

61

3

Part II Sustainable Finance and Corporate Governance 4

5

6

Redefining Corporate Purpose: Sustainability as a Game Changer Guido Ferrarini

85

Sustainable Corporate Governance: The Role of the Law Alessio M. Pacces

151

Integrating Sustainability in EU Corporate Governance Codes Michele Siri and Shanshan Zhu

175

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CONTENTS

Part III 7

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Climate Change as a Systemic Risk in Finance: Are Macroprudential Authorities Up to the Task? Seraina Grünewald Climate Change as a Threat to Financial Stability: Can Solutions to This Problem Accelerate the Transition to a Low-Carbon Economy? A Critical Review of Policy and Market-Based Approaches Sara Lovisolo Which Role for the Prudential Supervision of Banks in Sustainable Finance? Antonio Luca Riso

Part IV 10

11

Sustainable Finance and Systemic Risk

259

275

Sustainable Finance and Financial Markets

Sustainable Finance: An Overview of ESG in the Financial Markets Marieke Driessen

329

The Taxonomy Regulation: More Important Than Just as an Element of the Capital Markets Union Christos V. Gortsos

351

12

Sustainability Disclosure in the EU Financial Sector Danny Busch

13

Integrating Sustainable Finance into the MiFID II and IDD Investor Protection Frameworks Veerle Colaert

14

227

Emission Allowances as Financial Instruments Filippo Annunziata

Index

397

445 477

505

Notes on Contributors

Filippo Annunziata is Professor at Università Luigi Bocconi in Milano. Danny Busch is Chair in Financial Law and Director of the Financial Law Centre (FLC), which is part of the Radboud Business Law Institute of Radboud University Nijmegen. He is also Research Fellow at Harris Manchester College, Fellow at the Commercial Law Centre, University of Oxford, and Visiting Professor at the Université de Nice Côte d’Azur and Università Cattolica del Sacro Cuore di Milano. He is a member of the Dutch Appeals Committee of the Financial Services Complaints Tribunal (KiFiD). Chapter 12 of this book was completed on 2 April 2021. No account could be taken of developments since that date. The author is indebted to Johan Barnard, Bart Bierens, Daniel Cash, Christos V. Gortsos, Seraina Grünewald, Arthur van den Hurk, Xenia Karametaxas, Enno Roelofsen, Victor de Serière, Hristina Stoyanova and Karl-Philipp Wojcik for their valuable comments on earlier drafts of this chapter. A draft version of this paper was presented on 20 November 2020 at the ‘Geneva-Zurich Seminar on Sustainable Finance with a special focus on Disclosure and Sustainability Risks’, co-organized by the University of Geneva and the University of Zurich. The recordings of the seminar are available at https://www.susfin.ch/news/geneva-zurich-seminar-serieson-sustainable-finance-disclosure-and-sustainability-risks-12-november2020-amp-26-march-2021.

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NOTES ON CONTRIBUTORS

Veerle Colaert is Professor at KU Leuven and UHasselt; visiting professor at the University of Genua; chair of the Securities and Markets Stakeholder Group (SMSG) advising ESMA. The author would like to thank Drs Arnaud Van Caenegem for many fruitful discussions on this theme, and especially for bringing to her attention the interesting behavioural finance literature on the gap between investors’ intentions and behaviour. Marco Dell’Erba is Assistant Professor of Law, University of Zurich, and Academic Fellow, NYU School of Law, Institute for Corporate Governance and Finance. Marieke Driessen is lawyer and partner in the Financial Markets team at Simmons & Simmons. She is specialised in advising on financial transactions in the fields of capital markets, structured finance, project finance and banking. Marieke obtained her Master’s degree in law from Maastricht University in 1996 and her M.Jur. degree in European and comparative law from Oxford University in 1997. She also obtained an LL.M. degree from Columbia University in New York in 2001. She has been admitted to the Bar in The Netherlands since 1997 and is also admitted to the Bar in New York and England. She regularly speaks and publishes on areas of her expertise. Guido Ferrarini is Emeritus Professor of Business Law at the University of Genoa; Fellow Academic Member at the European Banking Institute (EBI); Fellow and Research Member at the European Corporate Governance Institute (ECGI); Academic Member at the Jean Monnet Centre of Excellence EU Sustainable Finance and Law (EUSFiL). Christos V. Gortsos is Professor of Public Economic Law at the Law School of the National and Kapodistrian University of Athens, and President of the Academic Board of the European Banking Institute (EBI). Seraina Grünewald is Professor of European and Comparative Financial Law at Radboud University Nijmegen, and member of the Academic Board of the European Banking Institute (EBI). She is also affiliated as an academic fellow with the EUSFiL Jean Monnet Centre of Excellence at the University of Genoa and with the interdisciplinary University Research Priority Programme Financial Market Regulation at the University of Zurich.

NOTES ON CONTRIBUTORS

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Arthur van den Hurk is senior regulatory counsel at Aegon N. V. in The Hague, and academic fellow at the Financial Law Centre (FLC), which is part of the Radboud Business Law Institute of Radboud University Nijmegen. This chapter was completed on 15 December 2020. No account could be taken of developments since that date. This chapter is an expanded and updated version of an earlier contribution of the authors to the 2019 book edited by Frits-Joost Beekhoven van den Boezem, Corjo Jansen and Ben Schuijling, Sustainability and financial markets (Law of Business, and Finance series, volume 17), Wolters Kluwer, Deventer, The Netherlands. Sara Lovisolo is Group Sustainability Manager of the EU Technical Expert Group on Sustainable Finance (TEG). She is also member of the European Financial Reporting Advisory Group (EFRAG). Alessio M. Pacces is Professor of Law and Finance at University of Amsterdam and Director, Amsterdam Center for Law and Economics. Antonio Luca Riso is Team Lead in the Supervisory Policies Division of the ECB-Banking Supervisor. The views expressed are those of the author and do not necessarily reflect those of the ECB. Michele Siri is Professor at the University of Genoa. Shanshan Zhu is Professor at the University of Genoa.

List of Figures

Fig. 8.1

Fig. 8.2

The double materiality perspective of the non-financial reporting directive in the context of reporting climate-related information (Source European Commission, Guidelines on non-financial reporting: Supplement on reporting climate-related information, 24 June 2019) Direct and indirect effects of the choice of alternative KPIs in bank climate-disclosures (Source Lovisolo 2019)

268 270

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List of Tables

Table 6.1 Table 6.2

National codes of corporate governance (EU countries) The integration of sustainability factors in corporate governance codes in the EU

192 195

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PART I

General Aspects

CHAPTER 1

Sustainable Finance in Europe: Setting the Scene Danny Busch, Guido Ferrarini, and Seraina Grünewald

1.1

Introduction

The European Union (EU) has launched ambitious climate plans. According to the European Commission’s Sustainable Finance Action Plan, the financial sector must play a key role in this green transition by bringing together supply and demand for green capital.1

1 See the Green Deal presented by the European Commission on 10 December 2019 (COM (2019) 640 final) and the proposal dated 4 March 2020 for a ‘European Climate Law’ (COM(2020) 80 final), amended on 17 September 2020 to include a revised EU emission reduction target of at least 55% by 2030 (COM(2020) 563 final). The Sustainable Finance Action Plan was launched by the previous European Commission on 8 March 2018 (COM (2018) 97 final); for the present position, see https://ec.europa.eu/info/ business-economy-euro/banking-and-finance/sustainable-finance_nl.

D. Busch (B) · S. Grünewald Financial Law Centre (FLC), Radboud University Nijmegen, Nijmegen, The Netherlands e-mail: [email protected]

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_1

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The aim of this book is to collect the views of expert academics and practitioners on the latest regulatory developments in sustainable finance in the EU. The volume deliberately includes a wide range of cutting-edge issues. Although it focuses on the green transition, it also addresses social and governance issues. The individual contributions deploy different methods of analysis, including theoretical contributions on the status quo of macrofinancial research as well as law and economics approaches, encouraging interdisciplinary readership. The book chapters are grouped in a thematic way, covering the following areas: (i) general aspects (Part I); (ii) sustainable finance and corporate governance (Part II); (iii) sustainable finance and systemic risk (Part III); and (iv) sustainable finance and the financial markets (Part IV). This chapter provides a summary and overview of the chapters. But before doing so we will discuss the impact of the COVID-19 crisis on the sustainability agenda.

1.2

Sustainable Finance and COVID-19

In the blink of an eye, COVID-19 paralysed the world economy. Restaurants, hotels, bars, theatres, cinemas and concert halls closed their doors, and their income dried up. Events were cancelled, and the aviation and tourism industries came to an almost complete standstill. Demand for oil largely dried up. As businesses in the directly affected sectors suddenly ceased to generate income, they are no longer able to pay their employees, banks, landlords and suppliers, throwing the economy into a downward spiral. This in turn is reducing tax revenue, putting extra pressure on government finances. The consequent uncertainty has caused extreme volatility in the financial markets. While a successful rollout of vaccination programmes internationally may induce governments to lift lockdown

S. Grünewald e-mail: [email protected] G. Ferrarini Department of Law, University of Genoa, Genoa, Italy e-mail: [email protected]

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restrictions in the short to medium term, the economic impact will be felt for a long time to come. A deep global recession seems inevitable. Investors and the business community are being hit hard. As the current crisis has reduced the amount of capital available generally, less private sector capital is also available for the transition to a greener economy. Implementation of the climate plans is likely to be delayed by the COVID-19 crisis. This is particularly tragic since a link may exist between climate change and the outbreak of pandemics.2 A delay in the realisation of the climate plans would therefore be unacceptable. However, three more positive observations may perhaps be made. First, the COVID-19 crisis may help us to realise that a video link, despite all its limitations, works quite well and that flying around the world for face-toface meetings is often not really necessary. Second, the massive state aid provided by governments to their corporate sector (e.g. KLM-Air France) gives them the opportunity to impose green conditions.3 And last but not least, the Member States and the EU themselves can act as providers of green or social funding. The interest rate is historically low so they can borrow cheaply on the capital markets and transfer the money to the market parties as a loan, as equity or even as a gift.4 Moreover, in cooperation with the national central banks of the eurozone, the European Central Bank (ECB) will likely continue to buy government bonds on a massive scale via the secondary markets for the time being. In fact, the EU is already acting as provider of social and green funding. First of all, there is the EU programme for Support to mitigate Unemployment Risks in an Emergency (SURE). SURE is funded by raising a total of EUR 100 billion through social bonds issued by the EU itself. By 26 January 2021, the European Commission had raised EUR 53.5 billion through the issuance of social bonds in four rounds 2 That link is in any event assumed by the European Commission in the ‘Consultation on the renewed sustainable finance strategy’ dated 8 April 2020 (p. 3) (https://ec.eur opa.eu/info/consultations/finance-2020-sustainable-finance-strategy_en). 3 See also D. Schoenmaker: https://www.bruegel.org/2020/04/a-green-recovery/ (6 April 2020). 4 Always subject to state aid restrictions of course. To ensure that national govern-

ments can act swiftly and know what is allowed during the COVID-19 crisis, the European Commission published a specific temporary state aid framework. The Commission is currently handling applications under state aid rules with unprecedented speed and applying the rules in a generous spirit. See: https://ec.europa.eu/competition/state_aid/ what_is_new/covid_19.html.

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under the EU SURE instrument to help protect jobs and keep people in work. The issuings consisted of 5-, 10- and 15-year bonds. There was very strong investor interest in these highly rated instruments, and the oversubscription resulted in favourable pricing terms for the bonds. The raised funds are transferred to the beneficiary Member States in the form of loans to help them directly cover the costs related to the financing of national short-time work schemes and similar measures as a response to the pandemic. On 27 October 2020, the EU SURE social bond was listed on the Luxembourg Stock Exchange, and will be displayed on the Luxembourg Green Exchange, the world’s leading platform exclusively dedicated to sustainable securities.5 Moreover, at the extraordinary European Council of 17–21 July 2020, the European Heads of Government reached an agreement on the European Multiannual Budget and the Corona Recovery Fund (the Next Generation EU Plan).6 The Agreement on the EU budget (2021–2027) looks roughly as follows. The European budget for 2021–2027 will be EUR 1.074 billion. More money is going to innovation, sustainability and the climate. 30% of all expenditure in the budget must contribute to the European climate target. Member States that receive money from the EU budget must put the European values of freedom and democracy into practice. Thus, they must have independent judges.7 The Corona Recovery Plan consists of the following. There will be a fund of EUR 750 billion, funded by bonds issued by the European Commission itself. Of this amount, EUR 390 billion are for subsidies. The other EUR 360 billion are loans. 30% of all expenditure of the Corona Recovery Fund must contribute to the European climate target. So as soon as the Corona Recovery Fund is released, the European Commission will over time issue bonds of a total nominal value of EUR 750 billion. At least 30% of those bonds will be issued as green bonds. Member States must implement reforms and investment plans to get or borrow money from the Recovery Fund. Member States that receive subsidies or loans from the Fund must strengthen their 5 See https://ec.europa.eu/info/business-economy-euro/economic-and-fiscal-policycoordination/financial-assistance-eu/funding-mechanisms-and-facilities/sure_en/. 6 See https://ec.europa.eu/info/strategy/eu-budget/long-term-eu-budget/eu-budget2021-2027_en. 7 See https://ec.europa.eu/info/strategy/eu-budget/long-term-eu-budget/eu-budget2021-2027_en.

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economies. The European Commission advises the Member States on this. This concerns, for example, reduction of the national debt, pension reforms and combating (youth) unemployment. Other Member States can (temporarily) stop grants or loans if there is insufficient progress in the implementation of reforms and investment plans. Here too, Member States that receive money must put the European values of freedom and democracy into practice. Thus, they must have independent judges.8 The European Parliament has further tightened the requirement that the rule of law must be respected. In Poland and Hungary, the independence of the judiciary is under threat, the freedom of the press is under pressure, and the rights of LGBTI people are being curtailed. For a long time, Poland and Hungary threatened to exercise their right of veto to block the European Multiannual Budget and the Corona Recovery Fund, because in their view according to the new agreements they could be punished in the future if they would not comply with the rule of law. On 10 December 2020 they ceased their opposition after everyone agreed to a compromise proposal from Germany.9 Unfortunately, a new obstacle has appeared on the road. According to the Bundnis Bürgerwille action group, the Corona Recovery Fund is in violation of European law and Germany runs the risk of being liable for the entire sum of 750 billion euros if the other member states do not comply with their obligations. At the request of this action group, the German Constitutional Court (Bundesverfassungsgericht, BVG) has for the time being prohibited the head of state (the Bundespräsident) from signing the German Corona Restoration Fund Ratification Act (Hängebeschluss). The next step is a substantive procedure at the BVG. If the BVG is of the opinion that European law is at stake, it can submit preliminary questions about this to the European Court of Justice (CJEU). All this could, least of all, delay the Corona Recovery Fund becoming operational.10

8 See https://ec.europa.eu/info/strategy/eu-budget/long-term-eu-budget/eu-budget-

2021-2027_en. 9 https://nos.nl/artikel/2360118-akkoord-over-begroting-op-top-europese-unie.html (10 December 2020). 10 See https://www.bundesverfassungsgericht.de/SharedDocs/Pressemitteilungen/ DE/2021/bvg21-023.html; https://buendnis-buergerwille.de/bverfg-bundespraesiden ten/.

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1.3

General Aspects

We will now turn to providing a summary and overview of the chapters contained in this book. Apart from the current Chapter 1, Part I features an overview chapter on the European Commission’s Sustainable Finance Action Plan (Chapter 2). In this chapter, Danny Busch, Guido Ferrarini and Arthur van den Hurk conclude that the actions proposed by the European Commission’s Action Plan respond to five broad strategies that can be defined as ‘public incentives’, ‘standardisation’, ‘disclosure’, ‘corporate governance’ and ‘financial regulation’. The first strategy consists of fostering investments through financial and technical support for sustainable infrastructure and other projects. In perspective, the European Commission will establish a single investment fund providing support and technical assistance to crowd in private investment. The second strategy includes the establishment of an EU taxonomy of sustainable activities which should help shifting capital flows towards them. It also includes the setting of standards and labels for green financial products, which should enhance the trust in the market of these products and ease investors’ access to them. These two strategies will help establishing well-defined and deep markets in sustainable investments and will work as preconditions to the others. The third strategy covers both corporate disclosure and third party information and assessments. The Non-Financial Disclosure Directive is being reviewed and complemented by other measures, such as an impact assessment of International Financial Reporting Standards (IFRS) on sustainability, and potentially changes to the roles and functioning of institutions such as the IFRS Foundation and the European Financial Reporting Advisory Group (EFRAG), to facilitate the credibility and reliability of non-financial information for users of that information. Sustainability benchmarks have been developed in order to allow investors to track and measure performance and allocate assets accordingly. In addition, credit rating agencies and market research services should integrate sustainability into their assessments. The fourth strategy combines sustainable corporate governance with attenuating short-termism in capital markets and assumes that boards should develop their own sustainability strategies and act in the company’s longterm interest. Both disclosure and corporate governance are traditional strategies in capital markets regulation and functioning, while their extension to sustainability is a reflection of the new interest of investors and

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corporate stakeholders for ESG issues in addition to financial performance. The fifth strategy implies at least three types of regulatory reform. First, the Markets in Financial Instruments Directive (MiFID II) and the Insurance Distribution Directive (IDD) should be amended in the sense that investment firms and insurance distributors should consider sustainability issues when offering financial advice. Second, fiduciary duties of asset managers and institutional investors should be clarified so as to include ESG factors in the investment processes. Third, ESG should be incorporated in prudential requirements of financial institutions so that they channel their investments towards a more sustainable economy, while reducing the risks deriving from unsustainable economic development and at the same time maintaining credible and effective risk-based prudential frameworks in Europe. These five strategies represent a very ambitious design of the European Commission which will require multiple actions at all levels. These actions generally require regulation and/or supervision often at EU level, but private incentives and cultural developments towards an environmentally sustainable economic system will also be important in furthering the success of the Action Plan. The third and final chapter included in Part I (Chapter 3) is written by Marco Dell’Erba. The author focuses on sustainable digital finance and the pursuit of environmental sustainability. In recent years technology and sustainability emerged as two main drivers for the economy and finance, each with its own characteristics and following independent paths of development. The general discourse on the relationship between technology (more recently financial technology or fintech) and sustainability tends to emphasise the role of technology as a tool for pursuing sustainability mostly from the perspective of financial inclusion. Therefore, the relationship with environmental sustainability is less often considered. The author tries to answer the question on the role of digital finance as a tool for pursuing environmental sustainability and the way specific policies might contribute to pursuing this goal. Adopting this perspective, the author considers the emergence of sustainable digital finance as the clearest result of the interplay between technology and sustainability, assessing its potential for contributing to environmental sustainability. In doing this, he considers the most relevant public initiatives at the international level, and provides a brief overview of the technologies involved in sustainable digital finance, assessing their own specificities and complementarity. Finally, the author makes some policy suggestions

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to strengthen sustainable digital finance in view of achieving ambitious societal goals.

1.4 Sustainable Finance and Corporate Governance Part III of this book deals with sustainable finance and corporate governance. Chapter 4, written by Guido Ferrarini, concentrates on sustainability and corporate purpose. An increasing number of firms make reference to the pursuit of environmental and social goals in the definition of their purpose. This raises important issues with respect to the way in which the trade-offs between profit maximisation and social value should be solved. As the author shows in this chapter, there are different perspectives that can be adopted to this end depending on the field of scholarship selected: economics, finance, management and law. Each perspective offers different nuances as to the way in which corporate purpose is defined and the conflict between the pursuit of profit and social value is dealt with. The author argues that a broader concept of corporate purpose has gradually emerged over the years in economics, finance and management studies, as a result of various approaches to corporations such as corporate social responsibility (CSR) and stakeholder theory, which have been gradually integrated into the corporate governance framework. Environmental and social sustainability has come to characterise most of the instances of CSR and some core aspects of stakeholder governance, without discarding the pursuit of corporate profits as a long-term goal of the corporation. At the start of this century, sustainability concerns have entered into the area of finance studies through the theory of ‘enlightened shareholder value’ (ESV) and its homologues like ‘shared value’. The author furthermore argues, from a comparative law perspective, that corporate purpose has been variously defined in different jurisdictions, while European laws often consider the company’s interest rather than corporate purpose. However, corporate purpose is generally identified in practice with the pursuit of corporate profits, albeit with variations concerning the relevance of given stakeholders and social values in corporate governance. In general, legal definitions of corporate purpose are flexible and allow for different types of solution to the conflict between economic value and social value at firm level and within a given system. Then the author goes on to critically analyse recent economics and management studies which argue that corporate purpose should be

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modified to reflect the prevalence of social value over shareholder value, and that the latter should be pursued by managers only derivatively, as a result of pro-stakeholders actions directed to increase the ‘total pie’. The author objects to this recent trend from a law and finance perspective and shows his preference for keeping the relevant discussion within the confines of the ESV theory. However, the author admits that corporate purpose should be larger than profit from a behavioural perspective if we want to motivate people to perform outstandingly and sustainably in organisations. Finally, the author emphasises the mounting role of regulatory and ethical constraints to business conduct deriving from sustainability concerns. These constraints go beyond the mere calculus required by ESV, which asks management to pursue stakeholder interests only to the extent that this increases the long-term value of the firm. According to the author, ethical considerations as reflected by international standards and consolidated best practices should apply to the running of businesses without necessarily requiring a prior analysis of their precise impact on financial performance. In Chapter 5, Alessio Pacces discusses sustainable finance from a shareholders perspective. The debate on sustainable finance seldom includes the perspective of shareholders. However, the author argues that shareholders are important for the governance of publicly held corporations today, because their holdings are concentrated in the hands of few institutional investors. Institutional investors can therefore have an impact on the sustainability of the largest companies in the world, as they often claim they do—particularly in communications with their beneficiaries. Whether institutional investors actually have such an impact is an open question according to the author. Recent changes in EU financial regulation aim to bring more clarity on this matter. For instance, the revised Shareholder Rights Directive requires companies, on a comply-or-explain basis, to disclose voting policies and behaviours concerning sustainability. More in general, EU law is increasing the supply of standard measures of sustainable investment, to be used in institutional investors’ communications with their beneficiaries. This chapter also discusses whether this legislation can align the incentives of institutional investors to pursue sustainable corporate governance with the prosocial preferences of their beneficiaries. Part III of the book concludes with a chapter by Michele Siri and Shanshan Zhu on sustainability considerations in corporate governance codes (Chapter 6). In the light of the strong commitment by the EU

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to a sustainable path towards the goals set by the Paris Agreement and the UN 2030 Agenda, and the EU initiatives concerning the establishment of a sustainable corporate governance, the authors argue that it is more pressing than ever to evaluate how companies can truly integrate a long-term sustainable approach in their strategies and operations, and therefore whether corporate governance codes could provide a useful tool towards such objectives. Many authors have investigated the effective implementation of corporate governance codes, but only a few have considered the role of the codes in promoting environmental and social responsibility. The aim of this chapter is to comparatively evaluate the most recent attempts to integrate sustainability considerations in corporate governance codes of listed companies within the EU Member States, in order to understand whether such progress is on the way and which best practices could be taken into consideration and disseminated by the EU authorities in the years to come.

1.5

Sustainable Finance and Systemic Risk

Part IV of the book concentrates on sustainable finance and systemic risk. In Chapter 7, Seraina Grünewald addresses the topic of climate change as a systemic risk in finance. The author highlights that there is growing acknowledgement among policymakers that climate change may give rise to (potentially catastrophic) financial risk and may impact financial stability. This chapter thus explores the specific features of climate-related financial risks, drawing on a growing body of macrofinancial literature and policy work, and discusses the options macroprudential policymakers have in the face of such risk. It finds that there are significant challenges associated with ‘greening’ macroprudential policy, both epistemological and methodological as well as behavioural, and points to potential ingredients of a ‘green macroprudential policy’. Separate sections are devoted to the crucial questions of the timing of policy action in the light of the radical uncertainty in relation to the nature of climate-related financial risks and of the role that Central Banks can and should play in the transition to a low-carbon economy. In the second contribution to Part IV of this book, Sara Lovisolo offers a critical review of policy and market-based approaches to climate change as a threat to financial stability (Chapter 8). The author explains that sustainable finance has so far been primarily defined through two complementary approaches, one centred around the notion of impact

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and the other one around risk management. The author argues that this twofold theory of change, also formalised in the Sustainable Finance Action Plan, requires deeper scrutiny when applied to the banking sector, in the context of the Basel accords and their aim to foster financial stability. This chapter sets out to answer the question of whether the risk management or financial stability goal, decoupled from its impact twin, can—from a theoretical perspective and based on a critical review of models embedded in policy and market-based solutions—achieve the objectives of sustainable finance. Chapter 9, written by Antonio Luca Riso, explores the role that prudential supervisors can and should play with a view to sustainable finance. After analysing how climate-related risks may affect the prudential framework, the chapter discusses the difficulty of apprehending risks in a scenario of radical uncertainty and highlights some methodological challenges. The author further offers his reflections on the implications that climate-related risks in combination with the limited current toolkit may have for the mandate of prudential supervisors. The chapter concludes with an overview of the status quo of supervisory practices and experiences in the light of the policies recently adopted by the ECB and the European Banking Authority (EBA).

1.6

Sustainable Finance and Financial Markets

The final part of this book (Part V) deals with sustainable finance and financial markets. In Chapter 10, Marieke Driessen provides an overview of ESG in the financial markets. The author sets out that sustainable finance has been around for years. After publication of the Sustainable Finance Action Plan by the European Commission in March 2018, sustainable finance rose to the top of the EU legislative agenda for the financial markets, as well as the regulatory and supervisory agenda of EU and national supervisors and competent authorities of the financial sector. The author provides an overview of various sustainable and ESG products that have been a feature of the international financial markets, such as green, ESG and sustainability-linked loans and bonds. The author also discusses the current legal framework in which these financial products are issued, with a focus on EU level legislation, including the Taxonomy Regulation and the Sustainable Finance Disclosure Regulation, and considers legal and regulatory developments on the horizon, such as the Green Bonds Standard and Climate Benchmarks. The chapter

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concludes with a few remarks on general trends in ESG and sustainable finance developments in the financial markets. In Chapter 11, Christos V. Gortsos analyses and discusses a crucial building block of the EU’s sustainable finance strategy: the Taxonomy Regulation. The author explains that, on the basis of the Sustainable Finance Action Plan of 8 March 2018, which forms part of the political priority to establish a (European) Capital Markets Union (CMU), the European Parliament and the Council already adopted on 27 November 2019 Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector and Regulation (EU) 2019/2089 as regards EU Climate Transition Benchmarks, EU Paris-aligned Benchmarks and sustainability-related disclosures for benchmarks. The third—and probably most important—part of the related ‘trilogy’ is the Regulation on the establishment of a framework to facilitate sustainable investment (the socalled Taxonomy Regulation), adopted on 18 June 2020. The objective of this legislative act is to establish the criteria for determining whether an economic activity qualifies as environmentally sustainable for the purpose of establishing the degree to which an investment is environmentally sustainable. It does not itself establish a label for sustainable financial products; the details of what constitutes an environmentally sustainable activity or product is being built up through delegated acts to be adopted by the European Commission, of which the first two are scheduled to apply from 31 December 2021 and the other four from 31 December 2022. The purpose of this chapter is threefold. First, it briefly albeit systematically presents the ‘system of rules’ relating to the ‘core element’ of the Taxonomy Regulation, namely the criteria according to which an economic activity will be considered environmentally sustainable and the six environmental objectives. Second, it analyses the Regulation’s scope of application and the obligations imposed on Member States and the EU with regard to existing or potentially new eco-labelling or other legislative measures, financial market participants who offer financial products as well as undertakings falling under the scope of the Non-Financial Reporting Directive. Third, the chapter makes some considerations on how the core element of the Regulation will be of primary importance even for entities which are not covered by its scope of application, namely beyond the reach of the CMU project. These considerations are based on the author’s view that the environmental objectives, as developed within the Taxonomy Regulation, will be used as a benchmark for the prudential

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regulation of several categories of regulated financial firms by virtue of other legislative acts. In Chapter 12, Danny Busch discusses another important building block of the EU’s sustainable finance strategy: the Sustainable Finance Disclosure Regulation. The aim of the chapter is twofold. On the one hand, it explores the main features of the Sustainable Finance Disclosure Regulation. On the other hand, it tries to assess whether the Sustainable Finance Disclosure Regulation is likely to succeed in harmonising sustainability-related disclosure rules and fiduciary duties, not only across Member States, but also across financial products and distribution channels. The author concludes that before we reach a sufficient degree of harmonisation of sustainability-related disclosure rules and fiduciary duties there is still a long way to go. And even if we reach the required degree of harmonisation in the EU, it is not given that this will necessarily lead to a more sustainable world. As may be gleaned from the European Green Deal and the Sustainable Finance Action Plan, the EU is aiming high when it comes to sustainability. But the EU is not an island. The author argues that there are roughly two opposite scenarios. In a pessimistic scenario, the more lenient or even non-existent sustainability agenda of other geopolitical powers gives them a competitive edge that is detrimental to the EU. In a positive scenario, the EU becomes a global standard-setter in the area of sustainability. Large global institutional investors such as Blackrock and State Street in any event say they are strong supporters of the sustainability agenda. Also, the re-entry of the United States of America in the Paris Climate Agreement under the Biden Administration may give us some hope. In Chapter 13, Veerle Colaert discusses the proposals to integrate sustainability considerations into the MiFID II and the IDD. MiFID II and IDD define the legal framework for the relationship between investment firms or insurance distributors and their clients. In April 2019 ESMA and EIOPA advised the European Commission on how to integrate sustainable finance into these frameworks, after elaborate consultations of the industry. The author critically assesses the changes to the MiFID II and IDD investor protection frameworks. She first sketches the behavioural problems explaining why retail investors do not always act upon their investment preferences and the role of the investment product distributor in this respect. Against this background, the author offers a critical overview of the most important changes to the MiFID II and IDD investor protection frameworks.

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In the final contribution to Part V of this book, Filippo Annunziata discusses the topic of emission allowances in relation to the MiFID II framework (Chapter 14). While the structure and the mechanisms that underpin the functioning of the EU Emissions Trading System (ETS) are, by now, well known, discussions on the protection of the environment, and the development of secondary markets for emission allowances, have stimulated a process of gradual inclusion of CO2 allowances in the perimeter of financial markets regulation. A first, significant step in this direction was taken by MiFID I: building on the definition of commodity derivatives introduced by the Investment Services Directive of 1993, MiFID I enlarged and amplified the catalogue of derivatives that would be considered as falling into its scope. The catalogue included then derivatives on emission allowances. The landscape set by MiFID I was, however, just a first step towards the inclusion of emissions trading in the scope of financial markets legislation. A second step has been taken by MiFID II, as the latter directly classifies rights on emissions allowances falling in the EU regime as financial instruments. The author argues that the reasons that led to the qualification of emissions allowances as financial instruments in MiFID II are basically a consequence of the tremendous evolution that secondary markets of allowances have seen in the last few years. The growing amount of transactions and the need to preserve and ensure the transparency and integrity of secondary markets convinced the European Commission of the opportunity to include emissions allowances in the scope of MiFID II and, therefore, in the scope of the Market Abuse Directive (now Market Abuse Regulation or MAR). Looking at the positive effects for environmental protection that may derive from the inclusion of emission allowances in the scope of capital markets legislation, these are basically linked to the fact that—as a consequence of the approach stemming from MiFID II—secondary markets should effectively become more transparent, efficient and secure. However, according to the author, some potential drawbacks must be considered. Trading in emission allowances has become more expensive after MiFID II, and transaction costs might impact negatively on the liquidity of the market. The application of the Capital Requirements Directive (CRD IV, now CRD V) prudential requirements might also require the absorption of important levels of capital that would be distracted from direct investments in the industry. The effect that this might have on the system is, at the moment, unclear. The landscape introduced by MiFID II is also quite

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complex: there are at least two, if not three, different sets of comprehensive legislation that may potentially be relevant for trading emission allowances, either on the spot, or on the derivatives market: the ‘old’ EU-ETS; MiFID II and MAR; and more tangentially, the Regulation on wholesale Energy Market Integrity and Transparency (REMIT). The author discusses the implications of each of them and argues that opting in and out of each of these systems, through a complicated system of exemptions and exclusions, does not benefit the overall coherence of the regulatory approach.

CHAPTER 2

The European Commission’s Sustainable Finance Action Plan and Other International Initiatives Danny Busch, Guido Ferrarini, and Arthur van den Hurk

2.1

Introduction

On 11 December 2019 the European Commission launched the European Green Deal and announced that it had reset its commitment to tackling climate and environmental-related challenges, such as the

D. Busch (B) · A. van den Hurk Financial Law Centre (FLC), Radboud University Nijmegen, Nijmegen, The Netherlands e-mail: [email protected] G. Ferrarini Department of Law, University of Genoa, Genoa, Italy e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_2

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warming of the atmosphere and changing climate, loss of species on the planet and destruction and pollution of oceans and forests.1 The European Green Deal also serves as a new growth strategy for the EU, to transform the European Union into a fair and prosperous society, with a modern, resource-efficient and competitive economy where there are no net emissions of greenhouse gases in 2050 and where economic growth is decoupled from resource use.2 The Green Deal is an integral part of this Commission’s strategy to implement the United Nation’s 2030 Agenda and the UN Sustainable Development Goals.3 The Commission has estimated that achieving the current 2030 climate and energy targets will require e260 billion of additional annual investment, about 1.5% of 2018 GDP. This flow of investment will need to be sustained over time. The magnitude of the investment challenge requires mobilising both the public and private sector. As already indicated with the announcement of the initial sustainable finance strategy in 2018, the European Commission reiterates in the context of the European Green Deal that the private sector is key to financing the green transition. Long-term signals are needed to direct financial and capital flows to green investment and to avoid stranded assets. The Commission announced that it would present a renewed sustainable finance strategy in the third quarter of 2020 that will focus on a number of actions.4 But let us go back in time a little further. At the end of 2016, the Commission appointed a High-Level Expert Group on Sustainable Finance. On 31 January 2018, the expert group published its final report, offering a comprehensive vision on how to build a sustainable finance strategy for the EU. The Report argues that sustainable finance is about two urgent imperatives: (1) improving the contribution of finance to

1 Communication from Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions, The European Green Deal, COM/2019/640 final, December 11, 2019. 2 Resolution 70/1 adopted by the United Nations General Assembly on 25 September

2015, https://www.un.org/ga/search/view_doc.asp?symbol=A/RES/70/1&Lang=E. 3 https://sdgs.un.org/goals. 4 Communication from Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions, The European Green Deal, COM/2019/640 final, December 11, 2019, paragraph 2.2.1.

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sustainable and inclusive growth by funding society’s long-term needs; (2) strengthening financial stability by incorporating environmental, social and governance (ESG) factors into investment decision-making. The Report proposes eight key recommendations, several cross-cutting recommendations and actions targeted at specific sectors of the financial system.5 On 8 March 2018 the Commission launched its initial Action Plan on Sustainable Finance. The Action Plan builds upon the expert group’s recommendations to set out an EU strategy for sustainable finance. The Action Plan on sustainable finance is part of broader efforts to connect finance with the specific needs of the European and global economy for the benefit of the planet and society.6 Specifically, the Action Plan aims to: (i) reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth; (ii) manage financial risks stemming from climate change, resource depletion, environmental degradation and social issues; and (iii) foster transparency and long-termism in financial and economic activity.7 In the Action Plan these aims are translated into ten concrete actions: (1) establishing an EU classification system for sustainable activities; (2) creating standards and labels for green financial products; (3) fostering investment in sustainable projects; (4) incorporating sustainability when providing financial advice; (5) developing sustainability benchmarks; (6) better integrating sustainability in ratings and market research; (7) clarifying institutional investors’ and asset managers’ duties; (8) incorporating sustainability in prudential requirements; (9) strengthening sustainability disclosure and accounting rule-making; (10) fostering sustainable corporate governance and attenuating short-termism in capital markets.8 Following up on the announcement by the Commission in the context of the European Green Deal, the European Commission launched a

5 EU High-Level Expert Group on Sustainable Finance, Financing a Sustainable European Economy (https://ec.europa.eu/info/sites/info/files/180131-sustainable-financefinal-report_en.pdf). 6 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 2. 7 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 3. 8 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), pp. 4–11.

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consultation on 8 April 2020 on a renewed sustainable finance strategy, building on the 10 action points identified in the initial 2018 Action Plan. According to the Commission in the context of this consultation, the financial system as a whole is not yet transitioning fast enough. Substantial progress still needs to be made to ensure that the financial sector genuinely supports businesses on their transition path towards sustainability, as well as further supporting businesses that are already sustainable.9 The renewed sustainable finance strategy fits within the broader context of the European Green Deal Investment Plan (EGDIP or SEIP10 ), which is the investment pillar of the Green Deal. The objectives of the Investment Plan are threefold: (1) it will increase funding for the transition, and mobilise at least e1 trillion to support sustainable investments over the next decade through the EU budget and associated instruments, in particular InvestEU; (2) it will create an enabling framework for private investors and the public sector to facilitate sustainable investments; and (3) it will provide support to public administrations and project promoters in identifying, structuring and executing sustainable projects.11 Within the context of these objectives of the Investment Plan the renewed sustainable finance strategy will aim to: (1) create a strong basis to enable sustainable investment; (2) increase opportunities for citizens, financial institutions and corporates to have a positive impact on society and the environment; and (3) fully manage and integrate climate and environmental risks into the financial system. First, according to the Commission, the strategy will strengthen the foundations for sustainable investment, in particular by the adoption of the taxonomy for classifying environmentally sustainable activities. Furthermore, sustainability should be further embedded into the corporate governance framework and companies and financial institutions will

9 European Commission, consultation on the renewed sustainable finance strategy, April 8, 2020, https://ec.europa.eu/info/sites/info/files/business_economy_euro/ban king_and_finance/documents/2020-sustainable-finance-strategy-consultation-document_ en.pdf. 10 Sustainable Europe Investment Plan. 11 European Commission, The European Green Deal Investment Plan and Just Tran-

sition Mechanism explained, January 14, 2020, https://ec.europa.eu/commission/pressc orner/detail/en/qanda_20_24.

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need to increase their disclosure on climate and environmental data so that investors are fully informed about the sustainability of their investments. To this end, the Commission will review the Non-Financial Reporting Directive. To ensure appropriate management of environmental risks and mitigation opportunities, and reduce related transaction costs, the Commission will also support businesses and other stakeholders in developing standardised natural capital accounting practices within the EU and internationally. Second, the European Commission proceeds with the development of clear labels for sustainable retail investment products and the development of an EU green bond standard. Third, the European Commission will focus on the integration and management of climate and environmental risks into the financial system by integrating such risks into the EU prudential framework and assessing the suitability of the existing capital requirements for green assets. The Commission will also examine how our financial system can help to increase resilience to climate and environmental risks, in particular when it comes to the physical risks and damage arising from natural catastrophes.12 The ten concrete actions mentioned in the Action Plan (see point (1)(10) above) will be discussed in broad outline below. But before doing so, we will briefly put the Action Plan in a broader perspective.

2.2

The Broader Perspective

The Commission’s Green Deal and Sustainable Finance Action Plan follow global efforts towards a more sustainable economy. Governments from around the world have chosen a more sustainable path for our planet and our economy by adopting (1) the 2016 Paris Agreement on climate change and (2) the United Nations (UN) 2030 Agenda for Sustainable Development.13

12 Communication from Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions, The European Green Deal, COM/2019/640 final, December 11, 2019, paragraph 2.2.1. 13 Proposal for a Regulation of the European Parliament and of the Council on the establishment of a framework to facilitate sustainable investment, COM(2018) 353 final (24 May 2018), p. 1 (Explanatory Memorandum).

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On 25 September 2015, the UN General Assembly adopted a new global sustainable development framework: the 2030 Agenda for Sustainable Development14 having at its core the Sustainable Development Goals (SDGs) covering three pillars of sustainability: (1) environmental, (2) social and (3) economic/governance. The Commission’s Communication of 2016 on the next steps for a sustainable European future15 links the SDGs to the Union policy framework to ensure that all Union actions and policy initiatives, within the Union and globally, take the SDGs on board at the outset. The European Council conclusions of 20 June 201716 confirmed the commitment of the Union and the Member States to the implementation of the 2030 Agenda in a full, coherent, comprehensive, integrated and effective manner and in close cooperation with partners and other stakeholders.17 In 2016, the Council concluded on behalf of the Union the Paris Climate Agreement.18 Article 2(1)(c) of the Paris Climate Agreement sets the objective to strengthen the response to climate change, among other means by making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.19 The United Nations Environment Programme—Finance Initiative (UNEP FI), operating under the auspices of the United Nations Environment Programme predates the initiatives mentioned above.20 UNEP FI is a partnership between United Nations Environment and the global financial sector created in 1992, in the wake of the 1992 Earth Summit in Rio de Janeiro with a mission to promote sustainable finance. What was 14 Transforming our World: The 2030 Agenda for Sustainable Development (UN 2015) available at https://sustainabledevelopment.un.org/post2015/transformingourworld. 15 COM(2016) 739 final. 16 CO EUR 17, CONCL. 5. 17 Proposal for a Regulation of the European Parliament and of the Council on the

establishment of a framework to facilitate sustainable investment, COM(2018) 353 final (24 May 2018), recital (2). 18 Council Decision (EU) 2016/1841 of 5 October 2016 on the conclusion, on behalf of the European Union, of the Paris Agreement adopted under the United Nations Framework Convention on Climate Change (OJ L 282, 19.10.2016, p. 4). 19 Proposal for a Regulation of the European Parliament and of the Council on the establishment of a framework to facilitate sustainable investment, COM(2018) 353 final (24 May 2018), recital (3). 20 Established as part of the United Nations Conference on the Human Environment in Stockholm in 1972.

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launched in 1991 by a small group of commercial banks21 has grown into a group of hundreds of financial institutions, including banks, insurers and investors, from across the globe that work with UN Environment to understand today’s environmental, social and governance challenges, why they matter to finance, and how to actively participate in addressing them. The core document of UNEP FI is the UNEP Statement of Commitment by Financial Institutions on Sustainable Development, to which all financial institutions that have joined UNEP FI have agreed to adhere. An impressive number of initiatives has been developed under the umbrella of the UNEP FI in various areas of the financial sector, such as the UNsupported 2006 Principles for Responsible Investment22 and the 2012 UN Principles for Sustainable Insurance,23 whereas UNEP FI’s banking membership24 has developed principles that intend to define the banking industry’s role and responsibility in shaping and financing a sustainable future. Immediately after the launch of the UN principles on responsible banking on 22 September 2019, 33 of their signatories with over $13 trillion in assets have additionally announced a Collective Commitment to Climate Action (CCAA). Signatories of the Principles are taking tangible steps towards putting their commitment to align their business with international climate goals into practice. The CCAA sets out concrete and time-bound actions that banks will take to scale up their contribution to, and align their lending with, the objectives of the Paris Agreement on Climate, including: (1) aligning their portfolios to reflect and finance the low-carbon, climate-resilient economy required to limit global warming to well-below 2, striving for 1.5 degrees Celsius; (2) taking concrete action, within a year of joining, and use their

21 More or less in parallel, the UNEP joined forces in 1995 with leading insurance and reinsurance companies, forming the UNEP Insurance Industry Initiative, working closely together with the UNEP Financial Institutions Initiative, and subsequently, in 2000, merging into the UNEP Finance Initiative. 22 Created as a spin-off of from the UNEP FI and the UN Global Compact. 23 Which have become part of the insurance industry criteria of the Dow Jones Sustain-

ability Indices and FTSE4Good and (as of July 2015) representing 83 organisations, including insurers representing approximately 20% of the world premium volume and USD 14 trillion in assets under management. 24 Representing approximately 200 banks across the world.

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products, services and client relationships to facilitate the economic transition required to achieve climate neutrality; (3) being publicly accountable for their climate impact and progress on these commitments. On December 8, 2020, UNEP FI published the first progress report on the measures taken in the first year since the pledge. Furthermore, other international bodies and standard-setters have become increasingly active in the area of SDG. For instance, in 2015 the Financial Stability Board set up the Task Force on Climate-Related Disclosures (TCFD), which has led to the publication of the final recommendations of the TCFD in 2017. UNEP FI banks have declared their intention to jointly pioneer practical approaches to implement this forward-looking framework, whereas asset managers and owners, as well as insurance companies, have subsequently joined this pilot. As another example, the International Association of Insurance Supervisors (IAIS) (jointly with the Sustainable Insurance Forum25 ) has released two joint Issues Paper, a first one in 2018 on climate change risks to the insurance sector and as a follow-up, a second Issues Paper in February 2020 on the implementation of the Recommendations of the Task Force on Climaterelated Financial Disclosures (TCFD) in the insurance sector. In addition, the IAIS held a consultation on an application paper on the supervision of climate-related risks in the insurance sector.26 Worth mentioning as well is the Central Banks and Supervisors Network for Greening the Financial System (NGFS), established at the Paris Summit in December 2017 by an initial group of nine central banks and financial service authorities27 which has so far launched workstreams on supervisory/microprudential, macroprudential and on scaling up green finance.

25 The Sustainable Insurance Forum (SIF) is a leadership group of insurance supervisors and regulators working together to strengthen their understanding of and responses to sustainability issues facing the insurance sector. As of October 2020, the SIF has 30 jurisdictions as its members. 26 Available at www.iaisweb.org. 27 As of 15 December 2020, the NGFS consists of 83 members and 13 observers,

with the US Federal Reserve being among the most recent joiners: https://www.ngfs. net/en/about-us/membership. International or regional financial institutions and international or regional standard setting, regulatory, supervisory and central bank bodies which have demonstrated a proven commitment in sustainable finance are eligible to be NGFS observers.

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Furthermore, on 18 October 2019, in the margins of the International Monetary Fund (IMF)/World Bank annual meetings in Washington DC, the European Union launched together with relevant authorities of Argentina, Canada, Chile, China, India, Kenya and Morocco the International Platform on Sustainable Finance (IPSF). The ultimate objective of the IPSF is to scale up the mobilisation of private capital towards environmentally sustainable investments. The IPSF therefore offers a multilateral forum of dialogue between policymakers that are in charge of developing sustainable finance regulatory measures to help investors identify and seize sustainable investment opportunities that truly contribute to climate and environmental objectives. Through the IPSF, members can exchange and disseminate information to promote best practices, compare their different initiatives and identify barriers and opportunities of sustainable finance, while respecting national and regional contexts. Where appropriate, willing members can further strive to align their initiatives and approaches.28 Lastly, between September and December 2020, the IFRS Foundation has held a consultation to identify the demand from stakeholders in the area of sustainability reporting and understand what the Foundation could do in response to that demand. The IFRS Foundation highlights the need to improve the consistency and comparability in sustainability reporting. A set of comparable and consistent standards will allow businesses to build public trust through greater transparency of their sustainability initiatives, which will be helpful to investors and an even broader audience in a context in which society is demanding initiatives to combat climate change. As an established and recognised standardsetting body, the IFRS Foundation is considering whether its track record and expertise in standard-setting, and its relationships with global regulators and governments around the world, could be useful for setting sustainability reporting standards. In that context, it is considering three options: (1) maintaining the status quo, (2) facilitate existing initiatives or (3) create a Sustainability Standards Board and become a standard-setter working with existing initiatives and building upon their work.

28 https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainablefinance/international-platform-sustainable-finance_nl.

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2.3

EU Classification System (‘Taxonomy’)

Now that we have put the Action Plan in a broader perspective, we will turn to discussing the concrete actions included in Commission’s Action Plan. The first concrete action the Commission mentions in its Action Plan is the establishment of an EU classification system—or taxonomy—for sustainable activities. According to the Commission, a shift of capital flows towards more sustainable economic activities has to be underpinned by a shared understanding of what ‘sustainable’ means. A unified EU classification system should provide clarity on which activities can be considered ‘sustainable’. The Commission considered this as the most important and urgent action of its Action Plan.29 On 22 June 2020, the Taxonomy Regulation was published in the Official Journal of the European Union and entered into force on 12 July 2020. The Taxonomy Regulation sets out uniform criteria for determining whether an economic activity is environmentally sustainable. It further sets out a process involving a multi-stakeholder platform to establish a unified EU classification system based on a set of specific criteria, in order to determine which economic activities are considered sustainable. This should provide economic actors and investors with clarity on which activities are considered sustainable in order to inform their investment decisions. It should help ensuring that investment strategies are oriented towards economic activities which are genuinely contributing to the achievement of environmental objectives, while also complying with minimum social and governance standards. Greater clarity on what can be considered an environmentally sustainable investment will facilitate access to cross-border capital markets for environmentally sustainable investment.30

29 The Taxonomy Regulation is discussed in more detail in Chapter 10 of this book by C.V. Gortsos. 30 To this end, pursuant to article 8 of the Taxonomy Regulation, any undertaking

which is subject to an obligation to publish non-financial information pursuant to Article 19a or Article 29a of Directive 2013/34/EU shall include in its non-financial statement or consolidated non-financial statement information on how and to what extent the undertaking’s activities are associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9 of the Taxonomy Regulation.

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It will also serve as the basis for standards and labels for sustainable financial products under the Sustainable Finance Disclosure Regulation.31 As follows from the above, the Taxonomy Regulation is closely linked to other pieces of the EU legislation, in particular the Sustainable Finance Disclosure Regulation, the Non-Financial Reporting Directive and the Consolidated Accounting Directive. As part of the Taxonomy Regulation, the Commission is tasked with coming forward with technical screening criteria through delegated acts to develop the taxonomy further. The first two sets of criteria have been published for public consultation on 20 November 2020, relating to those activities that substantially contribute to climate change mitigation or climate change adaptation. It is the intent that the relevant criteria will apply as of 1 January 2022. The activities and criteria are based on the recommendations of the Technical Expert Group on Sustainable Finance (TEG) that were published in March 2020. This gradual approach demonstrates the evolving knowledge of environmental impacts and the developing expertise in this area, which necessitates an approach that is flexible enough to take account of future developments. Under article 20 of the Taxonomy Regulation, the European Commission has recently established a platform on sustainable finance.32 The platform is an advisory body and consists of experts from the private and public sector. This group of experts will have four main tasks: (1) advise the Commission on the technical screening criteria for the EU taxonomy, including on the usability of the criteria; (2) advise the Commission on the review of the Taxonomy Regulation and on covering other sustainability objectives, including social objectives and activities that significantly harm the environment; (3) monitor and report on capital flows towards sustainable investments; (4) advise the Commission on sustainable finance policy more broadly. In addition to the platform, a Member State Expert Group on Sustainable Finance has been established pursuant to article 24 of the Taxonomy Regulation that shall advise the Commission on the appropriateness of the technical screening criteria and the approach taken by the platform regarding the development of those criteria. 31 The Sustainable Finance Disclosure Regulation is discussed in more detail in Chapter 11 of this book by D. Busch. 32 European Commission, Platform on sustainable finance: https://ec.europa.eu/info/ publications/sustainable-finance-platform_nl.

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2.4

Standards and Labels for Green Products

Building on the EU sustainability taxonomy discussed in the previous paragraph, the Commission’s second concrete action included in the Action Plan concerns the creation of EU standards and labels for sustainable financial products.33 In the view of the Commission, this will protect the integrity of and trust in the sustainable financial market, as well as enable easier access for investors seeking those products. The Commission gives the example of green bonds, which allow entities (companies, banks, governmental organisations, etc.) to borrow money from investors in order to finance or re-finance ‘green’ projects, assets or business activities. While the green bond market is expanding rapidly, it still accounts for less than 1% of total bonds outstanding worldwide.34 Drawing on current best practices, an EU standard accessible to market participants would in the Commission’s view facilitate channelling more investments into green projects and would constitute a basis for the development of reliable labelling of financial products. According to the Commission, labelling schemes can be particularly useful for retail investors who would like to express their investment preferences on sustainable activities. They could facilitate retail investors’ choice by gradually being integrated in tools, like comparison websites or financial planning services, such as currently developed in the context of the Commission’s Consumer Financial Services Action Plan.35 According to the Commission, surveys suggest that retail investors increasingly want their investments to take into account climate, environmental and social considerations. However, the lack of labelled financial products may prevent investors from directly channelling their funds into sustainable investments. The Commission sees potential merit in the use of the already existing EU Ecolabel Regulation to create a voluntary EUwide labelling scheme. Criteria would have to be identified for specific

33 For a more elaborate discussion, we refer to Chapter 10 of this book by M. Driessen,

Sustainable Finance: an overview of ESG in the financial markets. 34 G20 Green Finance Study Group, G20 Green Finance Synthesis Report, 2016; European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), pp. 4–5. 35 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 5.

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financial products offered to retail investors (such as Packaged Retail Investment and Insurance Products or PRIIPs). The Commission will also consider the merits of a labelling scheme for socially responsible financial products, such as SRI (socially responsible investment funds or sustainable and responsible investment funds),36 building on the experience of the European Social Entrepreneurship Funds. In view of the above, the Commission wishes to create standards and labels for green financial products. On 12 June 2020 the European Commission has launched a consultation on a European standard for green bonds, building on earlier preparatory work undertaken by the Technical Expert Group.37,38 Finally, the Commission will explore the use of the EU Ecolabel framework for certain financial products, to be applied once the EU sustainability taxonomy is adopted.39 Recently the European Commission published a first study in this context on the use of EU Ecolabel criteria on UCITS equity funds.40 According to the Commission, the study will assist with the development of the Ecolabel criteria for financial products and assessing whether the proposed criteria achieve the right balance between promoting environmental excellence and maintaining the integrity of the EU Ecolabel while ensuring there are a sufficient number of eligible products available in the market. Somewhat related, and predating the Action Plan, is the request for advice and subsequent joint technical advice of the European Supervisory Authorities (or ESAs) to the European Commission on the procedures

36 These are funds integrating environmental, social and governance factors in their investment decision-making process. European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), footnote 20 on p. 5. 37 EU Technical Expert Group on Sustainable Finance, Proposal for an EU green bond standard, June 2019, https://ec.europa.eu/info/sites/info/files/business_eco nomy_euro/banking_and_finance/documents/190618-sustainable-finance-teg-reportgreen-bond-standard_en.pdf. 38 See further Chapter 9 of this book by M. Driessen. 39 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97

final (8 March 2018), p. 5. 40 European Commission, June 26, 2020, Study: the use of EU ecolabel criteria on UCITS equity funds, https://ec.europa.eu/info/publications/200626-study-eu-ecolabelcriteria-UCITS_en. The study examines the application of the proposed Ecolabel Criterion 1 to a sample of 100 ‘green’ UCITS equity funds domiciled in the EU to determine the eligibility of these funds for the Ecolabel.

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used to establish whether a PRIIP targets specific environmental or social objectives, pursuant to Article 8(4) of Regulation (EU) No. 1286/2014 on key information documents (KID) for packaged retail and insurancebased investment products (PRIIPs).41 The European Commission has requested this advice assuming that PRIIPs increasingly target specific social or environmental objectives, and not only financial objectives. The European Commission requested the ESAs to consider the processes required to ensure that disclosed environmental or social objectives are effectively met.42 The ESAs provided their advice to the European Commission on 28 July 2017. Although not specifically requested by the European Commission in the context of the development of the Sustainable Finance Disclosure Regulation (SFDR),43 this technical advice also served as input to the formation of the SFDR. On 29 December 2019, the SFDR entered into force and is expected to apply as from 10 March 2021. The SFDR introduces sustainabilityrelated disclosure requirements on financial market participants,44 and financial advisers,45 both at an entity level and at a product level. The

41 ESAs joint technical advice on the procedures used to establish whether a PRIIP targets specific environmental or social objectives pursuant to Article 8 (4) of Regulation (EU) No 1286/2014 on key information documents (KID) for packaged retail and insurance-based investment products (PRIIPs), July 28, 2017, JC 2017 43, https:// esas-joint-committee.europa.eu/Publications/Technical%20Advice/Joint%20Technical% 20Advice%20on%20the%20PRIIPs%20with%20environmental%20or%20social%20objecti ves.pdf. 42 ESAs joint technical advice on the procedures used to establish whether a PRIIP targets specific environmental or social objectives pursuant to Article 8 (4) of Regulation (EU) No 1286/2014 on key information documents (KID) for packaged retail and insurance-based investment products (PRIIPs), https://esas-joint-committee.europa. eu/Publications/Technical%20Advice/Joint%20Technical%20Advice%20on%20the%20P RIIPs%20with%20environmental%20or%20social%20objectives.pdf. 43 In fact, on 20 April 2020, the ESAs launched a specific consultation on draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of the SFDR. 44 As defined in article 2(1) of the SFDR. 45 As defined in article 2(11) of the SFDR. This includes financial market partici-

pants providing investment or insurance advice, as well as (e.g.) insurance intermediaries providing advice regarding insurance based investment products (IBIPs).

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SFDR distinguishes between disclosures regarding sustainability risks 46 and those concerning sustainability factors,47 and distinguishes between regular financial products, financial products that promote, among other characteristics, environmental or social characteristics, and financial products that have sustainable investment as their objective.48

2.5

Fostering Investments in Sustainable Projects

The third concrete action included in the Action Plan concerns fostering investment in sustainable projects. The Commission explains that mobilising private capital for sustainable projects, especially for infrastructure, is a prerequisite for the transition to a more sustainable economic model. According to the OECD, infrastructure contributes to about 60% of greenhouse gas emissions.49 Given the needs for sustainable infrastructure investment, continued progress in developing appropriate frameworks to leverage private investment alongside public funds is considered key by the Commission. The capacity to develop and implement projects, however, varies widely across the EU and between sectors. According to the Commission, greater advisory and technical assistance would contribute to a larger pipeline of sustainable projects.50 Beyond large-scale infrastructure projects, the clean energy transition also requires adequate finance available for smaller-scale, distributed projects. The Commission explains that this concerns particularly energy efficiency improvements, for example in buildings, and deployment of renewable energy. The Commission has proposed actions that stimulate such investments as part of the clean energy for all Europeans package.51

46 This means an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment (article 2(2) SFDR). 47 This means environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters (article 2(24) SFDR). 48 The Sustainable Finance Disclosure Regulation is discussed in more detail in Chapter 11 of this book by D. Busch. 49 OECD, Investing in Climate, Investing and Growth, 2017. 50 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97

final (8 March 2018), p. 5. 51 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 5 and footnote 22.

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In addition to grants (such as the Connecting Europe Facility), as part of the Investment Plan for Europe, the Commission claims that it has significantly boosted its financial and technical support for sustainable infrastructure investment, in particular through the European Fund for Strategic Investments (EFSI) and the European Investment Advisory Hub. As of February 2018, the EFSI has proven to be instrumental in crowding in private investment for strategic projects across the EU, mobilising almost EUR 265 billion in total investments.52 Following its successful first years of operation, the EFSI has been recently extended until 2020 (EFSI 2.0) and its investment target has been raised to half a trillion euros. In addition, the EFSI 2.0 will focus even more on sustainable projects, with at least 40% of EFSI financing for infrastructure and innovation to support climate action projects. The European Investment Advisory Hub, the EU’s gateway for investment support, will also provide greater advisory capacity at regional and local level to promote projects with a climate, environmental and social impact.53 The Commission explains that in parallel, the roll-out of the EU External Investment Plan (EIP) will encourage sustainable investments in partner countries, starting from Africa and the EU Neighbourhood. The EIP is expected to leverage more than e44 billion of investments by 2020, by mobilising public and private finance through the European Fund for Sustainable Development (EFSD), providing technical assistance on investment projects, and fostering a favourable investment climate and business environment. Sustainable development is integrated into the design of the instrument and all projects will have a clear sustainability dimension, for example by supporting sustainable agriculture and connectivity, as well as the creation of jobs.54 For the post-2020 multiannual financial framework, the Commission has come forward with the idea of establishing a single investment fund integrating all EU market-based instruments to further increase the efficiency of EU investment support for discussion by the European Union’s 52 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), pp. 5–6 and footnotes 23 and 24. 53 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 6. 54 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 6.

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Leaders.55 Building on the successful roll-out of the EFSI, such a fund could provide financial support and related technical assistance to crowd in private investment, including for sustainable infrastructure. Backed by an EU budgetary guarantee, a single investment fund could support investment priorities and simplify interaction between investors, beneficiaries, the EU Commission, implementing partners, like the European Investment Bank (EIB) and national promotional banks, and potential new partners, such as foundations and philanthropic organisations. As a continuation of the European Investment Advisory Hub, such support could also include a project development assistance component to continue to build more capacity for developing sustainable projects.56 Finally, as already mentioned in the introduction, there is the European Green Deal Investment Plan (EGDIP or SEIP57 ), which is the investment pillar of the Green Deal. The objectives of the Investment Plan are threefold: (1) it will increase funding for the transition, and mobilise at least e1 trillion to support sustainable investments over the next decade through the EU budget and associated instruments, in particular InvestEU; (2) it will create an enabling framework for private investors and the public sector to facilitate sustainable investments; and (3) it will provide support to public administrations and project promoters in identifying, structuring and executing sustainable projects.58

2.6 Incorporating Sustainability When Providing Financial Advice The fourth concrete action included in the Action Plan concerns the incorporation of sustainability when providing advice.59 By providing

55 Communication from the Commission “A new, modern Multiannual Financial Framework for a European Union that delivers efficiently on its priorities post-2020”—The European Commission’s contribution to the Informal Leaders’ meeting on 23 February 2018. 56 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 6. 57 Sustainable Europe Investment Plan. 58 European Commission, The European Green Deal Investment Plan and Just Tran-

sition Mechanism explained, January 14, 2020, https://ec.europa.eu/commission/pressc orner/detail/en/qanda_20_24. 59 See further Chapter 12 of this book by V. Colaert.

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advice, investment firms and insurance distributors (including insurers that offer products directly) can play a central role in reorienting the financial system towards sustainability. Prior to the advisory process, these intermediaries and distributors are required to assess clients’ investment objectives and risk tolerance in order to recommend suitable financial instruments or insurance products. However, according to the European Commission, investors’ and beneficiaries’ preferences as regards sustainability are often not sufficiently taken into account when advice is given. The Markets in Financial Instruments Directive (MiFID II) and the Insurance Distribution Directive (IDD) require investment firms and insurance distributors to offer ‘suitable’ products to meet their clients’ needs, when offering advice. For this reason, the Commission proposes that those firms should ask about their clients’ preferences (such as environmental, social and governance factors) and take them into account when assessing the range of financial instruments and insurance products to be recommended, i.e. in the product selection process and suitability assessment.60 In view of the above, the Commission has launched a consultation to assess how best to include ESG considerations into the advice that investment firms and insurance distributors offer to individual clients. The aim is to amend delegated acts under MiFID II and IDD (with respect to investment-based insurance products).61 Based on these delegated acts, the Commission has invited the European Securities Markets Authority (ESMA) to include provisions on sustainability preferences in

60 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), pp. 6–7. 61 Commission Delegated Regulation (EU) …/… of XXX, amending Delegated Regulation (EU) 2017/2359 with regard to environmental, social and governance preferences in the distribution of insurance-based investment products, Ref. Ares(2018)2681527— 24/05/2018, and Commission Delegated Regulation (EU) …/… of XXX amending Regulation (EU) 2017/565 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, Ref. Ares(2018)2681500—24/05/2018.

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its MiFID guidelines on the suitability assessment.62 Accordingly, ESMA has included a good practice to that end in its guidelines on suitability.63 Furthermore, the European Commission has invited the European Insurance and Occupational Pensions Authority (EIOPA) and ESMA to provide technical advice with regard to the integration of sustainability risks and sustainability factors, in particular on potential delegated acts under articles 25(2) (product governance and governance requirements) and 28(4) IDD and articles 16(12), 23(4) and 24(13) MiFID II.64 EIOPA has held a consultation on its draft technical advice between 28 November 2018 and 30 January 2019: EIOPA Consultation Paper on Technical Advice on the integration of sustainability risks and factors in the delegated acts under Solvency II and IDD. ESMA had held a comparable consultation between 19 December 2018 and 19 February 2019 on integrating sustainability risks and factors in MiFID II. This has led to a technical advice by ESMA and EIOPA to the European Commission, both dated 30 April 2019.65 As per the date of the finalisation of this chapter, this has not yet resulted in formal changes to MiFID and IDD.

2.7

Sustainability Benchmarks

The fifth concrete action included in the Action Plan concerns the development of sustainability benchmarks. Benchmarks are indices that play a central role in the price formation of financial instruments and other relevant assets in the financial system. Benchmarks are useful instruments for investors, as they allow to track and measure performance and allocate assets accordingly. Traditional benchmarks reflect the status quo and their methodologies, as a result, reflect sustainability goals only to a limited degree. As such, they are not appropriate to measure the performance of sustainable investments. The Commission explains that in response, index providers have been developing ESG benchmarks to capture sustainability goals, but that the lack of transparency regarding their methodologies has affected their reliability. More transparent and sounder sustainable 62 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 7. 63 ESMA, Final Report Guidelines on certain aspects of the MiFID II suitability requirements, May, 28, 2018, ESMA35-43-869, pp. 5–6. 64 Available at www.eiopa.europa.eu. 65 ESMA 35-43-1737 and EIOPA-BoS-19/172 respectively.

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indices’ methodologies are needed to reduce greenwashing risks (i.e. the use of marketing to portray an organisation’s products, activities or policies as environmentally friendly when they are not). For instance, a sound methodology for low-carbon indices should reflect compatibility with the objectives of the Paris Agreement, in order to improve the performance assessment of low-carbon funds.66 Against this backdrop, the Commission has published on 24 May 2018 a proposal for a Regulation amending Regulation (EU) 2016/1011 on low-carbon benchmarks and positive-carbon impact benchmarks, which has subsequently resulted in the adoption, on 27 November 2019, of a Regulation67 amending the EU Benchmarks Regulation68 as regards EU climate transition benchmarks, EU Paris-aligned Benchmarks and sustainability-related disclosures for benchmarks. This Regulation was published in the Official Journal on 9 December 2019 and entered into application on 30 April 2020.69 The rules create a new category of benchmarks, comprising (1) the low-carbon benchmark or ‘decarbonised’ version of standard indices, and (2) the positive-carbon impact benchmark. This new market standard should reflect companies’ carbon footprint and give investors greater information on an investment portfolio’s carbon footprint. While the low-carbon benchmark would be based on a standard ‘decarbonising’ benchmark, the positive-carbon impact benchmark would allow an investment portfolio to be better aligned with the Paris Agreement objective of limiting global warming to below 2° C.70

66 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 7. 67 (EU) 2019/2089. 68 (EU) 2016/1011. 69 See further Chapter 9 of this book by M. Driessen. 70 Proposal for a Regulation of the European Parliament and of the Council amending

Regulation (EU) 2016/1011 on low-carbon benchmarks and positive carbon impact benchmarks, COM(2018) 355 final (24 May 2018).

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Better Integrating Sustainability in Ratings and Market Research

The sixth concrete action included in the Action Plan concerns the better integration of sustainability in ratings and market research. The Commission explains that in recent years, market research providers and sustainability rating agencies have stepped up their efforts to assess companies’ environmental, social and governance performance and their ability to manage sustainability risks. Such assessments may indeed contribute to a more sustainable allocation of capital and improve the information flow between issuers and investors. The lack of broadly accepted market standards to assess companies’ sustainability performance makes the transparency of the methodology used by research providers particularly important. Additionally, some stakeholders argue that the focus of sustainability research providers on very large issuers has a negative impact on the attractiveness of smaller issuers for institutional investors.71 Credit ratings are also an important element of well-functioning financial markets, as they provide investors with assessments of the creditworthiness of companies and public institutions. Credit rating agencies operate in a highly concentrated market and adopt their credit ratings based on the relevant available information. However, it remains unclear to what extent sustainability factors are being considered. The Commission is monitoring developments in the credit rating market and acknowledges the need for greater understanding of and transparency about how credit rating agencies take sustainability factors into account. The Commission will invite ESMA to promote solutions which would ensure that credit rating agencies fully integrate sustainability and longterm risks. The Commission will also continue engaging on those issues with all relevant stakeholders, including as regards the possible emergence of new credit rating agencies that would meet this objective.72 Since mid-2018, the Commission has been engaged with all relevant stakeholders to explore the merits of amending the Credit Rating

71 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 7. 72 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), pp. 7–8.

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Agency Regulation to mandate credit rating agencies to explicitly integrate sustainability factors into their assessments in a proportionate way to preserve market access for smaller players.73 To strengthen disclosure on how ESG factors are being considered, ESMA updated its guidelines on disclosure requirements for credit ratings in July 201974 and has started checking how credit rating agencies apply these new guidelines in April 2020. Moreover, in December 2019, the Commission launched a study on sustainability ratings and research that explores the types of products that are provided in for ratings and market research, the main players, data sourcing, transparency of methodologies and potential shortcomings in the market. The study is expected to be completed by the Summer 2020. Furthermore, the Commission invited ESMA to: (1) assess current practices in the credit rating market by mid-2019, analysing the extent to which environmental, social and governance considerations are taken into account; (2) include environmental and social sustainability information in its guidelines on disclosure for credit rating agencies by mid-2019 and consider additional guidelines or measures, where necessary.75 In July 2019 ESMA published its technical advice on these matters.76

2.9 Clarifying Institutional Investors’ and Asset Managers’ Duties The seventh concrete action included in the Action Plan concerns the clarification of institutional investor’s and asset manager’s duties. As the Commission explains, several pieces of EU legislation (including Solvency

73 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 8. 74 Final Report: ESMA Guidelines on Disclosure Requirements Applicable to Credit Ratings, July 18, 2019. ESMA33-9-320 https://www.esma.europa.eu/sites/default/ files/library/esma33-9-320_final_report_guidelines_on_disclosure_requirements_applic able_to_credit_rating_agencies.pdf. 75 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 8. 76 ESMA, Technical Advice to the European Commission on Sustainability Considerations in the credit rating market (18 July 2019) (ESMA 33-9321) (https://www.esma.europa.eu/press-news/esma-news/esma-advises-credit-rating-sus tainability-issues-and-sets-disclosure).

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II, IORP II, UCITS, AIFMD, IDD and MiFID II) require institutional investors, advisors and asset managers to act in the best interest of their end-investors/beneficiaries. This is commonly referred to as ‘fiduciary duty’.77 In the context of the project ‘Fiduciary Duty in the 21st Century’,78 significant work is also undertaken at global level from the starting point that there are positive duties to integrate environmental, social and governance factors in the investment processes.79 However, current EU rules on the duty of institutional investors and asset managers to consider sustainability factors and risks in the investment decision process are neither sufficiently clear nor consistent across sectors. According to the Commission, evidence suggests that institutional investors and asset managers still do not systematically consider sustainability factors and risks in the investment process. Also, institutional investors and asset managers do not sufficiently disclose to their clients if and how they consider these sustainability factors in their decisionmaking. End-investors may, therefore, not receive the full information they need, should they want to take into account sustainability-related issues in their investment decisions. As a result, investors do not sufficiently take into account the impact of sustainability risks when assessing the performance of their investments over time.80 In view of the above, the Sustainable Finance Disclosure Regulation (SFDR) entered into force on 29 December 2019 and will apply as from 10 March 2021.81 The SFDR aims to introduce consistency and clarity on how institutional investors, such as asset managers, insurance companies, pension funds, insurance intermediaries which provide insurance advice and investment advisors should integrate environmental, social and governance (ESG) factors in their investment decision-making process or advisory process. The primary purpose of the Regulation is to provide 77 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 8. 78 www.fiduciaryduty21.org. 79 This project has three components: (i) work to develop and publish a global state-

ment on investors’ obligations and duties; (ii) publishing roadmaps on the policy changes required to achieve full ESG integration in investment practices across eight countries; (iii) extending research into investor’s obligations and duties to six Asian markets. 80 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 8. 81 About the SFDR, see further Chapter 11 of this book by D. Busch.

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harmonised rules on the transparency that these market participants have to apply with respect to the integration of sustainability risks in these activities or with respect to financial products that have as their targets sustainable investments, including the reduction of carbon emissions.82 Exact requirements will be further specified through delegated acts, which will be adopted by the Commission at a later stage. Interestingly, the feedback statement accompanying the initial proposal suggests that the majority of the respondents already takes into account sustainability factors in their investment decisions due to related national legal requirements or related soft law provisions (e.g. UN Global Compact, Human Rights). In addition, respondents from various member states also referred to national disclosure requirements or practices (e.g. in France, Italy and Germany).83 Apparently, this has also been a reason for the European Commission to maintain the application date of the SFDR as per 10 March 2021, and only postpone the level 2 measures. According to the Commission, because numerous financial market participants already comply with the non-financial reporting requirements under Directive 2013/34/EU or adhere to international standards and might consider using that information for compliance with the level 1 requirements of the SFDR. Even without the full regulatory technical standards, the Commission considers that there are no impediments to financial market participants and financial advisers complying with the level 1 requirements laid down in the Regulation.84

82 Proposal for a Regulation of the European Parliament and of the Council on disclosures relating to sustainable investments and sustainability risks and amending Directive (EU) 2016/2341, COM(2018) 354 final (24 May 2018). 83 Feedback Statement, Public Consultation on Institutional Investors’ and Asset Managers’. Duties regarding Sustainability page 23, https://ec.europa.eu/info/files/ 2017-investors-duties-sustainability-feedback-statement_en, May 24, 2018. 84 Letter of the European Commission to the three European Supervisory Authorities, dated October 20, 2020, application of Regulation (EU) 2019/2088 on the sustainabilityrelated disclosures in the financial services sector, https://www.esma.europa.eu/sites/def ault/files/library/eba_bs_2020_633_letter_to_the_esas_on_sfdr.pdf.

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2.10 Incorporating Sustainability in Prudential Requirements The eighth concrete action included in the Action Plan concerns the incorporation of sustainability in prudential requirements. As the Commission explains, banks, insurance companies and pension funds are the main source of external finance for the European economy and an important channel of savings for investments. As a result, they could provide the critical mass of investments needed to close the gap for the transition to a more sustainable economy.85 However, banks, insurance companies and pension funds may also be exposed to risks related to unsustainable economic development. According to the Commission, some estimates suggest that at least half of the assets of banks in the Euro area are currently exposed to climate change-related risks. Such risks for financial stability have also been flagged by macroprudential supervisors. According to the Commission this calls for a better reflection of risks associated with climate and other environmental factors in prudential regulation with a careful calibration that would not jeopardise the credibility and effectiveness of the current EU prudential framework and its risk-based nature.86 On 1 August 2018, EIOPA and ESMA received a formal request from the Commission to provide technical advice supplementing the initial package of proposals and to assist the Commission on potential amendments to, or introduction of, delegated acts under various sectoral directives with regard to the integration of sustainability risks and sustainability factors. Both EIOPA and ESMA submitted technical advice to the

85 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 9. 86 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 9.

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European Commission on 30 April 2019.87 Furthermore, EIOPA issued an opinion on sustainability within Solvency II on 30 September 2019.88 Building on the development of the EU sustainability taxonomy (see Sect. 2.3 above), the Commission committed to assess whether more appropriate capital requirements could be adopted to better reflect the risk of sustainable assets held by banks and insurance companies, with a careful calibration that would not jeopardise the credibility and effectiveness of the current EU prudential framework and its risk-based nature. Such a supporting factor would need to be progressively phased in, as the EU taxonomy develops. Also, when establishing and updating technical screening criteria for environmentally sustainable activities, the Commission should assess whether the establishment of those criteria would give rise to stranded assets or would result in inconsistent incentives, or would have any other adverse impact on financial markets.89 For instance, in its calibration, the Commission will consider all the available evidence on the link between energy efficiency savings and mortgage loan performance. Moreover, in its analysis of the Basel recommendations of December 2017, the Commission will pay particular attention to the possible negative impact on European bank lending, investment and other activities, which are critical for sustainable finance.90 Against this backdrop, the Commission committed to explore the feasibility of the inclusion of risks associated with climate and other environmental factors in institutions’ risk management policies and the potential calibration of capital requirements of banks as part of the Capital Requirement Regulation (CRR) and the Capital Requirements Directive

87 ESMA’s technical advice to the European Commission on integrating sustainability risks and factors in MiFID II, Final Report (ESMA 35-43-1737), April 30, 2019, https://www.esma.europa.eu/sites/default/files/library/esma35-431737_final_report_on_integrating_sustainability_risks_and_factors_in_the_mifid_ii.pdf and EIOPA’s Technical Advice on the integration of sustainability risks and factors in the delegated acts under Solvency II and IDD (EIOPA-BoS-19/172), April 30, 2019, https://register.eiopa.europa.eu/Publications/EIOPA-BoS-19-172_Final_Rep ort_Technical_advice_for_the_integration_of_sustainability_risks_and_factors.pdf. 88 EIOPA Opinion on Sustainability within Solvency II EIOPA-BoS-19/241, September 30, 2019, https://register.eiopa.europa.eu/Publications/Opinions/2019-09-30%20Opin ionSustainabilityWithinSolvencyII.pdf. 89 Recital 46 of the Taxonomy Regulation. 90 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97

final (8 March 2018), p. 9.

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IV (CRD IV). The aim would be to take into account such factors, where this is justified from a risk perspective, to safeguard the coherence and effectiveness of the prudential framework and financial stability.91 Any recalibration of capital requirements, based on data and the assessment of the prudential risk of banks’ exposures, would need to rely on and be coherent with the future EU taxonomy on sustainable activities (see Sect. 2.3 above).92 On 6 December 2019, the European Banking Authority (EBA) has published its action plan on sustainable finance, which includes a roadmap with the mandates and key milestones within EBA’s remit. In accordance with the EBA Founding Regulation, it has to take into account sustainable business models and the integration of ESG factors. Furthermore, EBA should also develop a monitoring system to assess material ESG risks, taking into account the Paris Agreement, as well as assess the effect of economic scenarios on a credit institutions’ or investment firms’ financial position, including risks from adverse environmental developments. EBA refers to a provision in the EBA Founding Regulation93 for the reflection of potential environmental-related systemic risk to be reflected in the stress-testing regime. The EBA should develop common methodologies assessing the effect of economic scenarios on an institution’s financial position taking into account, inter alia, risks stemming from adverse environmental developments and the impact of transition risk stemming from environmental policy changes. Furthermore, CRD V94 also requires from the EBA to develop appropriate qualitative and quantitative criteria, such as stress-testing processes and scenario analyses, to assess the impact of ESG risks under scenarios with different severities. EBA aims to develop a dedicated climate change stress test with the main objective of identifying banks’ vulnerabilities 91 Similarly, for insurers, EIOPA is of the opinion that within a risk-based framework like Solvency II any change to capital requirements must be based on a proven risk differential compared to the status quo. Assessment of the underlying risk is therefore also the starting point and guiding principle for the analysis and opinion on capital requirements related to sustainability: EIOPA Opinion on Sustainability within Solvency II EIOPA-BoS-19/241, September 30, 2019, paragraph 4.23. https://register.eiopa.europa.eu/Publications/Opi nions/2019-09-30%20OpinionSustainabilityWithinSolvencyII.pdf. 92 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 9. 93 Article 23 EBA Regulation (Identification and measurement of systemic risk). 94 Article 98 CRD V.

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to climate-related risk and quantifying the relevance of the exposures that could be potentially hit by physical risk and transition risk. Since climate risk stress-testing frameworks are developing, there are multiple constraints on designing a robust framework.95 In the first half of 2020, EBA has held a consultation on a discussion paper on a future stress test methodology. In addition, EBA will provide guidance to banks and supervisors regarding banks’ own stress testing.96 Also, the CRD V/CRR 2 package contains three mandates for EBA on sustainable finance. The first mandate 97 relates to the potential inclusion of ESG risks in the supervisory review and evaluation process performed by competent authorities. To that end, the EBA’s assessment must comprise, inter alia: (1) the development of a uniform definition of ESG risks including physical risks and transition risks; (2) the development of criteria for understanding the impact of ESG risks on the financial stability of institutions in the short, medium and long terms; (3) the arrangements, processes, mechanisms and strategies to be implemented by the institutions to identify, assess and manage these risks; and (4) the analysis methods and tools to assess the impact of ESG risks on lending and the financial intermediation activities of institutions. EBA should submit a report on its findings to the Commission, the European Parliament and to the Council by 28 June 2021. The second mandate 98 relates to the disclosure of information on ESG risks, physical and transition risks by large listed institutions. EBA shall develop technical standards implementing the disclosure requirements included in Part 8 of CRR 2.99

95 EBA Discussion Paper on the future changes to the EU-wide stress test (EBA/DP/2020/0; January 26, 2020, https://eba.europa.eu/calendar/discussion-paperfuture-changes-eu-wide-stress-test). 96 EBA Discussion paper On management and supervision of ESG risks for credit institutions and investment firms, October 30, 2020, https://eba.europa.eu/sites/def ault/documents/files/document_library/Publications/Discussions/2021/Discussion% 20Paper%20on%20management%20and%20supervision%20of%20ESG%20risks%20for%20c redit%20institutions%20and%20investment%20firms/935496/2020-11-02%20%20ESG% 20Discussion%20Paper.pdf. 97 Article 98 (8) CRD V. 98 Article 434a CRR 2. 99 Including article 449a CRR 2 on ESG risks.

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The third mandate 100 requires EBA to assess whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified (as a component of Pillar 1 capital requirements). In particular, the EBA must assess: (1) methodologies for the assessment of the effective riskiness of exposures related to assets and activities associated substantially with environmental and/or social objectives compared with the riskiness of other exposures; (2) the development of appropriate criteria for the assessment of physical risks and transition risks; and (3) the potential effects of a dedicated prudential treatment of exposures associated substantially with environmental and/or social objectives and activities on financial stability and bank lending in the Union. The final EBA report on classification and prudential treatment of assets from a sustainability perspective should be ready by 28 June 2025.101 Similar mandates are included in the IFR/IFD framework, to report on the introduction of technical criteria related to exposures to activities associated substantially with ESG objectives for the supervisory review and evaluation process of risks, with a view to assessing the possible sources and effects of such risks on investment firms102 and to report on its findings of whether a dedicated prudential treatment of assets exposed to activities associated substantially with environmental or social objectives, in the form of adjusted K-factors or adjusted K-factor coefficients, would be justified from a prudential perspective.103 In addition to the activities of EBA, on 27 November the ECB has published a guide on climate-related and environmental risks following a public consultation.104 The guide explains how the ECB expects banks to prudently manage and transparently disclose such risks under current prudential rules.

100 Article 501c of CRR 2. 101 Article 501c CRR 2. 102 Article 35 of the IFD. 103 Article 32a of the IFR. 104 European Central Bank, November 2020, Guide on climate-related and environmental risks Supervisory expectations relating to risk management and disclosure: https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.202011finalguideon climate-relatedandenvironmentalrisks~58213f6564.en.pdf.

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The ECB will now follow up with banks in two concrete steps. In early 2021 it will ask banks to conduct a self-assessment in the light of the supervisory expectations outlined in the guide and to draw up action plans on that basis. The ECB will then benchmark the banks’ self-assessments and plans, and challenge them in the supervisory dialogue. In 2022 it will conduct a full supervisory review of banks’ practices and take concrete follow-up measures where needed. In line with the growing importance of climate change for the economy and increasing evidence of its financial impact on banks, the ECB will conduct its next supervisory stress test in 2022 on climate-related risks. Further details will be provided in the course of 2021. For the financial sector more broadly, the Joint Committee of the three ESAs has also highlighted that climate change and the transition to a lower-carbon economy are relatively new, emerging risks for large parts of the financial sector. The ESAs point out that, while climate risk is receiving increased attention among supervisors, our knowledge about the impact of these risks on the financial sector is still relatively limited. In their 2018 report on risks and vulnerabilities in the financial sector,105 the ESAs point out that, while the transition to a lowercarbon economy also provides new opportunities in the area of sustainable finance, financial institution should be wary of new risks that may emerge, such as green bubbles and reputation damage resulting from greenwashing. Going forward, according to the ESAs, financial institutions should be encouraged to take a more forward-looking approach to include sustainability risk in their governance and risk management frameworks, and to develop responsible, sustainable financial products. In addition, competent authorities should enhance their analysis of potential risks related to climate change for the financial sector and financial stability. This also involves a stronger engagement of the ESAs in the area of climate change risks.

105 European Supervisory Authorities’ Joint Committee Report on risks and vulnerabilities in the EU Financial System, Autumn 2019: https://esas-joint-committee.europa.eu/ Publications/Reports/Joint%20Committee%20Risk%20Report.pdf.

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In their 2019 report,106 the ESAs further elaborate on this point. European supervisory authorities and financial institutions should continue the work on identifying exposures to climate-related risks and facilitate access to sustainable assets for investors wanting to invest in the transition to a low-carbon emission economy. As a starting point, the development of a taxonomy of green activities, as is currently being undertaken by the European Commission, can enable capital markets to identify and respond to investment opportunities that contribute to environmental policy objectives. Scenario analysis and stress testing are important tools which can be set in by supervisors to identify risks to the financial sector, with a goal to incorporate sustainability considerations into risk assessment and risk analysis. This should help the supervisory authorities to assess to which extent the build-up of buffers accounting for these risks is needed. The ESAs are currently developing these tools. Financial institutions should incorporate climate risk (and other environmental, social and governance (ESG) factors) into their risk management framework and policy decisions, if such risks are relevant, and should play a stewardship role by taking into account the impact of their activities (investment, lending and insuring) on ESG factors. Going forward, the ESAs should take a proactive stance in fulfilling upcoming tasks and mandates on sustainable finance, including on how ESG considerations can be incorporated into the regulatory and supervisory framework of EU financial institutions. In addition, on 24 July 2018 the Commission issued a formal request to EIOPA and ESMA to provide an opinion with regard to the integration of sustainability risks and sustainability factors, in the UCITS directive, the AIFMD, MiFID II, Solvency II and IDD in the decisions taken and applied by market participants subject to these rules.107 As a follow-up,

106 European Supervisory Authorities’ Joint Committee Report on risks and vulnerabilities in the EU Financial System, Autumn 2019, September 26, 2019, https://esasjoint-committee.europa.eu/Publications/Reports/Joint%20Committee%20Autumn%202 019%20Risk%20Report.pdf. 107 In the period between 12 September 2018 and 3 October 2018, EIOPA has held an online survey for the Call for Advice from the European Commission on potential amendment to the delegated acts under the Insurance Distribution Directive (IDD) and the Solvency II Directive (SII) with regard to the integration of sustainability risks and sustainability factors. EIOPA indicates that, in view of the novelty of the topic, it would like to involve market participants and stakeholders at an early stage seeking their input to build up a suitable ‘evidence base’ for the thorough

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EIOPA has held a consultation on its draft technical advice between 28 November 2018 and 30 January 2019.108 ESMA had held a comparable consultation between 19 December 2018 and 19 February 2019 on integrating sustainability risks and factors in MiFID II. This has led to a technical advice by ESMA and EIOPA to the European Commission, both dated 30 April 2019.109 As mentioned before, EIOPA has also issued an opinion on sustainability within Solvency II on 30 September 2019.110 As a follow-up of the EIOPA opinion, EIOPA published a consultation on the use of climate change risk scenarios in the Own Risk and Solvency Assessment (ORSA) in the form of a draft supervisory Opinion on 5 October 2020111 and on 2 December 2020, a discussion paper on a methodology for the potential inclusion of climate change in the Solvency II standard formula when calculating natural catastrophe underwriting risk.112 The draft Application Paper provides background and guidance on how the IAIS supervisory material can be used to manage the challenges and opportunities arising from climate-related risks. On 16 December 2020, EIOPA published its sensitivity analysis of climate change-related transition risks in the investment portfolio of European insurers. The results still illustrate that losses on equity investments in the high-carbon sector can be high, in particular driven by investments in fossil fuel extraction, especially oil and gas. While EIOPA acknowledges that the overall impact on the balance sheets of the insurance sector is counter-balanced both by investments in renewable energy and the fact that insurers’ portfolios are generally well diversified, EIOPA

development of robust policy recommendations, which will be consulted on at a later stage. https://eiopa.europa.eu/Pages/Surveys/Online-survey-on-the-integration-of-sustai nability-risks-and-sustainability-factors--in-the-delegated-acts.aspx. 108 EIOPA Consultation Paper on Technical Advice on the integration of sustainability risks and factors in the delegated acts under Solvency II and IDD. 109 ESMA 35-43-1737 and EIOPA-BoS-19/172, respectively. 110 EIOPA-BoS-19/241. 111 https://www.eiopa.europa.eu/content/eiopa-consults-supervision-use-climate-cha nge-scenarios-orsa. 112 https://www.eiopa.europa.eu/content/eiopa-launches-discussion-paper-method ology-integrating-climate-change-standard-formula.

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is working with national supervisors and expects insurers to follow up on the risks identified.113 At international level, to support supervisors in their efforts to integrate climate-related risks into supervisory frameworks, the IAIS has developed a draft Application Paper on the Supervision of Climate-related Risks in the Insurance Sector. The Paper was developed jointly with the Sustainable Insurance Forum (SIF), a leadership group of insurance supervisors convened by the United Nations Environment Programme (UNEP).114 This work at the international level coincides to a large extent with the work of EIOPA in this area. Another area with respect to insurance and sustainability that EIOPA is active on is the availability of insurance and the impact of climate risk. Non-life undertakings tend not to include climate-related risks in their pricing methodology, because the short-term nature of non-life contracts allows them to re-price annually. However, given that climate-related losses are expected to grow meaning premiums would likely increase, there is the risk that insurance coverage becomes unaffordable or unavailable to policyholders. This is also referred to as the protection gap. In a recent discussion paper EIOPA highlights challenges associated with current non-life underwriting practices and options to ensure the availability and affordability of insurance products, in the context of climate change.115 According to EIOPA, the insurance sector can address this potential protection gap not only by transferring and pooling risk, but also by implementing the concept of impact underwriting. Interestingly, for the insurance sector, IAIS mentions liability risks as one of the risks relating to climate change, that may be relevant to the insurance sector. This includes the risk of climate-related claims under 113 EIOPA sensitivity analysis of climate-change related transition risks, December 15, 2020, https://www.eiopa.europa.eu/content/sensitivity-analysis-of-climate-change-rel ated-transition-risks-eiopa%E2%80%99s-first-assessment. 114 IAIS, October 13, 2020, Public Consultation: Draft Application Paper on the Supervision of Climate-related Risks in the Insurance Sector https://www.iaisweb. org/page/consultations/current-consultations/application-paper-on-the-supervision-of-cli mate-related-risks-in-the-insurance-sector/. 115 EIOPA, December 2, 2020, discussion paper on a methodology for the potential inclusion of climate change in the Solvency II standard formula when calculating natural catastrophe underwriting risk: https://www.eiopa.europa.eu/content/eiopa-launches-dis cussion-paper-methodology-integrating-climate-change-standard-formula.

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liability policies, as well as direct claims against insurers for failing to manage climate risks.

2.11 Strengthening Sustainability Disclosure and Accounting Rule-Making The ninth concrete action included in the Action Plan concerns the strengthening of sustainability disclosure and accounting rule-making. Corporate reporting on sustainability issues enables investors and stakeholders to assess companies’ long-term value creation and their sustainability risk exposure. Since 2018, the EU Directive on the disclosure of Non-Financial Information (NFRD) requires large public interest entities to disclose material information on key environmental, social and governance aspects and how risks stemming from them are managed. The NFRD allows companies to report sustainability information in a flexible manner.116 Going forward, the Commission seeks to strike an appropriate balance between flexibility and the standardisation of disclosure necessary to generate the data needed for investment decisions. In terms of disclosure by the financial sector, the Commission argues that there is merit in enhancing transparency of asset managers and institutional investors, including the way in which they consider sustainability risks and their exposures to climate-related risks.117 Against this backdrop, the Commission has undertaken a fitness check of EU legislation on public corporate reporting, including the NFRD, to assess whether public reporting requirements for listed and non-listed companies are fit for purpose, including an evaluation of sustainability reporting requirements and the prospects for digitalised reporting.118 The Commission indicated that it would also evaluate relevant aspects of the International Accounting Standards Regulation and explore how the adoption process of IFRSs can allow for specific adjustments to standards where they are not conducive to the European public good, e.g. 116 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), pp. 9–10. 117 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 10. 118 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 10.

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where the standards could pose an obstacle to long-term investment objectives.119 The conclusions of the fitness check were published in November 2019.120 According to the Commission, supervisory reporting rules have been effective in delivering the necessary data. However, the assessment also shows that reporting is not as efficient as it could be. There are inconsistencies between reporting rules, which do not only increase the administrative burden for financial institutions and other market participants but also reduce the quality and usability of the data for supervisors. Additionally, the recent trend towards data-driven supervision and advances in big data technologies will require more high-quality and granular data going forward. The Commission highlights that targeted improvements are already under way—and in some cases have already been completed—as part of sectoral reviews of EU legislation and other initiatives. The fitness check also highlights the need for a comprehensive approach by the Commission, together with the relevant stakeholders, to further streamline the requirements and develop supervisory reporting that is fit for the future. This will require improvements in different areas, including: the legislative process for setting reporting rules; the review and justification of the data needs and uses by supervisors; consistency and harmonisation, including common terminology, data standards, formats and identifiers; governance, coordination and cooperation between the authorities, also when it comes to data re-use and data sharing; and the use of technological solutions for regulation and supervision.121 Furthermore, in 2018, a European Corporate Reporting Lab was established as part of the European Financial Reporting Advisory Group (EFRAG), to promote innovation and the development of best practices in corporate reporting, such as environmental accounting. In this forum, companies and investors can share best practices on sustainability

119 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 10. 120 Commission Staff Working Document, Fitness Check of EU Supervisory Reporting Requirements, November 6, 2019, {SWD(2019) 403 final} https://ec.europa.eu/info/ sites/info/files/business_economy_euro/banking_and_finance/documents/191107-fit ness-check-supervisory-reporting-staff-working-paper_en.pdf. 121 European Commission daily news, November 7, 2019, https://ec.europa.eu/com mission/presscorner/detail/en/mex_19_6235.

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reporting, such as the climate-related disclosure in line with the TCFD’s recommendations.122 More recently, in its Communication on the European Green Deal, the Commission committed to review the Non-Financial Reporting Directive, as part of the strategy to strengthen the foundations for sustainable investment. In line with that commitment, the European Commission held a public consultation between 20 February 2020 and 11 June 2020 on the review of the NFRD. According to the revised Commission Work Programme for 2020, the Commission now expects to adopt a proposal regarding the review of the NFRD in the first quarter of 2021. Also in the context of the NFRD, in June 2020, the European Commission has issued a request for technical advice mandating EFRAG to undertake preparatory work for possible EU non-financial reporting standards in a revised Non-Financial Reporting Directive. In addition, EFRAG Board President and European Lab Steering Group Chairman Jean Paul Gauzès was invited to consider the possible need for changes to the governance and financing of EFRAG in the context of the possible development of European non-financial reporting standards.123 One of the questions that is being considered is that, in case EFRAG were entrusted with the development of possible EU nonfinancial reporting standards, its new mission would be different from its present mission of influencing the IASB and providing endorsement advice. In this respect, it is also worthwhile mentioning the developments at international level by the IFRS Foundation, mentioned in paragraph 2. Furthermore, on 18 June 2019, the Commission has revised the guidelines on non-financial information which in practice consisted of a new supplement to the existing guidelines on non-financial reporting, which remain applicable. Building on the metrics to be developed by the Commission Technical Expert Group on sustainable finance, the revised guidelines provide further guidance to companies on how to disclose climate-related information, in line with the Financial Stability Board’s Task Force on Climate-related Financial Disclosure (TCFD) and the 122 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 10. 123 A consultation document was recently published in respect of this request. https:// www.efrag.org/Assets/Download?assetUrl=%2Fsites%2Fwebpublishing%2FProject%20D ocuments%2F2010051124018235%2FJPG%20Ad%20Personam%20Mandate%20-%20% 20Consultation%20%20Document%20-%2030%20Nov%202020.pdf.

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climate-related metrics developed under the new classification system (see Sect. 2.3 above). The guidelines will be amended again in the near future to include other environmental and social factors as well.124 In terms of disclosure by asset managers and institutional investors, as part of the Commission’s legislative proposal in action seven (see Sect. 2.4 above), they would be requested to disclose how they consider sustainability factors in their strategy and investment decision-making process, in particular for their exposures to climate change-related risks.125 In addition, the Commission explains that there are also growing concerns that the current accounting rules are not conducive to sustainable investment decision-making. In particular, the European Parliament’s resolution on International Financial Reporting Standard (IFRS) 9, adopted on 6 October 2016, raised concerns about the impact the new accounting standard on financial instruments (IFRS 9) might have on long-term investments.126 The Commission recognises the importance of ensuring that accounting standards do not directly or indirectly discourage sustainable and long-term investments. In this regard, the Commission feels that consideration is needed about whether there could be more flexibility regarding the endorsement of IFRSs wherever specific adjustments would be more conducive to long-term investment.127 The Commission has requested EFRAG to assess the impact of new or revised IFRSs on sustainable investments and to explore potential alternative accounting treatments to fair value measurement for longterm investment portfolios of equity and equity-type instruments. On 28 November 2018, EFRAG has provided the Commission with its technical advice on possible ways to improve the requirements of IFRS 9 on the accounting for equity instruments from a long-term investment perspective.128 Subsequently, on 30 January 2020, EFRAG delivered technical

124 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 10. 125 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 10. 126 http://www.europarl.europa.eu/oeil-mobile/fiche-procedure/2016/2898(RSP). 127 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 10. 128 https://www.efrag.org/Activities/2010051123028442/Non-financial-reporting-sta ndards.

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advice to the European Commission on the request for technical advice on alternative accounting treatments for long-term equity investments.129

2.12

Fostering Sustainable Corporate Governance and Attenuating Short-Termism in Capital Markets

The tenth and final concrete action included in the Action Plan concerns the fostering of sustainable corporate governance and attenuating shorttermism in capital markets.130 In the view of the Commission, corporate governance can significantly contribute to a more sustainable economy, allowing companies to take the strategic steps necessary to develop new technologies, to strengthen business models and to improve performance. This would in turn improve their risk management practices and competitiveness, thus creating jobs and spurring innovation. The Commission explains that many companies have corporate governance strategies to this end, even if they are not always easily comparable.131 Despite the efforts made by several European companies, undue short-term market pressures may make it difficult to lengthen the time horizon in corporate decision-making. Corporate managers may become overly focused on short-term financial performance and disregard opportunities and risks stemming from environmental and social sustainability considerations. As a consequence, the interactions between capital market pressures and corporate incentives may lead to unnecessary exposure in the long term to sustainability risks. The Commission will engage with all relevant stakeholders to analyse this issue more closely.132 In this context, the three ESAs have been asked to collect evidence of potential undue short-term pressure from capital markets on corporations. The focus is on the time horizon in corporate decision-making and the undue short-term pressures that financial market participants may exert on corporate managers. The

129 https://www.efrag.org/Activities/2010051124018235/Ad-personam-governancemandate. 130 See further Chapter 4 of this book by G. Ferrarini and Chapter 5 by A. Pacces. 131 See further Chapter 6 of this book by M. Siri and S. Zhu. 132 European Commission, Action Plan: Financing Sustainable Growth, COM(2018)

97 final (8 March 2018), p. 11.

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underlying concern is that for companies to consider and address relevant long-term risks and opportunities, such as those related to climate change, and invest in long-term value drivers, short-term pressures from the financial sector could be a problem. The three ESAs published their reports on 18 December 2019.133 This action was reconfirmed in the European Green Deal and the Commission’s Communication on the (COVID-19) Recovery Plan, in which the Commission reiterated the importance of further embedding sustainability into the corporate governance framework. According to the European Commission, sustainability in corporate governance encompasses encouraging businesses to consider environmental (including climate, biodiversity), social, human and economic impact in their business decisions, and to focus on long-term sustainable value creation rather than short-term financial value. Competitive sustainability will contribute to the COVID-19 recovery and to the long-term resilience and development of companies. In this context, the European Commission launched a consultation on 21 October 2020134 to collect stakeholder views on policy options. A Commission proposal for an EU Directive on this specific action is currently foreseen for the second quarter of 2021.

2.13

Concluding Remarks

The actions proposed by the Commission’s Action Plan and analysed in this chapter respond to five broad strategies that can be defined as ‘public incentives’, ‘standardisation’, ‘disclosure’, ‘corporate governance’ and ‘financial regulation’. The first strategy consists of fostering investments through financial and technical support for sustainable infrastructure and other projects.

133 ESMA, Report on undue short-term pressure on corporations, https://www. esma.europa.eu/press-news/esma-news/esma-proposes-strengthened-rules-address-undueshort-termism-in-securities: EBA Report on undue short-term pressure from the financial sector on corporations, https://eba.europa.eu/sites/default/documents/files/document_ library/Final%20EBA%20report%20on%20undue%20short-term%20pressures%20from% 20the%20financial%20sector%20v2_0.pdf; EIOPA: Potential undue short-term pressure from financial markets on corporates: Investigation on European insurance and occupational pension sectors Search for evidence, year-end 2018, https://www.eiopa.europa.eu/ content/potential-undue-short-term-pressure-financial-markets. 134 Ending February 8, 2021.

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In perspective, the European Commission will establish a single investment fund providing support and technical assistance to crowd in private investment. The second strategy includes the establishment of an EU taxonomy of sustainable activities which should help shifting capital flows towards them. It also includes the setting of standards and labels for green financial products, which should enhance the trust in the market of these products and ease investors’ access to them. These two strategies will help establishing well-defined and deep markets in sustainable investments and will work as preconditions to the others. The third strategy covers both corporate disclosure and third party information and assessments. The Non-Financial Disclosure Directive is being reviewed and complemented by other measures, such an impact assessment of IFRS on sustainability, and potentially institutional changes to the roles and functioning of institutions such as the IFRS Foundation and EFRAG, to facilitate the credibility and reliability of non-financial information for users of that information. Sustainability benchmarks have been developed in order to allow investors to track and measure performance and allocate assets accordingly. In addition, credit rating agencies and market research services should integrate sustainability into their assessments. The fourth strategy combines sustainable corporate governance with attenuating short-termism in capital markets, and assumes that boards should develop their own sustainability strategies and act in the company’s long-term interest. Both disclosure and corporate governance are traditional strategies in capital markets regulation and functioning, while their extension to sustainability is a reflection of the new interest of investors and corporate stakeholders for ESG issues in addition to financial performance. The fifth strategy implies at least three types of regulatory reform. First, the Markets in Financial Instruments Directive (MiFID II) and the Insurance Distribution Directive (IDD) should be amended in the sense that investment firms and insurance distributors should consider sustainability issues when offering financial advice. Second, fiduciary duties of asset managers and institutional investors should be clarified so as to include ESG factors in the investment processes. Third, ESG should be incorporated in prudential requirements of financial institutions so that they channel their investments towards a more sustainable economy,

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while reducing the risks deriving from unsustainable economic development and at the same time maintaining credible and effective risk-based prudential frameworks in Europe. These five strategies represent a very ambitious design of the European Commission which will require multiple actions at all levels. These actions generally require regulation and/or supervision often at EU level, but private incentives and cultural developments towards an environmentally sustainable economic system will also be important in furthering the success of the Action Plan.

CHAPTER 3

Sustainable Digital Finance and the Pursuit of Environmental Sustainability Marco Dell’Erba

3.1

Introduction

Technology and sustainability emerged as the two main drivers of development for society in recent years. In the context of economy and finance, these forces are reshaping financial markets, corporate governance, and central banking operations, and the recent pandemic crisis of COVID-19 has further highlighted their importance. Technology and sustainability are penetrating the economy and finance each independently one from the other, and each of them is contributing to the emergence of specific economy paradigms, such as digital finance, decentralized economy and finance, crypto-economy, sustainable economy and finance, green finance and economy. Not only these two forces follow their own paths of development, but they are also intersecting, leading to the emergence of “sustainable digital finance” as a new paradigm which promises to leverage technology for strengthening sustainability in a rather different

M. Dell’Erba (B) New York University School of Law, University of Zurich, Zurich, Switzerland e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_3

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way, in comparison with the previous initiatives. While both technological and sustainable initiatives in finance mostly focused on more “traditional” aspects of sustainability, in particular financial inclusion, sustainable digital finance could also focus on environmental sustainability, contributing to climate change. Adopting this perspective, this book chapter is structured as follows. Section 3.2 provides a brief analysis of the way technology and sustainability developed, ultimately identifying sustainable digital finance as the result of a new paradigm based on both of them. Section 3.3 maps the initiatives at the level of national states and international organizations. Section 3.4 refers to the major disruptive technologies, highlighting their complementarity, and Sect. 3.5 analyzes the way such disruptive technologies may contribute to sustainable digital finance, and the way they may pursue environmental sustainability. Section 3.6 provides some policy consideration, emphasizing the importance to create a sound regulatory framework for technology and sustainability, instead of creating a new regulatory framework for sustainable digital finance. Section 3.7 draws some brief conclusions.

3.2 Technology, Sustainability and the Emergence of Sustainable Digital Finance Since the financial crisis of 2008, technology experienced an exponential growth, with great efforts pursuing theoretical research and practical applications in the area of distributed ledger technology (DLT, and in particular the subtype of blockchain technology), artificial intelligence (AI), Internet of Things (IoT), and big data. All these technologies have the potential or in some cases already proved to be disruptive for different established financial institutions and governments. Via a massive implementation of fintech and corptech innovations, disruptive they might contribute to the emergence of new economic paradigms, such as “decentralized finance”, “crypto-economy”, and more generally enhancing the concept of “digital finance”. These terms have become of common usage, spreading beyond the technical and academic circles, and became of mainstream usage. Digital financing broadly refers to the provision of financial services via digital processes and infrastructures, and characterizes for three main

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aspects.1 First, a major shift in digital finance is data: compared to the past, in this new paradigm data is generally cheaper, more reliable, and abundant.2 Second, in terms of structure digital finance generally attempts to systematically implement a full financial disintermediation, with beneficial consequences at the level of cost-cutting.3 Third, digital finance is a driver for innovation at the level of financial products, private actors, and market structures: the crypto-revolution, peer-to-peer lending, and crowdfunding platforms4 are all examples of these changes, where to the emergence of new business models corresponded the emergence of new market actors, new financial products, that drastically changed traditional market structures. The geography of digital finance is an indicator of the growing interest for it and how this is spreading in different jurisdictions. Such increased attention is a driver for competition among the most established financial centers in the world, in particular New York, Singapore, Hong-Kong, Switzerland, and other outsiders, such as Malta and Estonia, that has a relatively long tradition in innovating even the public sphere with new technologies. Paris is another interesting case, and it is emerging in the map, because of a broad strategy that the French government pursued to implement a friendly approach to technology (the French Autorité des Marchés Financiers was extremely active in the blockchain sphere) and pushing for the adoption of environmentally sustainable practices.* In these new trends, regulation plays a central role in enhancing such competition. Much of the underlying technologies not only proved to be disruptive from a financial and technical standpoint, but they also proved to be “regulatory disruptive”,5 and forced regulators to rethink their traditional regulatory approaches. Those countries with an advanced regulatory approach of technology experienced great benefits, and their respective financial centers are emerging as fintech hubs in the international map. Another example of such is the European Commission’s 1 UN Sustainable Development Group, People’s Money: Harnessing Digitalization to Finance a Sustainable Future, August 2020, https://unsdg.un.org/resources/peoplesmoney-harnessing-digitalization-finance-sustainable-future. 2 UN Sustainable Development Group, People’s Money. 3 UN Sustainable Development Group, People’s Money. 4 UN Sustainable Development Group, People’s Money. 5 See generally Nathan Cortez, “Regulating Disruptive Innovation,” Berkeley Technology Law Journal 29, no. 1 (Spring 2014): 175–228.

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digital finance strategy, supporting the development of digital finance. Here the approach is to set out general lines to support digital finance, which simultaneously will play a key role in the European Green Deal, while at the same time identifying and regulating the main risks involved.6 Almost simultaneously to technology, sustainability has become a hot topic in the agenda of policy-makers and private actors (including investment funds, corporations, and financial institutions), who approached this issue from different angles and with different purposes. Among the most representative initiatives from the past months, the Business Roundtable declaration in 20197 and Blackrock Chairman Larry Fink’s Letter to investors8 announcing the centrality of sustainability for future investment choices have had an important symbolic relevance and contributed to re-open the traditional debate on the role of the corporations within society, stakeholderism, as part of the general role of private actors in building a new paradigm.9 On the side of the international policy agenda, the adoption of the 2030 Agenda for Sustainable Development by all the UN members in 2015 providing seventeen Sustainable Development

6 “Digital Finance Package,” Communication, European Commission, published September 24, 2020, https://ec.europa.eu/info/publications/200924-digital-finance-pro posals_en; “Digital finance Package: Commission sets out new, ambitious approach to encourage responsible innovation to benefit consumers and businesses,” Digital finance Package, European Commission, published September 24, 2020, https://ec.europa.eu/ commission/presscorner/detail/en/IP_20_1684. 7 Business Roundtable, Statement on the Purpose of a Corporation, August 19, 2019, https://s3.amazonaws.com/brt.org/BRT-StatementonthePurposeofaCorporationO ctober2020.pdf. 8 Larry Fink, “A fundamental Reshape of Finance,” accessed January 14, 2020, https:// www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter. 9 See Edward B. Rock, “For Whom Is the Corporation Managed in 2020?: The Debate over Corporate Purpose” (European Corporate governance Institute - Law Working Paper No. 515/2020, New York University School of Law, Law and Economics Research Paper Series Working Paper No. 20-16, New York, May 1, 2020), https://ssrn.com/abstract= 3589951; see also Jill E. Fisch and Steven Davidoff Solomon, “Should Corporations have a Purpose?” (European Corporate governance Institute—Law Working Paper No. 510/2020, University of Pennsylvania Law School, Institute for Law and Economics, Research Paper No. 20-22, Pennsylvania, Aug. 3, 2020), https://ssrn.com/abstract=356 1164;and see also Lucian A. Bebchuk and Roberto Tallarita, “The Illusory Promise of Stakeholder Governance”, Cornell Law Review (Forthcoming, December 2020), https:// ssrn.com/abstract=3544978.

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Goals (SDGs)10 is a cornerstone for the international policy agenda. As part of the 2030 Agenda, there was the establishment of the Task Force on Digital Financing of the Sustainable Development Goals, in charge of fostering digitalization as a way to accelerate financing of the SDGs. The European Commission has expressed this agenda in the European Green Deal framework, announcing a renewed sustainable finance strategy, aiming to support the transition of businesses toward sustainability and contributing to the European Green Deal investment plan’s objectives.11 Sustainability shares with technology the characteristic of being multidimensional, and the essence of such multidimensionality can be easily summarized by referring to the so-called environmental, societal, and governance (ESG) factors. Similar to the course of the events characterizing technology and its development, in particular referring to an emerging economic paradigm, sustainability has also led to the emergence of its own labeled economic paradigm, i.e., the one of “sustainable economy” and “sustainable finance”, as well as green economy and green finance, more explicitly focusing on the environmental aspects. The approach of sustainable finance is broadly oriented toward a long-term investment horizon, and refers to “investment decisions in the financial sector, leading to increased longer-term investments into sustainable economic activities and projects”, on the basis of the ESG dimensions.12 On the other hand, green finance identifies “financing of investments that provide environmental benefits in the broader context of environmentally sustainable development”.13

10 UN General Assembly, Resolution 70/1, Transforming our world: the 2030 Agenda for Sustainable Development, A/RES/70/1 (September 25, 2015), https://sustainabled evelopment.un.org/post2015/transformingourworld. 11 “Renewed Sustainable Finance Strategy and Implementation of the Action Plan on Financing Sustainable Growth,” European Commission, last updated August 5, 2020, https://ec.europa.eu/info/publications/sustainable-finance-renewed-str ategy_en; “Overview of Sustainable Finance,” European Commission, accessed December 8, 2020, https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustai nable-finance/overview-sustainable-finance_en#action-plan. 12 “What Is Sustainable Finance,” Overview of sustainable finance, European Commission, accessed December 1, 2020, https://ec.europa.eu/info/business-economy-euro/ban king-and-finance/sustainable-finance/what-sustainable-finance_en. 13 G20, Green finance Synthesis Report, September 5, 2016, http://unepinquiry.org/ wp-content/uploads/2016/09/Synthesis_Report_Full_EN.pdf.

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Because of their relevance and the potentially disruptive consequences, both technology and sustainability contribute to radically transform the economic and societal dimensions following each of them separate paths of development, and each of them leading to specific consequences impacting different layers of economy and finance. The analysis of such separate paths falls outside the scope of the present chapter. However, a crucial perspective of analysis is the way these two elements interact to reshape finance and economy. Adopting this angle of analysis, a key question is whether technology, and the resulting digital finance, could play a major role for the pursuit of sustainability, as part of the global policy agenda. In another words, could disruptive technologies as well as the resulting economic paradigms that are emerging be instrumental to the achievement of a sustainable paradigm? While the role of new technologies (in particular blockchain) was generally associated with the achievement of higher societal and governance standards (with an emphasis on financial inclusion), the nexus between such new technologies and an enhanced environmental sustainability remained more marginal, both in academia as well as at the level of policy-making. The increasing concerns related to climate change make this issue particularly relevant, and very recent developments have contributed to increase the attention on this specific topic. In particular the UN Task Force on Digital Financing and the Sustainable Digital Finance Alliance have published important reports, that advanced the debate in this specific field. As mentioned earlier, technology and sustainability individually and independently led to the emergence of new economic and financial paradigms. However, when considering the intersection of these two driving forces, a new paradigm is also emerging, so-called Sustainable digital finance. Sustainable digital finance is the result of the intersection between technology and sustainability. Sustainable digital finance identifies a financial paradigm implementing a “technological ecosystem”, to pursue sustainability, to be intended as “a strong, sustainable, balanced and inclusive growth, by directly and indirectly supporting the targets set in the Sustainable Development Goals”.14 Therefore, sustainable digital finance is also strictly connected to “aspirations captured in the business community”, including not only sustainability but also “corporate social 14 DBS and Sustainable Digital Finance Alliance, Sustainable Digital finance in Asia: Creating Environmental Impact Through Bank Transformation, https://greendigitalfinanc ealliance.org/wp-content/uploads/2019/11/SustainableDigitalFinanceinAsia.pdf.

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responsibility”, “multicapital or shared value” and the ESG agenda.15 Similar to digital finance, sustainable digital finance relies on a technological ecosystem, where disruptive technologies including mobile payments platforms, crowd-funding, peer-to-peer lending, finance-related big data, artificial intelligence, machine learning, blockchain, digital tokens, and the Internet of Things operate with a high degree of complementarity.16 Sustainable digital finance could definitely leverage technologies and provide a significant contribution toward environmental sustainability, in addition to other sustainable goals.

3.3 International, National, and European Initiatives Governmental authorities and international organizations are increasingly shifting their attention toward sustainable digital finance. A key initiative was the creation of the abovementioned Green digital finance Alliance, a partnership created at the World Economic Forum in Davos in 2017, with the objective of leveraging digital technologies and innovations to enhance sustainable development, by providing a platform for public and private actors to cooperate.17 The two main partners are Ant Financial and the United Nations Environment Programme (UNEP). Ant Financial is a technology company with a focus on developing “inclusive financial services to the world”, pursuing the creation of a “technology-driven open ecosystem”.18 UNEP is in charge of setting the global environment agenda, and promoting the environmental dimension of sustainable development within the United Nations system,19 with a longtime engagement in sustainable finance. An important step designed and implemented by the UNEP was the Inquiry into the Design of a Sustainable Financial 15 UN Environment Inquiry, Green Digital Finance: Mapping Current Practice and Potential in Switzerland and Beyond, September 2018, https://www.greengrowthknow ledge.org/sites/default/files/downloads/resource/Green_Digital_Finance_Mapping_in_S witzerland_and_Beyond.pdf. 16 DBS and Sustainable Digital Finance Alliance, Sustainable Digital finance. 17 UN Environment, accessed December 1, 2020, https://web.unep.org/revolutionary-

digital-platform-boost-green-finance. 18 “About GDFA,” Green Digital Finance Alliance, accessed December 1, 2020, https://greendigitalfinancealliance.org/about-gdfa2/. 19 Green Digital Finance Alliance, “About GDFA.”

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System in 2014, to support the activity of policy-makers, as well as market actors and other stakeholders for the creation of sustainable financial system.20 Following this first initiative, other important initiatives took place in recent years, at the level of the G20, OECD, and World Bank. In 2018, the G20 Sustainable Finance Study Group started to work on the role of digital finance in capital markets, private equity, and venture capital, concluding that the development of sustainable digital finance essentially relies on market forces, with an increasing role of policymakers.21 As mentioned earlier, the United Nations launched in 2018 the Task Force on Digital finance for the SDGs, where private and public sectors co-exist. The OECD partnered with the UN Environment, the World Bank considered the possibility that digital finance could play in financing climate-smart infrastructures futures.22 Complementary to these initiatives, sixteen major financial centers engaged in exploring ways to strengthen the role of green and sustainable finance, with the establishment of the Financial Centres for Sustainability (FC4S).23 This includes an initiative on testing Green Assets Wallets, developed by capital market actors and technology innovators under the leadership of the Stockholm Green digital finance, to increase the transparency and the efficiency of the green debt market “in support of scaling the supply of, and investment in, credible green investment opportunities through cost-efficient and immutable validation and reporting of green impacts”.24 Other initiatives not directly designed toward the implementation of green finance and sustainable digital finance might contribute to their development. Such initiatives include: the World Bank Blockchain Lab (launched in 2017) focusing on exploring the potential of blockchain adopting a cross-sectorial perspective; the World Bank Group in partnership with the International Telecommunication Union (ITU) and the 20 “Inquiry into the Design of a Sustainable Financial System,” UNEP Finance Initiative, published January 22, 2014, https://www.unepfi.org/news/inquiry-into-the-designof-a-sustainable-financial-system/. 21 G20 Sustainable Finance Study Group, Synthesis Report, July 2018, http://www. G20.utoronto.ca/2018/G20_sustainable_finance_synthesis_report.pdf. 22 UN Environment Inquiry, Green Digital Finance. 23 UN Environment Inquiry, Green Digital Finance. 24 “About,” Green Asset Wallets, December 1, 2020, https://greenassetswallet.org/

about.

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Committee on Payments and Market Infrastructures (CPMI) created the Financial Inclusion Global Initiative; the International Finance Corporation’s (IFC) Global Innovative Retail Payments Program focuses on innovation and sustainability in retail payment services.25 At the national level, countries like Switzerland and Singapore rely on strong regulatory platform capable of attracting fintech players, favoring a strong development of sustainable digital finance. However, France is one of the countries that implemented clear steps in order to become a leading actor in sustainable digital finance, and its strategic plans explicitly mention technology and environmental sustainability. The French Strategy for green finance jointly promoted by the ministries of finance and environment promoted the development of green finance in Europe and initiatives such as “Fintech for Green” to implement technology in this framework.26 In Switzerland, the State Secretariat for International Finance has launched a similar initiative, the “Green Fintech Initiative”, to leverage the combination of sustainable financial services with technology, considered as particularly promising.27 Compared to other national and governmental authorities, the European Union was extremely proactive in attempting to provide a regulatory framework for sustainability. To do that, the European Union opted for a rule-based approach and issued a series of new regulations or amendments to existing regulations to reflect the increasing importance of environmental sustainability. Consistent with this rule-based approach to enhance the development of a regulated framework for sustainability, the European Commission started a new process to further develop sustainable

25 UN Environment Inquiry, Green Digital Finance. 26 See Sylvie Lemmet and Pierre Ducret, Executive Summary French Strategy for

Green Finance, December 2017, https://2017.climatefinanceday.com/wp-content/upl oads/2017/12/EXECUTIVE-SUMMARY-finance-verte-sircom-v3.pdf. 27 “SIF launches Green Fintech Network,” State Secretariat for International Finance, last modified November 5, 2020, https://www.sif.admin.ch/sif/en/home/dokumenta tion/fokus/fintech-network.html.

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finance, and recently launched a Consultation on the Renewed Sustainable Finance Strategy.28 In this consultation document,29 the European Commission dedicates a paragraph on Digital Sustainable Finance, explicitly acknowledging the role that technological advancements might have in the era of sustainable finance. In particular the European Commission emphasizes that artificial intelligence and machine learning could contribute “to better identify and assess to what extent a company’s activities, a large equity portfolio, or a bank’s assets are sustainable”, whereas blockchain and the Internet of Things (IoT) may foster “transparency and accountability in sustainable finance, for instance with automated reporting and traceability of use of proceeds for green bonds”. In the document, the European Commission poses three questions on the role of policy action (whether “EU policy action is needed to maximise the potential of digital tools for integrating sustainability into the financial sector”),30 public authorities (whether “public authorities, including the EU and Member States should support the development of digital finance solutions that can help consumers and retail investors to better channel their money to finance the transition”)31 and finally on the involvement of EU citizens (whether “the EU, Member States, or local authorities [should] use digital tools to involve EU citizens in co-financing local sustainable projects”).32 When assessing the role of digital finance and fintech with regard to pursuing the general UN Sustainable Development Goals, scholars have identified three specific elements. First, they contribute to allocating the financial resources in a way that is instrumental to the achievement of sustainable developments, and this generally happens in different ways (including business models, incentives, policies, and regulations) to channel funding toward sustainability, as in the case of ESG-related

28 European Commission, Consultation on the Renewed Sustainable Finance Strategy, April 8, 2020, https://ec.europa.eu/info/sites/info/files/business_economy_euro/ban king_and_finance/documents/2020-sustainable-finance-strategy-consultation-document_ en.pdf. 29 Please note that at time of writing the results of the consultation are not available

yet. 30 European Commission, Consultation, 23. 31 European Commission, Consultation. 32 European Commission, Consultation.

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finance.33 Second, they contribute to expanding the financial resources in support of the SDGs.34 Finally, they might serve to directly transform the system by directly addressing sustainability concerns, as in the case of Regulatory technology (Regtech).35 Similar roles might have digital finance and fintech specifically with regard to green finance. In a 2018 report, the UN highlighted the costs generated by environmentally sustainable growth, and the challenges for green finance, as they were identified by the G20 Green finance Study Group Synthesis Report.36 Among them, “inadequate internalization of environmental externalities; maturity mismatches; lack of clarity of green finance definitions; information asymmetries; and the lack of adequate analytical capabilities by financial institutions to understand the opportunities and financial risks associated with green investments”.37 According to the UN, digital finance and fintech can play a crucial role in all these respects, especially because of the power of data, which are more abundant, cheaper, and more accurate in their role of supporting “financial decision making”, while promoting inclusion and innovation.38

3.4

The Infrastructural Technological Framework and How Does Digital Finance Become “Sustainable Digital Finance” or “Green Digital Finance”?

The infrastructural technological framework underlying sustainable (digital) finance relies on a mix of different technologies. Big data, mobile technologies, web-based financing, artificial intelligence, DLT,

33 Ross P. Buckley et al., “Sustainability, Fintech and Financial Inclusion” (European Banking Institute Working Paper Series 2019/41, University of Luxembourg Law Working Paper No. 006-2019, UNSW Law Research Paper No. 19-63, University of Hong Kong Faculty of Law Research Paper No. 2019/038, European Business and Organization Law Review, Nov. 1, 2019, Forthcoming), https://ssrn.com/abstract=3387359. 34 Buckley et al., “Sustainability, Fintech and Financial Inclusion”. 35 Buckley et al., “Sustainability, Fintech and Financial Inclusion”. 36 UN Environment Inquiry, Green Digital Finance. 37 UN Environment Inquiry, Green Digital Finance. 38 UN Environment Inquiry, Green Digital Finance.

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and Internet of Things (IoT) are the pillars of a technological transition toward new economic paradigms. Big data characterizes for the so-called 3Vs, volume, velocity, and variety, as they were identified by Doug Laney. Big data originates from different channels, such as business transactions, smart devices, and social media, and because of the heterogeneity of such sources they are extremely heterogeneous, too. The growth of such channels, a significant growth involved also the data flow to businesses with an impact on the way they should be managed almost in real time.39 Artificial intelligence and machine learning (a branch of artificial intelligence) are functional to the analysis of complex, fast, and heterogeneous big data sets via complex mathematical algorithms and calculations.40 Mobile technologies mostly refer to “portable two-way communications devices”, which includes computing devices (such as notebook computers, mobile telephones, and GPS-navigation devices) and the networking technology connecting these devices (wireless technologies),41 favoring data sharing. Web-based financing, such as peer-to-peer (P2P) platforms and investment crowdfunding platforms, favors electronic money transfers and direct financing of project by small investors located in different areas of the world. DLT allows the creation of a decentralized network relying on the consensus of participants, as a tool to validate the transactions, replacing the role of a decentralized authority. The ledger is made of blocks (representing the transactions), that are securely chained together via cryptographic technologies, that make it immutable, verifiable, and transparent. Cryptocurrencies (such as Bitcoin) are one of the most popular applications built on DLT. Finally, the Internet of Things (IoT), like DLT and mobile technologies, relies on connectivity, in particular a platform of devices connected to the Internet and to other devices, via sensors to an Internet of Things platform, in charge of integrating data originating from each

39 “Big Data: What It Is and Why It Matters,” SAS, accessed December 1, 2020, https://www.sas.com/en_us/insights/big-data/what-is-big-data.html. 40 “Machine Learning: What It Is and Why It Matters,” SAS, accessed December 1, 2020, https://www.sas.com/en_us/insights/analytics/machine-learning.html; see also “Artificial intelligence: What It Is and Why It Matters,” SAS, accessed December 1, 2020, https://www.sas.com/en_us/insights/analytics/what-is-artificial-intelligence.html. 41 “What Is Mobile Technology?,” Mobile Technology, IBM, accessed December 1, 2020, https://www.ibm.com/topics/mobile-technology.

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device and developing analytics, identifying the relevant information for specific applications and needs.42 These technologies are complementary and have different applications serving different purposes. Not surprisingly, successful stories of entrepreneurial activities relying on sustainable digital finance, such as M-KOPA in Kenya, Trine in Sweden, and Solar Coin in the United States successfully combined crowd-sourcing, payment platforms, cryptocurrencies, and clean technology in order to pursue the mobilization of capital and the delivery of distributed solar energy options to communities located in other latitudes, including sub-Saharan Africa. Another most obvious element emerging from this overview is the absolute centrality and relevance of data as a key element for understanding and interpreting the structural changes related to a new economic paradigm. The implementation of any technology for these purposes relies on a better utilization of data as the most important resource, and a tool to pursue significant advancements, at different levels, including individual actions as well as coordinating multiple efforts and designing proper infrastructures. As the recent report released by the UN Task Force on Digital Financing has highlighted, technologies such as satellites, sensors, scientific data are all tools that would provide better information, and would be extremely useful to internalize information related to climate change, biodiversity loss, pollution and disaster risks into financing decisions, recurring to green securities and sustainable robo-advisors.43 Data storage and organization via DLT and implementation of AI mechanism become instrumental to the exploitation of data.

3.5 How Such Technologies Improve Sustainable Finance The relevance of data as a key element for sustainable digital finance and the complementarity of a broad array of disruptive technologies emerge also when taking into account the way technologies can effectively contribute to environmental sustainability. First, the abovementioned availability of data contributes to strengthen risk capabilities while at the

42 Jen Clark, “What Is the Internet of Things (IoT)?,” Internet of Things (blog), IBM , November 17, 2016, https://www.ibm.com/blogs/internet-of-things/what-is-the-iot/. 43 UN Sustainable Development Group, People’s Money.

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same time adjusting pricing.44 These results are possible because of a significant improvement at the level of sensor technologies, helpful to cut the costs related to having access to environmental data from customers.45 Better and abundant data contributes to strengthening reporting on environmental impact, with an impact on the decision making at the level of banks’ capital allocation.46 Generally speaking, data has an impact on strengthening decision making in order to mobilize capital and investments toward sustainable environmentally sustainable investments. The 2018 Synthesis Report elaborated by the G20 highlighted, among others, two specific problems that could undermine the development of sustainable assets, in particular lack of information and information asymmetry, because of a lack of transparency or difficulty in assessing such products, because of an inherent “lack of definitions, information disclosure and the specific analytical capacity in the financial industry”.47 All this lead to increasing the costs for sustainable projects while negatively affecting the financial flows.48 Furthermore, the G20 identified a lack of appropriate labeling to identify sustainable products.49 In both these respects data could prove to be a reliable tool for increasing available information and reducing information asymmetry, providing more helpful insights to the different entities part of financial industry (financial institutions active in the field, as well as gatekeepers and investors). In the same way, reliable data can be helpful for regulators, to adopt a “datadriven approach” as a complimentary way to regulate sustainable finance and sustainable digital finance. Data may have another key role by favoring the traceability. Traceability could trigger important behavioral consequences for consumers, increasing their awareness in relation to the supply chain and value chain, and therefore they might change their habits and preferences, and ultimately make different choices underlying a different attention to sustainability.50 The improvement of DLT-based proofs of concepts 44 DBS and Sustainable Digital Finance Alliance, Sustainable Digital Finance. 45 DBS and Sustainable Digital Finance Alliance, Sustainable Digital Finance. 46 DBS and Sustainable Digital Finance Alliance, Sustainable Digital Finance. 47 G20 Sustainable Finance Study Group, Synthesis Report. 48 G20 Sustainable Finance Study Group, Synthesis Report. 49 G20 Sustainable Finance Study Group, Synthesis Report. 50 G20 Sustainable Finance Study Group, Synthesis Report.

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can be helpful for ensuring the best advancements to the process of traceability. The increased digitalization of securities is another vector for developing green bonds, and at the corporate level contributes to increase shareholders engagement. With regard to green bonds, the label “green” requires burdensome activities of certification and monitoring, therefore green bond participants incur in higher costs. The opportunity to digitize bond offerings leads to a significant reduction of the cost, that would also open this market to small–medium enterprises (SMEs), facilitated in meeting the requirements to issue green bonds. At the level of corporate securities such as stocks, digitizing them would solve many problems related to proxy-voting, and might have the effect to increase the attention of individual shareholders motivating them to vote for specific decisions in the direction of sustainability. DLT infrastructures are promising for these applications, and infrastructural transformations. In addition to green bond issuance and corporate voting, major benefits related to DLT, crypto-assets, and tokens were the ones generally associated with the energy industry, and market actors in this field were among the first adopters. Cryptocurrencies in the energy industry are beneficial for both consumers and companies. In a situation of peer-topeer energy trading, consumers benefit from cryptocurrencies because they are in the position to trade with other peers, while at the same time receive money for excess power as well as trade carbon using smart contracts.51 At the same time, companies are empowered to buy and sell network assets, settling the transactions in a way that cuts the costs, and contributes to increasing the efficiency in the use of energy.52 In the banking industry, digital technologies may play a role in greening finance in connection to payments, lending, and investments. The European Banking Federation (EBF) has considered the role of credit and debit cards in contributing to the abovementioned traceability, strengthening the activities of tracking consumers’ climate impact for their purchases, while it had remarked the lack of fintech applications that would go in this direction.53 Fintech is permeating the banking industry

51 UN Environment Inquiry, Green Digital Finance. 52 UN Environment Inquiry, Green Digital Finance. 53 EBF, Towards a Green finance Framework, https://www.ebf.eu/wp-content/upl

oads/2017/09/Geen-finance-complete.pdf.

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via increasing partnerships between existing banks and new startups, and the abovementioned Green digital finance Alliance that could contribute to spur innovation in the context of lending and investment practices in order to align them with environmental sustainability.54 In the specific context of banking, data can have an impact at the banking level by increasing the ability of credit institutions to create new environmentally responsible investment products and investment portfolios for High Net Worth Individuals (HNWI). This would be functional to channeling private wealth for pursuing the SDGs. While data could be helpful to mobilize HNWI resources, robo-advisory might serve the complementary purpose to attract private (non-HNWIs) individuals and retail-banking customers, with benefits in terms of total amounts invested in environmentally sustainable products.55 The banking industry is especially important for the relationship between technology and environmental sustainability to highlight the need for platforms, that would serve as a tool capable of connecting new entrepreneurs with established financial and credit institutions.

3.6

Policy Consideration for Supporting Sustainable Digital Finance

As the denomination suggests, the locution “sustainable digital finance” explicitly refers to two different contexts, or driving forces, sustainability and implicitly, via the utilization of the word “digital”, technology. Notwithstanding the ability of technology and, to some more limited extent, sustainability to independently develop and spread as marketdriven trends, the role of regulation and policy is still a key pillar to contribute to the creation of a stronger and more sustainable “sustainable digital finance”. To achieve significant results, it won’t be enough to start regulating “sustainable digital finance” as a new stage of economy, or in broader terms of capitalism. Regulators should design a multistep strategy where the regulation of “sustainable digital finance” is the last of a three-step strategy, and should be preceded by appropriate policy approaches and regulations of (i) disruptive technologies applied to finance and the paradigm of “digital finance”; and (ii) sustainability, as 54 EBF, Towards a Green finance Framework. 55 EBF, Towards a Green finance Framework.

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the next revolution in the economy. A weak and inconsistent approach and regulation of one of these two pillars, i.e., technology applied to finance and sustainability, might result in significant inconsistencies when approaching (or potentially regulating) “sustainable digital finance”, or, at least, when designing specific policy initiatives serving as a stimulus for the development of this new environment. At the current stage, both the formalization of an adequate policy approach and the regulation of disruptive technologies in finance and sustainability did not achieve adequate satisfactory levels. The regulation of disruptive technologies is far from being perfected and completed. There is no consensus on what should be the most appropriate regulatory approach in relation to innovation, with significant differences between countries on the role of new regulations, and at a broader level the design of more complex “smart solution” based on regulatory sandboxes and fintech hubs. Challenges not only emerge when designing more general policy approaches, but significant frictions also characterize the debate on the regulation of more specific instruments. From this perspective, multiple examples of the difficulties that regulators encountered in the last years are observable and still not solved. Among the regulation of disruptive technologies, blockchain and its multiple applications have caused major concerns, and the reason could be the immediate economic and financial impact of its applications on market structure and distribution of powers among markets, posing a threat to established private corporations as well as governmental institutions. The problems emerging at the level of initial coin offerings (ICOs) and their developments (including security token offerings, STOs, and Initial Exchange Offerings, IEOs) made clear how appropriate regulations are important for supporting the development of new markets.56 Singapore, Hong-Kong, and Switzerland emerged as important fintech hubs because the regulatory approach implemented in these jurisdictions was probably more effective than others, as in the case of the United States. Here divisions between the Securities Exchange Commission (SEC) and the Commodity Futures and Trading Commission (CFTC) in the enforcement of the securities and commodities laws, and significant problems to propose exemptions and new regulations slowed down the process of innovation. US regulators 56 See generally Marco Dell’Erba, “Initial Coin Offerings: The Response of Regulatory Authorities,” New York University Journal of Law & Business 14, no. 3 (Summer 2018): 1107–1136.

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were not able to replicate the success of adapting to the Internet transformations, when the “do-no harm” approach was first theorized and developed.57 Another example of the difficulties encountered by regulators when dealing with new instruments emerging from new technologies comes from stablecoins. Stablecoins are stable cryptocurrencies and a way to tokenize fiat currencies, therefore they are part of the broad category of digital assets. They are perhaps even more complicated to regulate then ICOs, STOs and IEOs, because of the intrinsic relationship to central banking activities,58 which also triggers different political and technical aspects, make it more difficult the design of an appropriate response. In all these cases, the lack of a strong international cooperation was a burdensome obstacle to the development of a strong regulatory environment capable of supporting a specific type of innovation.59 International coordination has become an especially important trait because technologies like DLT are structured and operate in a manner where the nexus between such structures and operations and a specific jurisdiction may not be as strong as in the case of traditional finance. The regulation of sustainability is also imperfect. Consistent with the differences experienced in the regulation of fintech and disruptive technologies, the regulation of sustainability in general and sustainable finance in particular is extremely fragmented. The European Union has taken important steps for regulating sustainability and sustainable finance, although other key international players did not implement a similar rulebased strategy. The different political views on the role of sustainability in economy and finance as well as the different approaches questioning the existence of climate change as a threat to humanity do not facilitate the adoption of a common policy approach to strengthen environmental sustainability. When dealing with sustainability, an example of the current unsolved criticalities comes from the debate on ESG data providers and

57 See generally Marco Dell’Erba, “From Inactivity to Full Enforcement: The Implementation of the ‘Do No Harm’ Approach in Initial Coin Offerings,” Michigan Technology Law Review 26, no. 2 (Spring 2020): 175–227. 58 See generally Marco Dell’Erba, “Stablecoins in Cryptoeconomics from Initial Coin Offerings to Central Bank Digital Currencies,” New York University Journal of Legislation and Public Policy 22, no. 1 (2019): 1–47; see also Marco Dell’Erba, “Shadow Central Banking,” November 6, 2019 (unpublished manuscript), https://papers.ssrn.com/sol3/ papers.cfm?abstract_id=3488040. 59 Dell’Erba, supra note 54, at 52.

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the ESG scores or ratings. ESG ratings significantly differ from credit ratings in many important respects. First they target entire companies, because they assess overall business activities. Hence, all securities issued by the same entity, both equity and debt instruments, are identically treated for the purposes of ESG because both instruments are evaluated based on the sustainability of the company’s business. The ESG quality measurement is a much more multifaceted and complex task when compared to the estimation of credit risk. At current stage, there is no agreement on the classification of ESG indicators and the ESG ratings elaborated by the major ESG data providers let emerge a strong inconsistency, when compared to other more established measures of economy, such as credit ratings. ESG ratings are fundamental for the establishment of sustainability exactly as ratings are essential for traditional finance, and they might be especially important for unlocking and mobilizing more significant financial resources, contributing to increasing the reliability of financial information for sustainability. With specific regard to environmental sustainability and green economy, not even these specific aspects could benefit from strong regulations, both at national and international levels. The political sensitiveness of such topics was an obstacle for unanimously identifying specific regulations to support the transition toward green economy, and at current times significant frictions still continued to emerge. This kind of uncertainties and inconsistencies at the level of technology and sustainability will likely negatively impact “sustainable digital finance”, and regulators will need to solve these issues if they intend to drive the change in environmental sustainability, by effectively leveraging the tool of “sustainable digital finance”. Approaching sustainable digital finance (and probably and more generally financial regulation from this perspective), regulators should consider sustainable digital finance as the last step in the regulation of capital markets, where the first two are necessarily sustainability and technology. Taking into account the examples from the previous paragraphs, ICOs and their multiple developments (in particular STOs and IEOs) might contribute to reach a broader audience of investors interested in investing in green bonds, while data and artificial intelligence are tremendously useful for strengthening an increased level of reliability of ESG indicators, and might contribute to achieving stronger levels of uniformity among the different data providers. Unequivocally regulating these aspects will significantly accelerate the

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development of sustainable digital finance, benefitting from the advancements at the policy level and the regulatory clarity achieved in technology and finance. Another aspect to take into account when approaching sustainable digital finance is the way this new paradigm redistributes the roles within financial markets, and the way new and established actors interact in a changed environment. Consistent with the trends of fintech in the last years, newcomers populating “sustainable digital financial” will continue to emerge as a result of the disruptive technologies underlying “sustainable digital finance”. Established financial institutions will be forced to rethink their business, re-considering the role of technology in their organizations, and they might do that in two ways: either they will independently develop new technologies as part of their business, or they will acquire newcomers or their technologies, as it happened in the case of “traditional fintech”. To advance the development of new entrepreneurial projects, it will be crucial to reconsider the role of platforms, following the successful model implemented by the Green Digital Financial Alliance. Not only these platforms favor the development of new initiatives and projects in the private sphere, but they might also contribute to strengthen private-public partnerships, with both established financial institutions and newcomers. The role of public actors might have two positive effects. First, public actors could be directly engaged with new projects, and therefore be in the position of directly injecting financial resources in specific projects or programs tailored with the purpose of making the shift toward environmental sustainability more concrete and faster. Such projects should have an infrastructural aim, intended to create partnership between public and private actors, as well as favor new partnership among private actors, with the view of involving the highest number of stakeholders. Second, adopting the perspective of regulators, direct investments could be a strategy to drive the change toward new paradigms (sustainable digital finance), as a complementary tool to formal regulation, or even as a substitute for formal regulation. Irrespective of what is the view related to providing a new regulatory framework as a tool for developing sustainable digital finance, this might be a way to counterbalance a key characteristic of sustainable digital finance of being largely market-driven,60 and

60 G20 Sustainable Finance Study Group, Synthesis Report.

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contribute to development of stronger best practices within the market. Although the characteristic of being essentially market driven is not negative per se, an active role of public actors could increase the understanding of specific trends within the market and would increase the monitoring activity. In case of unintended consequences, the state would also be in the position to acting faster to unintended consequences by implementing more adequate policy responses, in case of non-satisfactory developments, effectively mitigating unintended financial and non-financial risks emerging from such developments.

3.7

Conclusions

Technology and sustainability emerged as two different drivers for economy and finance, each of them leading to the emergence of new paradigms. More recently technology and sustainability are converging, and the emergence of sustainable digital finance is the result of such intersection. A mix of complementary disruptive technologies, in particular big data, AI and machine learning, and blockchain could be a useful tool for driving the change toward a new paradigm, strengthening environmental sustainability, and contributing to climate change. To achieve this goal, it will be important a sound policy (and potentially regulatory) approach for solving the problems related to sustainability and technology, where sustainable digital finance is a third step in the policy-makers’ agenda. Formal regulation could be substituted or complemented by other initiatives on the side of public actors, as a stimulus for the development of this new paradigm.

PART II

Sustainable Finance and Corporate Governance

CHAPTER 4

Redefining Corporate Purpose: Sustainability as a Game Changer Guido Ferrarini

4.1

Introduction

The concept of corporate purpose is often articulated in today’s business practice to underline that companies should not only pursue profits, but also other objectives concerning the firm’s stakeholders, the environment and other public interests, including those of future generations. In this introductory section, I define the present chapter’s scope and offer some practical guidance as to the current understanding of corporate purpose also in the light of the current COVID-19 crisis.

G. Ferrarini (B) University of Genoa, Genoa, Italy e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_4

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4.1.1

Scope and Aims of the Chapter

Corporate purpose is a central corporate governance theme,1 even though its definition and role are still widely debated amongst lawyers, economists and management scholars.2 Possibly no other concept of corporate law better reflects the social norms and political ideologies prevalent in each society at a given time. Also, the practical relevance of this concept is widely discussed and often put into doubt by scholars showing that definitions of corporate purpose are of no consequence for individual corporations and their leaders. Two US legal scholars have even asked, as a research question, whether corporations should have a purpose,3 whereas a UK economist suggested that corporations should be required by law to articulate their purpose in the charter along the model of benefit corporations (para. 9 below). A similar direction has been followed by the French legislator that has allowed companies to specify their purpose in the charter (para. 7.2). An increasing number of firms, particularly the largest ones, make reference to the pursuit of environmental and social goals in the definition of their purpose. This raises important issues with respect to the way in which the trade-offs between profit maximization and social value are solved in capitalist systems. These trade-offs are treated differently depending on the corporate governance system concerned and the type of industry in which the individual firm operates. Their solution also depends on the perspective from which the relevant questions are asked. As I show in this chapter, there are different perspectives that can be adopted with respect to corporate purpose depending on the field of scholarship chosen: economics, finance, management and law. Each perspective offers different nuances as to the way in which corporate purpose is defined and the conflict between the pursuit of profit and social value is dealt with. In Sect. 4.2, I show that a broader concept of corporate purpose has gradually emerged over the years in economics, finance and management studies, as a result of various approaches to corporations such as 1 Fish, J., & Davidoff Solomon, S., “Should Corporations Have a Purpose?”, ECGI

Law Working Paper 510/2020, https://ecgi.global/working-paper/should-corporationshave-purpose, 3, define it as “the hottest topic in corporate governance”. 2 Rock, E. “For Whom Is the Corporation Managed in 2020: The Debate over Corporate Purpose”, ECGI Law Working Paper 515/2020, https://ecgi.global/working-paper/ whom-corporation-managed-2020-debate-over-corporate-purpose. 3 J. Fish and S. Davidoff Solomon, note 1.

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corporate social responsibility (CSR) and stakeholder governance, which have been gradually integrated into the corporate governance framework. Environmental and social sustainability has come to characterize most of the instances of CSR and some core aspects of stakeholder governance, without discarding the pursuit of corporate profits as a long-term goal of the corporation. In Sect. 4.3 I argue, from a comparative law perspective, that corporate purpose is an old concept, which has been variously defined in different jurisdictions without determining great variations in practice. Continental European laws often consider the company’s interest rather than the corporate purpose, i.e. the interest that a company should pursue and which may belong either to the company as such or to its shareholders. However, legal definitions have little relevance in practice, where corporate purpose is generally identified across jurisdictions with the pursuit of corporate profits, albeit with variations concerning the relevance of given stakeholders and social values in corporate governance. A distinction is made in this respect between shareholder governance and stakeholder governance, depending on whether shareholder primacy is the rule or a pluralist approach is followed in which at least some stakeholders are elevated to prominence, as happens for instance with employees under the German codetermination system. In general, legal definitions of corporate purpose are flexible and allow for different types of solution of the conflict between economic value and social value at firm level and within a given system. In Sect. 4.4, I critically analyse the recent economic theories and policy perspectives which either reformulate stakeholder governance more radically or try to restore shareholder primacy in its widest possible meaning. The former have been suggested by “social value acolytes”, who argue that firms should firstly maximize social value and secondly corporate profits, which shall naturally derive from businesses that excel in innovation and compliance with ethical standards. The latter have been suggested by “shareholder value purists” arguing that stakeholders’ interest should be taken into account by corporate leaders only to the extent that this is instrumental to shareholder wealth maximization. For example, employees should be offered either higher salaries or better welfare only if a similar action increases the value of the corporation in the long run. An intermediate position that I will also consider suggests that a distinction should be made between shareholder value and social value from the perspective of behavioural theory, with particular regard

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to the distinction between extrinsic and intrinsic motivation of the people working in an organization. In Sect. 4.5, I present a holistic view of corporate purpose based on the comments developed throughout the chapter, including my preference for the enlightened shareholder value (ESV) approach as proposed by Michael Jensen and followed by some legislators when defining corporate purpose. However, I suggest that Jensen’s approach should be specified today in the sense that stakeholders’ interests are met not only when they are strictly instrumental to the maximization of firm value, but also when required by regulation or recommended by ethical standards that firms are expected to follow quite apart from their impact on corporate profit. In the same section, I also consider ways to promote corporate purpose in practice through official statements, corporate charter provisions and company law. I conclude in the last paragraph of Sect. 4.5 summarizing the main outcomes of the present chapter. 4.1.2

The New Stakeholderist Credo

The new credo of large corporations and institutional investors as to corporate purpose is largely reflected in the official pronouncements of national trade associations—like the US Business Roundtable—and of international bodies, like I World Economic Forum (WEF) which recently adopted the Davos Manifesto 2020. The Manifesto opens with the following statement: “The purpose of a company is to engage all its stakeholders in shared and sustained value creation. In creating such value, a company serves not only its shareholders, but all its stakeholders – employees, customers, suppliers, local communities and society at large. The best way to understand and harmonize the divergent interests of all stakeholders is through a shared commitment to policies and decisions that strengthen the long-term prosperity of a company”.4 The economic and management theories reviewed below in Sect. 4.2 shed light on the

4 Davos Manifesto 2020: The Universal Purpose of a Company in the Fourth Industrial

Revolution, https://www.weforum.org/agenda/2019/12/davos-manifesto-2020-the-uni versal-purpose-of-a-company-in-the-fourth-industrial-revolution. The Manifesto adds inter alia that companies should pay their fair share of taxes, show zero tolerance for corruption, uphold human rights throughout their global supply chains and advocate for a competitive level playing field.

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origins and meaning of this statement, which reflects the rise of corporate social responsibility and stakeholder theory in the last decades, and the diffusion of relatively new concepts such as that of “shared value” to express the broadening of corporate purpose. In commenting on the Manifesto, Klaus Schwab, the founder of WEF, underlined that shareholder capitalism is currently the dominant model, which first gained ground in the US in the 1970s and then extended its influence globally.5 However, the “single-minded focus” on profits and short-term results caused this type of capitalism “to become increasingly disconnected from the real economy”. As a consequence, attitudes of the public have begun to change thanks to Greta Thunberg and other climate change activists reminding us of environmental unsustainability. Moreover, younger generations “no longer want to work for, invest in, or buy from companies that lack values beyond maximizing shareholder value”. In addition, “executives and investors have started to recognize that their own long-term success is closely linked to that of their customers, employees, and suppliers”. As a result, stakeholder capitalism is quickly gaining ground, as also shown by the US Business Roundtable’s announcing this year that it would formally embrace it, while “impact investing” rises to prominence “as more investors look for ways to link environmental and societal benefits to financial returns”.6 The Davos Manifesto was preceded by a paper written for the WEF by Martin Lipton, the celebrated New York lawyer, suggesting a “new paradigm”, which “conceives of corporate governance as a collaboration among corporations, shareholders and other stakeholders working

5 Why we need the ‘Davos Manifesto’ for a better kind of capitalism https://www.wef orum.org/agenda/2019/12/why-we-need-the-davos-manifesto-for-better-kind-of-capita lism/. 6 See the BRT’s Statement on the Purpose of a Corporation, at https://opportunity.bus inessroundtable.org/ourcommitment/. The CEOs of large corporations who subscribed to it committed to delivering value to their customers; investing in their employees; dealing fairly and ethically with their suppliers; supporting the communities in which they work; respecting the people in their communities and protect the environment by embracing sustainable practices across their businesses; generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. They also committed to transparency and effective engagement with shareholders, concluding: “Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country”.

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together to achieve long-term value and resist short-termism”.7 The new paradigm should “encourage corporations to pursue thoughtful strategies for maximizing profits and equity share value in the long term” and “to incorporate relevant sustainability, ESG (environmental, social and governance) and CSR (corporate social responsibility) considerations in developing their long-term strategies and operations planning”. At the same time, the new paradigm should encourage investors to support the pursuit of long-term strategies by the corporations in which they invest, while discouraging them from “supporting short-term financial activists that advocate only short-term profits and value maximization”.8 In a more recent blog post,9 Lipton argued that the proposals of his 2016 paper were closely paralleled by the UK Stewardship Code 2020 7 Martin Lipton et al., The New Paradigm: A Roadmap for an Implicit Corporate governance Partnership Between Corporations and Investors to Achieve Sustainable LongTerm Investment and Growth, 2 September 2016, International Business Council of the World Economic Forum, downloadable at https://www.wlrk.com/webdocs/wlrknew/Att orneyPubs/WLRK.25960.16.pdf. 8 In a revised version of his paper, Lipton approvingly cited the British Academy project on the Future of the Corporation, led by Professor Colin Mayer whose proposals I critically discuss in sec. IV: Lipton et al., It’s Time to Adopt the New Paradigm, a 2019 blog post of the Harvard Law School Forum on Corporate governance and Financial Regulation, https://corpgov.law.harvard.edu/2019/02/11/its-time-to-adopt-the-new-par adigm/. However, Lipton criticizes Mayer’s proposals to the extent that they require legislation. In his opinion, “no legislation or regulation is necessary to implement The New Paradigm. Corporations, asset managers, and institutional investors can unilaterally announce their acceptance of and adherence to the principles of The New Paradigm. Consistent with observations made by Chief Justice Leo Strine of the Supreme Court of Delaware, in his 2017 Yale Law Journal article, “Who Bleeds When the Wolves Bite?: A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate governance System”, from both a corporate law and a trust law standpoint the principles of The New Paradigm are intended to achieve long-term growth in value while eschewing actions and policies that threaten future growth and value, or the franchise itself. Adoption of and adherence to the principles of The New Paradigm is consistent with the fiduciary duties of boards of directors to their corporations and shareholders, and of asset managers to investors and the underlying beneficiaries for whom they are acting”. Lipton also endorsed the statements on corporate purpose by several index fund managers, including Larry Finck, the CEO of Blackrock, the world’s largest asset manager, who in his 2018 letter to CEOs noted: “Society is demanding that companies, both public and private, serve a social purpose. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.” 9 See at https://corpgov.law.harvard.edu/2019/10/28/the-new-paradigm/.

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and by the UK Corporate Governance Code 2018, which fundamentally commit companies and asset managers and asset owners to sustainable long-term investment. As stated by the UK Financial Reporting Council that has issued both codes, the new Stewardship Code establishes a clear benchmark for stewardship as the responsible allocation, management and oversight of capital “to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society”.10 Similar statements are found in the UK Corporate Governance Code 2018, which is introduced amongst others by the following comments: “Companies do not exist in isolation. Successful and sustainable businesses underpin our economy and society by providing employment and creating prosperity. To succeed in the long-term, directors and the companies they lead need to build and maintain successful relationships with a wide range of stakeholders. These relationships will be successful and enduring if they are based on respect, trust and mutual benefit. Accordingly, a company’s culture should promote integrity and openness, value diversity and be responsive to the views of shareholders and wider stakeholders”.11 These comments are reflected by the first Principle stated in the Code with respect to corporate purpose under 1. A.: “A successful company is led by an effective and entrepreneurial board, whose role is to promote the long-term sustainable success of the company, generating value for shareholders and contributing to wider society”. 4.1.3

Narratives of Corporate Purpose in Business Practice

A few quick references may help clarifying how corporate purpose has been publicly specified by some of the major companies engaged in promoting their business success and sustainability. Looking at their websites, we find either ad hoc definitions of corporate purpose or indirect references to it in other documents, such as those defining the corporate

10 See at https://www.frc.org.uk/investors/uk-stewardship-code. 11 See at https://www.frc.org.uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f4

8069a2/2018-UK-Corporate-Governance-Code-FINAL.pdf.

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“mission” and “vision”12 and/or including the company’s sustainability report. Danone, to start with, the French food and beverage company, defines its goal as building a balanced, profitable and sustainable growth model.13 In particular, the company has set its ambition to receive a B Corp certification as a major milestone in its dual economic and social project:14 “As part of this approach, which aims to create value for consumers and shareholders, Danone is transforming the way in which the food and beverages of its flagship brands are designed and produced, notably by reducing the number of ingredients, and proposing new organic and non-GMO product lines. The Company also commits to promoting sustainable agriculture, encouraging the circular economy, conserving water, reducing waste, reducing its carbon footprint, promoting animal welfare and investing in the community”.15 Vodafone enounces its corporate purpose under the heading “we connect for a better future” as follows: “Through our business, we aim to build a connected society that enhances socio-economic progress, embraces everyone and does not come at the cost of our planet. That is why we have committed to improve one billion lives and halve our 12 See, for a definition of these concepts, Enacting Purpose Initiative, Enacting Purpose within the Modern Corporation. A Framework for Boards of Directors, 2020, 12 ff., https://www.enactingpurpose.org/assets/enacting-purpose-initiative---eureport-august-2020.pdf. 13 See https://www.danone.com/about-danone/sustainable-value-creation.html, where

the corporate purpose is defined under the heading “creating and sharing sustainable value”, as follows: “Through our commitment to social and economic progress, and our passion for bringing health through food to as many people as possible, we aim to generate profitable, sustainable growth now and for many years to come”. See also https://www.danone.com/about-danone/sustainable-value-creation/our-uniquegrowth-model.html, where it is stated: “In an purpose increasingly volatile and complex environment, Danone strives to strengthen its model of growth through disciplined resource allocation, efficiency gains and cost optimization with a permanent balance in managing the short, mid and long-term horizons. The company therefore favours strategic growth opportunities that create long-term value over tactical short-term allocations”. 14 See https://www.danone.com/about-danone/sustainable-value-creation/BCorpA mbition.html, where it is specified: “Since 2015, Danone has partnered with B Lab to help define a meaningful and manageable path to certification for multinationals and publicly traded companies, as well as accelerate growth of the B Corp movement into the mainstream”. 15 See https://www.danone.com/about-danone/sustainable-value-creation/our-uniquegrowth-model.html.

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environmental impact by 2025, by taking concrete action in three areas: Digital society, Inclusion for All, and Planet”.16 Enel, the Italian electricity and energy company, defines its “vision” as follows: “Openness is the key feature of our strategy. For this reason we are ensuring our services reach more and more people in a growing number of countries, boosting local economies and extending access to energy… This is the approach that underpins our day-to-day commitment and that motivates all of us in the Enel team. We are Open Power to improve the future for everyone, to drive sustainable progress, to leave no one behind and to make the planet a more welcoming place for future generations. We are Open Power and our aim is to overcome some of the greatest challenges facing the world. This is to be achieved through a new approach which combines attention to sustainability with the best in innovation”.17 Electrolux, the Swedish home appliance manufacturer, employs similar language in its Sustainability Report 2019, which opens with the following statements concerning the company’s sustainability framework: “Sustainability has gone from being very important to crucial for Electrolux, as our planet approaches several extremely significant tipping points…The Better Living Program is an integral part of our new For the Better 2030 sustainability framework, which will enable Electrolux to continue to create better and more sustainable living for people around the world through to 2030. With bold targets focusing on better eating, better garment care and a better home environment, as well as to become climate neutral in our operations and strive towards a more circular business, the program intensifies our contribution to key global challenges”. These are just a few examples of a trend which is on the rise highlighting the role of corporate purpose and similar concepts (such as mission, vision and values) in the communication and practices of large corporations, and its connection with sustainability. There is no need to

16 See https://www.vodafone.com/our-purpose. 17 See https://www.enel.com/company/about-us/vision, where the following is added:

“In line with our Open Power strategic approach, Enel has placed environmental, social and economic sustainability at the centre of its corporate culture and is implementing a sustainable development system that is based on the creation of shared value, both inside and outside of the company …”.

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remark that the rhetoric of similar statements does not necessarily correspond to corporate behaviour in practice, so that they should not be taken at face value. Moreover, the pronouncements just reviewed are no doubt generic and need to be substantiated by other documents and corporate actions. However, they show—prima facie at least—the new directions of corporate purpose in large enterprises, its constant link to sustainability and the essential value of both concepts (purpose and sustainability) together with that of value maximization in delineating the goals of corporations and the ways in which they should be reached. As this chapter tries to show, similar practices are meaningfully aligned with national and international public policies, showing the need for cooperation between governments, corporations, investors and other stakeholders in the attainment of the economic and social goals of modern capitalism. They are also aligned with current trends in the legal and economic literature, which often highlight the need to review the core concepts of the corporation and its regulation. This chapter makes reference to some of the most remarkable scholarly works in these areas and to the policy choices underlying the current trends. 4.1.4

The Impact of COVID-19

The debate over corporate purpose will likely intensify and find new applications as the COVID-19 crisis continues.18 Since the onset of the pandemic, many companies have demonstrated their commitment to social goals by keeping employees on the payroll, extending benefits post-termination or showing forbearance to customers’ non-payment of debts.19 However, it is too early to say whether the crisis will have a broader impact on the companies’ social sustainability.20 It is likely 18 See the note ‘Governing Through the Pandemic’ posted by D. McCormack and R. Lamm, Deloitte LLP, on June 24, 2020, on the Harvard Law School Forum on Corporate governance, at https://corpgov.law.harvard.edu/2020/06/24/governing-thr ough-the-pandemic/. 19 Ibidem. 20 Criticism has been raised towards companies that have cut jobs rather than dividends

and share buy-backs: see A. Scott, R. Kerber, J. DiNapoli, R. Spalding, ‘U.S. companies criticized for cutting jobs rather than investor payouts’, Reuters, Business News, April 8, 2020, who argue: “While most U.S. companies are scaling back payouts after a decade in which the amount of money paid to investors through buybacks and dividends more than tripled, some are maintaining their policies despite the economic pain. Royal

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that the pandemic will increase the focus on social issues such as diversity, poverty and inequality. But the economic crisis may also determine a new emphasis on profits as the primary goal of corporations. Indeed, COVID-19 has forced boards to focus on many short-term issues, such as the rupture of supply chains; immediate and severe drops in revenues, liquidity and cash flows; decisions on laying-off employees, shutting down facilities and in some cases closing the business permanently.21 In any case, the corporate governance of sustainability requires a longterm view for the recovery of firms and the build-up of their resilience in order to survive and grow post-pandemic.22 Indeed, corporations should now consider how to prepare for future shocks which include other pandemics and the disruption of climate change. Like banks after the great financial crisis, businesses need to build thicker buffers against shocks.23 Pandemics and climate risk are similar in that they both represent exogenous shocks, which then translate into socioeconomic impacts. The current pandemic anticipates what a future climate crisis could entail in terms of simultaneous shocks to supply and demand, disruption of supply chains, and global transmission and amplification mechanisms.24 Ideally, firms should aim for an “antifragile” approach, which goes

Caribbean Cruises Ltd (RCL.N), Halliburton Co (HAL.N), General Motors Co (GM.N) and McDonald’s Corp (MCD.N) have all laid off staff, cut their hours, or slashed salaries while maintaining payouts, according to a Reuters review of regulatory filings, company announcements and company officials”. 21 See ‘Governing Through the Pandemic’, note 19. 22 See The FT View, “Companies should shift from ‘just in time’ to ‘just in case’.

Pandemic has shown that businesses neglected vital safety margins”, 22 April 2020, at https://www.ft.com/content/606d1460-83c6-11ea-b555-37a289098206?shareType= nongift. The COVID-19 outbreak has exposed the thin margins on which much of global business was run: “Highly indebted companies, working from lean inventory, supported by just-in-time supply chains and staffed by short-term contractors, have borne the brunt of the sudden blow. They will now suffer the rolling, longer-term impact of its unpredictable consequences. Too late, many executives and owners have realised that by pursuing the holy grail of ever greater efficiency, they sacrificed robustness, resilience and effectiveness. In many cases, they will turn out to have sacrificed the business itself”. 23 See Pinner, D., Rogers, M., & Samandari, H. “Addressing Climate Change in a Post-pandemic World”. McKinsey Quarterly, April 7, 2020, https://www.mckinsey.com/ business-functions/sustainability/our-insights/addressing-climate-change-in-a-post-pan demic-world#. 24 Ibidem.

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“beyond resilience and robustness” so that they can adapt to, and even thrive on, disorder.25

4.2 The Evolution of Corporate Purpose in Economics and Finance In this section, I consider corporate purpose from an economics, finance and management perspective. In particular, I analyse the main changes concerning the notion of corporate purpose since the great economist Milton Friedman famously stated: “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud”.26 As I argue below, Friedman’s approach to social responsibility of business has been widely replaced by a broader notion of corporate purpose encompassing both the pursuit of corporate profit and other social goals. However, a tension still exists between shareholder value theory—which dominates the financial approach to corporate purpose—and the notion of social value, which largely permeates CSR and stakeholder governance as depicted by management theorists. Recent scholarly works tend to polarize to the extremes, either restoring a pure theory of shareholder value or subordinating corporate profit to social value and its direct implementation by firms. 4.2.1

Corporate Profits and Social Values

Three scholarly streams ran parallel in the last decades of the past century concerning the relationship between corporate profits and social values. The first stream is represented by shareholder value theory, the second by corporate social responsibility (CSR) theory and the third by stakeholder theory. All three scientific domains have been heavily influential in business practice. They only changed course with the start of the present century, crossing their paths in ways that I will explain in para. 6.

25 See FT View, note 23, citing N. Taleb, Antifragile: How to Live in a World We Don’t Understand, Allen Lane, 2012. 26 Friedman, M., Capitalism and Freedom, University of Chicago Press, 1962, 112.

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4.2.1.1 Milton Friedman on the Social Responsibility of Business Friedman is often considered as the father of shareholder value theory and therefore also responsible, to some extent, for its negative consequences in the two financial crises of this century.27 His famous 1970 paper in the New York Times Magazine 28 is widely quoted as the foundation of such theory, even though such a reading is not entirely correct.29 Indeed, what is striking about that paper is Friedman’s attack on corporate social responsibility (CSR), which was in its infancy at that time and successfully developed in the following years. Moreover, shareholder value theory was developed later by finance scholars and consultants, while its diffusion in corporate practice mainly occurred in the last two decades of the last century.30 Friedman referred to the corporate practices of his time, but his emphasis on corporate profits somehow reflected a critical approach to those practices, including normative elements that anticipated shareholder value theory. As Nobel laureate B. Holmstrom and S. Kaplan later explained: “Before 1980, corporate managements tended to think of themselves as representing not the shareholders, but rather ‘the corporation.’ In this view, the goal of the firm was not to maximize shareholder wealth, but to ensure the growth (or at least the stability) of the enterprise by ‘balancing’ the claims of all important corporate ‘stakeholders’—employees, suppliers, and local communities, as well as shareholders”.31 The external governance mechanisms available to dissatisfied shareholders, such as proxy fights and hostile takeovers, were seldom used. Corporate boards tended to be dominated by management, making board oversight weak, while internal incentives from management ownership of

27 See Cheffins, B., “Stop Blaming Milton Friedman!”, University of Cambridge Faculty of Law Legal Studies Research Paper Series, Paper N. 9/2020, March 2020, https://pap ers.ssrn.com/sol3/papers.cfm?abstract_id=3552950. 28 Friedman, M. The Social Responsibility of Business is to Increase its Profits, The New York Times Sunday Magazine, September 13, 1970, 32. 29 See B. Cheffins, note 65. 30 See Davis, G., Managed by the Markets, How Finance Reshaped America, Oxford

University Press, 2009, 50 ff. 31 Holmstrom, B., & Kaplan, S. (2003). “The State of U.S. Corporate Governance: What’s Right and What’s Wrong?” Journal of Applied Corporate Finance, 15(3), 10.

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stock and options were also modest.32 Partly in response to the neglect of shareholders, the 1980s saw the emergence of the corporate raider and hostile takeovers: “Nearly half of all major U.S. corporations received a takeover offer in the 1980s—and many companies that were not taken over responded to hostile pressure with internal restructurings that made themselves less attractive targets”.33 In the 1990s, the pattern of corporate governance activity changed again, as hostile takeovers and leverage declined substantially. However, other corporate governance mechanisms began to play a larger role, particularly executive stock options and the greater involvement of boards of directors and shareholders34 : “With the implicit assent of institutional investors, boards substantially increased the use of stock option plans that allowed managers to share in the value created by restructuring their own companies. Shareholder value thus became an ally rather than a threat”.35 In his 1970 paper, Friedman focused on the rejection of corporate social responsibility as a “fundamentally subversive doctrine”.36 He argued that the executives are agents of the stockholders and cannot spend the company’s money for social purposes. He also offered a few examples to explain why using corporate resources for social purposes would run counter the interest of shareholders. The first example refers to the case of an executive who refrains from increasing the price of a product in order to contribute to the social objective of preventing inflation. The second considers an executive who makes expenditures on reducing pollution beyond the amount that is in the best interests of the corporation or that is required by law, in order to contribute to the social objective of protecting the environment. The notion of best interest of the corporation is ambiguous, depending on whether we look at short-term accounting figures or long-term firm value. Under today’s CSR standards, reducing pollution beyond what is required by law could 32 Ibidem. For example, in 1980 only 20% of the compensation of U.S. CEOs was tied to stock market performance. Long-term performance plans were widely used, but they were typically based on accounting measures like sales growth and earnings per share that tied managerial incentives less directly, and sometimes not at all, to shareholder value. 33 Ibidem. 34 Ibidem, 11. 35 Ibidem. 36 See M. Friedman, note 66, using an expression already found in his book Capitalism and Freedom, note 64, 113.

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be instrumental in increasing the reputation of the firm and substantially reducing its exposure to environmental risks. Nevertheless, Friedman recognized that the long-run interest of the corporation could lead a firm that is a large employer in a small community to devote resources to provide amenities to that community or to improve its government. In his opinion, “that may make it easier to attract desirable employees, it may reduce the wage bill or lessen losses from pilferage or sabotage or have other worthwhile effects”. He rejected, however, the idea that this was an example of social responsibility, arguing that the action in question was justified by self-interest. In Friedman’s view, social responsibility meant pursuing an interest in conflict with the corporate interest. He admitted that stakeholders could be taken into account in the management of corporations, but only to the extent that this would further the corporate interest. 4.2.1.2 The Rise and Success of CSR Subsequent developments of CSR have gone in a direction different than that advocated by Friedman. Thirty years after the publication of his New York Times paper, it was possible to note that “CSR has never been more prominent on the corporate agenda”.37 Some of the plausible reasons for it were offered by the WEF a few years after the great financial crises38 : “In the face of high levels of insecurity and poverty, the backlash against globalisation, and mistrust of big business, there is growing pressure on business leaders and their companies to deliver wider societal value. This calls for effective management of the company’s wider impacts on and contributions to society, making appropriate use of stakeholder engagement”. CSR practices are considered today as predominantly aligned with the company’s interest, for they promote the reputation of the firm as an entity which regularly complies with ethical standards and satisfy the expectations of those shareholders who follow responsible investment practices.39 In addition, the coverage of CSR has been expanded 37 Smith, N. (2003). “Corporate Social Responsibility: Whether or How?” California Management Review, 45, 52. 38 See World Economic Forum, Responding to the Challenge: Findings of a CEO Survey on Global Corporate Citizenship, cited by N. Smith, note 75. 39 See Smith, N., & Lenssen, G. (2009) “Mainstreaming Corporate Responsibility: An Introduction”, in N. Smith and G. Lenssen (eds.), Mainstreaming Corporate Responsibility,

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to include a range of topics which did not belong to it at its origin, such as environmental sustainability, employees’ welfare and supply chain monitoring.40 As argued by academic experts of the field: “… CSR encompasses issues such as sustainability (meeting the needs of the present without compromising the ability of future generations to meet their needs), stakeholder management and corporate governance, as well as corporate philanthropy, although the latter is increasingly seen as a peripheral consideration”.41 Thirdly, CSR is increasingly integrated with business strategy and positively affects corporate purpose that extends to social goals in addition to the pursuit of corporate profit.42 Nonetheless, some finance studies still argue—as Friedman did in his 1970 paper—that CSR is often a manifestation of agency problems within the firm and therefore problematic.43 Agency problems are manifested, for example, by corporate managers engaging in CSR that either benefits themselves rather than shareholders or reduces their engagement on core responsibilities within the firm.44 According to this “agency view”, CSR is generally not in the interest of shareholders. However, under another view socially responsible firms often implement value-maximizing practices, while well-governed firms are more likely to follow CSR standards.45 The empirical studies testing these two theories have offered Wiley, 2, who argue: “The business case at the level of the firm is becoming increasingly clear as more companies come to understand that, aside from any moral obligation, it is in their economic interest to address environmental, social and governance issues and in a manner that is integrated with strategy and operations”. 40 See Crane, A., Matten, D., & Spence, L. (2008). “Corporate Social Responsibility in a Global Context”, in A. Crane, D. Matten and L. Spence (eds.), Corporate Social Responsibility. Readings and Cases in a Global Context, Routledge, 3 ff., where current definitions of CSR and analysis of its core characteristics. 41 N. Smith and G. Lenssen, note 78, 2, also noting that the case for business to engage in ESG issues is based on the realization that a new global social contract between business, government and society is needed. 42 See Pettigrew, A., “Corporate Responsibility in Strategy”, in N. Smith and G. Lenssen (eds.), note 76, 12. 43 See Benabou, R., & Tirole, J. (2010). “Individual and Corporate Social Respon-

sibility”. Econometrica, 77, 1, and the other works cited by Ferrell, A., Liang, H., & Renneboog, L. (2016). “Socially Responsible Firms”. Journal of Financial Economics, 122, 585. 44 See Krueger. (2015). “Corporate Goodness and Shareholder Wealth”. Journal of Financial Economics 115, 304. 45 See A. Ferrell, H. Liang and L. Renneboog, note 92, 586.

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mixed results.46 We shall consider the evidence concerning the “good governance” view again in the final section of this paper. 4.2.1.3 Advances in Stakeholder Theory Stakeholder theory has been developed in the last forty years to counter the dominant theory of the corporation which is shareholder centric.47 As originally outlined by E. Freeman,48 this theory tried to explain how business could be understood against the backdrop of the environmental turbulence which was already in motion. Freeman assumed that the “current approaches to understanding the business environment fail to take account of a wide range of groups who can affect or are affected by the corporation, its ‘stakeholders’”.49 Moreover, stakeholder theorists argue that, contrary to what is traditionally assumed in economic theory, the questions of values and ethics must be considered and dealt with together with economic reality.50 They criticize the separation of business decisions from ethical decisions and suggest to integrate the two types of decisions and recognize the managers’ moral responsibility for them. Stakeholder theory therefore is directed to solve the problem of the “ethics of capitalism” and shows how business can be managed “to take full account of its effects on and responsibilities towards stakeholders”.51 Indeed, such theory has been developed and discussed within the normative business ethics literature and there are many reasons to see stakeholder theory “as having a central place in business ethics (and vice versa)”, also considering that “values, a sense of purpose that goes beyond profitability, and concern for the well-being of stakeholders were critical to the origins of stakeholder theory”.52 Also, CSR scholars have used stakeholder theory to better specify and operationalize their concepts.53

46 Ibidem, for a review of the relevant works. 47 See Freeman, R.E., Harrison, J., Wicks, A., Parmar, B., & De Colle, S. (2010).

Stakeholder Theory. The State of the Art, Cambridge University Press, 4. 48 Freeman, R.E. (1984). Strategic Management. A Stakeholder Approach, Pitman. 49 Ibidem, 1. 50 R.E. Freeman et al., note 48, 4. 51 Ibidem, 9. 52 Ibidem, 196. 53 Ibidem, 242, with reference to Wood, D. (1991). “Corporate Social Performance

Revisited”. Academy of Management Review, 16, 691.

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In fact, the stakeholder approach to strategic management requires abandoning the idea that shareholder value maximization is the exclusive purpose of the corporation and accepting that specific stakeholder interests should be considered in defining it.54 4.2.2

Combining Value Maximization with Stakeholder Theory and CSR

After the two financial crises at the beginning of this century, there have been repeated scholarly efforts directed to reconcile shareholder value with the social instances represented by stakeholder theory and CSR. Indeed, shareholder value has shown its limits (or its dark side), with flawed corporate governance and excessive executive compensation being indicated amongst the main causes of both crises, and short-termism being also considered as one of the main problems of the failures of non-financial companies (in the 2001 crisis) and financial institutions (in the 2008 crisis). In recent years, the increasing attention devoted to environmental and social issues has enhanced the pressure towards a reconciliation of economic value and social value also on a theoretical level. 4.2.2.1 Michael Jensen on “Enlightened Shareholder Value” In a seminal paper on value maximization and stakeholder theory, M. Jensen argued that it is logically impossible to maximize in more than one dimension at the same time.55 For instance, “telling a manager to maximize current profits, market share, future growth in profits, and anything else one pleases will leave that manager with no way to make a reasoned decision. In effect, it leaves the manager with no objective”.56 Consequently, a firm should specify the trade-offs amongst the various dimensions and then identify an “objective function” that explicitly incorporates the positive and negative effects of decisions on the firm. In essence, a firm must have a single objective that tells the directors and managers what is better and what is worse. Jensen submitted that 54 R.E. Freeman et al., note 48, 242. 55 Jensen, M. (2010). “Value Maximization, Stakeholder Theory, and the Corporate

Objective Function”. Journal of Applied Corporate Finance, 22, 32, and (2002) Business Ethics Quarterly, 12, 235 (from which I quote). 56 Ibidem, 238.

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“200 years’ worth of work in economics and finance indicate that social welfare is maximized when all firms in an economy maximize total firm value. The intuition behind this criterion is simply that (social) value is created when a firm produces an output or set of outputs that are valued by its customers at more than the value of the inputs it consumes (as valued by their suppliers) in such production. Firm value is simply the long-term market value of this stream of benefits”.57 Maximizing the total market value of the firm—that is the sum of the market values of equity, debt and any other contingent claim on the firm—will resolve the trade-off problem amongst multiple constituencies.58 To the extent that stakeholder theory argues that firms should pay attention to all their constituencies, it is completely consistent with value maximization, which also requires managers to pay attention to all constituencies, such as customers, employees, suppliers of capital, communities and so on. The objective function must specify how to make the trade-offs between the often conflicting demands of these constituencies. In the words of Jensen, value maximization offers an answer to these trade-offs: “Spend an additional dollar on any constituency to the extent that the long-term value added to the firm from such expenditure is a dollar or more”.59 Traditional stakeholder theory, in contrast, contains no conceptual specification of how to make the trade-offs amongst stakeholders, leaving boards of directors and executives without a principled criterion for problem solving. However, according to Jensen, the conflict between value maximization and stakeholder theory can be solved by melding together what he calls “enlightened value maximization” and “enlightened stakeholder theory”.60 Value maximizing tells the participants in an organization how their success in achieving a vision or in implementing a strategy will be assessed. However, it does not say anything about how to create a superior vision or strategy and about how to find or establish initiatives or ventures that create value. It only tells how success in the activity will be measured. Therefore, employees and managers must be

57 Ibidem, 239, where it is also specified: “When monopolies or externalities exist, the value-maximizing criterion does not maximize social welfare.” 58 Ibidem. 59 Ibidem. 60 Ibidem, 245.

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given a “structure” that will help them to resist the temptation to maximize the short-term financial performance of the organization, which is a way to destroy value. Enlightened stakeholder theory plays an important role by leading corporate managers and directors to think more generally and creatively about how the organization treats all constituencies of the firm, not only financial markets, but stakeholders in general.61 Value cannot be created in the absence of good relations with customers, employees, investors, suppliers, regulators, communities and so on. Moreover, the value criterion can be used for choosing amongst those competing interests, because no constituency can be given full satisfaction if the firm is to flourish and survive. Enlightened stakeholder theory includes the processes and audits to measure and evaluate the firm’s management of its relations with all important constituencies, while specifying that the objective function of the firm is to maximize total long-term firm market value. In fact, changes in total long-term market value of the firm are the scorecard by which success is measured. The reference to long-term market value is justified by the fact that markets may not know the full implications of a firm’s policies until they show up in cash flows over time. Markets will recognize the real value of the firm’s decisions as they become evidenced in market share, employee loyalty and finally cash flows and risk.62 4.2.2.2 Michael Porter and Mark Kramer on “Shared Value” In a largely influential paper of 2011, Porter and Kramer essentially propose to merge the two concepts of shareholder value and societal value in that of “shared value”.63 This new concept refers to creating economic value in a way that also creates value for society by addressing its needs and challenges. The two authors argue that in the old view of capitalism business contributes to society by generating a surplus, which supports employment, wages, purchases, investments and taxes. The firm is a selfcontained entity and social issues fall outside its proper scope, as argued by Milton Friedman in his critique of CSR.64 Today, a growing number of 61 Ibidem. 62 Ibidem, 246. 63 Porter, M., & Kramer, M. (2011). “Creating Shared Value: How to Reinvent Capi-

talism—And Unleash a Wave of Innovation and Growth”. Harvard Business Review, 3. 64 Ibidem, 6.

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companies make important efforts to create shared value by “reconceiving the intersection between society and corporate performance”.65 The purpose of the corporation should therefore be redefined in terms of shared value, not just profit. The new concept includes the policies and operating practices that enhance the competitiveness of a company while simultaneously advancing the economic and social conditions in the communities in which it operates.66 The underlying premise is that both economic and social progress must be addressed through value principles, i.e. by looking at benefits relative to costs. Value creating has long been recognized in business, where profit is revenues earned from customers minus the costs incurred.67 However, societal issues have rarely been approached from a value perspective. Porter and Kramer show that companies can create economic value by generating societal value in at least three possible ways. Firstly, by reconceiving products and markets in response to the growing demand for products and services that meet societal needs. Food companies, for example, that traditionally concentrated on taste and quantities to drive more and more consumption are refocusing on the fundamental need for better nutrition.68 Secondly, by redefining productivity in the value chain, where societal problems (externalities) can create internal costs to the firm. The authors refer to the problems of excess packaging of products and of greenhouse gases, which are not just costly to the environment, but also to the business.69 On the one side, innovation in disposing of plastic used in stores can save millions in lower disposal costs to landfills. On the other, efforts to minimize pollution do not inevitably increase business costs, as major improvements in environmental performance can often be achieved with better technology at nominal incremental costs.70 Thirdly, by building supportive industry clusters at the company’s locations, firms create shared value by improving company productivity while

65 Ibidem, 4. 66 Ibidem, 6. 67 Ibidem. 68 Ibidem, 7. See the example of Danone referred to in para. 3 above. 69 Ibidem, 9. 70 Ibidem.

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addressing gaps or failures in the framework conditions surrounding the cluster.71 On the whole, the shared value approach does not differ significantly from ESV. Rather, it specifies the role that the reduction of social costs by an enterprise can play in the generation of profits. As we shall see again when considering Pieconomics (para. 9.2), the situations described by Porter and Kramer are generally of the “win-win” type for they consider actions which are at the same time beneficial to society and to the business concerned. Of course, the authors do not assume that this will always be the case. They rather suggest that the observation of reality shows that businesses which take care of societal problems are generally profitable. Clearly, this could also be a case of reverse causality, given that profitable businesses could more likely seek societal benefits in the performance of their activities. 4.2.2.3 Hart and Zingales on “Shareholder Welfare” In a much cited paper,72 Nobel laureate Oliver Hart and Luigi Zingales argue that companies should maximize shareholder welfare, which includes ethical issues, not just shareholder value. Their core intuition is simple: “The ultimate shareholders of a company (in the case of institutional investors, those who invest in the institutions) are ordinary people who in their daily lives are concerned about money, but not just about money. They have ethical and social concerns”.73 It is therefore reasonable to assume that they would want the companies in which they invest to behave accordingly, i.e. to take social factors into account and internalize externalities in their own behaviour. Hart and Zingales feel close to that part of the literature on corporate purpose that emphasizes CSR and considers the empirical implications of a company’s pursuing a broader objective.74 Despite sharing Milton

71 Ibidem, 12. 72 Hart, O., & Zingales, L. (2017). “Companies Should Maximize Shareholder Welfare

Not Market Value”. Journal of Law, Finance, and Accounting, 247. 73 Ibidem, 248. 74 Ibidem, 251, quoting approvingly two legal works in particular: Elhauge, E. (2005).

“Sacrificing Corporate Profits in the Public Interest”. New York University Law Review, 80, 733; Stout, L., & Stout, L. (2012). The Shareholder Value Myth. San Francisco: BK Publishers.

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Friedman’s theory of corporate purpose, they reject his criticism of corporate social responsibility. Friedman famously argued that public companies should focus on making money and leave ethical issues to individual shareholders and governments (paragraph 5.1). The former—rather than companies—should decide whether and how to spend their money on prosocial issues, like charity and similar activities. The latter should correct externalities through public regulation. Hart and Zingales submit that Friedman was right only to the extent that “the profit making and damage generating activities of companies are separable or if government perfectly internalizes externalities through laws and regulations”.75 The condition of separability occurs in particular with respect to charity activities, which can be equally or better performed by shareholders. However, Hart and Zingales believe that corporate activities are often inseparable76 and invite to consider as an example “the case of Walmart selling high-capacity magazines of the sort used in mass killings. If shareholders are concerned about mass killings, transferring profits to shareholders to spend on gun control might not be as efficient as banning the sales of high capacity magazines in the first place”.77 As a result, “when profit and damage are inextricably connected for technological reasons”, companies should maximize shareholder welfare, not market value.78 In similar situations, shareholder welfare cannot be assumed to be equal to market value, as it also includes ethical issues which should also be taken care of by firms. Moreover, the two economists argue that regulation is not always efficient in similar cases and that writing rules on the relevant issues (like treating workers with dignity) may be difficult, so that it is better to leave their implementation to shareholders. One way for the shareholders to intervene would be to let them vote on the broad outlines of corporate policy, so that they would be able to express their preferences also in terms of ethical and social values.79 Hart and Zingales suggest that their theory is practically relevant for the debate on fiduciary duties of corporate directors.80 They submit, in 75 Ibidem, 248. 76 Ibidem, 249. 77 Ibidem. 78 Ibidem, 249. 79 Ibidem, 270. 80 Ibidem, 262.

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particular, that the fiduciary duties to shareholders should be understood as directed to promote shareholder welfare, not just shareholder value. To the possible objection concerning the cost of reaching consensus amongst investors about what objectives (other than money) a company should pursue, they answer that directors could poll their members on some fundamental choices and then decide accordingly. However, it is not sure that the proposed interpretation of fiduciary duties would add much to what is already the law in many jurisdictions, as shown in Sect. 4.3.81 Where a pluralistic approach to corporate purpose is followed, it is already clear that directors can take social issues into account when deciding on corporate actions. Where a profit purpose is narrowly assigned to stock corporations, directors are nevertheless generally allowed or even required to consider ethical and social values in the pursuit of profit. Polling shareholders would not be a good choice in many cases, given the well-known collective action problems affecting similar procedures, which lead the same authors to opine, in the end, that “market value maximization can be justified as a second best objective in a world where the social preferences of shareholders are sufficiently heterogeneous”.82

4.3

The Comparative Law of Corporate Purpose

In this section, I make a brief comparison of the laws concerning corporate purpose (or broadly similar concepts, such as the company’s interest) in a few major jurisdictions and try to understand whether the highlighted differences are meaningful in practice or mainly reflect dominant ideologies of the jurisdictions in question at the relevant time without producing substantial effects on the way in which corporations are run. I also classify the different legal systems depending on whether they follow a shareholder primacy or a pluralistic approach, without overemphasizing, however, such distinction given that most systems in practice tend to find a place somewhere between the two extremes, notwithstanding their formal shareholder or stakeholder orientation. 81 Rock, note 2, at 18, makes the following comment on Hart and Zingales paper: “Whether, overall, it would make sense as a matter of corporate governance to embrace the ‘shareholder welfare’ objective in place of a ‘shareholder value’ objective is a real world question that their interesting model does not resolve”. 82 Hart and Zingales, note 94, 271.

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Continental Europe

In the absence of a comprehensive company law harmonization at EU level, corporate purpose is mainly governed by the national laws of member states, which have a long tradition in this area and show some similarities, at least in Continental Europe. However, there are harmonization efforts presently pending at EU level that I critically consider below in para. 13.3. 4.3.1.1 The German Pluralistic Approach A comparative paper by Holger Fleisher shows that the first definition of corporate purpose in Germany was found in the Corporate Law of 1937, which was strongly influenced by the ideology of the time and made reference to the common good of the enterprise, the people and the Empire, without specifically mentioning the interest of shareholders.83 This definition was kept in post-war legislation with the understanding that it should be adapted to describe the new economic and political system commonly known as social market economy. The management board was tasked with the reconciliation of the company’s interest with the collective one, however as a matter of public policy rather than as a duty of board members. Corporate purpose was considered again in the works for the German Corporate Law of 1965, the first draft of which reformulated the 1937 provision by stating that the management board should manage the company under its own responsibility, as required by the good of the enterprise, its workers and shareholders, and by the common good.84 However, the proposed provision was rejected as superfluous and other proposals were also rejected by the legislator, while acknowledging in the preparatory works that corporations should not be run only for profit, but also in the interest of the national economy and in the collective interest. In the end, the old provision which emphatically defined corporate purpose was cut back to the following: “the management

83 See Holger Fleischer, “Gesetzliche Unternehmenszielbestimmungen im Aktienrecht – Eine vergleichende Bestandsaufnahme”, in ZGR, 46, p. 411. I cite from the Italian version of this paper, “La definizione normativa dello scopo dell’impresa azionaria: un inventario comparato”, in Rivista delle Società, 2018, 803. 84 Ibidem, at 806.

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board should manage the corporation under its own responsibility”.85 According to Fleischer, the 1965 provision has shown practical importance only in a few cases,86 while scholars and courts tend to implicitly assume the enduring validity of the 1937 provision and defend a pluralist vision of corporate purpose. The concept of shareholder value has also gained ground in the definition of corporate purpose.87 Fleischer recalls that the original formulation of corporate purpose in the German Corporate Governance Code made reference to long-term value creation,88 but was changed in 2009 to emphasize the role of stakeholders, given the criticism addressed to capitalism after the financial crisis.89 The same provision was changed once more in 201790 and was further amended in the 2019 edition of the Code, which simply states under Principle 1: “The Management Board is responsible for managing the enterprise in its own best interests”. However, the Foreword to the Code highlights “the obligation of Management Boards and Supervisory Boards – in line with the principles of the social market economy – to take into account the interests of the shareholders, the enterprise’s workforce and the other groups related to the enterprise (stakeholders) to ensure the continued existence 85 Sec. 76 (1) of the German Corporate Law. 86 Fleischer, note 15, 806. 87 See the seminal paper by P. Mülbert, “Shareholder Value aus rechtlicher Sicht”, 26

Zeitschrift für Unternehmens- und Gesellschaftsrecht (2009) 2, 129. 88 Fleischer, note 15, 808. See Para. 4.1.1 of the German Code of Corporate governance 2002, convenience translation, which stated: ‘The Management Board is responsible for independently managing the enterprise. In doing so, it is obliged to act in the enterprise’s best interests and undertakes to increase the sustainable value of the enterprise’. 89 See Para. 4.1.1 of the German Corporate Governance Code 2009, conve-

nience translation, at https://www.dcgk.de/files/dcgk/usercontent/en/download/code/ D_CorGov_final_2009.pdf, stating: ‘The Management Board is responsible for independently managing the enterprise with the objective of sustainable creation of value and in the interest of the enterprise, thus taking into account the interests of the shareholders, its employees and other stakeholders’. 90 See Para. 4.1.1 of the German Corporate Governance Code 2017, conve-

nience translation, at https://www.dcgk.de/files/dcgk/usercontent/en/download/code/ 170214_Code.pdf, stating: ‘The Management Board assumes full responsibility for managing the company in the best interests of the company, meaning that it considers the needs of the shareholders, the employees and other stakeholders, with the objective of sustainable value creation.’

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of the enterprise and its sustainable value creation (the enterprise’s best interests)”.91 These repeated changes testify to the continuing discussion and the fluctuating political values involved in it, rather than to the practical relevance of the definitions found in successive editions of the Code. At the same time, they reflect the pluralistic vision of corporate purpose, its link to the social market economy and an overall preference for stakeholder governance. 4.3.1.2

French New Legislation and the Raison D’être of Companies Interesting developments have recently occurred in France, where Article 1833 Civil Code simply provided that any company shall have “a legal purpose and shall be formed in the common interest of the partners”. The PACTE Act of 22 May 2019 added a second paragraph to this Article stating: “A company shall be managed in its corporate interest, factoring in the social and environmental issues raised by its business activity”.92 Alain Pietrancosta, in a comment of this new provision, remarks that Article 1833 has remained almost unchanged since the time of Napoleon and has always represented one of the cornerstones of the French economic model.93 Nonetheless, “the new wording broadly reflects French case law which leans towards an open concept of corporate interest and, therefore, one that is not limited to maximizing shareholder value, as has been often alleged during discussions”.94 He also noted that the “reference to factoring in the social and environmental issues is, in itself, more innovative and raises a number of questions”, such as the content and scope of the new obligations placed on corporate organs.95 Pierre-Henri Conac similarly remarks that the recent reform

91 See German Corporate Governance Code 2019, convenience translation, at https:// www.dcgk.de//files/dcgk/usercontent/en/download/code/191216_German_Corpor ate_Governance_Code.pdf. 92 See the Law No. 019-486 of 22 May 2019 concerning the growth and transformation of enterprises, known as Loi PACTE. 93 See Pietrancosta, A. (2019) “‘Intérêt social’ and ‘raison d’être’: Thoughts About Two Core Provisions of the Business Growth and Transformation Action Plan (PACTE) Act That Amend Corporate Law”. In Réalités Industrielles, November 2 (I quote from an English translation which was kindly provided to me by the author). 94 Ibidem, 3. 95 Ibidem.

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has a strong political dimension, envisaging a broad conception of the company’s interest and the need for “un droit des sociétés sociétal”, i.e. a company law subject to social imperatives.96 In his view, the reform should be seen more as a restatement than a revolution, as French law in the last twenty years and particularly after the 2008 financial crisis has repeatedly acknowledged the corporate social responsibility (CSR) of enterprises in several pieces of legislation. Interestingly, however, the reform bill found strong opposition in the French Senate, which has presently a right-wing majority and objected that the new provisions will increase the legal risk for business enterprises, which could be sued for not taking the environmental and social issues sufficiently into account.97 The PACTE Act also added a new provision to article 1835 of the Civil Code, under which companies can specify their “raison d’être” (corporate purpose) in their charter, which consists of the principles that the company adopts and complies with in the performance of its activities. Clearly, the more specific is corporate purpose, the more likely it is that obligations will derive from it to the company and its directors.98 A generic statement of purpose will no doubt be less meaningful and more difficult to enforce. French law distinguishes corporate purpose from the company’s interest; however, overlaps may occur between these two concepts, given that the company’s interest must factor in those social and environmental issues that will be more specifically defined in the charter when dealing with corporate purpose.99 Also, wealth maximization is part of both concepts, to the extent that it characterizes the concept of corporate interest together with other objectives, while the charter’s definition of corporate purpose can refer to it at least as a requirement to satisfy when taking care of other interests, such as those of the workers or the local communities. In the end, French corporate law leans towards a mixed notion of the intérêt social, which reconciles the

96 See P. Conac, “Le nouvel article 1833 du Code Civil Français et l’integration de l’intérêt social et de la responsabilité social d’entreprise: constat ou revolution?”, in Orizzonti del diritto commerciale, 3, 2019, 500, available at http://www.rivistaodc.eu/Hom ePage. 97 Ibidem, 501. 98 See S. Schiller, ‘L’évolution du röle de sociétés depuis la Loi PACTE’, in Orizzonti

del diritto commerciale, note 28, 525. 99 See I. Urbain Parleani, ‘L’article 1835 et la raison d’être’, in Orizzonti del diritto commerciale, note 28, 533, at 542.

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interest of shareholders to profit maximization with those of stakeholders and more generally with the interests of the environment and society. 4.3.1.3

From Shareholder Value to Sustainable Success in Italian Corporate Governance Italian law is aligned with French law, however more from a doctrinal perspective than based on the text of individual rules. Italian legal scholars traditionally recognize that companies must be managed in the company’s interest and the majority of them defines it as the common interest of shareholders.100 Moreover, they tend to identify the company’s interest with the purpose of profit, which is one of the core elements of the general definition of a company under Article 2247 Civil Code.101 As a result, corporate purpose is usually constructed in terms of maximization of either corporate profits or shareholder value.102 Exceptions are found in judicial cases, where courts (including the Supreme Court) have in the past defined the company’s interest as the interest of the company as such, rejecting the contractarian approach followed by the great majority of the scholars.103 Interestingly, contemporary legal scholars argue that companies could also pursue the interest of stakeholders whenever a similar behaviour is instrumental to the maximization of corporate profits in the medium-long term.104 Moreover, they argue that corporate purpose can be specified in the company’s charter, despite the fact that this is not explicitly stated in

100 See A. Mignoli, ‘L’interesse sociale’, in Rivista delle società, 1958, 725; P.G. Jaeger,

L’interesse sociale, Giuffrè, 1964; on the evolution of legal scholarship in this area, see the collective volume L’interesse sociale tra valorizzazione del capitale e protezione degli stakeholders. In ricordo di Pier Giusto Jaeger, Giuffrè 2010. 101 See L. Enriques, Il Conflitto d’interessi degli amministratori di società per azioni, Giuffrè, 2000, 173; U. Tombari, “Potere” e “interessi” nella grande impresa azionaria, Giuffrè Francis Lefebvre, 2019, 62. 102 See Ferrarini, G. (2003). “Shareholder Value and the Modernization of European Corporate Law”, in K. Hopt and E. Wymeersch (eds.), Capital Markets and Company Law, Oxford University Press, 230. For a radical criticism of this and other concepts of modern corporate law, see G. Rossi, Il conflitto epidemico, Adelphi edizioni, 2003, 47 and 71. 103 See L. Enriques, note 33, 162, n. 64. 104 See the discussion by M. Libertini, in Orizzonti del diritto commerciale, note 28,

602; U. Tombari, “Potere” e “interessi” nella grande impresa azionaria, Giuffrè Francis Lefebvre, 2019, 30 ff.

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the law.105 They also acknowledge that a similar definition could include a reference to stakeholders and to sustainability in general.106 Consistently, the 2020 edition of the Italian Corporate Governance Code107 states under Principle 1.I that the board of directors leads the company in the pursuit of its “sustainable success”, while defining the latter as the “creation of value in the long term to the benefits of shareholders, taking account of the interests of other relevant stakeholders”. This definition follows the enlightened view of shareholder value that I consider in para. 6 above. In the end, French and Italian laws are close to each other despite the clear differences in the nature and text of the relevant provisions, which have clarified the essence of what scholars already argued in both countries when discussing the company’s interest. Yet, the reference to the “raison d’être” of the company is an innovation of French law which could bring about significant developments in corporate practice and in the end could influence future developments of European law. 4.3.2

UK and US

In this section, I briefly consider the role of corporate purpose under UK law and US law. Grounded on the same old cases, these two jurisdictions have evolved in different directions as to corporate purpose, even though the practical impact of such differences is modest. 4.3.2.1 Enlightened Shareholder Value in the UK Companies Act Under Section 172 (1) of the 2006 UK Companies Act: “A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole (…)”. This duty is “the modern version of the most

105 See M. Libertini, ‘Un commento al manifesto sulla responsabilità sociale dell’impresa

della Business Roundtable, in Orizzonti del diritto commerciale, note 28, 627, at 633. 106 See the discussion by U. Tombari, in Orizzonti del diritto commerciale, note 28, 627, at 633. See however, for critical remarks, F. Denozza, ‘Lo scopo della società: dall’organizzazione al mercato’, ibidem, 615, at 617. 107 Available at https://www.borsaitaliana.it/comitato-corporate-governance/codice/ 2020.pdf.

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basic of the loyalty duties owed by directors”,108 which applies to every exercise of judgement that the directors undertake either in the straight implementation of their powers or in situations of conflict of interest.109 The formulation of this duty was the subject of considerable controversy in the preparatory works of the Companies Act, especially since it was proposed that the statute should not simply repeat the common law duty of directors to act in good faith in what they believed to be “the best interests of the company”.110 A similar test was considered as too vague, so that the question arose whether the directors should be required to act in the interests of shareholders (shareholder primacy), or give equal status to all the company’s various stakeholders (pluralist approach).111 The final outcome is something between these two extremes. Section 172 (1) continues by setting a non-exhaustive list of six matters to which the directors must “have regard” in performing their duty to promote the success of the company, such as: “(a) the likely consequences of any decision in the long term, (b) the interests of the company’s employees, (c) the need to foster the company’s business relationships with suppliers, customers and others, (d) the impact of the company’s operations on the community and the environment, (e) the desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to act fairly as between members of the company”. This provision not only rejects the pluralist approach—given that the interests of stakeholders are subordinate to those of shareholders—112 but also redefines shareholder primacy. According to the Company Law Review, the philosophy behind the statutory formulation was to be one of “enlightened shareholder value (ESV)”, a concept that I have analysed under para. 6.1.113

108 See Gower & Davies. (2012). Principles of Modern Company Law, 9th ed. by P. Davies and S. Worthington, Sweet & Maxwell, 540. 109 Ibidem. 110 Ibidem. 111 Ibidem, 541. 112 Ibidem. 113 See DTI, Company Law Reform, 2005, 20.

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4.3.2.2 US Law Fish and Davidoff depict the evolution of corporate purpose under US corporate law.114 The two authors explain that the statutory requirement that corporations articulate in their charter the purpose for which they are formed goes back to the time when there were statutory limitations to the use of the corporate form. Modern corporation statutes eliminated these limitations and presently do not restrict the permissible purpose for which a corporation may be formed, save for the requirement that it is lawful. As a result, most corporate charters contain a generic statement that the purpose of the corporation is to engage in any lawful activity.115 At the same time, statutes do not require the charters to endorse a shareholder profit maximization norm. Fish and Davidoff believe that the pursuit of stakeholder and societal interest can be reflected in the purpose provisions of traditional for-profit corporations (as typically happens for public benefit corporations); however, “few corporations contain any language in their charters reflecting a commitment in such a way as to provide questionable legal impact”.116 No doubt, in the often cited Dodge v. Ford, the Michigan Supreme Court in 1919 held that a corporation’s purpose was to maximize shareholder profit.117 However, this was an old case, decided with reference to a non-public company, in a non-Delaware jurisdiction.118 Moreover, it mainly concerned the duties of a controlling shareholder (Henry Ford) towards minority shareholders (Horace and John Dodge).119 Few other cases have subsequently addressed corporate purpose, notably a number of cases in Delaware concerning mergers and acquisitions. In Revlon v. MacAndrews & Forbes Holdings, Inc.,120 the court held that in a change of control situation the board was required to obtain the “highest price for the benefit of the stockholders” rather than prioritizing the interests

114 J. Fish and S. Davidoff Solomon, note 1. 115 Ibidem, 105. 116 Ibidem, 105–106. 117 204 Mich. 459 (MI 1919). 118 See L. Stout, note 75, 27. 119 Ibidem, 26 arguing that the court’s statements on corporate purpose are to be seen as a dictum. 120 506 A.2d 173 (Del. 1985), 182.

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of noteholders.121 As argued by E. Rock, in such cases the corporation is sold for cash and the shareholders will not have any long-term interest in it.122 In similar circumstances, “Delaware courts are crystal clear that the duty of the board is to secure the highest value reasonably available for shareholders, and may not balance the interest of shareholders against the interests of other stakeholders”.123 More generally, Rock analyses corporate purpose focussing on the corporate form. He argues that in “traditional” jurisdictions the “objective” of the corporation is that identified by Chancellor William Chandler of the Delaware Supreme Court: “to promote the value of the corporation to the benefit of its stockholders”.124 The situation is different in “constituency jurisdictions” like Pennsylvania, where the statute explicitly rejects the shareholder primacy and allows the board of directors to consider all relevant interests, making it clear that the board need not put shareholders’ interest first. Nevertheless, in traditional jurisdictions like Delaware, shareholder primacy is not dictated by the statute, but grounded on case law.125 In cases of conflict between the interests of shareholders and those of stakeholders, the courts either are in a condition to defer to the discretion of the board under the business judgement rule or affirm the primacy of shareholders interest. Rock also criticizes the thesis advanced by shareholder value opponents, including the late Lynn Stout, who argued passionately that the business judgement rule would ensure that managers of public company have no enforceable legal duty to maximize shareholder value.126 Rock concedes that outside of the sale of company context there is no general legal duty to maximize shareholder value, but insists that there is a general legal duty to pursue or promote such value as decided in the e-Bay

121 J. Fish and S. Davidoff Solomon, note 40, 120, who argue that the rationale behind Revlon and other Delaware takeover cases was regulating inherent conflicts of interest and therefore managerial loyalty, rather than shareholder primacy, citing Z. Gubler, What’s the Deal with Revlon? (working paper, draft dated Feb. 24, 2020) to this effect. 122 E. Rock, note 2, 9. 123 Ibidem. 124 Ibidem, 8, referring to e-Bay Domestic Holdings, Inc. v. Newmark, 16 A.3rd 1, 34 (Del. Ch. 2010). 125 Ibidem, 9. 126 See L. Stout, note 75, 32.

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case.127 He concludes, however, that the shareholder primacy framework of Delaware corporate law does not answer many of the questions that “partisans” think it should. It does not decide, for instance, that shareholders as “owners” of the corporation “have the right to tender into a tender offer at a premium to the current market price”, or that corporations “must reduce wages to the minimum to maximize current share price”.128 He adds that Delaware corporate law is deeply “board centric” and that under the business judgement rule courts give great discretion to the board to the extent that directors are disinterested and act in good faith. As a result, “disinterested directors seeking in good faith to promote the value of the corporation have the discretion to make the decisions that they believe are best for the corporation and its stakeholders”.129 Moreover, Rock believes that constituency jurisdictions do not diverge from traditional ones beyond the point of rejecting the Revlon doctrine in the sale of control context.130 On one side, boards in traditional jurisdictions may take into account the interests of stakeholders in a large range of areas under the discretion granted to boards outside of “conflict” scenarios. On the other, courts in constituency jurisdictions follow traditional approaches outside of the sale of company context; some of them even interpret the constituency laws as consistent with the shareholder primacy approach. 4.3.2.3 A Brief Comparison Corporate law is criticized by some for mainly focusing on shareholder wealth and considering profit as the corporate purpose par excellence.131 However, this criticism does not hold from a comparative law perspective, as shown by our analysis of European and US laws, which do not necessarily consider shareholder value as the sole corporate purpose despite the emphasis put on this concept in financial practice. Noteworthy examples are the “constituency” jurisdictions in the US and German law, which are more oriented to the enterprise than to the corporation and are

127 Rock, note 2, 13. For the e-Bay case, see note 124. 128 Ibidem, 11. 129 Ibidem, 12. 130 Ibidem. 131 See the works by C. Mayer and A. Edmans discussed below at para. 9.1. and 9.2.

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to some extent focussed on stakeholders, as shown in particular by the codetermination regime applicable to large corporations in Germany.132 True, other corporate laws in Europe and the US define corporate profit as the main purpose of the company and the shareholders’ interest as the main interest to pursue in the management of companies.133 However, stakeholders are taken care of on governance grounds even in countries that do not follow the pluralist model of corporate governance, but a shareholder primacy model. Stakeholders’ protection in these countries mainly depends on either contracts or regulation (such as environmental and labour laws), but also on corporate governance to the extent that stakeholders’ interests are considered at board and management levels. Under this approach, the task of the board of directors and top management is to reconcile the interests of shareholders with those of stakeholders in view of maximizing the enterprise value over the long term.134 In a similar vein, the theory of enlightened shareholder value that I considered in para. 4.2.2.1 above suggests that shareholder wealth should be maximized in the medium-long term, which requires the interests of stakeholders to be met as a condition for maximizing the value of the firm.135 Section 172 of the UK Companies Act, which was quoted above, reflects this theory.136 Moreover, a shareholder value approach has been widely followed by corporate governance codes applicable to listed companies in all major jurisdictions, including Germany where corporate law is stakeholder oriented, but shareholder value concepts have been imported as a consequence of capital markets development.137 No doubt, the emphasis on shareholder value is stronger when a company is listed

132 See Hopt, K. (1996). “Labour Representation on Corporate Boards: Impacts and Problems for Corporate Governance and Economic Integration in Europe”. In R. Buxbaum et al. (eds.), European Economic and Business Law. Berlin and New York, 269. 133 See G. Ferrarini, note 103, 230 ff. 134 See Becht, M., Bolton, P., & Roell, A. “Corporate Governance and Control”, ECGI

Finance Working Paper 02/2002, arguing that corporate governance is concerned with the resolution of collective action problems among dispersed investors and the reconciliation of conflicts of interest between various corporate claimholders. 135 See M. Jensen, note 56, 8. 136 See Harper Ho, V. (2010). “Enlightened Shareholder Value: Corporate Governance

Beyond the Shareholder-Stakeholder Divide”. Journal of Corporation Law, 36, 59. 137 See Ferrarini, note 103, 232 ff.

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and its shares are traded on the capital markets, given that investors expect a return on their investment which can derive from both dividends and capital gains.138

4.4 Social Value Acolytes V. Shareholder Value Purist The statements of international bodies and corporations cited in Sect. 4.1 of this paper find strong support in recent scholarly writings on the economics and politics of corporate purpose, but are heavily disapproved by others. In the present section, I critically analyse four of these works, three supporting to various degrees the current stakeholderist trends and the fourth one objecting to them from a pure shareholder value perspective. My criticism of similar approaches moves from an intermediate perspective, which is substantially grounded on ESV, however with the refinements specified in para. 13 below. 4.4.1

Colin Mayer on “Prosperity” and Corporate Purpose

Prosperity by Colin Mayer, an Oxford economist and professor of management,139 has influenced the policy discussion in several countries, suggesting an enlarged view of corporate purpose that goes beyond the mere pursuit of profit. Having recently published an extensive review of this book,140 in this paragraph I summarize its main ideas and limits. 4.4.1.1 Commitment to Corporate Purpose Mayer defines the corporation as an instrument of commitment, which must be understood as commitment to corporate purpose. In his words, the corporation assures commitment, which generates trust and facilitates

138 See Davies, P. “Shareholder Value, Company Law, and Securities Markets Law”. In

Hopt and Wymeersch (eds.), note 19, 261 ff. 139 Mayer, C. (2018). Prosperity. Better Business Makes the Greater Good. Oxford University Press. 140 Ferrarini, G. (2020). “An Alternative View of Corporate Purpose: Colin Mayer on Prosperity”. Rivista delle società, 1, 27 (downloadable as a working paper at https://pap ers.ssrn.com/sol3/papers.cfm?abstract_id=3552156).

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the relations with the different parties involved, in adherence to corporate purpose.141 He argues that the firm’s key determinants are purpose, ownership and governance. But corporate purpose is not simply to make profits, which are rather its product. Successful corporations have a clearly defined purpose, stable and supportive ownership, and accountability of boards and directors. Mayer defines them as “enlightened corporations”. They balance and integrate the six components of capital that ground business activities: human, intellectual, material, natural, social and financial capital. In his opinion, company law should be reformulated to require corporations to articulate their purposes, along the model of the benefit corporation under US corporate law.142 Mayer believes that it is wrong to protect shareholders by emphasizing their rights and powers, and viewing the corporation as their instrument. However, he also thinks that it would be wrong to transfer control of the corporation to stakeholders such as creditors, customers or employees, for this would make it difficult to raise capital. He rather suggests to enhance the separation of management control from ownership of the firm and focus on the fiduciary responsibility of directors to the members of the corporation. This is what Hansmann and Kraakman define as the “trustee model” of stakeholder governance, distinguishing it from the “representative model”.143 Both models address the problem of protecting non-shareholder interests in the corporation. However, under the representative model qualified non-shareholder constituencies appoint their own directors, who together elaborate policies that maximize the jointwelfare of all stakeholders subject to the bargaining between different groups in the boardroom. Under the trustee model, the board of directors and the senior managers act on behalf of the entire enterprise by co-ordinating the contributions and returns of all of its stakeholders.

141 Mayer thinks of the corporation as an institution: “the law recognizes that the corporation is a legal personality distinct from its shareholders” (Prosperity, …). However, in his theory relations play a decisive role. 142 The benefit corporation has a stated public purpose alongside its commercial objectives, which are enshrined in its charter. Moreover, directors have a fiduciary duty to uphold those public purposes and “if they fail to do so then shareholders can seek injunctive relief to prevent them abusing the corporation’s purposes” (p. 42). 143 See Hansmann, H., & Kraakman, R. (2001). “The End of History for Corporate Law”. Georgetown Law Journal, 89, 439.

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4.4.1.2 Governance of Purpose In Mayer’s proposed model, directors balance the interests of shareholders with those of creditors, employees, customers and communities, in pursuit of the long-term prosperity of the corporation. In fact, an excessive focus either on shareholders returns or on stakeholder interests would jeopardize the delicate balance between present members and future generations. A similar argument was advanced by Blair and Stout in their works on the team production theory of corporate law, which focuses attention on the mediating role of the boards of directors.144 Mayer similarly assigns to the board the role of defining and implementing the corporate purpose and of monitoring the firm’s commitment to it. In his theory, corporate purpose should be defined by contract and fiduciary duties should be based on the corporate purpose so defined. This would originate trust in the corporation by its members. The solution proposed is clearly grounded on private law. Indeed, Mayer argues that regulation has been a failure because the interests of regulators are opposed to those of shareholders. Company law should be reformed so as to replace regulation, which would require redefining corporate purpose and avoiding its identification with the pursuit of profit. Mayer describes corporate governance as “governance of purpose”, while defining purpose as “the reason for a company’s existence”.145 However, “corporate governance is not and should not be about 144 Blair, M., & Stout, L. (1999). “A Team Production Theory of Corporate Law”. Vanderbilt L. R. 85, 247. The two authors started from the premise that the central problem to be solved in organizing production activities in corporations is a ‘team production’ problem, which typically occurs when several types of resources are used, the product is not the sum of separable outputs of each cooperating source, and not all resources used in the team production belong to one person. Some economists have suggested that one solution to the team production problem is to give final authority over the allocation of the output to an outsider to the team. Blair and Stout argue that this governance arrangement fits the role that the law assigns to boards of directors in corporations. Indeed, corporate law requires that many of the most conflicted and contentious decisions about corporate policy must be made by the board of directors and in some cases by a subset of directors who form a committee of disinterested directors. See also Blair, M. (2015). “Boards of Directors and Corporate Performance Under a Team Production Model”, in J. Hill and Randall Thomas (eds.), Research Handbook on Shareholder Power. Elgar, 249, at 257. 145 Mayer, note …, 109. He also argues that companies exist to do things, not simply to make profits: ‘The purpose of companies is to produce solutions to problems of people and planet and in the process to produce profits, but profits are not per se the purpose of companies’.

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enhancing shareholder value”.146 The correct focus of corporate governance should be about how all aspects of ownership, boards, and remuneration promote corporate purpose and the success of companies. Company’s customers should comprise all of its consumers, communities, and citizens. In this way, corporate governance enhances economic growth, entrepreneurship, innovation and value creation. It may also lead to increased shareholder value; but in an inversion of the traditional ranking “purpose is primary and shareholder value derivative”.147 This last statement reflects the widespread and well-known criticism of the shareholder value philosophy. However, similar criticism is usually addressed to managerial excesses in the pursuit of corporate profits, particularly short-term profits, rather than to the practice of long-term value maximization which also takes into account stakeholders’ interests. If we take the suggested “inversion” literally—purpose is primary and shareholder value derivative—Mayer’s theory appears to be a radical version of stakeholder theory. Under the prevailing theory, stakeholders’ interests are satisfied subject to long-term shareholder value maximization, whereas Mayer subordinates shareholder value maximization to the realization of corporate purpose. Therefore, shareholder wealth is not necessarily maximized when corporate purpose, as announced in the corporate charter, is fulfilled. Indeed, there might be cases in which the activities required by the commitment to corporate purpose are pursued by the managers even in the absence of a foreseeable long-term value maximization. Mayer rejects regulation as an appropriate response to the problems of today’s corporations, save for financial firms. He would mainly rely on private law and corporate governance as means to ground commitment to corporate purpose. He also suggests to specify corporate purpose in the articles of association of companies, a solution that has been recently adopted by the French legislator allowing them to define their raison d’être in the statute. Clearly, there are limits to this remedy, for the wording of corporate purpose will often be generic; managers will always find ways to circumvent it; shareholders will find it difficult to monitor

146 Ibidem, 113. 147 Ibidem, 114.

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compliance; enforcement of similar undertakings in cases of breach will be too difficult.148 4.4.1.3 Our View I personally believe that regulation should have a greater say in disciplining corporations than Mayer suggests. We cannot expect companies to fully internalize the social costs of their externalities in areas like, for instance, climate change or corruption. Similarly, we cannot rely on corporate governance and shareholders as the main instruments to preserve the integrity of corporations. We need regulation and to some extent criminal law to obtain compliance with the legal principles protecting the environment and the social conditions within the firms. No doubt, corporate governance and ownership (including institutional investors and controlling shareholders) can contribute to effective compliance and are therefore good complements to regulation, but we should not expect them to become substitutes for regulation. Environmental and social issues are, for many aspects, similar to the stability and systemic issues generated by financial institutions, which are widely dealt with under financial regulation. Company law is largely enabling today and leaves room for private autonomy, including the definition of corporate purpose. However, mandatory provisions for corporations are increasingly found in securities regulation, which applies to listed companies and often works as a substitute for corporate law.149 Also, corporate governance is to some extent subject to regulation, the reason being that we cannot always expect corporations and their managers to take care of investor protection. Mayer rightly comments that rules protecting minorities may diminish the effectiveness of controlling shareholders in pursuing idiosyncratic value and

148 For a strong criticism of this type of solution from a legal perspective, see Ventoruzzo, M. (2020). “Brief Remarks on ‘Prosperity’ by Colin Mayer and the Often Misunderstood Notion of Corporate purpose”. Rivista delle società, 1, 43, at 46. 149 The importance of corporate law is, however, declining as a result of the rise of insti-

tutional investors: see Goshen, Z., & Hannes, S. The Death of Corporate Law, ECGI Law Working Paper N° 402/2018 May 2018, arguing that the more competent shareholders become, the less important corporate law will be. Increases in shareholder competence reduce management agency costs, intensify market actors’ preference for private ordering outside of courts, ultimately driving corporate law into oblivion.

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therefore reduce the growth and prosperity of companies. However, arguments of this type highlight some serious limits of regulation, but should not substantially detract from the core reasons for it. As argued in my review of Prosperity, corporate purpose should rather be seen from the intermediate perspective of the enlightened shareholder value theory, which represents a compromise between the traditional shareholder primacy theory and the stakeholder approach to the corporation.150 Moreover, corporate purpose should be specified and implemented in practice mainly by the board of directors and the top managers, who should reconcile the interests of the shareholders with those of other stakeholders and the community in general. 4.4.2

Alex Edmans’s “Pieconomics”

Another book deals innovatively with corporate purpose and with the question whether firms should be run mainly for shareholders. In Grow the Pie by Alex Edmans,151 a professor of finance at London Business School, the pie represents the value an enterprise creates for society. The different members of society capture different slices of the pie, depending on what strategy management chooses to adopt. They are investors, on one side, and stakeholders (customers, employees, suppliers, environment, government and communities), on the other. Investors enjoy profits, but the pie includes more than profits. It includes the value that an enterprise gives to its employees, “their pay, but also training, advancement opportunities, job security, and the ability to pursue a vocation and make a profound impact on the world”.152 4.4.2.1 Pie-Splitting V. Pie-Growing The pie also includes the value that customers enjoy over and above the price they pay (“surplus”). Moreover, it includes the value accruing to

150 The former is well exemplified by Friedmann, M. “The Social Responsibility of

Business Is to Increase its Profits”, The New York Times Magazine, September 13, 1970; the latter by Freeman, R. (2010). Strategic Management: A Stakeholder Approach, 2nd ed. Cambridge University Press. 151 Edmans, A. (2020). Grow the Pie. How Great Companies Deliver Both Purpose and Profit. Cambridge University Press. 152 Ibidem, 19.

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suppliers through a stable source of revenue, i.e. the value of funding.153 Furthermore, the pie includes the value provided to the environment, by reducing resource consumption and carbon emissions. In addition, it includes the value enjoyed by communities, as an enterprise provides employment opportunities, contributes to schools, donates its knowledge or products to local initiatives, etc. Lastly, the pie includes the value given to the government through tax revenues. On the whole, stakeholders enjoy value, while investors enjoy profits which are a form of value. Edmans defines the traditional approach to his book’s topic as “piesplitting mentality”. Such approach views the pie as being fixed in size, so that the only way to increase one member’s share of the pie is to split it differently. Since the pie is fixed, at least in the short term, the only way to maximize profits is by taking from stakeholders.154 Piesplitting can be done almost immediately at zero cost. Enterprises can take surplus from customers either by “price-gouging” or by pushing products that customers don’t need or don’t understand.155 They can also exploit employees—e.g. by paying workers below the minimum wage—or squeeze suppliers by paying them as late as possible.156 The new approach suggested by Edmans—that he dubs “pie-growing mentality”—sees the pie as expandable “to create value for society … Profits, then, are no longer the end goal, but instead arise as a by-product of creating value (…)”.157 Investors do not need to take from stakeholders, and stakeholders don’t need to defend themselves from investors. Edmans uses the term Pieconomics to capture “an approach to business that seeks to create profits only through creating value for society”.158 His views differ from traditional CSR which in his opinion typically refers to activities such as charitable contributions. Pieconomics rather ensures that the primary mission of the core business is to serve society. Being 153 Ibidem, arguing that “what matters is not only how much money suppliers receive, but how promptly they’re paid”. 154 Ibidem, 20. 155 Ibidem, 23, noting that from 1990 until the mid-2010s, UK banks sold payment

protection insurance to customers who took out mortgages, loans and credit cards. This insurance had the potential to create value by repaying customers’ debts if they lost their jobs or became ill, but it was mis-sold. 156 Ibidem. 157 Ibidem, 26. 158 Ibidem.

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a responsible business isn’t about splitting the pie differently (e.g. sacrificing profits to reduce carbon emissions), but about growing the pie by innovating and being excellent at its own business. Indeed, enterprises often fail to serve society not by giving too much to leaders or investors, but by failing to grow the pie by sticking to the status quo.159 4.4.2.2 Comparison with ESV Edmans shows that enlightened shareholder value (ESV) agrees with the pie-splitting mentality that an enterprise’s goal is to maximize profits, but recognizes that doing so in the long run requires it to grow the pie and thus serve stakeholders. Therefore, ESV takes a long-term approach, albeit to maximize profits rather than social value. ESV has many similarities with Pieconomics. Both highlight the criticality of companies investing in their stakeholders. Both argue that investor value and stakeholder value are highly correlated in the long run. Both stress the importance of profits. However, ESV argues that an enterprise’s ultimate goal is to increase long-term profits, while Pieconomics argues that an enterprise’s ultimate goal is to create value for society—and by doing so, it will increase profits as a by-product. Profits are an outcome, as in Mayer’s Prosperity, not a goal. Edmans concedes that ESV is better than Pieconomics under two angles. First, ESV is “concrete” having a single, clear objective: to increase long-term profit. Pieconomics has multiple objectives and therefore does not offer a clear-cut way to take decisions.160 Second, ESV is “focused”. A company practising ESV will only take an action if it boosts its profits. It won’t spend millions on reducing emissions if they’re already below the level that would lead to a fine, whereas a pie-growing enterprise might do so, simply to help the environment and such actions may reduce profits.161 Edmans argues, nonetheless, that the pie-growing mentality is preferable because it is “intrinsic” rather than “instrumental”. Under ESV, a company should only create value for stakeholders if this increases profits in the long term. In other words, for ESV an enterprise should

159 Ibidem, 27. 160 Ibidem, 43: “By trying to be everything to everybody, a pie-growing enterprise can

end up being nothing to nobody”. 161 Ibidem.

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be instrumentally motivated to create profits, whereas for Pieconomics it should be intrinsically motivated to create social value. However, Edmans also focuses on the limits of the ESV approach. He objects that the idea of instrumental profit maximization often does not work in practice, because it is very difficult to estimate the costs and benefits of most actions. When decisions are driven by the desire to achieve outcomes, they should be made on the basis of outcomes that can be quantified with some degree of accuracy, but most important outcomes cannot be quantified. He refers to “stakeholder capital” as an example, i.e. to the strength of an enterprise’s relationships with its stakeholders, including the trust that customers place in a company’s brand and the commitment of employees to its mission. The returns to intangibles like stakeholder capital are uncertain and distant: “even if they do arise, they will be far into the future”.162 Edmans argues that Pieconomics is different. A pie-growing enterprise makes decisions for intrinsic reasons—to create value for society. Stakeholders are the end itself, rather than a means to an end. Moreover, in the long run, almost all value becomes financial value. Growing the pie provides clearer practical guidance than growing profits and leads to more investments, because it’s much easier to see how an investment will affect stakeholders than profits.163 4.4.2.3 Assessment All this is interesting, but raises some difficulties. Why is creating social value directly better than creating it through the pursuit of profit? Who assures that the pursuit of social value will generate profits in the long run? Here the limits of Pieconomics as a multiple-objectives approach emerge. Edmans offers elaborate criteria for decision-making which focus on stakeholders rather than profits. However, it is not sure that increasing stakeholder value will also allow to increase corporate profits in most cases. Edmans adds to the merits of Pieconomics that it takes externalities into account, while ESV considers only profits. Most actions creating social value will increase long-run profits, but a few will not. Pieconomics

162 Ibidem, 45. 163 Ibidem, 47, noting that “Maximize shareholder value is a futile objective, since you

can’t predict how most actions will affect long-term shareholder value”.

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argues that corporate leaders should go beyond their legal responsibility to shareholders and care about externalities. Also, investors care about externalities not only due to being stakeholders themselves, but also for altruistic reasons. As Oliver Hart and Luigi Zingales have argued, shareholder welfare includes not only shareholder value, but also externalities (para. 4.2.2.3 above). Indeed, these externalities are becoming increasingly important to investors who largely invest under Socially Responsible Investing (SRI) strategies, which choose stocks on social rather than purely financial criteria.164 Even many mainstream investors, who are not classified as “socially responsible”, take externalities very seriously.165 All this is fine, but still we should better understand what motivates the “intrinsic” approach, that is to say what are the values justifying a similar approach and which are the sources of these values, a task that I will try to perform in sect. 4.5. 4.4.3

Rebecca Henderson on Reimagining Capitalism

Another brilliant book touching upon the topics of this section and emphasizing the role of social value in the management of big business was recently published by Rebecca Henderson, an economist and University Professor at Harvard Business School.166 The book is based on a successful MBA course on Reimagining Capitalism regularly given by the author and is considered here mainly for those parts which are connected with this chapter’s topic. 4.4.3.1 The Promise and Limits of Shared Value Henderson starts her journey to a new conception of capitalism from shared value, a theory that we have seen championed by Porter and Kramer (para. 4.2.2.2). She argues that the evidence supports “a business case for creating shared value or for treating people well and reducing

164 Ibidem, 53. 165 Ibidem, arguing that “Across all investors, 2,372, representing $86.3 trillion of

assets, had signed the UN Principles for Responsible Investment – a commitment to incorporate environmental, social and governance (ESG) issues into investment decisions – by March 2019. That’s substantially higher than the 63 investors and $6.5 trillion of assets when the principles were founded in 2006”. 166 Rebecca Henderson, Reimagining Capitalism. How Business Can Save the World, Penguin Business, 2020.

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environmental damage”.167 She considers particularly three cases of large companies which have shown how business and therefore capitalism can be rethought. The first case is Unilever’s switching to the distribution of 100% sustainably grown tea under the Lipton brand, which took place after the beginning of this century and was motivated by risk management and marketing considerations. The first was that ensuring the supply of tea would reduce the firm’s exposure to risk, given that the prevailing practices of growing tea—such as deforestation and large-scale application of insecticides, pesticides and fertilizers—were putting the entire viability of the supply chain at risk.168 The second argument also concerned risk exposure on the supply chain, with particular regard to the grim working conditions on conventional tea plantations: tea workers were often paid less than $1 a day and many suffered from inadequate housing and sanitation.169 The third argument stated that embracing sustainability would increase consumer demand for Unilever’s teas. Indeed, most consumers are not willing to pay more for sustainable products, which are seen by most of them as something “nice to have” rather than a “must have”.170 However, “if they find a product that they like – one that ticks all the right boxes in terms of quality, price, and functionality – then many of them will switch to the more sustainable product”.171 As a result of this and other initiatives, “in June 2019, Unilever announced that its ‘sustainable living’ brands were growing 69 percent faster than the rest of the business and generating 75 percent of the company’s growth”.172 The second case referred to by Henderson is that of Walmart, the gigantic retail company which over thirty years reinvented its business developing skills in logistics, purchasing and distribution that led it becoming one of the largest companies in the world.173 After being increasingly under fire for anti-union activities, gender discrimination, employment of illegal immigrants, child labour, etc., Walmart decided 167 Henderson, note 166, 49. 168 Ibidem, 52. 169 Ibidem, 53. 170 Ibidem, 54. 171 Ibidem, 59. 172 Ibidem. 173 Ibidem, 60.

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to take a strong stance on corporate responsibility.174 As a result of its sustainability programs, the company found to its surprise that saving energy was making it gain a great amount of money: “By 2017 Walmart had met its goal of doubling the transportation fleet’s efficiency and was saving more than a billion dollars a year in transportation costs – around 4 percent of net income”.175 While at Unilever building a sustainable business model meant identifying fundamental shifts in consumer behaviour, Walmart’s success came from focussing on the everyday operational details of its business from the profoundly different perspective of sustainability: “In its way, Walmart’s commitment was just as transformative as Lipton’s”.176 The third business case concerns renewable energy and in particular CLP, one of the largest investor-owned utilities in Asia. CLP announced in 2004 that 5% of its power would come by 2010 from renewables and in 2007 reiterated that 20% of its generating capacity would be carbon free by 2020.177 In 2013, the CEO of CLP explained the company’s strategy by saying: “We see carbon as a long-term threat to any business. In 2050, if you are a carbon-intensive business, you are in big trouble; chances are you won’t be in business by then”.178 Henderson comments that “the flip side of risk is opportunity … moving to carbon-free energy ahead of the competition was potentially an exceedingly attractive business opportunity”.179 Subsequent events have proven this assumption to be correct, as alternative energies like solar and wind are already in some places cheaper than coal. Henderson concludes the case studies just summarized by noting that there is enormous opportunity to create shared value.180 By addressing environmental and social problems, firms can build successful new businesses (CLP), reduce their costs (Walmart), and ensure long-term sustainability of their supply chains while increasing demand for their products

174 Ibidem, 62. 175 Ibidem, 64. 176 Ibidem, 64–65. 177 Ibidem, 65. 178 Ibidem, 69. 179 Ibidem. 180 Ibidem, 82.

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(Unilever).181 This is in line with what already argued by Porter and Kramer who showed that companies can create economic value by generating societal value in at least three possible ways (para. 4.2.2.2). Firstly, by reconceiving products and markets in response to the growing demand for products and services that meet societal needs (CLP and alternative energy; Unilever and sustainable tea). Secondly, by redefining productivity in the value chain, where societal problems can create internal costs to the firm (Walmart and the reorganization of its logistics to save on energy and transportation costs). Thirdly, by building supportive industry clusters at the company’s locations, improving company productivity while addressing gaps or failures in the framework conditions surrounding the cluster (Unilever and the tea industry). 4.4.3.2 Organizational Purpose as Key to Change Henderson argues that, in addition to shared value, organizational purpose is key to change.182 The reasons for it are grounded on organizational psychology more than anything else. Purpose “aligns everyone in the organization around a common mission”; “it gives everyone a reason to work toward the goals of the organization as a whole”; “it unleashes … creativity, trust and sheer excitement”.183 Henderson acknowledges the importance of “extrinsic” motivation—such as that deriving from money, status and power—but argues that “intrinsic” motivation is often more powerful.184 “Shared purpose” makes people in the organization feel that their work has “meaning”, “creates a strong sense of identity” and enhances “positive emotions”.185 This is the language of behavioural science and motivational theory. We know that human motivation has at least three drivers: autonomy, mastery and purpose.186 As argued by Daniel Pink, the prolific writer on business and human behaviour, “autonomous people working toward mastery perform at very high levels. But those who do so in the service of some greater objective can achieve even more. The most motivated 181 Ibidem. 182 Ibidem, 83. 183 Ibidem, 92. 184 Ibidem. 185 Ibidem, 93. 186 See D. Pink, Drive, Canongate, 2009, 85 ff.

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people … hitch their desires to a cause larger than themselves”.187 Mihaly Csikszentmihaly, the great psychologist, similarly remarked: “In the lives of many people it is possible to find a unifying purpose that justifies the things they do day in, day out – a goal that like a magnetic field attracts their psychic energy, a goal upon which all lesser goals depend”.188 If we translate these concepts into the language of business, we recognize that “the profit motive, potent though it is, can be an insufficient impetus for both individuals and organizations”.189 To illustrate it, Gary Hamel, the influential business thinker, makes reference to Whole Food Market, a company with a game-changing business model and the following corporate purpose: “to reverse the industrialization of the world’s food supply and give people better things to eat”.190 Its CEO “sees profits as a means to the end of realizing Whole Foods’ social goals”.191 In 2005, he wrote: “We want to improve the health and wellbeing of everyone on the planet through higher quality food and better nutrition”, but also specified: “We cant’ fulfil this mission unless we are very profitable”.192 Hamel acutely posits: “At Whole Foods, profits are the score, not the game”.193 4.4.3.3 Comparative Assessment If we compare Henderson’s work with the other papers examined in this section, two main differences are worth noticing beyond the obvious commonalities. Firstly, Henderson explicitly adheres to the shared value approach highlighting its potential contribution to the promotion of sustainability in business. True, it is not always easy to create shared value, which often requires technological innovation, investment of large amounts of money and management foresight, as documented by the business cases referred to by the author. However, the shared value

187 Ibidem, 133. 188 See. M. Csikszentmihalyi, Flow. The Psychology of Optimal Experience, Harper-

Collins, 1990, 218. 189 Pink, note 187, 134. 190 See G. Hamel, The Future of Management, Harvard Business Review Press, 2007,

76. 191 Ibidem, 77. 192 Ibidem. 193 Ibidem.

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approach is a good candidate to explain many of the situations in which Mayer and Edmans see the need for social value to prevail over corporate profit or at least for corporate profit to play a balancing role in corporate actions directed to the pursuit of social value. Secondly, Henderson follows a conception of corporate purpose which is mainly grounded on organizational theory and behavioural science, helping to explain the role of corporate purpose as a motivator beyond profit. This allows the author to keep both profit and social value in her reference framework, possibly configuring profit as an intermediate step in the way to produce social benefits through business activities. 4.4.4

Lucian Bebchuk and Roberto Tallarita on Stakeholderism

Departing from the theoretical approach just examined, which highlights the importance of social value in business firms, a recent paper by two Harvard law and economics scholars, Lucian Bebchuk and Roberto Tallarita, takes issue with the views indicated in sect. 4.1 and warns against the growing acceptance of stakeholderism.194 Their opposition to this rising trend in corporate governance is unconditional. Stakeholderism should not be expected to benefit stakeholders; on the contrary, it would impose substantial costs on them and society, as well as on shareholders.195 4.4.4.1 Is ESV Different to Traditional Shareholder Value? The two authors argue that corporate leaders have strong incentives to enhance shareholder value, but little incentive to treat stakeholder interest as an end in itself. Corporations will pursue stakeholder interests only to the extent that it is beneficial to shareholders. In addition, stakeholderism

194 L. Bebchuk and R. Tallarita, ‘The Illusory Promise of Stakeholder Governance’ (February 26, 2020), forthcoming, Cornell Law Review, December 2020, available at https:/ssrn.com/abstract = 3544978. See also, in a similar direction, Matteo Gatti and Chrystin Ondersma, ‘Can a Broader Corporate purpose Redress Inequality? The Stakeholder Approach Chimera’ forthcoming The Journal of Corporation Law, November 2020, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=354 7791, focussing, however, on stakeholderism’s incapacity to redress inequality. Gatti and Ondersma aim to demonstrate that a stakeholder approach can do nothing to ameliorate inequality concerns and suggest a multidisciplinary framework to evaluate policies inside and outside corporate governance. 195 Ibidem, 2.

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makes corporate leaders less accountable by insulating them from shareholder pressures: “Indeed, (…) the support of corporate leaders and their advisors for stakeholderism is motivated, at least in part, by a desire to obtain insulation form hedge fund activists and institutional investors”.196 Bebchuk and Tallarita distinguish between two different versions of stakeholderism: the “enlightened shareholder value” (ESV) approach and the “pluralistic approach”. Under the ESV, corporate directors and top executives take stakeholder interests into account as a means to maximize long-term shareholder value. The two authors call it “instrumental stakeholderism”, but suggest that it is not different to shareholder value tout court. In their opinion, whenever treating stakeholders well in a given way is useful for long-term shareholder value maximization, such treatment would be called for under either ESV or shareholder value.197 The two authors ask what could be the reason for switching to ESV and offer three possible reasons. The first is that referring to stakeholder effects has “informational and educational value” for the board and management of corporations.198 However, they argue that there is no evidence that corporate leaders have systematically underestimated the stakeholders’ effects on shareholder value maximization, finding therefore no reason for educating the same. The second reason is that ESV provides “moral support and practical coverage for directors who wish to offer some benefit to stakeholders at the expense of shareholders”.199 They object nonetheless that also under “old-fashioned” shareholder value directors would be able to justify a stakeholder-friendly decision on the basis that it would contribute to long-term value maximization. The third reason is that the move to ESV would improve the way in which corporations are perceived by outsiders and therefore produce positive reputational effects.200 Nevertheless, they argue that the move could have significant adverse effects by reducing demand for meaningful legal and regulatory reforms that could effectively protect stakeholders. In my opinion, none of these objections is decisive. Firstly, the fact that directors and managers already consider stakeholder interests that 196 Ibidem, 5. 197 Ibidem, 12. 198 Ibidem, 13. 199 Ibidem. 200 Ibidem, 14.

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are instrumental to long-term shareholder value maximization does not deprive ESV of educational value. In fact, reiterating the benefits of similar behaviour is not costly and may be beneficial in some cases. Secondly, the fact that not only ESV, but also “old-fashioned” shareholder value allows directors and managers to act in the interest of selected stakeholders when their actions are in the long-term interest of shareholders, is insufficient to discard ESV, which is different to shareholder value exactly for its emphasis on the long-term, enlightened view of the corporation. Thirdly, there are no doubt reputational advantages from the corporations’ acting in the interest of selected stakeholders, which, however, should not necessarily lead to the legislator’s excluding or limiting their protection. A similar outcome will mainly occur when the incentives for corporations to further the interest of given stakeholders at the expense of shareholders’ short-term interest are too low. 4.4.4.2 Limits of the Pluralistic Approach Bebchuk and Tallarita describe the second version of stakeholderism as one treating “stakeholder welfare as an end in itself rather than a mere means”. It is a “pluralistic approach” because it requires directors to weigh and balance a plurality of autonomous ends. They see several conceptual problems arising in this respect. The first is to identify the stakeholder groups whose interests should be taken into account. The term “stakeholders” usually refers to individuals who are affected by corporate decisions; however, “for many companies, the set of individuals who are directly or indirectly affected by the activities of the corporation is very large indeed”.201 Deciding which stakeholders should be especially considered is difficult and the criteria for taking this type of determinations are often impossible to establish ex ante. As a result, much discretion is left to directors who are therefore free to choose which interests should be prioritized and for what reasons. Moreover, the two authors note that “potential trade-offs between shareholders and stakeholders are ubiquitous”, and that the criteria for solving them are often left unexplored by stakeholderists.202 I agree on this critique of stakeholderism for reasons already explained in the two preceding paragraphs, given the risk that the interests of

201 Ibidem, 18. 202 Ibidem, 20.

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stakeholders will prevail over those of shareholders even on a long-term view, if the decision criteria are not specified ex ante and the corporate decision makers want to advantage selected stakeholders. This would be clearly against ESV, which remains my preferred choice subject to the qualification that I further explain below.

4.5

Corporate Purpose and Sustainability

In the preceding sections, I have critically reviewed the main theories and the current trends concerning corporate purpose and tried to understand the role played by sustainability inside this concept. A more general question to ask in the light of similar theories and trends is to what extent corporations can effectively contribute to the enhancement of sustainability goals in practice, complementing government regulation of environmental and social issues. To this end, one should explore what are (or should be) the respective domains of public regulation, soft law—including international guidelines and national codes of best practice—and corporate governance in facing the urgent issues that the environment and society pose to mankind on a global scale.203 No doubt, answering these questions comprehensively would require another paper addressing the suitability of the corporate governance framework to deal with sustainability issues. Given the limits of the present chapter, I will confine my comments to a research agenda on “repurposing” the corporation and ask whether and to what extent a redefinition of corporate purpose could help in the policy discussion concerning sustainable governance. 4.5.1

A Holistic View of Corporate Purpose

For the proposed aim, I shall adopt a holistic view of corporate purpose— rather than a sectoral one, such as those found either in law or in economics and finance—and test it on the policy issues presently debated at international level as to sustainable governance. I shall then submit my own view on the role of sustainability in the analysis of corporate purpose.

203 See the fundamental work by Sachs, J. (2015). The Age of Sustainable Development. Columbia University Press, 42, where the pathways to sustainable development are examined, including the good governance of firms.

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4.5.1.1 The Multiple Uses of Corporate Purpose As shown throughout the chapter, corporate purpose has been analysed from different perspectives with different aims in mind.204 Lawyers look at corporate purpose mainly to establish for whom the corporation is run and what are the duties of directors.205 The legal systems examined diverge on definitions, but not very much on substance, given the limited relevance of corporate purpose in the practice of law. Moreover, the discussion on corporate purpose generally extends to the definition of the company’s interest, which grounds the duty of loyalty of directors and the rules on conflicts of interest.206 Economists focus on corporate purpose to define the role of firms in a market economy and the incentives—including the pursuit of profit— through which business corporations efficiently serve their productive function.207 Finance scholars are especially interested in valuation issues and mainly think of corporate purpose in terms of either shareholder value or firm value maximization. Recent works by finance and management scholars argue, however, that the value to maximize is not only shareholder value (or firm value), but also (and for some predominantly) social value.208 Similar works implicitly vindicate the importance of CSR and stakeholder management, which have been largely neglected by economists and finance scholars until the beginning of this century.209 Management studies in general show how corporate purpose and its derivatives (like corporate mission, vision and values) can be resorted to in orienting the corporate organization towards the goals that the directors and managers choose to follow in the strategy and activities of their firm. Clearly, these goals are not identified exclusively with the pursuit of profit, but extend to social responsibility issues. Moreover, the definition 204 See Rock, note 2, 6, arguing that there are four separate debates over corporate

purpose: the legal, academic finance and economics, management and political debates. 205 Ibidem and Sect. 4.3. On the goals of corporate law, see in general Armour, J., Hansmann, H., Kraakman, R., & Pargendler, M. (2017). “What Is Corporate Law?” in R. Kraakman et al. (eds.), The Anatomy of Corporate Law: A Comparative and Functional Approach, 3rd ed. Oxford University Press, 28. 206 Armour, J., Hansmann, H., & Kraakman, R. “Agency Problems and Legal Strategies”, in R. Kraakman et al., note 169. 207 See Sect. 4.2 and particularly the references to M. Friedman and M. Jensen’s works. 208 See para. 4.4.1. and 4.4.2. 209 See Sect. 4.2.

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of purpose in detail depends on management style, corporate culture and the specificities of the industry concerned. I have already expressed my preference for an approach to corporate purpose based on ESV, which requires stakeholder interests to be satisfied subject to firm value maximization. This approach essentially moves from a law and finance perspective, but also concerns other disciplines concerning the management of corporations. Indeed, after being suggested by economics and finance scholars, ESV has been accepted— explicitly or implicitly—by a good number of legal systems and is widely adopted in policy discussions and in corporate practice, possibly with variations such as those suggested by the theory of shared value (para. 4.2.2.2). However, ESV needs refinement today to take account of some of the criticisms and insights found in the scholarly works analysed in sect. 4.4 as I argue below. 4.5.1.2

Enhancing Economic Value Under Environmental and Social Constraints To start with, stakeholder protection in corporate governance should not be seen exclusively as instrumental to long-term value maximization—as narrowly suggested by ESV—but also as an outcome of the compliance with legal rules and ethical standards, which apply to different types of firms and aim at controlling externalities that either directly or indirectly derive from their activities. In a rising number of situations, firms internalize externalities not only because they find it profitable in the long run or at least suitable to reduce their risk exposures, but also to comply with the regulatory or ethical standards that protect given stakeholders. In such cases, social value is created as a result of the firms’ compliance with legal requirements, soft standards and moral obligations, which are either binding on the individual firms or voluntarily accepted by them, their directors and managers. The role of regulation in constraining firm value maximization is easily understood. Environmental protection, to make an obvious example, largely depends on government regulation, which is binding on firms and models their actions. No doubt, firms comply with this type of regulation not only for ethical reasons, but also to avoid the administrative and criminal sanctions which would derive from violations of the relevant rules and would negatively affect their economic value. Stakeholder protection in similar cases cannot be seen as directly instrumental to firm value maximization, for it is primarily required by regulation. No matter what the

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corporate managers think about the merits of regulation and its effectiveness in protecting the relevant stakeholders, they have to comply with the prescriptions in question. Moreover, many actions are performed by firms, particularly the largest ones, in compliance with ethical standards that are globally recognized in statements and guidelines issued by international organizations and subscribed by firms for the protection of given stakeholders. Prominent examples are the documents either published or referred to by the UN Global Compact210 and the Guidelines for Multinational Corporations published by the OECD.211 These documents are not binding per se, but their principles are often reflected in the applicable national laws and for the rest may be followed voluntarily by the corporations concerned, especially when their managers are officially committed to respect the relevant standards. The voluntary application of international standards might be motivated by reputational concerns, but also by the personal conviction of the managers about the morality of the actions undertaken. Therefore, like in the case of regulation, the calculus of instrumentalism may be “indirect” in similar cases and the protection of stakeholders may simply derive from the compliance with the relevant standards. As a result, the managers do not compare the shareholders’ interests with those of given stakeholders, nor ask to what extent protecting the latter will enhance the long-term value of the firm—as theoretically required under the ESV approach—given that their action is required per se under the international standards. Of course, to the extent that discretion is left to the managers under the individual standard—particularly if the latter is broadly formulated and there are no implementing provisions—the managers will also refer

210 See the Ten Principles of the UN Global Compact (https://www.unglob alcompact.org/what-is-gc/mission/principles), which are derived from the Universal Declaration of Human Rights (https://archives.un.org/sites/archives.un.org/files/ UDHR/udhr.pdf), the ILO Declaration on Fundamental Principles and Rights at Work (http://www.ilo.org/wcmsp5/groups/public/---ed_norm/---declaration/docume nts/normativeinstrument/wcms_716594.pdf), the Rio Declaration on Environment and Development (https://www.un.org/ga/search/view_doc.asp?symbol=A/RES/66/288& Lang=E) and the United Nations Convention against Corruption (https://www.unodc. org/documents/treaties/UNCAC/Publications/Convention/08-50026_E.pdf). 211 See the OECD Guidelines for Multinational Enterprises, 2011, at http://mnegui delines.oecd.org/guidelines/.

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to the impact of their actions on the long-term value of the firm. But they may also decide on similar actions on purely moral grounds, filling their discretion in a way that they deem consistent with the content and spirit of the standard to apply. Once more, reputational concerns will also be at play, in addition to the ethical beliefs of the managers, to the extent that either the consumers or the investors monitor the firm’s compliance with the relevant standards. 4.5.1.3 Sustainability as a Game Changer The increasing importance of sustainability multiplies this type of situations, given that not all aspects of sustainable growth are specifically dealt with by regulation, while the urgency of the problems involved requires the active cooperation of corporations, which increasingly follow (or simply declare to follow) the international guidelines and standards in both environmental and social matters. Sustainability can therefore be seen as a game changer, to the extent that not only regulation, but also conduct guidelines and ethical standards operate as constraints on the behaviour of enterprises and their pursuit of profits. These regulatory and ethical constraints on firm behaviour do not necessarily determine a reduction of firm value. Some empirical studies on the relationship between CSR and economic performance rather prove the opposite. A. Ferrell, H. Liang and L. Renneboog in particular find that well–governed firms that suffer less from agency concerns engage more in CSR and have higher CSR ratings.212 They also find that a positive relation exists between CSR and value, suggesting that CSR in general is not inconsistent with shareholder value maximization.213 Their general argument is interesting for present purposes: “Corporate social responsibility need not to be inevitably induced by agency problems but can be consistent with a core value of capitalism, generating more returns to investors, through enhancing firm value and shareholder wealth”.214 These conclusions support the thesis advanced by some scholars that “doing good does also well”.215 However, we should not forget that 212 Ferrell, Liang and Renneboog, note 92, 585. These authors consider well-governed firms as represented by lower cash hoarding and capital spending, higher pay-out and leverage ratio and stronger pay-for-performance. 213 Ibidem, 602. 214 Ibidem, 605. 215 See Mayer, note 140, 116.

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behaving badly is often profitable, at least in the short term. As shown by Nobel laureates George Akerlof and Robert Shiller,216 markets have no morals and economic and commercial conduct often succeeds by deceit and manipulation. Therefore, as argued by Colin Mayer, doing well by doing good is a management innovation as challenging as technological innovation.217 In addition, while it may be easy to measure profits, social performance is difficult to measure, which makes it difficult to establish whether a CEO is doing well by doing good.218 Also, excellent empirical works, like that by A. Ferrell et al. quoted above, are based on CSR indices which may present limits in their design and effectiveness. 4.5.2

Promoting a Sustainable Corporate Purpose

Both scholars and practitioners often ask whether corporate purpose can be an useful tool in practice and whether the recourse to it should be promoted as suggested particularly by the supporters of social value and stakeholder capitalism. In this section, I briefly examine three aspects of this question concerning respectively the credibility of the official statements of CEOs on corporate purpose; the proposals directed to specify corporate purpose in the corporate charter; and the proposals directed to reform company law as to corporate purpose and directors’ duties. 4.5.3

Are Firms and CEOs Credible?

The first question concerns the practical impact of statements on corporate purpose such as those issued either by national trade bodies (like the BRT in the US) or by international private organizations (like the WEF) and briefly analysed in sect. 4.1. This topic has been expressly considered by Bebchuk and Tallarita in the paper commented upon in para. 4.4.4., where the two authors question the credibility in practice of the BRT statement.219 To this end, they examine whether the firms’ decision to join the statement was approved by each company’s board of directors as

216 Akerlof, G., & Shiller, R. (2015). Phishing for Phools. The Economics of Manipulation and Deception. Princeton University Press. 217 Mayer, note 140, 119. 218 Ibidem. 219 On the BRT statement, see note 7.

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required for the most important corporate decisions. Of the 48 companies that responded to their enquiry, 47 said that the decision was approved by the CEO but not by the board of directors.220 Two companies further specified that their best practices were already consistent with the BRT principles, so that they did not expect to make major changes in their treatment of stakeholders in the future. Bebchuk and Tallarita comment that this could explain why the decision to join the BRT statement was commonly not approved by the company’s board of directors. However, they also remark that in this case “the BRT statement merely reflected the CEO’s positive assessment of how their companies have been treating stakeholders thus far, as well as the CEOs’ expectation that the statement will not lead to substantial changes in how stakeholders are treated”.221 Another test that the two authors apply is asking whether companies whose CEOs signed the BRT statement amended their corporate governance guidelines following the BRT statement. They report that “none of the twenty companies reviewed amended its corporate governance guidelines to incorporate stakeholder welfare as an independent end of the corporation”.222 Interestingly, they also indicate that many of the companies reviewed “contain a strong statement of the shareholder primacy principle” contrary to what is foreseen by the BRT statement.223 We should therefore conclude that the impact of the BRT statement in practice will be modest and will mainly depend on the reputation of individual CEOs and corporations that have subscribed to it. Still, one could ask for what reason the BRT has taken the initiative to modify its traditional position on shareholder primacy by issuing a statement which emphasizes the role of stakeholders in the management of corporations. According to Mark Roe, two forces help to explain why the BRT felt that it needed to say something now.224 First, activist investors: “US corporate leaders are building a coalition against activist shareholders,

220 Bebchuk and Tallarita, note 166, 25. 221 Ibidem. 222 Ibidem, 26. 223 Ibidem. 224 Roe, M. “Why America’s CEOs Are Talking About Stakeholder capitalism”, Project Syndicate, November 4, 2019, https://www.project-syndicate.org/commentary/americabusiness-roundtable-ceos-corporate-purpose-by-mark-roe-2019-11?barrier=accesspaylog.

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and want employees, customers, and those demanding more ethical sourcing to support them. Freeing boards and executives from shareholder influence, the statement implies, will enable corporate America to treat employees, the environment, and communities better”. Second, public opinion: “Anti-corporate ideas are in the air, and they do not originate from the political leaders who are expressing them”. Moreover, any politician pursuing a similar agenda would need allies to implement policies targeting large corporations: “If their potential allies are more or less satisfied with corporate America’s new statement of purpose – especially if CEOs act on it in a media-visible way – then populist anti-business measures will lose traction”.225 4.5.3.1 Should Corporate Purpose Be Specified in the Charter? If the official statements of trade bodies have limited credibility, other ways are available to give force to the new concept of corporate purpose that corporations seem to be ready to follow. Mayer’s Prosperit y suggests that corporate purpose should be defined by contract and that fiduciary duties should be based on the corporate purpose so defined (para. 4.4.1). This would generate trust in the corporation by its members. The solution proposed shows a preference for private law. Indeed, Mayer argues that regulation has failed because the interests of regulators are opposed to those of shareholders. Company law should be reformed so as to replace regulation, which would require redefining corporate purpose and avoiding its identification with the pursuit of profit. Interestingly, French law was recently reformed along similar lines by the PACTE law which allows corporations to specify their corporate purpose (raison d’être) in their statute (para. 4.3.1.2). I do not believe that a contractarian approach, such as that proposed by Mayer, would lead to efficient outcomes in practice and that regulation should be replaced by company law. As argued already, we cannot expect companies to fully internalize the social costs of their externalities. Similarly, we cannot rely on corporate governance and shareholders as the main instruments to preserve the integrity of corporations. We need regulation and to some extent criminal law to obtain compliance with the legal principles protecting the environment and the social conditions within the firms. No doubt, corporate governance and ownership can contribute to

225 Ibidem.

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effective compliance and are therefore good complements to regulation, but we should not expect them to become substitutes for regulation. In any case, I do not expect corporations to meaningfully exploit the possibility of specifying corporate purpose in their charter. It is unclear why corporate leaders would propose shareholders to define corporate purpose in the charter in terms other than the pursuit of profit. Leaders are rather incentivized to stick to the pursuit of profits by the corporation, given that their variable pay is based on financial performance. It is also uncertain that shareholders would accept a similar proposal, unless the relevant clause in the charter was sufficiently generic simply adding other purposes to profit. However, the managers would likely pay lip service to similar undertakings and possibly circumvent the same, while shareholders would find it difficult to monitor compliance by the managers with the agreed definition of purpose. Most corporate actions in this regard would not be easily observable and the managers could justify their behaviour even when departing from corporate purpose as defined in the charter. In any case, the managers’ duties as to corporate purpose would be difficult to enforce, given that most of their actions in this regard would fall under the business judgement rule.226 Moreover, there is no need to specify the purpose of the corporation in its charter, even without considering the difficulties of such a definition and of its enforcement in practice. Several documents are periodically approved by the board which clarify the purpose pursued by the company and its management, such as the strategic plans, the financial statements and non-financial disclosure. Plenty of information is already published by corporations explaining their goals and the ways in which managers implement them, including statements on purpose, mission, vision and values that are published on the companies’ websites and circulated amongst stakeholders. No doubt, corporations could do more; however, no further stipulations are generally needed to specify their purpose. This is a task that the managers should perform, under the board’s monitoring and in compliance with their fiduciary duties, while running the company.227

226 See Ron Gilson’s remarks at the Columbia Law School Symposium on Corporate governance “Counter-Narratives”, note 4, at 19. 227 See Stout, note 23, 115.

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4.5.3.2 Should Company Law Serve Sustainability Goals? Assuming that a private law solution based on contract is not likely to assure that firms shall adopt an effective definition of corporate purpose including both corporate profit and sustainability constraints, policy makers should consider whether a similar definition should be given by company law along the lines already followed in the UK and France. The discussion is intertwined with that on fiduciary duties, which in the opinion of some policy makers should be clarified and include the compliance with sustainability standards as a condition for the performance of the directors’ duty of care along the British model considered above (para. 4.3.2.1). In a recent document,228 the European Commission considers preliminary legislative proposals on director duties and sustainability which could indirectly affect the concept of corporate purpose. The Commission refers to its communication on “The European Green Deal” stating amongst others that “sustainability should further be embedded into the corporate governance framework, as many companies still focus too much on short-term financial performance compared to their long-term development and sustainability aspects”.229 The Commission also grounds its proposals on a new Study on directors’ duties and sustainable corporate governance,230 which aims to show that many listed companies in Europe “focus on generating financial returns in a short timeframe and redistribute a large part of the income generated to shareholders, which may be to the detriment of the long-term development of the company, as well as of sustainability”.231 Yet, the data on short-termism in European listed companies used by the Study are open to discussion, particularly considering that many UK 228 European Commission (DG Justice, A3 Company law unit), Inception Impact Assessment, Sustainable corporate governance, available at https://ec.europa.eu/info/ law/better-regulation/have-your-say/initiatives/12228-Carbon-Border-Adjustment-Mec hanism. 229 European Commission, Communication on The European Green Deal, Brussels, 11.12.2019, COM(2019) 640 final, available at https://ec.europa.eu/info/strategy/pri orities-2019-2024/european-green-deal_en#actions. 230 Study on directors’ duties and sustainable corporate governance. Final report prepared by EY for the European Commission DG Justice and Consumers, July 2020, https://ec.europa.eu/info/business-economy-euro/doing-business-eu/com pany-law-and-corporate-governance_en#studies. 231 European Commission (DG Justice, A3 Company law unit), note 193, 1.

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companies are included in the relevant dataset despite Brexit.232 Moreover, the issue of short-termism and its negative impact on companies and markets are widely debated internationally, also with respect to US financial markets,233 so that policy conclusions cannot be drawn too hastily.234 Furthermore, the causal link between managerial short-termism and the neglect of sustainability matters by corporations is unclear, as the focus on short-term financial performance does not necessarily exclude the engagement of a corporation in either environmental or social issues, also considering that some of these issues need to be dealt within a short timeframe given their urgency and impact on firm value.235 Nonetheless, the Commission identifies a connection between what it defines as a narrow interpretation of company laws—particularly of the rules on the company’s interest and directors’ duties—which would favour short-term financial value and the fact that companies, in the Commission’s opinion, do not adequately address sustainability problems. As a result, it proposes to modify the codified Company Law Directive (2017/1132) and the consolidated Shareholder Rights Directive (2007/36). The Commission’s initiative aims to ensure that sustainability is further embedded into the corporate governance framework with a view to better align the long-term interest of managers, shareholders, stakeholders and society.236 Two specific areas of intervention are suggested. The first concerns the measures that companies should take to address their adverse sustainability impacts, such as climate change 232 See Consultation on Sustainable Corporate governance: Feedback from European Company Law Experts (ECLE), 28 September 2020, https://ec.europa.eu/info/law/ better-regulation/have-your-say/initiatives/12548-Sustainable-corporate-governance/fee dback?p_id=8270916&page=10; Feedback from Assonime, 8 October 2020 https://ec. europa.eu/info/law/better-regulation/have-your-say/initiatives/12548-Sustainable-cor porate-governance/F594565. 233 See Mark Roe, ‘Stock Market Short-Termism’s impact’, ECGI Law Working Paper N. 426/2018, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3171090. 234 See Mark Roe, Holger Spamann, Jessie Fried and Charles Wang, The European Commission’s Sustainable Corporate governance Report: A Critique, October 14, 2020, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3711652; Jessie Fried and Charles Wang, Short-termism, Shareholder Payouts, and Investment in the EU, ECGI Law Working Paper 544/2020, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=370 6499. 235 See Mark Roe et al., note 206, who object that the Commission’s Report conflates time-horizon problems (short-termism) with externalities and distributional concerns. 236 European Commission (DG Justice, A3 Company law unit), note 193, 2.

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and human rights harm, in their own operations and in their value chain, by identifying and preventing relevant risks and mitigating their impact (due diligence duty). The second concerns the duties of directors who should take into account all stakeholders’ interests which are relevant for the long-term sustainability of the firm, as part of their duty of care to promote the interests of the company and pursue its objectives. These two types of intervention appear to be aligned with international standards, but need better refining. The first appears to be grounded on risk management concepts and on international guidelines, such as those issued by the OECD on due diligence requirements in responsible business conduct.237 The second proposed intervention implicitly refers to those legislative solutions that have been adopted in the UK and in France, which require directors to pursue the company’s interest subject to due consideration being given to the interest of stakeholders and/or to environmental and social sustainability. However, the Commission’s proposals are still too generic to allow conclusions to be drawn in this regard and may develop in different directions depending on the detail of the relevant provisions and on the type of enforcement of fiduciary duties that a future directive may foresee. In any case, it is doubtful that a directive is needed to pursue similar goals. On one side, it is not sure that company law should be modified to host an enlarged concept of corporate purpose, given that most legal systems allow for sufficient flexibility in this respect, as already shown in Sect. 4.3 from a comparative law perspective. On the other side, it is still to be proven that member states cannot reach similar outcomes on their own, either through soft law measures—such as codes of corporate governance and stewardship codes—or national legislation, so as to justify a directive at EU level under the subsidiarity principle. Indeed, national corporate governance codes not only apply under comply or explain provisions, which reinforce their practical value, but already take sustainability into account either in the definition of corporate purpose

237 See OECD Due Diligence Guidance for Responsible Business conduct, 2018, https://www.oecd.org/investment/due-diligence-guidance-for-responsible-business-con duct.htm; OECD Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High- Risk Areas, https://www.oecd.org/daf/inv/mne/min ing.htm.

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or in the principles that apply to the organization and functioning of boards.238 4.5.4

Concluding Remarks

This chapter has shown that corporate purpose is an evolving concept, which has been analysed from different perspectives and has been periodically updated in the light of developments in practice. Since the 1980s, sustainability has been increasingly taken into consideration and has influenced the academic discussion particularly in the field of management studies which have focused on CSR and stakeholder theory. At the beginning of this century, sustainability concerns entered into the area of finance studies through the theory of enlightened shareholder value and its homologues (like shared value and shareholder welfare). Company law has offered little resistance to this evolution, given the relative flexibility and adaptability of corporate purpose and similar concepts, including company’s interest. However, company law reforms have been adopted in some European States touching upon corporate purpose and fiduciary duties in ways that reflect the increasing importance of environmental and social sustainability, and the enhanced focus on stakeholders in corporate governance. The mounting pressure on businesses to comply with sustainability standards in crucial areas like climate change, corruption and child labour, and the raising awareness of public opinion and politicians about the gravity and urgency of these and other problems are causing shock waves which invest both corporations and governments calling for immediate action. No doubt, government regulation is predominantly needed to give adequate responses to these calls, but corporations should also play their part within the constraints of their economic purpose and productive function. Recent economics and management studies argue that corporate purpose should be modified to reflect the prevalence of social value over shareholder value, and that the latter should be pursued by managers only derivatively, as a result of pro-stakeholders’ actions directed to increase the “total pie”. In the present chapter, I objected to this recent scholarship and showed my preference for keeping the sustainability discussion within the confines 238 See Shanshan Zhu and Michele Siri, ‘Integrating sustainability in EU Corporate governance Codes’, Chapter 6 in this volume.

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of ESV theory. At the same time, I suggested to emphasize the mounting role of regulatory and ethical constraints to business conduct deriving from sustainability concerns. These constraints go beyond the mere calculus required by ESV, which asks management to compare stakeholder interests with those of shareholders and pursue the former only to the extent that this increases the long-term value of the firm. Indeed, ethical considerations as reflected by international standards and consolidated best practices should apply to the running of businesses without necessarily requiring prior analysis of their precise impact on financial performance. Needless to say, the ethical behaviour of firms will generally reflect on their long-term economic success, but this should not always condition the compliance with the ethical standards that should apply per se, despite their cost to the firm.

CHAPTER 5

Sustainable Corporate Governance: The Role of the Law Alessio M. Pacces

5.1

Introduction

Sustainability is a buzzword and a policy goal. It synthesizes the aim to reduce the environmental and social imbalances of the world we live in, such as resource depletion, environment degradation, and inequality, among others. Traditionally, in economics, such imbalances have been characterized as negative externalities, namely the adverse impact of economic activities on the welfare of individuals and groups uninvolved in these activities. Regulation has policed these externalities by way of taxes or subsidies, regulations, and market-based instruments such as tradable pollution permits. The performance of these legal tools has been questioned on the grounds of their limited effectiveness. As a result, policymakers have switched gears and increasingly rely on financial markets

A. M. Pacces (B) Amsterdam Center for Law & Economics, University of Amsterdam, Amsterdam, The Netherlands e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_5

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to support the control of externalities. This strategy is called sustainable finance.1 One way to look at sustainable finance is through the lens of corporate governance. The intuition underlying sustainable finance is that individuals who care for sustainability prefer to invest in sustainable corporations, which results in a lower cost of capital for sustainable firms and, eventually, unsustainable firms exiting the market. In public corporations, the decision whether to invest in sustainability depends on corporate governance. Most individuals indirectly own shares in the largest corporations of the world as their personal or pension savings. However, they do not decide in which corporations to invest and how to vote on their shares. These are decisions that institutional investors, such as mutual funds and pension funds, make as agents holding shares on their beneficiaries’ behalf. Institutional investors own 41% of public equity worldwide.2 Their holdings are concentrated.3 Institutional investors often claim to care about the sustainability of portfolio companies.4 Whether they actually do is debated. Empirical finance is trying to shed light on this complex issue. Corporate governance, however, also depends on corporate and financial law. For instance, institutional investors have legal duties towards their beneficiaries and legal rights towards portfolio companies. These rights and duties determine the corporate governance behaviour of institutional investors, and therefore also whether sustainable finance can work. In this essay, I investigate the role that law potentially plays in supporting sustainable corporate governance. I ask the following question: Can legal tools support ultimate investors’ choice as to sustainability by affecting their relationship with institutional investors? This essay will look at EU legislation, which has taken the lead in promoting sustainable

1 European Commission COM(2018) 97 final.

(2018).

Action

Plan:

Financing

Sustainable

Growth.

2 At the end of 2017, there were approximately 41.000 listed companies in the world, worth some $84 trillion in market value, roughly equivalent to the world’s GDP. De La Cruz, A., Medina, A., & Tang, Y. (2019). Owners of the World’s Listed Companies. Paris: OECD Capital Market Series. 3 Gilson, R.J., & Gordon, J.N. (2013). “The Agency Costs of Agency Capitalism: Activist Investors and The Revaluation of Governance Rights”. Columbia Law Review, 113(4), 863–927. 4 Fink, L. (2020). “Letter to CEOs”, Blackrock: https://www.blackrock.com/corpor ate/investor-relations/larry-fink-ceo-letter.

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finance.5 In particular, this essay will discuss disclosure regulations, the transparency of institutional investors’ voting and touch upon the debate on fiduciary duties and corporate purpose. Although these are widely debated topics, they haven’t been consistently analysed in the perspective of ultimate investors’ choice as it concerns sustainability. In what follows, I will refer to ultimate investors as institutional investors’ beneficiaries. Moreover, I will confine sustainability to the environmental dimension and specifically, climate change mitigation. The rest of this chapter is as follows. The next section frames sustainable corporate governance as an externalities problem death with—in a somewhat Coasian flavour—as investors choice rather than government intervention. Because beneficiaries hold stock indirectly, sustainable corporate governance is complicated by the agency problems of institutional investors and their business models, both of which are analysed in Sect. 5.3. Section 5.4 discusses how legal rules may foster the incorporation of beneficiaries’ preferences into voting by institutional investors. Section 5.5 concludes.

5.2

Framing Sustainable Corporate Governance

In economics, negative externalities have been regarded as a matter for corrective taxation, named Pigouvian taxation after Pigou.6 Taxes, e.g. on CO2 are supposed to bridge the gap between the private and the social cost of using the environment. Alternatives include commandand-control regulation (e.g. setting maximum pollution standards) or “economic instruments” other than taxes, such as subsidies to “green” investment and tradable emission permits.7 These strategies reflect a topdown public intervention in markets producing negative externalities.8 Particularly in the context of climate change, this approach has proven insufficient. The commitment by the signatories of the Paris Agreement

5 See European Commission (2018). Action Plan: Financing Sustainable Growth. COM(2018) 97 final; and European Commission (2019). The European Green Deal. COM(2019) 640 final. 6 Pigou, A. (1920). The Economics of Welfare. London: Macmillan. 7 Ogus, A.I. (1994). Regulation: Legal Form and Economic Theory. Oxford University

Press. 8 Faure, M.G. (2012), “Environmental Regulation”. In R.J. Van den Bergh & A.M. Pacces (eds.), Regulation and Economics, Encyclopedia of Law and Economics, 2nd edition, Cheltenham: Edward Elgar, 229–301.

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2015 to keep global warming well below 2 degrees Celsius compared to pre-industrial level, along with the best-effort promise to further limit it to 1.5 degrees, seems to require additional bottom-up efforts from the private sector.9 The ability of governments to police environmental externalities is limited for several reasons.10 First, large corporations can lobby to influence regulation and taxation considerably. A well-known limitation of emission standards and Pigouvian taxation is that the first is too lax and the second too low to effectively constrain environmental degradation.11 Second, environmental externalities have an international dimension. While coordinating regulations is hard for states, regulatory arbitrage is easy for multinational corporations especially today, because competitive advantage is largely based on intangibles whereas production facilities (and the externalities thereof) can be relocated to more favourable jurisdictions.12 Third, some governments may be less concerned with correcting externalities because the more environment-friendly citizens are underrepresented.13 In the spirit of Coase,14 externalities can be tackled in a more decentralized fashion so long as transaction costs are comparatively lower than in the public policy setting. Publicly underrepresented consumers and investors may oppose externalities-generating companies privately, for instance through boycotts, selloffs and activism. Differently from regulation, such decentralized behaviours work across borders and are not susceptible to lobbying. These behaviours are borne out by the empirical

9 In this essay, I take this policy goal as a given assuming it reflects the effort to maximize global social welfare. Andersson, M., Bolton, P., & Samama, F. (2016). “Governance and Climate Change: A Success Story in Mobilizing Investor Support for Corporate Responses to Climate Change”. Journal of Applied Corporate Finance, 28(2), 29–33. 10 Tirole, J. (2017). Economics for the Common Good. Princeton University Press. 11 Gunningham, N., Grabosky, P., & Sinclair, D. (1998). Smart Regulation: Designing

Environmental Policy. Oxford University Press. 12 Kraakman, R., Armour, J., Davies, P., Enriques, L., Hansmann, H., Hertig, G.,

Hopt, K., Kanda, H., Pargendler, M., Ringe, W.G. and Rock, E. (2017). The Anatomy of Corporate Law: A Comparative and Functional Approach. Oxford University Press. 13 Bénabou, R., & Tirole, J. (2010). “Individual and Corporate Social Responsibility”. Economica, 77(305), 1–19. 14 Coase, R.H. (1960). “The Problem of Social Cost”. Journal of Law and Economics, 3, 1–44.

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evidence and seem to have an impact on corporate choice.15 Intuitively, the challenge of this approach is coordination. Corporate governance may help to overcome this challenge to the extent that a company’s decision-making reflects the preferences of investors. If the latter indeed prefer climate change mitigation, corporations will emit less greenhouse gas (GHGs) not because they are compelled to do so by regulation, or induced to do so by taxes, but because so they choose. This is the role of corporate governance in the broader context of sustainable finance.16 Whether sustainable corporate governance can actually reduce GHGs and mitigate climate change is unclear. The answer depends on the sustainability preferences of investors and whether they are reflected by corporate choice. Investors typically select investment based on the expected rate of return, along with other considerations such as risk and time preferences. If carbon-intensive investments are more profitable than “green” investments, it seems hard for profit-driven financial markets to support sustainability. This reflects the traditional view, in economics, that corporations should maximize profits leaving policing externalities to other institutions. Investors, however, particularly shareholders, may also base their investment choice on other, prosocial considerations. Following this intuition, Hart and Zingales have recently overturned the traditional economic approach on the grounds that, if externalities such as GHGs cannot be separated from the production process, it is more efficient for prosocial shareholders to make corporations reduce GHGs directly than rely on governments and other charitable institutions to police the externality.17 The question remains how much profit shareholders are prepared to give up to pursue sustainability. Bénabou and Tirole distinguish three theories of investor preferences towards Corporate Social Responsibility (CSR).18 For the purpose of this

15 Gantchev, N., Giannetti, M., & Li, R. (2019). “Does Money Talk? Market Discipline Through Selloffs and Boycotts”. European Corporate governance Institute (ECGI)—Finance Working Paper No. 634/2019, http://dx.doi.org/10.2139/ssrn.340 9455. 16 European Commission (2018). Action Plan: Financing Sustainable Growth. COM(2018) 97 final. 17 Hart, O., & Zingales, L. (2017). “Companies Should Maximize Shareholder Welfare Not Market Value”. Journal of Law, Finance, and Accounting, 2(2), 247–275. 18 Bénabou, R., & Tirole, J. (2010). “Individual and Corporate Social Responsibility”. Economica, 77(305), 1–19.

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chapter, I take a somewhat narrow view of CSR as a trade-off between profit, or financial returns, and the prosocial goal to reduce GHGs. On this perspective, different CSR theories can be framed as the opportunity cost of increasing levels of sustainability preferences. The three theories are: (a) “doing well by doing good”; (b) “delegated philanthropy”; and (c) “corporate philanthropy”. I discuss them in turn. “Doing well by doing good” is a short-termism theory. According to this theory, long-term investors temporarily accept lower returns on “green” investments to avoid future losses from climate change risk. This risk can be divided into three components. First, there is physical risk of natural disasters affecting supply, demand, or both. Second, there is the technological risk that products and processes will become obsolete undermining the value of the assets involved (stranded assets). Third, there is regulatory risk: regulation can prohibit carbon-intensive productions or make them uneconomical. Short-sighted financial markets fail to incorporate climate change risk into pricing as it is unclear how this risk will materialize and when. Doing-well-by-doing-good investors both avoid an intertemporal loss and reduce externalities.19 Investors’ concern for climate change risk is borne out by survey evidence.20 Empirical evidence also supports the view that CSR correlates with higher firm performance in the long term,21 although this may rather reflect better corporate governance.22 A second CSR theory is “delegated philanthropy”. According to this theory, investors permanently accept to earn less on “green” investments for ethical reasons, effectively requesting corporations to transfer resources to non-shareholder constituencies such as consumer and employees. In the context of climate change, these stakeholders

19 Bénabou, R., & Tirole, J. (2010). “Individual and Corporate Social Responsibility”. Economica, 77(305), 9. 20 Ilhan, E. Krueger, P., Sautner, Z. & Starks, L.T. (2020). “Climate Risk Disclosure and Institutional Investors”. European Corporate governance Institute (ECGI)—Finance Working Paper No. 661/2020, http://dx.doi.org/10.2139/ssrn.3353239. 21 Verheyden, T., Eccles, R.G., & Feiner, A. (2016). “ESG for All? The Impact of ESG Screening on Return, Risk, and Diversification”. Journal of Applied Corporate Finance, 28(2), 47–55. 22 Ferrell, A., Liang, H., & Renneboog, L. (2016). “Socially Responsible Firms.” Journal of Financial Economics, 122(3), 585–606.

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include future generations. Transfers to future generations are complicated by the choice of the appropriate rate of discount. According to Weisbach & Sunstein, cost and benefits of future generations should be discounted, but at a very low rate because the distant future is uncertain and uncertainty magnifies the impact of lower rates.23 Environmentfriendly projects with a positive intertemporal balance increase welfare, even though they decrease shareholder wealth. In a similar vein, Hart and Zingales have argued that shareholders should be allowed to maximize welfare instead of wealth.24 But why should shareholder delegate philanthropy to the corporation rather than donating themselves? The reason is transaction cost.25 Undoing externalities is costlier than preventing them, whereas corporations may enjoy transaction cost savings in transferring resources to current and future stakeholders. From this perspective, corporations are regarded as substitute for governments and other collective institutions: shareholders who want to police climate change may do so by corporate voting instead of political voting. The third theory is “corporate philanthropy”. According to this theory, corporations should pursue ethical goals at any cost, even though a majority of investors do not want it. This theory is akin to the stakeholder theory of corporate governance, according to which the corporation must balance the interest of all its stakeholders.26 This approach has been popular among European legal scholars,27 particularly in jurisdictions featuring multiple stakeholders in the corporate purpose. Albeit with exceptions,28 economists have been more sceptical. Milton Friedman 23 Weisbach, D., & Sunstein, C.R. (2009). “Climate Change and Discounting the Future: Guide for the Perplexed”. Yale Law & Policy Review, 27(2), 433–458. 24 Hart, O., & Zingales, L. (2017). “Companies Should Maximize Shareholder Welfare Not Market Value”. Journal of Law, Finance, and Accounting, 2(2), 247–275. 25 Bénabou, R., & Tirole, J. (2010). “Individual and Corporate Social Responsibility”. Economica, 77(305), 10 26 Blair, M., & Stout, L. (1999). “A Team Production Theory of Corporate Law”. Virginia Law Review, 85(2), 247–328. 27 E.g. Sjåfjell, B. (2017). “Achieving Corporate Sustainability: What Is the Role of the Shareholder?”. In H. Birkmose (ed.), Shareholders’ Duties in Europe. Alphen aan den Rijn: Kluwer Law International; Winter, J. (2018). “A Behavioral Perspective on Corporate Law and Corporate governance”. In J.N. Gordon and W.-G. Ringe (eds.), The Oxford Handbook of Corporate Law and Governance, Oxford University Press, 159–183. 28 Mayer, C. (2018). Prosperity: Better Business Makes the Greater Good. Oxford University Press.

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famously argued against corporations doing philanthropy with other people’s money.29 As there is no objective criterion to balance different stakeholder interests, corporate philanthropy must give management full discretion over the firm resources. This approach discourages investment as it disenfranchises shareholders, increasing agency cost.30 The debate on the corporate purpose has recently gained popularity in the U.S. too, with many scholars31 finding that a commitment to pursuing multiple stakeholder interests would be unenforceable under U.S. state laws. Moreover, shareholders, who retain the exclusive right to vote, would always be in the position to overturn such a commitment.32 In practice, CSR often reflects a mixture of the three theories, which makes them hard to test empirically. Consider a company switching to carbon-free equipment, which is so popular these days. This may reflect climate change risk management (theory 1). It may also reflect a genuine shareholder concern for the environment and future generations (theory 2). Finally, it may reflect a management preference for the environment or, more cynically, for the equipment’s producer (theory 3). The first two theories are compatible with a notion of corporate governance geared towards shareholder preferences. The third is not. Having framed sustainable corporate governance as investor choice, I focus on the first two theories and discuss below how they reflect on investor behaviour in theory. Doing-well-by-doing-good investors are mindful about financial returns. As they believe that the market is under-pricing climate risk in the short term, such investors naturally seek to avoid high-GHG companies and rather invest in companies with low GHG emissions, whether direct (Scope 1) or indirect (Scope 2 and Scope 3).33 These portfolio 29 Friedman, M. (1970). “The Social Responsibility of Business Is to Increase Its Profits”. New York Times Magazine, September 13. 30 Jensen, M.C. (2002). “Value Maximization, Stakeholder Theory, and The Corporate Objective Function”. Business Ethics Quarterly, 235–256. 31 Fisch, J.E. (2020). “The Uncertain Stewardship Potential of Index Funds”. European Corporate governance Institute (ECGI)—Law Working Paper No. 490/2020, http://dx. doi.org/10.2139/ssrn.3525355; Gilson, R. (2019). “Legal and Political Challenges to Corporate Purpose”. Journal of Applied Corporate Finance, 31(3), 18–21. 32 Rock, E.B. (2020). “For Whom Is the Corporation Managed in 2020?: The Debate over Corporate Purpose”. European Corporate Governance Institute—Law Working Paper No. 515/2020, http://dx.doi.org/10.2139/ssrn.3589951. 33 See the Greenhouse gas Protocol, https://ghgprotocol.org/guidance.

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choices imply a mix of negative and positive screening of the stock market. Climate-risk minded investors may also choose to steer the management of portfolio companies towards GHGs reduction. However, engagement in corporate governance reflects a longer-term commitment towards portfolio companies, which is more compatible with delegated philanthropy. As explained by Hirschman,34 the exercise of voice within an organization implies a commitment not to exit. Investors who want to reduce externalities, also for the benefit of future generations, are committed to voice—i.e. influencing decision-making in corporations that would otherwise degrade the environment. Investors that only aim to manage climate change risk benefit more from exit, in principle, at least until the moment in which negative screening undermines risk diversification.35 This breakdown neglects a crucial aspect of modern investing, namely institutional ownership. Institutional investors own the bulk of public equity worldwide. They hold and vote their shares according to a business model, which does not necessarily align with the preferences of their beneficiaries. For example, index funds cannot really choose which companies to invest in even though their beneficiaries may have strong views on that. Some fund managers do not have the resources to engage with individual companies, regardless of what beneficiaries expect. And yet, empirical evidence that beneficiaries want institutional investors to invest in sustainable corporations is mounting. Two recent studies reveal that the introduction of sustainability labels—such as the Morningstar “5 Globes” Rating and the Low Carbon Designation—significantly affected the inflows into U.S. mutual funds.36 Both studies find that investor

34 Hirschman, A.O. (1970). Exit, Voice and Loyalty. Cambridge, MA: Harvard University Press. 35 Recent research suggests that this moment may have already arrived. See Ceccarelli,

M., Ramelli, S., & Wagner, A.F. (2020). “Low-Carbon Mutual Funds”. European Corporate governance Institute (ECGI)—Finance Working Paper No. 659/2020, http://dx. doi.org/10.2139/ssrn.3353239 (finding that climate-responsible funds experience higher idiosyncratic risk) and Hoepner, A.G., Oikonomou, I., Sautner, Z., Starks, L.T., & Zhou, X. (2020). “ESG Shareholder Engagement and Downside Risk”. European Corporate governance Institute (ECGI)—Finance Working Paper No. 671/2020, http:// dx.doi.org/10.2139/ssrn.2874252 (finding that shareholder engagement with portfolio companies reduces downside risk). 36 See, respectively, Hartzmark, S.M., & Sussman, A.B. (2019). “Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows”. Journal of Finance, 74(6), 2789–2837; and Ceccarelli, M., Ramelli, S., & Wagner, A.F. (2020).

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demand for more sustainable funds is motivated by non-pecuniary goals, as investors give up substantial returns to pursue sustainability. This evidence on U.S. mutual fund beneficiaries is consistent with delegated philanthropy. However, the presence of institutional investors brings in two fundamental questions for sustainable corporate governance. First, are the incentives of institutional investors aligned with the preferences of their beneficiaries? Second, can institutional investors better influence corporate choice by way of exit, voice, or both? Answering these questions is crucial to determine whether externalities such as climate change can be controlled by corporate governance rather than government regulation.

5.3

Questions and Challenges

Whether delegated philanthropy is what investors want in general is hard to say. Even if that was the case, sustainable finance could only succeed in reducing GHGs if investor preferences translated into sustainable corporate choices. This depends on the ability of investors, qua shareholders, to influence decision-making in public corporations. In the most developed financial markets worldwide, however, individual shareholding is a phenomenon of the past. Today, individuals mainly invest in public companies indirectly, as beneficiaries of institutional investors such as mutual funds and pension funds.37 Institutional investors are supposed to act on behalf of their beneficiaries when they decide in which companies to invest and how to vote their shares therein. This circumstance provides both an opportunity and a challenge for sustainable finance. It is an opportunity because institutional ownership of public companies is big and global. According to a 2017 research, 100 corporations worldwide are responsible for 71% of global GHG emissions; almost

“Low-Carbon Mutual Funds”. European Corporate Governance Institute (ECGI)— Finance Working Paper No. 659/2020, http://dx.doi.org/10.2139/ssrn.3353239. 37 De La Cruz, A., Medina, A., & Tang, Y. (2019). Owners of the World’s Listed Companies. Paris: OECD Capital Market Series. Notable exceptions include controlling shareholders and state ownership, both of which are prominent worldwide. These are large investors who are sufficiently powerful to foster prosocial goals, if they so wish.

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one-third of these companies are publicly held.38 In 2017, institutional investors owned collectively 41% of the world stock market capitalization, namely almost $35 trillion.39 This is big and, given the role of publicly held companies in GHGs, potentially impactful. Moreover, differently from governments, institutional investors can influence corporations across borders because their holdings are diversified internationally. Finally, and most importantly, institutional investors have a crucial advantage over individual investors: their holdings in individual companies are concentrated. Shareholders of public companies used to be too small and dispersed to matter.40 But more recently, the rise of defined-contribution retirement plans and the awareness of the benefits of portfolio diversification have made institutional investors prominent vehicles for private savings. As a result, ownership of publicly held companies has become concentrated.41 In the U.S. and the UK, the 20 largest investors own a majority of the capital of a typical company. In most of continental Europe, where controlling shareholders are still relatively frequent, they control 15% or more of the votes, on average.42 Such investors can exercise a considerable influence on their portfolio companies. This observation does not only apply to the largest, U.S.-based, institutional investors, such as Blackrock, Vanguard, and State Street (known as the “Big Three”). EU-based institutional investors, which are the second-largest institutional owners in the world—and, as I will discuss shortly, are subject to a different regulation as it relates to sustainability—are also potentially influential in all the countries in which institutional ownership is large. Institutional investors 38 https://www.cdp.net/en/articles/media/new-report-shows-just-100-companies-aresource-of-over-70-of-emissions. 59% of the top-100 GHGs producers are state-owned companies and 9% are private companies. 39 De La Cruz, A., Medina, A., & Tang, Y. (2019). Owners of the World’s Listed Companies. Paris: OECD Capital Market Series. 40 Berle, A. & Means, G. (1932). The Modern Corporation and Private Property. New York: Macmillan. 41 Gilson, R.J., & Gordon, J.N. (2013). “The Agency Costs of Agency Capitalism: Activist Investors and The Revaluation of Governance Rights”. Columbia Law Review, 113(4), 863–927. 42 The 20 largest institutional investors own 25% or more, on average, in Canada, the Netherlands, Poland, South Africa, Finland, Japan, Sweden and Norway. De La Cruz, A., Medina, A., & Tang, Y. (2019). Owners of the World’s Listed Companies. Paris: OECD Capital Market Series.

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are influential because they can credibly threaten to divest from a company that doesn’t meet their requirements in terms of Environmental, Social or Governance (ESG) goals, or—as a coalition with other investors—to defeat the management in a voting contest.43 The key role played by institutional investors in corporate governance presents us with a challenge. Do such powerful investors foster the sustainability preferences of their beneficiaries, and if yes, how? The problem is threefold. First, there is an agency cost problem as the incentives of institutional investors are not aligned with the interest of the beneficiaries. Secondly, and relatedly, institutional investors have different business models which prompt them to be active or inactive in corporate governance and, when they are active, choose exit, voice or a mix thereof. Thirdly, beneficiaries may have different preferences for sustainability and disagree on how to foster it. I discuss these issues in turn. Agency cost is the cost for principals (individual investors) to delegate a task (sustainable corporate governance) to an agent (institutional investors).44 Because, inter alia, agency cost makes monitoring expensive for beneficiaries, institutional investors may pretend to pursue ESG Goals while in reality they pursue private interests. Fortunately, there are legal and market mechanisms to cope with this problem. An example of legal rules is the investment advisers’ fiduciary duties and the corresponding obligation to verify that investment advice is in line with the investor preferences—that is, investment suitability.45 An example of market mechanism is gatekeepers,46 such as rating agencies, which should help beneficiaries to screen institutional investors based on ESG performance and to choose where to invest depending on their preferences, 43 Aguilera, R.V., Bermejo, V.J., Capapé, A.J., & Cuñat, V. (2019). “Firms’ Reaction to

Changes in the Governance Preferences of Active Institutional Owners”. European Corporate Governance Institute—Finance Working Paper No. 625/2019, http://dx.doi.org/10. 2139/ssrn.3411566; Brav, A., Jiang, W., Li, T., & Pinnington, J. (2019). “Picking Friends Before Picking (Proxy) Fights: How Mutual Fund Voting Shapes Proxy Contests”. European Corporate Governance Institute (ECGI)—Finance Working Paper No. 601/2019, http://dx.doi.org/10.2139/ssrn.3101473. 44 Jensen, M.C., & Meckling, W.M. (1976). “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”. Journal of Financial Economics, 3(4), 305–360. 45 Armour, J., Awrey, D., Davies, P.L., Enriques, L., Gordon, J.N., Mayer, C.P., & Payne, J. (2016). Principles of Financial Regulation. Oxford University Press. 46 Kraakman, R.H. (1986). “Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy”. Journal of Law, Economics, & Organization, 2(1), 53–104.

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discussed above, on how much return to give up in order to pursue sustainability. Both mechanisms are, in general, imperfect ways to cope with the agency cost of retail investment.47 The agency cost of institutional investment stems from conflicts of interest. Beneficiaries have a mix of financial and non-financial preferences. To simplify, let us assume that the former is a certain risk/return combination and the latter, as explained earlier, is a prosocial environmental goal that may imply lower short-term financial returns. Institutional investors have incentive to maximize fee income net of management cost. For most investors—notably excluding hedge funds—fee income is based on Assets Under Management (AUM). AUM is affected by the value of the investment, but even more so by the inflow of beneficiaries. To attract as many beneficiaries as possible, institutional investors try to offer attractive performance, in different risk classes, combined with a prosocial goal widely supported by beneficiaries. Environment-friendly investments are a good example of such a prosocial goal. However, institutional investors may not be entirely honest in pursuing ESG investment and, even if they are, their ESG labels may not correspond with what beneficiaries actually want. The problem is akin to the pursuit of financial performance: there too institutional investor’s choices may not reflect the interest of beneficiaries. However, over time, the fiduciaries duties of institutional investors as financial advisors have evolved into a full set of disclosure obligations and conduct of business rules. Both items are well under-developed as far as sustainable investments are concerned. Meanwhile, private markets have provided a full host of sustainability ratings to support the quest of beneficiaries for environmentfriendly investment. According to recent research, these ratings have a significant impact on mutual fund’s beneficiaries. The introduction of Morningstar 1–5 Globes indicator of sustainable investment—a coarse but salient indicator of sustainability—significantly affected inflows and outflows of mutual funds.48 Moreover, the subsequent introduction of a less discrete rating—Morningstar Low Carbon Designation—has further affected beneficiaries’ decision on where to invest, as well as 47 Armour, J., Awrey, D., Davies, P.L., Enriques, L., Gordon, J.N., Mayer, C.P., & Payne, J. (2016). Principles of Financial Regulation. Oxford University Press. 48 Hartzmark, S.M., & Sussman, A.B. (2019). “Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows”. Journal of Finance, 74(6), 2789–2837.

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the competition between mutual funds to attract these sustainabilityminded beneficiaries.35 While it is clear that sustainability matters to retail investors, finance studies also show that ESG ratings are unreliable and prone to conflicts of interest.49 In contrast to a longstanding law & finance literature on financial ratings,50 the discussion on how legal rules can enhance the reliability of ESG ratings is still in its infancy.51 The second problem with the role of institutional investors in sustainable corporate governance is that they have different business models. Consequently, they may influence the sustainability of portfolio companies in different ways, or not at all. According to a longstanding distinction,52 institutional investors may “voice” their dissatisfaction, by voting or otherwise engaging with the management, or (threaten to) “exit” the investment. These behaviours correspond with different preferences of beneficiaries regarding sustainability and financial returns. For instance, exit from unsustainable investment is largely compatible with “doing well by doing good”, namely long-term profit maximization. However, “delegated philanthropy” may require a stronger engagement with producers of GHGs and correspondingly accepting lower financial returns to foster long-term shareholder welfare. The impact of these corporate governance strategies differs, too. Exit tends to depress the stock price of portfolio companies, but because not all investors are committed to sustainability, it may take a while before the price of unsustainable companies incorporates the negative externality. Voice is more immediate, as it affects the sustainability of corporate decision-making directly, but implies foregone profits for both the portfolio companies and the investors engaging with them.

49 Daines, R.M., Gow, I.D., & Larcker, D.F. (2010). “Rating the Ratings: How Good Are Commercial Governance Ratings?”. Journal of Financial Economics, 98(3), 439–461; Shackleton et al. 2019, mimeo (on file with author). 50 Partnoy, F. (2001). “Barbarians at the Gatekeepers? A Proposal for A Modified Strict Liability Regime”. Washington University Law Quarterly, 79(2), 491–548; Coffee, J.C. (2004). “Partnoy’s Complaint: A Response”. Boston University Law Review, 84(2), 377– 382. 51 Siri, M., & Zhu, S. (2019). “Will the EU Commission Successfully Integrate Sustainability Risks and Factors in the Investor Protection Regime? A Research Agenda”. Sustainability, 11(22), 6292. 52 Hirschman, A.O. (1970). Exit, Voice and Loyalty. Cambridge, MA: Harvard University Press.

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Whether institutional investors pursue exit, voice, both or neither of them is essential to understand their impact on portfolio companies, hence whether sustainable corporate governance can correct negative externalities. In theory, the optimal strategy of institutional investors depends on the business model. As I argued in previous work,53 shortterm, transient investors are not interested in corporate governance, apart from activist hedge funds that admittedly do not pursue sustainability. The key difference in corporate governance is between active, dedicated investor and passive investors that track market indices to a varying degree.54 Both categories of investors are long-term investors, so they potentially care for sustainability. However, active investors have powerful incentives to exit/enter investments based on non-public information,55 because timely actions boost their performance, which in turn increases AUM and attractiveness for beneficiaries. That applies to ESG investment too. The situation of passive funds is different. Because they track a market index, they cannot exit strategically. Whether they like it or not, they must be loyal to their companies, which in principle commits them to voice. Index funds that want to pursue ESG Goals must persuade portfolio companies to do so. Pursuing sustainability, however, clashes with another key element of the business model: minimizing cost. Index funds compete on low fees (some of them even offer nominally zero fees), whereas engaging with individual companies is costly. To reduce this cost, most institutional investors rely on proxy advisors such as ISS or Glass Lewis to advise on engagement. However, because proxy advisors are not accountable to the institutional investor’s beneficiaries, this solution exacerbates agency costs. Empirical evidence suggests that institutional investors foster the sustainability of portfolio companies. However, it is unclear whether they do so by way of exit or voice, which makes it impossible to say whether institutional investor behaviour is in line with what beneficiaries want. Overall, institutional investors have an impact on several ESG ratings of

53 Pacces, A.M. (2016). “Exit, Voice and Loyalty from the Perspective of Hedge Funds Activism in Corporate Governance.” Erasmus Law Review, 9(4), 199–216. 54 Bushee, B.J. (1998). “The Influence of Institutional Investors on Myopic R&D Investment Behavior”. Accounting Review, 73(3), 305–333. 55 Edmans, A., & Manso, G. (2011). “Governance Through Trading and Intervention: A Theory of Multiple Blockholders”. Review of Financial Studies, 24(7), 2395–2428.

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portfolio companies. According to some studies,56 this depends on exit; according to others, voice plays a role too.57 Most actions by institutional investors are not observable because engagement takes place behind closed doors.58 This is reflected by the limitations of the extant empirical studies, which either try to identify engagement indirectly or are based on surveys59 and non-public data from specific investors.60 While one has to be cautious about the generalizability of these studies, they suggest that active investors tend to participate in corporate governance by way of both voice and exit. In particular, engagement provides information spillovers that benefit the exit strategy. There isn’t much evidence about the impact of index investors on sustainability, which is unfortunate because such investors have a huge potential to engage portfolio companies on sustainability. First of all, index investors are very large. The “Big Three” U.S.-based investors (Blackrock, Vanguard and State Street) have together $15,5 trillion of Assets Under Management and the vast majority of the equity funds they operate is indexed. Moreover, each of the Big Three has large stakes in virtually every listed company in the world. Finally, as mentioned, index funds cannot exit, which commits them to voice. However, because they pursue a low-cost investment strategy, it is questionable that they care

56 Gantchev, N., Giannetti, M., & Li, R. (2019). “Does Money Talk? Market Discipline Through Selloffs and Boycotts”. European Corporate Governance Institute (ECGI)— Finance Working Paper No. 634/2019. http://dx.doi.org/10.2139/ssrn.3409455. 57 Dyck, A., Lins, K.V., Roth, L., & Wagner, H.F. (2019). “Do Institutional Investors Drive Corporate Social Responsibility? International Evidence”. Journal of Financial Economics, 131(3), 693–714. 58 McCahery, J.A., Sautner, Z., & Starks, L.T. (2016). “Behind the Scenes: The Corporate governance Preferences of Institutional Investors”. Journal of Finance, 71(6), 2905–2932. 59 Krueger, P., Sautner, Z., Starks, L.T. (2019). “The Importance of Climate Risks for Institutional Investors”. European Corporate Governance Institute (ECGI)—Finance Working Paper No. 610/2019, http://dx.doi.org/10.2139/ssrn.3235190. 60 Dimson, E., Karaka¸s, O., & Li, X. (2019). “Coordinated Engagements”. Mimeo, http://dx.doi.org/10.2139/ssrn.3209072; Becht, M., Franks, J.R., & Wagner, H.F. (2019). “Corporate Governance Through Exit and Voice”. European Corporate Governance Institute (ECGI)—Finance Working Paper No. 633/2019, http://dx.doi.org/10. 2139/ssrn.3456626.

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about corporate governance at all.61 According to some commentators,62 this reflects a severe agency problem that regulation should fix by incentivizing index investors’ expenditures on engagement. In contrast, Rock & Kahan have argued that index investors have sufficient incentives to engage companies particularly on universal issues, such as ESG, which apply indistinctively across diversified portfolios and thus have a lower cost per company.63 Their argument is twofold. First, particularly the Big Three invest on a very large scale, which implies a substantial interest in the long-term performance of their portfolio companies. Engaging any of these on sustainability and other long-term issues will affect the investor’s fee income as a proportion of AUM. Secondly, not all the funds operated by the Big Three are indexed. The sustainability information acquired to engage the companies in the index funds will be also useful to decide investments and divestments of the active funds. If especially index investors hold a promise to engage on sustainability, the third remaining question is whether this will be consistent with the preferences of their beneficiaries. Differently put, why should climatechange minded beneficiaries prefer to foster sustainability via corporate governance rather than political voting?64 The main challenge to incorporate the preferences of end-shareholders in corporate governance is that these preferences differ. Some beneficiaries are willing to give up more financial return to foster sustainability; other less, or not at all. For this reason, in the recent debate on corporate purpose, several commentators have argued that shareholder wealth maximization is the only norm on which all shareholders could agree.65 However, the picture is more 61 Isaksson, M., & Celik, ¸ S. (2013). “Who Cares? Corporate Governance in Today’s Equity Markets”. OECD Corporate Governance Working Papers, No. 8, OECD Publishing, http://dx.doi.org/10.1787/5k47zw5kdnmp-en. 62 Bebchuk, L.A., & Hirst, S. (2019). “Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy”. Columbia Law Review, 119(8), 2029–2146. 63 Rock, E.B., & Kahan, M. (2019). “Index Funds and Corporate Governance: Let Shareholders Be Shareholders”. European Corporate governance Institute (ECGI)—Law Working Paper No. 467/2019, http://dx.doi.org/10.2139/ssrn.3295098. 64 Rock, E.B. (2020). “For Whom Is the Corporation Managed in 2020?: The Debate over Corporate Purpose”. European Corporate governance Institute—Law Working Paper No. 515/2020, http://dx.doi.org/10.2139/ssrn.3589951. 65 Fisch, J.E., & Davidoff Solomon, S. (2020). “Should Corporations Have a Purpose?”. European Corporate Governance Institute—Law Working Paper No. 510/2020, https:// ssrn.com/abstract=3561164.

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nuanced. In theory, institutional investors who care for sustainability could offer their beneficiaries a sort of “opt-in stewardship” and let the beneficiaries who want sustainability choose them.66 Another possibility is pass-through voting, which is, however, fraught with problems—most notably the risk for large institutional investors to disband their biggest advantage: concentrated voting power.67 To address the comparison between corporate voting and political voting, institutional investors may be framed as parties in a political spectrum. Like parties, institutional investors can reflect the varying sustainability preferences of beneficiaries so long as their behaviour is consistent over time. Both economists68 and legal scholars69 have recently studied the voting behaviour of U.S. institutional investors in this fashion. The result, albeit preliminary, are interesting as they suggest that the voting behaviour of large institutional investors (e.g. the Big Three) or proxy advisors (e.g. ISS) is predictable in a comparable way as political parties in a parliament. If institutional investors and their advisors behave predictably, beneficiaries might choose the investors depending on their stance on sustainability. Beneficiaries, however, may be completely unaware of how institutional investor cast their vote and, even more so, that they follow a “political” patterns in exercising corporate governance. Here the law has an important role to play.

66 See Griffith, S.J. (2020). “Opt-In Stewardship: Toward an Optimal Delegation of Mutual Fund Voting Authority”. Texas Law Review, 98(6), 983–1047, wondering why private ordering has not yet offered this solution. Hart, O., & Zingales, L. (2017). “Companies Should Maximize Shareholder Welfare Not Market Value”. Journal of Law, Finance, and Accounting, 2(2), 247–275, discuss the same question, assuming incorrectly that fiduciary duties in the U.S. would prevent such arrangement. On why this is not the case, see e.g. Williams, C.A. (2018). “Corporate Social Responsibility and Corporate governance”. In J.N. Gordon and W.-G. Ringe (eds.), The Oxford Handbook of Corporate Law and Governance, Oxford University Press, 634–678. 67 Fisch, J.E. (2020). “The Uncertain Stewardship Potential of Index Funds”. European Corporate Governance Institute (ECGI)—Law Working Paper No. 490/2020, http://dx. doi.org/10.2139/ssrn.3525355. 68 Bolton, P., Li, T., Ravina, E., & Rosenthal, H.L. (2019). “Investor Ideology”. European Corporate Governance Institute (ECGI)—Finance Working Paper No. 557/2018, http://dx.doi.org/10.2139/ssrn.3119935. 69 Bubb, R., & Catan, E. (2019). “The Party Structure of Mutual Funds”, Mimeo, http://dx.doi.org/10.2139/ssrn.3124039.

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The Role of the Law

The challenge for sustainable corporate governance is the alignment of institutional investors’ behaviour with the environment-friendly preferences of their beneficiaries. This is not conceptually different from the conflicts of interest affecting the delegation of investment to intermediaries such as investment firms, mutual funds, and pension funds. However, as the foregoing discussion reveals, there are at least two complications. One is the transparency of institutional investor behaviour as it relates to sustainability, as opposed to financial performance, which affects the coordination of beneficiaries’ preferences in corporate governance. The second complication is that, whereas risk and return are well-trotted concepts, what counts as sustainable investment is undefined, particularly in the context of specific economic activities. This potentially undermines the knowledgeable screening of institutional investors by the beneficiaries. The recent EU regulatory framework tries to address both problems. In 2018, the European Commission published an ambitious Action Plan to support sustainable finance.70 To tackle the transition of existing activities to more sustainable production processes, finance is crucial. A comprehensive discussion of the Action plan and its legislative implications is out of the scope of this paper.71 I will focus on two major aspects. First, the Taxonomy Regulation (EU) 2020/852 introduces the first legislative framework in the world defining sustainable economic activities with reference to 6 grand goals, the first and perhaps most important of which being mitigation of GHGs in line with the more ambitious Paris agreement target. Second, the Disclosure Regulation (EU) 2019/2088 compels all financial market participants (including all categories of institutional investors) and financial advisors to disclose the climate risk exposure and investment sustainability in terms of the Taxonomy Regulation regime. A third, crucial legislative aspect affecting sustainable corporate governance is not part of the action plan. Only one year earlier, the Revised Shareholder Right Directive (EU) 2017/828 (hereinafter SRD II) established, on a comply-or-explain basis, the transparency of

70 European Commission (2018). Action Plan: Financing Sustainable Growth. COM(2018) 97 final. 71 See Siri, M., & Zhu, S. (2019). “Will the EU Commission Successfully Integrate Sustainability Risks and Factors in the Investor Protection Regime? A Research Agenda”. Sustainability, 11(22), 6292 for an excellent overview.

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voting policies and voting behaviour of all institutional investors. Importantly, such policies (and the consequent voting behaviour) must describe social and environmental impact. Let me start with SRD II. With this Directive, the EU caught up on an important difference with the U.S. Since 2003, U.S.-based institutional investors must be transparent about their voting policies and voting behaviour. While funds managing retirement schemes were long required to vote their shares and be transparent about it, the other mutual funds are only required to have a policy. However, to avoid liability risk, American mutual funds routinely cast their vote in a transparent manner.72 Whereas the largest asset manages (e.g. the Big Three) have in-house stewardship groups advising voting, smaller institutional investors cannot afford this and rely on proxy advisors.73 In the EU, similar rules apply since the general meeting season 2020 based on art. 3g of SRD II. Institutional investors must disclose annually their voting policy and how they have implemented it by engaging with individual companies, specifying aspects such as social and environmental impact and corporate governance, among others. This is an important difference from the U.S., where the voting transparency requirements do not refer to ESG Goals. A second difference is that the EU voting transparency rules can be opted out of, if only the institutional investor explains why these rules should not apply to them. Although it is too early to evaluate the first year of application of SRD II, it is hard to imagine that institutional investors will opt out of transparency of voting on this particular aspect, given the momentum of sustainability in Europe. As I argued elsewhere,74 the question is rather the quality of engagement and the individual company’s decision-making on sustainability, because particularly institutional investors which follow a low-cost index-tracking strategy hardly have any company-specific information. This question is, however, superseded if one takes a market-wide approach to the sustainability problem. From that standpoint, what 72 Griffith, S.J. (2020). “Opt-In Stewardship: Toward an Optimal Delegation of Mutual

Fund Voting Authority”. Texas Law Review, 98(6), 998–1000. 73 Iliev, P., & Lowry, M. (2015). “Are Mutual Funds Active Voters?”. Review of Financial Studies, 28(2), 446–485. 74 Pacces, A.M. (2018). “Shareholder Activism in the Capital Markets Union,” in E. Avgouleas, D. Busch, & G. Ferrarini (eds.), Capital Markets Union in Europe, Oxford University Press, 507–525.

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matters is not so much how the individual company manages the transition to more sustainable production processes, but rather how a portfolio of companies integrates investment in sustainable activities. This perspective confers upon index investors a comparative advantage. As they care about universal issues, index investors can devise consistent voting policies about these issues and implement them in hundreds of companies, without having to micromanage any of them. Moreover, the positioning of institutional investors on these issues, particularly ESG, allows beneficiaries to choose the funds that best reflect their sustainability preferences. The remaining challenge is the reliability and the saliency of the information provided by institutional investors about their engagement on sustainability. Establishing how sustainability-minded institutional investors really are is a problem transcending voting and engagement with portfolio companies. The first question is whether funds that claim to make sustainable investments actually do so. This is a crucial aspect for a knowledgeable choice by beneficiaries, which the EU Disclosure Regulation has tackled. Among other obligations, market participants which advertise products with sustainable characteristics or that feature sustainable investment must elaborate on what sustainability means concretely, for instance in terms of a market index or GHGs reduction, and provide prospective customers with succinct and understandable information in this regard. This mandatory disclosure is a big step to support knowledgeable choice by retail investors, which would otherwise be plagued by the reluctance of companies to provide proprietary information and the lack of standardization of this information.75 This step, however, would not be sufficient if market participants had full discretion to define what is sustainable, and then earmark their products to that definition. The EU Taxonomy Regulation aims to fix this problem. Having come into force on 12 July 2020, it only establishes a framework that will have to be detailed by secondary legislation on technical standards. However, the Taxonomy Regulation already sets the principle that in order for any activity to be labelled as sustainable, it must fulfil four conditions: (i) contribute significantly to one of the 6 sustainability goals (climate change mitigation; climate change adaptation;

75 On these problems and the economic rationale of mandatory disclosure, see Armour, J., Awrey, D., Davies, P.L., Enriques, L., Gordon, J.N., Mayer, C.P., & Payne, J. (2016). Principles of Financial Regulation. Oxford University Press.

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sustainable use of water resources; transition to circular economy; pollution prevention; protection of biodiversity); (ii) do not significantly harm any of the other goals; (iii) comply with the relevant technical standards; (iv) respect additional safeguards to be specified by secondary legislation. It is worth noting that the first and most prominent goal is climate change mitigation, which implies that the specific targets of GHG reduction cannot be undermined for any activity to be sustainable. Relatedly, power generation by way of solid fossil fuels can never be regarded as a sustainable activity.76 It is too early to predict the impact of this monumental EU legislation on the sustainability of beneficiaries’ choices and institutional investors’ behaviour, also considering that this regime will only start becoming effective in 2022 or 2023, depending on the goal.77 However, because financial markets are forward-looking, some effects will start materializing earlier, as soon as the technical standards applying to specific activities will become known. The immediate impact will be most likely on the portfolio choices of institutional investors. An increasing alignment of equity investment with the EU Taxonomy will be necessary to appease to environment-friendly beneficiaries who will immediately see what is sustainable and what is not. Revealing a good understanding of the functional meaning of investment suitability for retail investors, art. 7 of the Taxonomy Regulation mandates explicit disclosure of the non-sustainable character of products that do not qualify as sustainable according to the Taxonomy and the Disclosure Regulation.78 Moreover, it is hard to imagine that the introduction of the Taxonomy will not have an impact on corporate governance. Index investors who want to improve on their sustainability scores will have no choice but to engage with companies on ESG matters, because they cannot simply avoid companies that do not qualify as sustainable under the Taxonomy

76 Art. 19(3) Taxonomy Regulation. 77 The Taxonomy Regulation prioritizes climate change mitigation and adaptation. The

relevant technical standards will apply from 1 January 2022. The technical standards relating to the other goals will apply from 1 January 2023. 78 See Pacces, A.M. (2000). “Financial Intermediation in the Securities Markets: Law and Economics of Conduct of Business Regulation.” International Review of Law and Economics, 20(4), 479–510, recommending this approach to flag the lack of suitability of financial investment.

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Regulation. Active investors, too, will have to strike an increasingly difficult balance between pursuing sustainability and forgoing the benefits of diversification, or else engage with the companies they are invested in for them to become more sustainable. Not every institutional investor will be concerned with sustainability to the same degree, and some may be not at all, but the introduction of a taxonomy of sustainable activities will enable beneficiaries to understand institutional investors’ effective involvement in sustainability—both as engagement and as portfolio choice—and choose accordingly. Being supported by regulation, the Taxonomy brings back to the forefront the old problems of lobbying and regulatory capture that have plagued environmental regulation during the past decades. I leave this aspect of the comparison between political voting and corporate voting for another day. Yet, in closing, it is worth noting that sustainable corporate governance only adds an additional player to the picture: the institutional investors. Institutional investors are not only subject to sustainable finance regulation, but also contribute to the production of such regulation. Institutional investors’ interest is not necessarily aligned with the social welfare, but is also not confined to the interest of any particular sector or national economy, because especially the largest investors invest in virtually every sector in every part of the world. Adding this additional player to the production of rules to curb negative externalities is unlikely to decrease social welfare.

5.5

Conclusion

The meaning of sustainability is often in the eye of the beholder. From an economic standpoint, sustainability implies inter alia reducing the negative externalities of production on the environment. Law has traditionally policed these externalities by way of taxes or regulations. To achieve the ambitious climate change mitigation goals of the Paris Agreement 2015, a more substantial contribution from private investment is needed, which calls for sustainable finance. Whether sustainable finance can work notably depends on the role of institutional investors in corporate governance. Most individuals indirectly own shares in the world’s largest corporations via institutional investors, which are big and influential on corporate decision-making. This holds a considerable promise to the extent that these individuals care for sustainability, but also brings the question whether their preferences are reflected by institutional investors’

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actions and impact. A major claim of this essay is that law plays a decisive role in this respect. In this essay, I have analysed the recent EU legislation as it relates to sustainable corporate governance. Institutional investors may pursue sustainability in corporate governance, whether by portfolio choices, voting power, or both. However, it is unclear whether they actually do this, and if so, how. The incentives of institutional investors are imperfectly aligned with the interest of their beneficiaries as it relates to sustainability. The recent and upcoming EU law on standard sustainability indicators, transparency of voting behaviour, and disclosure of sustainable investment by institutional investors is likely to improve this incentive alignment, making institutional investors increasingly cater to the preferences of their beneficiaries for sustainability. Whether and to what extent sustainable corporate governance is compatible with the business model of different kinds of institutional investors remains to be seen. The first years of application of the EU legislation on sustainable finance and corporate governance will provide interesting material to answer this question empirically.

CHAPTER 6

Integrating Sustainability in EU Corporate Governance Codes Michele Siri and Shanshan Zhu

6.1

Introduction

The transition to a more responsible economic system—that considers the impact of business activities in terms of environmental and social effects—has become an urgent and unavoidable demand. In such a context, corporate governance of listed companies and financial institutions—considered in the past as one of the determinants of the global

Although this chapter is the result of joint work, Paragraphs from 6.2 to Paragraph 6.5.8 should be attributed to Shanshan Zhu. M. Siri · S. Zhu (B) University of Genoa, Genoa, Italy e-mail: [email protected] M. Siri e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_6

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financial crisis—1 is a key factor that can contribute to the promotion of sustainable strategies and decision-making processes, as essential for «aligning businesses more closely with long-term perspectives».2 The recent COVID-19 outbreak confirmed the importance of ensuring that non-financial risks—especially those associated with loss of biodiversity and wildlife habitat—are duly taken into account in order to reduce the risks of future pandemics which would threaten human health and economic development.3 Notably, EU policymakers essentially left the regulation of corporate governance practices of non-financial companies to self-regulatory and soft law mechanisms. In particular, Directive 2006/46/EC now requires that all listed companies refer to a national corporate governance code in their corporate governance statement, explaining the reason for any departure from it. However, further developments are on the way, as the EU Commission recently launched a public consultation on possible legislative and

1 See, for example, Kirkpatrick, G. (2009). “The Corporate Governance Lessons from the Financial Crisis”. OECD Journal of Financial Market Trends, 1, 61; and EU Commission, Green Paper, Corporate governance in financial institutions and remuneration policies, Bruxelles, 284 final, 2010. For a critical evaluation in relation to the banking sector, see: Fahlenbrach, R. & Stulz, R.M. (2010). “Bank CEO Incentives and the Credit Crisis”. Journal of Financial Economics, 99(1), 11; Hopt, Klaus J., Better Governance of Financial Institutions (April 1, 2013). “Corporate Governance of Banks and Other Financial Institutions After the Financial Crisis”. Journal of Corporate Law Studies, 13 Part 2 (2013), 219–253 (Part B), “Corporate Governance of Banks after the Financial Crisis”, in E. Wymeersch, K.J. Hopt, and G. Ferrarini (eds.), Financial Regulation and Supervision, a Post-crisis Analysis. Oxford University Press 2012, pp. 337–367 (Part A), ECGI—Law Working Paper No. 207, Available at SSRN: https://ssrn.com/abstract=221 2198; Mülbert, Peter O., Corporate Governance of Banks after the Financial Crisis— Theory, Evidence, Reforms (April 2010). ECGI—Law Working Paper No. 130/2009, Available at SSRN: https://ssrn.com/abstract=1448118 or http://dx.doi.org/10.2139/ ssrn.1448118; Beltratti, Andrea, & Stulz, Rene M., Why Did Some Banks Perform Better during the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation (July 13, 2009). Charles A Dice Center Working Paper No. 2009-12, Fisher College of Business Working Paper No. 2009-03-012, Available at SSRN: https://ssrn.com/abs tract=1433502 or http://dx.doi.org/10.2139/ssrn.1433502 (with mixed results about the role of corporate governance during the crisis). 2 See High-Level Expert Group on Sustainable Finance (HLEG) (2018). Final Report,

38. 3 European Commission, Consultation document: Renewed sustainable finance strategy (8 April 2020), p. 37.

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soft law measures to support a sustainable corporate governance.4 In such a context, it is even more important that soft law and self-regulatory tools, such as corporate governance codes, are analyzed as a possible response to the need to integrate sustainability «...into the corporate governance framework, as many companies still focus too much on shortterm financial performance compared to their long-term development and sustainability aspects».5 Many authors investigated the effective implementation of corporate governance codes,6 but a few considered the role of the codes in promoting environmental and social responsibility.7 Even though many

4 EU Commission, Inception Impact Assessment, Sustainable corporate governance, Ref. Ares(2020)4034032—30/07/2020. 5 EU Commission, Communication on the European Green Deal, 11 December 2019, COM(2019) 640 final p. 17. 6 See, for example: Wymeersch, E. (2013). “European Corporate Governance Codes

and Their Effectiveness”, in M. Belcredi and G. Ferrarini (eds.), Boards and Shareholders in European Listed Companies Facts, Context and Post-crisis Reforms. Cambridge University Press, 67–142; Böckli, P., Davies, P.L., Ferran, E., Ferrarini, G., Garrido Garcia, J.M., Hopt, K.J., Pietrancosta, A., Pistor, K., Roth, M., Skog, R.R., Soltysinski, S., Winter, J.W., & Wymeersch, E.O. (2014). Making Corporate Governance codes More Effective: A Response to the European Commission’s Action Plan of December 2012. Oxford Legal Studies Research Paper No. 56/2014; Ferrero-Ferrero, I., & Ackrill, R. (2016). “Europeanization and the Soft Law Process of EU Corporate Governance: How Has the 2003 Action Plan Impacted on National Corporate Governance Codes?” Journal of Common Market Studies, 54(4), 878–895; Stiglbauer, M., & Velte, P. (2014). “Impact of Soft Law Regulation by Corporate Governance Codes on Firm Valuation: The Case of Germany”. International Journal of Business in Society, 14, 395–406; Bianchi, M., Ciavarella, A., Novembre, V., & Signoretti, R. (2011). “Comply or Explain: Investor Protection Through the Italian Corporate Governance Code”. Journal of Applied Corporate Finance, 23(1), 107–121; and RiskMetrics Group et al. (2009). Study on Monitoring and Enforcement Practices in Corporate Governance in the Member States. Study commissioned by the European Commission. 7 See Sjåfjell, B. (2016). “When the Solution Becomes the Problem: The Triple Failure of Corporate Governance Codes”, in J.J. Du Plessis and C.K. Low (eds.), Corporate Governance Codes for the 21st Century: International Perspectives and Critic, 23–55; Szabó, D.G., & Sørensen, K.E. (2013). “Integrating Corporate Social Responsibility in Corporate Governance Codes in the EU”. European Business Law Review, 24(6), 781–828.

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corporate governance codes already require that boards address stakeholders’ (employees, creditors, customers, suppliers, and local communities) interests,8 existing studies denounce that the meaning and real implications of such indication diverge, the recommendations are quite generic and vague,9 and the interests of stakeholders are nonetheless subordinate to the shareholder primacy principle.10 In the light of the strong commitment by the EU in undertaking a sustainability path towards the goals set by the Paris Agreement and the UN 2030 Agenda, it is more pressing than ever evaluating how companies can truly integrate a long-term sustainable approach in their strategies and operations, and therefore whether corporate governance codes could provide a useful guidance towards such objectives. The aim of the chapter is to comparatively evaluate the most recent attempts to integrate sustainability considerations in corporate governance codes of listed companies within the EU Member States, in order to understand if such progress is on the way and which best practices could be taken into consideration and disseminated by the EU authorities in the years to come. The chapter starts by briefly analyzing the EU approach to the promotion of corporate governance practices, with a particular focus on the diffusion of corporate governance codes.11 Then, it focuses on the recent EU actions addressing sustainable development, from the launch of the EU Sustainable Development Strategy in 200112 to the announcement of the European Green Deal strategy in December 2019 and the latest regulatory proposals in 2020. It follows a description of the methodology adopted in the comparative analysis, conducted on corporate governance 8 See Szabó, D.G., & Sørensen, K.E. (2013). “Integrating Corporate Social Responsibility in Corporate Governance Codes in the EU”. European Business Law Review, 24(6), 781–828. 9 Id. 10 See Sjåfjell, B. (2016). “When the Solution Becomes the Problem: The Triple Failure of Corporate Governance Codes”, in J.J. Du Plessis and C.K. Low (eds.), Corporate Governance Codes for the 21st Century: International Perspectives and Critic, 23–55. 11 Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions the European Green Deal, COM/2019/640 final. 12 European Commission. Communication from the Commission a Sustainable Europe for a Better World: A European Union Strategy for Sustainable Development, COM/2001/0264 final (15 May 2001).

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codes currently in force in the EU Member States, also considering the G20/OECD Principles of Corporate Governance (2015) [‘OECD Code’] and UK Corporate Governance Code (2018) as undeniably the most influential codes around the globe. Finally, the paper describes the results of such research and concludes.

6.2 Corporate Governance Codes: The EU Approach The first modern corporate governance code was adopted in the UK in 1992 as a series of best governance practices—known as the Cadbury Code—by the Cadbury Committee on Corporate Governance Issues, which defined corporate governance as «the system by which companies are directed and controlled».13 The aim of the Code was to raise standards of corporate governance in order to increase the level of confidence in financial reporting and auditing, by clearly defining the rights and responsibilities of shareholders, directors, and auditors. In particular, the Code was developed in reaction to the series of business scandals that hit the UK, including the Guinness share-trading fraud, the collapse of the Bank of Credit and Commerce International and Maxwell’s pension fund affair.14 The issuance of the Code was associated with the birth of the corporate governance movement in Europe,15 as it paved the way for the adoption of corporate governance codes throughout Europe.16 As so, for many years, the improvement of corporate governance standards was left by 13 Cadbury, A. (1992), The Financial Aspects of Corporate Governance (Cadbury Report), London, UK: The Committee on the Financial Aspect of Corporate Governance (The Cadbury Committee) and Gee and Co, Ltd, p. 15, §2.5. 14 Boyd, Colin. (1996). “Ethics and Corporate Governance: The Issues Raised by the Cadbury Report in the United Kingdom.” Journal of Business Ethics, 15(2), 167–182. 15 Gerner-Beuerle, Carsten. (2016). “Diffusion of Regulatory Innovations: The Case of Corporate Governance Codes”. Journal of Institutional Economics, 13(2) (October 26), 271–303. 16 See Clarke, T. (2007). International Corporate Governance. Routledge, 175–179;

Wymeersch, E. (2008). “The Corporate Governance ‘Codes of Conduct’ Between State and Private Law”, in R. Zimmermann et al. (eds.), Globalisierung und Entstaatlichung des Rechts (Mohr Siebeck) vol 2, 66–72; and Zattoni, A., & Cuomo, F. (2008). “Why Adopt Codes of Good Governance? A Comparison of Institutional and Efficiency Perspectives”. Corporate Governance: An International Review, 16(1), 6–7.

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EU policymakers to soft law mechanisms, with an exception for the financial sector where—following the 2007 financial crisis—stricter governance requirements were provided for banks and other financial institutions.17 However, a relevant step towards a model including hard law elements was registered with the introduction of Directive 2006/46/EC that requires listed companies to include a corporate governance statement in their annual reports, containing a reference to the national corporate governance code to which each company adheres and, in the event of non-application of any of the provisions enclosed in such code, an explanation for such choice.18 As to other interventions on corporate governance practices, the main intentions by the EU legislator were set in three Green Papers published in 2003, 2010, and 2011, which described the evolution of the Commission’s thinking with regard to future regulatory initiatives concerning corporate governance. The EU policies on corporate governance following such documents, and disclosed in the Corporate Governance Action Plan of 2012,19 focused on the enhancement of specific issues, such as corporate transparency, protection of shareholder rights, board effectiveness, and the promotion of shareholder long-term engagement and stewardship.20 The improvement of corporate governance code reporting—based on companies’ general tendency to provide insufficient explanation for company choice to depart from national corporate governance provisions—was among the initiatives included in the Corporate Governance 17 See, for example, Guido Ferrarini, “CRD IV and the Mandatory Structure of Bankers’ Pay”, in ECGI Law Working paper Series, ECGI—Law Working Paper No. 289, 2015, p. 20; M¨ulbert, Peter O., & Wilhelm, Alexander (2015). “CRD IV Framework for Banks’ Corporate Governance”, in Danny Busch and Guido Ferrarini (eds.), European Banking Union. Oxford University Press, 155, 196–197. 18 Directive 2006/46/EC of 14 June 2006 amending Council Directives 78/660/EEC on the annual accounts of certain types of companies, 83/349/EEC on consolidated accounts, 86/635/EEC on the annual accounts and consolidated accounts of banks and other financial institutions and 91/674/EEC on the annual accounts and consolidated accounts of insurance undertakings. 19 EU Commission Communication, Action Plan: European company law and corporate governance - a modern legal framework for more engaged shareholders and sustainable companies, COM/2012/0740 final. 20 In this regard, consider Directive 2013/50/EU (‘Transparency Directive’) revised in 2013, and the recent Directive 2017/828 (‘Shareholder Rights Directive II’) replacing the 2007 version.

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Action Plan and was finally addressed by the EU Commission in its recommendations on the quality of corporate governance reporting issued in 2014.21 However, the explicit link between corporate governance and sustainable development was not mentioned by EU policymakers until 2018, in the context of the implementation of the Commission Action Plan on financing sustainable growth, as better described in the next section.22

6.3

EU Approach to Sustainable Development and the Need for a Sustainable Corporate Governance Since the launch of the EU Sustainable Development Strategy in 2001,23 the EU Commission has made a clear commitment to contribute to the promotion of sustainable development. The introduction of the Europe 2020 Strategy in 2010,24 the signing of the Paris Agreement,25 the adherence to the UN Sustainable Development Goals in 2016,26 as well as the announcement of the European Green Deal strategy in December 201927

21 EU Commission, Recommendations of 9 April 2014 on the quality of corporate governance reporting (‘comply or explain’). 22 EU Commission. Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions, Action Plan: Financing Sustainable Growth, COM (2018) 97 final (March 2018). 23 European Commission, Communication from the Commission A Sustainable Europe for a Better World: A European Union Strategy for Sustainable Development, COM/2001/0264 final. 24 EU Commission, Europe 2020: A strategy for smart, sustainable and inclusive growth, COM(2010) 2020 final. 25 UN, Paris Agreement on Climate Change, UN Doc. FCCC/CP/2015/L.9/Rev.1 (12 December 2015). 26 EU Commission, Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, Next steps for a sustainable European future European action for sustainability, COM(2016) 739 final. 27 Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions the European Green Deal, COM/2019/640 final.

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clearly confirmed the EU’s intention to lead the global evolution towards a new economic model. In particular, the first EU legislative interventions addressing the promotion of corporate sustainability developed along two main intertwined dimensions: sustainable finance and corporate non-financial disclosure. As to non-financial disclosure, Directive 2014/95/EU on disclosure of non-financial and diversity information [‘Non-Financial Reporting Directive’]28 —entered into effect in January 2018—requires that certain large companies29 disclose information about their due diligence processes and policies in relation to environmental, social and employee matters, respect of human rights, anti-corruption and bribery issues, and diversity on company boards (in terms of age, gender, educational, and professional background). Notwithstanding the potentially strong impact performed by the introduction of such directive on corporate practice,

28 In accordance with Article 2 of the same directive, in 2017 the EU Commission published some voluntary guidelines on methodology for reporting non-financial information in order “to help companies disclose high quality, relevant, useful, consistent and more comparable non-financial information in a way that fosters resilient and sustainable growth and employment, and provides transparency to stakeholders.” The EU Commission further integrated such guidelines to improve the corporate disclosure of climate-related information in line with recommendations made by the EU Technical Expert Group on Sustainable Finance. European Commission. See Guidelines on non-financial reporting 2017/C 215/01 and European Commission. Guidelines on Non-Financial Reporting: Supplement on Reporting Climate-Related Information, C (2019) 4490 Final (17 June 2019). Available online: https://ec.europa.eu/finance/ docs/policy/190618-climate-related-information-reporting-guidelines_en.pdf (accessed on 28 September 2019). 29 Such directive applies, specifically, to “large undertakings which are public-interest entities exceeding on their balance sheet dates the criterion of the average number of 500 employees during the financial year. See Article 19a of the Non-Financial Reporting Directive.”

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many concerns were raised in relation to its implementation,30 and empirical research found that non-financial statements are generally affected by lack of quantitative disclosure, lack of clarity concerning the selection and measurability of non-financial targets, but also that they are over-generic, they do not appropriately address climate-related risks nor provide sufficient descriptions of due diligence processes, especially related to human rights and social matters.31 The consequences of such failure could be particularly harmful, especially considered that the quality of sustainability disclosure is a key aspect to prevent market actors from relying exclusively on financial metrics which may encourage a focus on short-term measures of performance.32 Moreover, the lack of reliable corporate nonfinancial disclosure is undoubtedly one of the main challenges faced by financial market participants and financial advisers in performing their new disclosure duties in relation to ESG factors in the context of EU sustainable finance regulation.33 In considerations of such limitations, the revision of the Non-Financial Reporting Directive is one of the first key actions included in the initial roadmap of the policies and measures needed to achieve the European Green Deal,34 and a public consultation on its review was launched on February 20, 2020.35 Interestingly, 30 Recital 16 of the Non-Financial Reporting Directive requires that “statutory auditors and audit firms should only check that the non-financial statement or the separate report has been provided’ and leaves to the Member States the discretionary power to ‘require that the information included in the non-financial statement or in the separate report be verified by an independent assurance services provider.” The lack of mandatory thirdparty verification of non-financial statements reduces their reliability level. See Siri, M., & Zhu, S. (2019). “Will the EU Commission Successfully Integrate Sustainability Risks and Factors in the Investor Protection Regime? A Research Agenda”. Sustainability, 11, 1–23. 31 See ESMA, Report Enforcement and regulatory activities of European enforcers in 2019 (April 2020) and Alliance for Corporate Transparency, 2019 Research Report: An analysis of the sustainability reports of 1000 companies pursuant to the EU Non-Financial Reporting Directive (February 2020). 32 See ESMA, Report Undue short-term pressure on corporations (18 December 2019). 33 Regulation (EU) 2019/2088 of 27 November 2019 on sustainability-related

disclosures in the financial services sector. 34 Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions the European Green Deal, COM/2019/640 final, Annex. 35 https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12129Revision-of-Non-Financial-Reporting-Directive/public-consultation. See Commission,

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the majority of respondents expressed support for a great number of proposals that would greatly impact the existing directive.36 In particular, support was shown in relation to: the adoption of a common reporting standard in order to avoid issues concerning comparability, reliability, and relevance; the development of simplified standards for SMEs; the imposition of stronger audit requirements; the digitalization of nonfinancial information which should be available through a single access point and machine-readable; the requirement on companies to disclose their materiality assessment process; the expansion of the scope of the Non-Financial Reporting Directive to other categories of companies; and the alignment of environmental disclosure with the EU Taxonomy structure. The finalization and entrance into force of the EU regulation providing a common EU Taxonomy for sustainable financial products37 and EU climate benchmarks38 will undeniably help to prevent greenwashing practices among companies, but also to increase transparency and comparability of disclosed information. As to the second dimension—sustainable finance—the EU Commission has recently started intervening in the regulation of the financial sector, as it became clear that a real change would be possible only by reorienting private capital to more sustainable investments. In fact, it was estimated that more capital flows should be oriented towards sustainable investments to close the e180-billion gap of additional investments needed to meet the targets of the Paris Agreement. In the meantime, great financial risks might occur for business activities in case of inaction, as it was estimated that delays in tackling the climate issue could cost

‘Consultation strategy for the revision of the Non-Financial Reporting Directive – Background document’ (20 February 2020). 36 See EU Commission, Summary Report of the Public Consultation on the Review of the Non-Financial Reporting Directive, Ares(2020)3997889—29/07/2020, available at https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12129-Rev ision-of-Non-Financial-Reporting-Directive/public-consultation. 37 See Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088. 38 Regulation (EU) 2019/2089 of the European Parliament and of the Council of 27 November 2019 amending Regulation (EU) 2016/1011 as regards EU Climate Transition Benchmarks, EU Paris-aligned Benchmarks and sustainability-related disclosures for benchmarks.

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companies nearly $1.2 trillion over the next 15 years for a universe of 30,000 listed companies.39 As a consequence, at the end of 2016, the EU Commission appointed a High-Level Expert Group (HLEG) on sustainable finance to advise it on developing a comprehensive EU strategy on sustainable finance and development. The HLEG final report,40 issued in January 2018, stressed the importance of promoting sustainable finance through a systemic review of the financial framework and proposed eight recommendations, as well as many crosscutting recommendations and actions, addressed to specific financial sectors. In relation to corporate governance, the HLEG Report recommended, inter alia, the strengthening of director duties related to sustainability and invited the Commission to explore ways to enhance director duties and incorporate sustainability in corporate practice, by taking into account the interests of all stakeholders, employees included, and the likely consequences of any decision in the long term on the community and environment. The report suggested that directors should be adequately trained in order to exercise reasonable care, skill, and due diligence in relation to the company’s affairs, so as to consider the direct and indirect impact of the company’s business model, production, and sales processes on stakeholders and the environment. The HLEG also recommended that sustainability-related competencies should be considered during board nomination processes, the company management should develop a climate strategy aligned with climate goals, and remuneration should be aligned with long-term and sustainability goals. Such suggestions, addressed to the financial sector, could and should reasonably apply as best practices to non-financial companies as the main drivers of economic change. In March 2018, on the basis of the final report published by the HLEG, the EU Commission developed a framework, the “Action plan on Financing Sustainable Growth” (‘Action Plan’),41 which established

39 UN Environment-Finance Initiative. Changing Course 2019. Available online: https://www.unepfi.org/publications/investment-publications/changing-course-a-compre hensive-investor-guide-to-scenario-based-methods-for-climate-risk-assessment-in-responseto-the-tcfd/ (accessed on 28 September 2019). 40 HLEG. Final Report. 2018. Available online: https://ec.europa.eu/info/sites/info/ files/180131-sustainable-finance-final-report_en.pdf (accessed on 28 September 2019). 41 EU Commission. Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European

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a strategy to support the re-orientation of private capital flows towards sustainable investments, so enhancing the connection between the financial industry and sustainable development. The EU strategy specifically develops around 10 key actions to be fully implemented by the end of 2019,42 the last of which concerns the promotion of sustainable corporate governance and reducing short-termism in capital markets. As to such action, the Commission argues that corporate governance «can significantly contribute to a more sustainable economy, allowing companies to take the strategic steps necessary to develop new technologies, to strengthen business models and to improve performance», but also «improve their risk management practices and competitiveness».43 Indeed, a corporate governance framework excessively focused on shortterm performance could lead managers to take risks that are unsustainable in the long term, also in economic terms. Moreover, the EU Commission committed itself to carry out analytical and consultative work with relevant stakeholders to assess: (i) the possible need to require corporate boards to develop and disclose a sustainability strategy, including appropriate due diligence throughout the supply chain, and measurable sustainability targets; and (ii) the possible need to clarify the rules according to which directors are expected to act in the company’s longterm interest. As to the former, in February 2020, the Commission published a study on due diligence,44 which indicated the need for policy

Economic and Social Committee and the Committee of the Regions, Action Plan: Financing Sustainable Growth, COM (2018) 97 final (March 2018). 42 The 10 key actions are: a) establishing an EU classification system for sustainable activities; (b) creating standards and labels for green financial products; (c) fostering investment in sustainable projects; (d) incorporating sustainability when providing financial advice; (e) developing sustainability benchmarks; (f) better integrating sustainability in ratings and market research; (g) clarifying institutional investors’ and asset managers’ duties; (h) incorporating sustainability in prudential requirements; (i) strengthening sustainability disclosure and accounting rule-making; and (l) fostering sustainable corporate governance and attenuating short-termism in capital markets. See also Siri, M., & Zhu, S. (2019). “Will the EU Commission Successfully Integrate Sustainability Risks and Factors in the Investor Protection Regime? A Research Agenda”. Sustainability, 11, 1–23. 43 EU Commission, n 740, 11. 44 Lise Smit, Claire Bright, Robert McCorquodale, Matthias Bauer, Hanna Deringer,

Daniela Baeza- Breinbauer, Francisca Torres-Cortés, Frank Alleweldt, Senda Kara and Camille Salinier and Héctor Tejero Tobed, Study on due diligence requirements through the supply chain, Final report (January 2020), available at https://op.europa.eu/en/pub lication-detail/-/publication/8ba0a8fd-4c83-11ea-b8b7-01aa75ed71a1/language-en.

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intervention for the identification and mitigation of adverse social and environmental impact in a company’s own operations and supply chain. As to the latter, the recent publication, in July 2020, of the “Study on directors’ duties and sustainable corporate governance”—prepared by EY for the EU Commission DG Justice and Consumer—45 represented an important step towards the establishment of a sustainable corporate governance, even though it raised much criticism by scholars and other stakeholders. Based on the assumption that “there is a trend for publicly listed companies within the EU to focus on short-term benefits of shareholders”,46 the report identifies seven main problem drivers contributing to such “short-termism” in corporate governance47 and also analyzes the impacts of possible EU level solutions, from the publication of guidance documents or recommendations to the adoption of hard/legislative measures (including, for example, the requirement that directors should integrate ESG issues while performing their mandate, that corporate boards consider sustainability criteria in the board nomination process, and that Member States introduce mechanisms to incentivize longer shareholding periods). Building on the report, the EU Commission has recently launched a public consultation on possible legislative and soft law measures to support a sustainable corporate governance.48 However, the EY report, the inception impact assessment, and consultation questionnaire all have been subject to strong criticism by respondents, as accused of not being adequately evidence-based, moving from biased assumptions, and being poorly structured (especially in relation to the structure of the questions of the public questionnaire), but also inadequate to respond

45 EY, Study on directors’ duties and sustainable corporate governance, July 2020, available at https://op.europa.eu/en/publication-detail/-/publication/e47928a2-d20b-11eaadf7-01aa75ed71a1/language-en/format-PDF. 46 Ibidem, p. 10. 47 According to the study, these are: (1) directors’ duties and company’s interest

tendency to favour the short-term maximization of shareholder value; (2) growing pressures from investors with a short-term horizon; (3) companies lack of a strategic perspective over sustainability; (4) board remuneration structures that incentivise the focus on short-term shareholder value; (5) current board composition inadequacy to support a shift towards sustainability; (6) current corporate governance frameworks and practices insufficient stakeholder engagement and involvement; and (7) limited enforcement of the directors’ duty to act in the long-term interest of company. 48 EU Commission, Inception Impact Assessment, Sustainable corporate governance, Ref. Ref. Ares(2020)4034032—30/07/2020.

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to the real problems at stake (which could not be simply considered to be the strong short-term market pressure and the lack of a stakeholder approach).49 Moreover, it should be noted that the existence of nonregulatory incentives—such as the evaluation by rating agencies, score providers, and institutional investors of sustainability aspects such as the adherence to international standards (e.g., the UN Guiding Principles on Business and Human Rights and the ILO Declaration on Fundamental Principles and Rights at Work) and the general tendency by institutional investors to adopt a long-term view on investment activities50 —should be considered when evaluating the best tools for supporting a more responsible decision-making by corporations. In the light of the strong criticism moved to a possible hard/regulatory approaches to support the establishment of a sustainable corporate governance, we find it useful performing an analysis of existing practices concerning the integration of CSR, sustainability, environmental and social issues among corporate governance codes adopted by the EU Member States, so as to investigate a possible role of such self-regulatory and soft law measures in enhancing more responsible corporate behaviors. Notwithstanding the initiatives undertaken by the EU legislator, the integration of corporate sustainability is still at its infancy, and many policy interventions have to be done. However, the restructuring of corporate governance practices will be an obliged step to the achievement of international sustainability targets. As already mentioned, many authors investigated the effective implementation of corporate governance codes,51 but a few considered the role 49 See, for example, Roe, Mark J. and Spamann, Holger and Fried, Jesse M. and Wang, Charles C.Y., The European Commission’s Sustainable corporate governance Report: A Critique (October 14, 2020). European Corporate Governance Institute— Law Working Paper 553/2020, available at SSRN: https://ssrn.com/abstract=371 1652 or http://dx.doi.org/10.2139/ssrn.3711652. See also Ringe, W.-G., Bassen, A., Lopatta, K., EC Corporate Governance Initiative Series: “The EU Sustainable Corporate Governance Initiative—Room for Improvement”, Opinion (15 Oct 2020), available at https://www.law.ox.ac.uk/business-law-blog/blog/2020/10/ec-corporate-govern ance-initiative-series-eu-sustainable-corporate. 50 Consider, one for all, Larry Fink’s Letter to CEOs, available at: https://www.blackr ock.com/corporate/investor-relations/larry-fink-ceo-letter. 51 See, for example, Wymeersch, E. (2013). “European Corporate Governance Codes and Their Effectiveness”, in M. Belcredi & G. Ferrarini (Eds.), Boards and Shareholders in European Listed Companies Facts, Context and Post-crisis Reforms. Cambridge University Press, 67–142; Böckli, P., Davies, P.L., Ferran, E., Ferrarini, G. and Garrido Garcia, J.M.,

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of the codes in promoting environmental and social responsibility.52 Even though many corporate governance codes already include CSR recommendations, by requiring, for instance, that the board addresses stakeholders’ (employees, creditors, customers, suppliers, and local communities) interests,53 scholars denounce that the meaning and real implications of such indication diverge, the recommendations are quite generic and vague,54 and the interests of stakeholders are nonetheless subordinate to the shareholder primacy principle.55 As such, the integration of CSR in corporate governance codes seems superficial and usually done by using boilerplate language.

Hopt, K.J., Pietrancosta, A., Pistor, K., Roth, M., Skog, R.R., Soltysinski, S., Winter, J.W., & Wymeersch, E.O. (2014). Making Corporate Governance Codes More Effective: A Response to the European Commission’s Action Plan of December 2012. Oxford Legal Studies Research Paper No. 56/2014; Ferrero-Ferrero, I., & Ackrill, R. (2016). “Europeanization and the Soft Law Process of EU Corporate Governance: How Has the 2003 Action Plan Impacted on National Corporate Governance Codes?” Journal of Common Market Studies, 54(4), 878–895; Stiglbauer, M., & Velte, P. (2014). “Impact of Soft Law Regulation by Corporate Governance Codes on Firm Valuation: The Case of Germany”. International Journal of Business in Society, 14, 395–406; Bianchi, M., Ciavarella, A., Novembre, V., & Signoretti, R. (2011). “Comply or Explain: Investor Protection Through the Italian Corporate Governance Code”. Journal of Applied Corporate Finance, 23(1), 107–121; and RiskMetrics Group et al. (2009). Study on Monitoring and Enforcement Practices in Corporate Governance in the Member States. Study commissioned by the European Commission. 52 See Sjåfjell, B. (2016). “When the Solution Becomes the Problem: The Triple Failure

of Corporate Governance Codes”, in J.J. Du Plessis and C.K. Low (eds.), Corporate Governance Codes for the 21st Century: International Perspectives and Critic, 23–55; and Szabó, D.G., & Sørensen, K.E. (2013). “Integrating Corporate Social Responsibility in Corporate Governance Codes in the EU”. European Business Law Review, 24(6), 781– 828. 53 See Szabó, D.G., & Sørensen, K.E. (2013). “Integrating Corporate Social Responsi-

bility in Corporate Governance Codes in the EU”. European Business Law Review, 24(6), 781–828. 54 Id. 55 See Sjåfjell, B. (2016). “When the Solution Becomes the Problem: The Triple Failure of Corporate Governance Codes”, in J.J. Du Plessis and C.K. Low (eds.), Corporate Governance Codes for the 21st Century: International Perspectives and Critic, 23–55.

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6.4

Methodology

The present study is based on the analysis of the content of corporate governance codes in force in all EU 27 Member States56 as of November 2020, with specific reference to the approaches followed in integrating Corporate Social Responsibility and/or sustainability issues among the recommendations included therein. In addition to the examination of EU corporate governance codes, the study also includes a comparison with the OECD Code and the UK Code as reference frameworks. The study builds on a previous work conducted in 2013 on the integration of Corporate Social Responsibility in corporate governance codes in the EU.57 Undoubtedly, the present study partially provides some updates on the state of the codes. At the same time, it differs in the scope of the analysis, as it is limited to the 27 EU corporate governance codes instead of all European codes and includes the analysis of some additional factors, such as the presence in the codes of provisions concerning gender diversity, non-financial disclosure, compensation linked to non-financial/sustainability criteria, and the institution of specific CSR committees. The findings of this study have to be seen in the light of some limitations. First of all, it should be specified that the broad scope of the research made it necessary for the study to be based on the English convenience translations of the codes provided by the issuers,58 and therefore, it could present biases to the extent that such translations show some inconsistencies with the official codes issued in the original language. Further limitations of the study could also originate from the different historical, cultural, and institutional contexts in which each code is implemented, that have not been the object of this study but could have influenced in multiple ways the consideration of sustainability-related issues in corporate governance recommendations. It is also important to specify that the 56 Austria, Belgium, Bulgaria, Croatia, Republic of Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, and Sweden. 57 Szabó, D.G., & Sørensen, K.E. (2013). “Integrating Corporate Social Responsibility in Corporate Governance Codes in the EU”. European Business Law Review, 24(6), 781–828. 58 Excepted for the Czech Corporate Governance Code, as only the Czech version was provided and, therefore, the authors had to rely on a software-based translation.

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study does not assess the level of implementation/efficiency of corporate governance rules nor the integration of sustainability concerns in national legislation. Finally, it should be noted that, in some cases, more than one code of corporate governance was published in some Member State, but that only the main code into effect has been considered for the current analysis. In this regard, Table 6.1 provides the list of codes analyzed for each EU country.59

6.5

Findings

The final results of the study are summarized in Table 6.2 and described in the next 7 sections, as briefly specified below: (a) The purpose of corporate governance and of codes: this part includes many indicators, such as the explicit mentioning of sustainability/CSR considerations in the description of the main purpose of the code, but also the approach adopted in defining the function and objective of corporate governance. (b) CSR/Sustainability: this section analyzes how corporate governance codes address sustainability, either by mentioning concepts such as ‘sustainable success’, ‘Corporate Social Responsibility’, ‘sustainable value creation’, ‘sustainable long-term value’, ‘sustainable development’, or by dedicating an entire chapter/principle prescribing the duties of the company towards its stakeholders. (c) Stakeholders: this part addresses the presence of recommendations/principles concerning the consideration and treatment of stakeholders’ interests, as well as the provision of a definition of the concept of ‘stakeholder’. (d) Employees: the paragraph focuses on the inclusion in the codes of specific provisions fostering employee engagement and participation. (e) Gender diversity: the section describes how codes consider gender diversity, distinguishing among corporate governance codes that only recommend that board should be elected promoting gender

59 Data are partially drawn from OECD, The Corporate Governance Factbook, 2019, pp. 43–46.

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Table 6.1 National codes of corporate governance (EU countries) Country

Selected corporate governance code

Custodian

First code

Latest update

Austria

Austrian Corporate Governance Codea

2002

2020

Belgium

The Belgian Code on Corporate Governanceb National Corporate Governance Codec Corporate Governance Coded

Austrian Working Group for Corporate Governance Corporate Governance Committee National Corporate Governance Committee Croatian Financial Services Supervisory Agency, Zagreb Stock Exchange Cyprus Stock Exchange

2004

2020

2007

2016

2007

2019

2011

2019

…f

2001

2018

Committee on Corporate Governance Estonian Financial Supervision Authority (EFSA), NASDAQ OMX Tallinn Stock Exchange Securities Market Association Association Française des Entreprises Privées (AFEP), Mouvement des Entreprises de France (MEDEF) Commission of the German Corporate Governance Code Hellenic Corporate Governance Council

2001

2019

2005

2006

1997

2020

2003

2018

2002

2019

Bulgaria Croatia

Republic of Corporate Governance Cyprus Codee Czech Republic Czech Corporate Governance Code Denmark Recommendations on Corporate Governanceg Estonia Corporate Governance Recommendationsh

Finland France

Finnish Corporate Governance Codei Corporate governance code of listed corporationsj

Germany

German Corporate Governance Codek

Greece

Hellenic Corporate Governance Code For Listed Companiesl Corporate Governance Recommendationsm

Hungary

Ireland

Irish Corporate Governance Annexn

2013

Budapest Stock 2004 Exchange Company Limited Irish Stock Exchange 2010 (following UK Financial Reporting Council recommendations)

2018

2019

(continued)

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Table 6.1 (continued) Country

Selected corporate governance code

Custodian

First code

Latest update

Italy

Corporate Governance Codeo NASDAQ Principles of Corporate Governance/Disclosure Rules on KOSPI Marketp The Corporate Governance Code for the Companies Listed on NASDAQ OMX Vilniusq Ten Principles of Corporate Governancer The Code of Principles of Good Corporate Governances Dutch Corporate Governance Codet

Corporate Governance Committee Nasdaq Riga

1999

2020

2005

2010

Nasdaq Vilnius

2006

2010

Luxembourg Stock Exchange Malta Financial Services Authority

2007

2017

2001

2019

Monitoring Committee Corporate Governance Code Warsaw Stock Exchange (WSE) Portuguese Corporate Governance Institute (IPCG) Bucharest Stock Exchange Central European Corporate Governance Association Ljubljana Stock Exchange, Slovenian Directors’ Association National Securities Market Commission (CNMV) Swedish Corporate Governance Board

2003

2016

2002

2016

2013

2020

2001

2015

2003

2016

2004

2016z

1998

2020

2005

2020

Latvia

Lithuania

Luxembourg Malta

Netherlands

Poland Portugal

Romania Slovak Republic Slovenia

Spain

Sweden

Code of Best Practices of WSE Listed Companiesu The Corporate Governance Code of IPCGv Code of Corporate Governancew Corporate Governance Code for Slovakiax Corporate Governance Code for Listed Companiesy Good Governance Code of Listed Companiesaa The Swedish Corporate Governance Codeab

a Available at: https://www.corporate-governance.at/uploads/u/corpgov/files/code/corporate-govern

ance-code-012020.pdf b Available at: https://www.corporategovernancecommittee.be/en/over-de-code-2020/2020-belgian-

code-corporate-governance c Available at: http://download.bse-sofia.bg/Corporate_governance/CGCode_April_2016_EN.pdf d Available at: https://zse.hr/userdocsimages/legal/Corporate%20Governance%20Code-eng2010.pdf

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e Available at: http://www.cse.com.cy/CMSPages/GetFile.aspx?guid=b77dda20-8bfb-4ab6-86c7-84c dcc6df050 f In the Czech Republic, there is no formal custodian since 2006, when the Czech Securities Commission (the former custodian) was formally integrated into the Czech National Bank. The Code is available at: https://www.mfcr.cz/cs/o-ministerstvu/odborne-studie-a-vyzkumy/2019/kodex-spr avy-a-rizeni-spolecnosti-cr-201-34812 g The (Danish) Recommendations on Corporate Governance are available at: https://corporategov ernance.dk/recommendations-corporate-governance h Available at: https://ecgi.global/code/corporate-governance-recommendations-1 i Available at: https://cgfinland.fi/wp-content/uploads/sites/39/2019/11/corporate-governancecode-2020.pdf j Available at: https://afep.com/wp-content/uploads/2018/06/Afep-Medef-Code-revision-June2018-ENG.pdf. Actually, other private entities published codes of best practices in France such as the Middlenext Governance Code For Small And Midcaps (2016), available at: https://www.fsa.go. jp/en/refer/councils/corporategovernance/reference/france-middlenext.pdf k Available at: https://www.dcgk.de/files/dcgk/usercontent/en/download/code/191216_German_ Corporate_Governance_Code.pdf l Available at: https://www.athexgroup.gr/documents/10180/2227279/HCGC_EN_20131003.pdf/ c32f35ac-2f4b-459a-989f-4f41618cfdc5 m Available at https://www.bse.hu/Issuers/Corporate-Governance-Recommendations n Available at: https://www.ise.ie/Products-Services/Sponsors-and-Advisors/Irish-Corporate-Govern ance-Annex.pdf. -The code integrates the main applicable corporate governance code in Ireland, i.e. the UK Corporate Governance Code developed by the Financial Reporting Council, available at https://www.frc.org.uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f48069a2/2018UK-Corporate-Governance-Code-FINAL.pdf o Available at https://www.borsaitaliana.it/comitato-corporate-governance/codice/2020eng.en.pdf p Available at https://www.nasdaqbaltic.com/files/riga/corp_gov_May_2010_EN.pdf q Available at: https://www.nasdaqbaltic.com/files/vilnius/teisesaktai/The%20Corporate%20Governa nce%20Code%20for%20the%20Companies%20Listed%20on%20NASDAQ%20OMX%20Vilnius.pdf r Available at https://www.bourse.lu/corporate-governance s Available at: https://www.mfsa.mt/publications/corporate-publications/corporate-governance/. Actually, two other codes were issued: the Corporate Governance Manual for Directors of Investment Companies and Collective Investment Schemes and the Corporate Governance Guidelines for Public Interest Companies. We chose to limit our analysis to the first code since mandatory disclosure duties are provided only in relation to it t Available at https://www.mccg.nl/?page=4738 u Available at https://www.gpw.pl/pub/GPW/o-nas/DPSN2016_EN.pdf v In 2017, the CMVM concluded a protocol with the Portuguese Institute of Corporate Governance (IPCG) in order to establish a model of self-regulation of the corporate governance recommendation regime. Therefore, the CMVM Corporate Governance Code was replaced by the Corporate Governance Code of the IPCG. The Code is available at: https://cam.cgov.pt/images/ficheiros/ 2020/revis%C3%A3o_codigo_en_2018_ebook_copy.pdf w Available at https://ecgi.global/code/code-corporate-governance-romania-2015 x Available at http://www.bsse.sk/Portals/2/Issuers%20Guide/2018/kodex_ENG_akt.pdf y Available at: https://ecgi.global/code/slovenian-corporate-governance-code-listed-companies-2016updated-2018 z The Code was updated in 2018 aa Available at https://www.cnmv.es/DocPortal/Publicaciones/CodigoGov/CBG_2020_ENen.PDF ab Available at: http://www.bolagsstyrning.se/UserFiles/Koden/2020/The_Swedish_Corporate_Gov

ernance_Code_1_January_2020_00000002.pdf

1 1 0 1 0 0 0 0 0 0 0 0 0 0 0 0

0 0 1 0 0

1

1 1 1 0 1 1 1 0 1 1

1 0 0 0 0 0 0 0 0 1

0

0 0 0 0 0

0 0 0 0 0 1 0 0 0 0

0

0 0 0 0 0

II Approach

I Approach

Non-CSR

CSR

Definition of CG

Purpose of the code

0 0 0 0 1 0 0 0 0 0

0

0 0 1 0 0

III Approach

1 0 0 1 1 0 0 0 1 0

1

1 1 1 1 0

Sustainability

1 0 0 1 1 1 1 0 1 0

1

0 1 1 1 0

Mentioning of stakeholders

The integration of sustainability factors in corporate governance codes in the EU

Austria (2020) Belgium (2020) Bulgaria (2016) Croatia (2019) Republic of Cyprus (2019) Czech Republic (2018) Denmark (2019) Estonia (2006) Finland (2020) France (2018) Germany (2019) Greece (2013) Hungary (2018) Ireland (2019) Italy (2020) Latvia (2010)

Country

Table 6.2

(continued)

0 0 0 0 0 1 0 0 0 0

1

0 0 1 1 0

Definition of stakeholders

6 INTEGRATING SUSTAINABILITY IN EU …

195

1 0 0 0 0

0 1 0 1 1

1 0 1 0 0

Austria (2020) Belgium (2020) Bulgaria (2016) Croatia (2019) Republic of Cyprus (2019)

0 0 0 0

0 1 1 1

Employee interests

0 1

1 0

Country

0 1

0 0

1 1 0 0 1

Gender balance

0 0 0 1 1

1 0 1 0

0 0

0 0

0 0 0 0 0

CSR committee

0 0 0 0 0

0 0 0 0

0 0

1 0

II Approach

I Approach

Non-CSR

CSR

Definition of CG

Purpose of the code

(continued)

Lithuania (2010) Luxembourg (2017) Malta (2019) Netherlands (2016) Poland (2016) Portugal (2020) Romania (2015) Slovak Republic (2016) Slovenia (2016) Spain (2020) Sweden (2020) OECD (2015) UK (2018)

Country

Table 6.2

1 1 0 0 1

Sustainable compensation

0 0 1 0 0

0 1 0 0

0 1

0 1

III Approach

1 1 1 0 0

Non-financial disclosure

1 1 1 1 1

0 0 0 1

1 1

1 1

Sustainability

0 1 1 0 0

Concept of ethics

1 1 1 1 1

0 1 1 1

1 1

1 1

Mentioning of stakeholders

0 1 1 0 0

Code of ethics

1 1 0 1 0

0 0 0 1

1 1

1 1

Definition of stakeholders

196 M. SIRI AND S. ZHU

1 1 0 1 1 1 0 1 0 1 0 0 1 0 1 1 1 1 0 1 1 1 1 1

0

1 0 1 1 1 1 1 0 0 1 1 1

1 1

0 0 0 1

1 1 1 1 0

Czech Republic (2018) Denmark (2019) Estonia (2006) Finland (2020) France (2018) Germany (2019) Greece (2013) Hungary (2018) Ireland (2019) Italy (2020) Latvia (2010) Lithuania (2010) Luxembourg (2017) Malta (2019) Netherlands (2016) Poland (2016) Portugal (2020) Romania (2015) Slovak Republic (2016) Slovenia (2016) Spain (2020) Sweden (2020) OECD (2015) UK (2018)

Gender balance

Employee interests

Country

0 1 0 0 0

0 0 0 0

0 0

1 0 0 0 0 0 0 0 0 0 0 1

0

CSR committee

1 1 0 0 1

0 0 0 0

0 0

0 0 0 1 1 0 0 0 1 0 0 1

1

Sustainable compensation

1 1 1 1 0

0 0 0 1

0 1

1 1 1 0 1 0 0 0 1 0 1 1

1

Non-financial disclosure

1 1 0 1 1

0 0 0 1

1 1

1 0 0 1 1 0 1 0 0 1 0 1

1

Concept of ethics

0 0 0 1 0

0 0 0 1

0 1

0 0 0 0 0 0 0 0 0 0 0 1

0

Code of ethics

6 INTEGRATING SUSTAINABILITY IN EU …

197

198

M. SIRI AND S. ZHU

diversity and codes that even set a minimum percentage for the representation of the female gender. (f) Sustainability/CSR committee: this part concerns the presence of provisions recommending the establishment of specific sustainability/CSR committee with the task of performing CSR functions. (g) Compensation and sustainability: the section analyses the presence of provisions recommending the integration of non-financial and sustainability-related factors in compensation policies. 6.5.1

The Purpose of Corporate Governance and of Codes

The 2004 version of the OECD Code defines ‘corporate governance’ as «a set of relationships between a company’s management, its board, its shareholders and other stakeholders».60 To this definition, the 2015 version adds also that «the purpose of corporate governance is to help building an environment of trust, transparency and accountability necessary for fostering long-term investment, financial stability and business integrity, thereby supporting stronger growth and more inclusive societies».61 Supporting sustainable growth is therefore among the ultimate objectives included in the latest OECD Code, alongside the support of economic efficiency and financial stability through the improvement of the legal, regulatory, and institutional framework for corporate governance.62 The current version of the UK Corporate Governance Code, similarly to the OECD Code, mentions the original definition of corporate governance provided in 1992 by the Cadbury Committee as «the system by which companies are directed and controlled» but, at the same time, specifies that the long-term success of any business depends on its relationships with its stakeholders, and states that good corporate governance should ensure company’ long-term sustainable success, generating value for shareholders and contributing to wider society.63 The latest version of both codes seems therefore to have started including some specific references to the need for companies to perform 60 OECD Code (2004), p. 11. 61 OECD Code (2015), p. 7. 62 OECD Code (2015), p. 9. 63 UK Code (2018), p. 1 and Principle A.

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their activities with a long-term perspective, taking into account the interests of other stakeholders and the society in general, so moving away from a shareholder-centric vision based on the need to define corporate bodies functions for agency costs reduction. As to the EU 27 analyzed codes, we found that 12 companies out of 27 define the purpose and function of corporate governance (Greece, Denmark, Lithuania, Portugal, Luxembourg, The Netherlands, Bulgaria, Germany, Sweden, Latvia, Poland, and Romania). In particular, we identified three approaches to the definition of corporate governance function. The first approach, followed by the codes from Latvia, Poland, Denmark, and Romania, focuses on corporate value creation, market competitiveness, and transparency, with no mention of stakeholders’ interests, nor to corporate responsibility towards the society. A second approach—adopted by the Lithuanian and Greek codes— defines corporate governance as a framework of the company’s management and control involving a set of relationships between bodies of corporate management and supervision, the company’s shareholders and stakeholders. It should be noted that the codes that follow this approach clearly adhere to the 2004 definition provided by the OECD Code stating that «corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders».64 The third approach, which aligns with the current integrated definition of corporate governance by the OECD Principle65 and the UK Code66 —and adopted by codes from Bulgaria, Germany, Luxembourg, the Netherlands, Portugal, and Sweden—mentions the contribution of corporate governance to sustainable development/growth and pays attention to corporate responsibility towards society. In particular, Bulgarian Code states that «modern corporate governance practices contribute to global sustainable development and growth of national economies» and that «good corporate governance requires corporate boards to be 64 OECD Code, 2015, p. 9. 65 “The purpose of corporate governance is to help build an environment of trust,

transparency and accountability necessary for fostering long-term investment, financial stability and business integrity, thereby supporting stronger growth and more inclusive societies”, G20/OECD Code of Corporate Governance (2015), p. 7. 66 UK Code (2018), p. 1.

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accountable, loyal, responsible, transparent and independent in order to act in the best interest of the company and society».67 The German Code specifies that «with their actions, the company and its governing bodies must be aware of the enterprise’s role in the community and its responsibility vis-à-vis society» as «social and environmental factors influence the enterprise’s success».68 The Luxembourg Code highlights concepts such as ‘integrity’, ‘responsibility’, and ‘respect for the interests of shareholders and any other stakeholders’.69 The Dutch Code defines governance as a concept related to «management and control, about responsibility and influence, and about supervision and accountability», based on the underlying notion that «a company is a long-term alliance between the various stakeholders of the company», of which interests should be taken into account with «a view to ensuring the continuity of the company and its affiliated enterprise, as the company seeks to create long-term value».70 Swedish Code defines ‘good governance’ as a tool to ensure that «companies are run sustainably, responsibly and as efficiently as possible on behalf of their shareholders», and adds that «the confidence of legislators and the public that companies act sustainably and responsibly is crucial if companies are to have the freedom to realize their strategies to create value».71 Similarly, Portuguese Code suggests that corporate governance should strengthen the trust of investors, employees, and the general public in the quality and transparency of management and supervision, as well as in the sustained development of the companies.72 As to the purpose of the code, 20 out of 27 codes (Austria, Belgium, Bulgaria, Czech Republic, Croatia, Denmark, Estonia, Finland, Germany, Greece, Hungary, Latvia, Luxembourg, Malta, the Netherlands, Portugal, Sweden, Romania, Slovakia, Slovenia, and Spain) specify what objectives the code was arranged for and its function in relation to the targeted companies. Of these, only 7 (Austria, Belgium, Croatia, Luxembourg, the Netherlands, Portugal, and Spain) mention CSR/sustainability

67 (Bulgarian) National Corporate Governance Code (2016), p. 3. 68 German Corporate Governance Code (2020), p. 2. 69 The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), p. 6. 70 The Dutch Corporate Governance Code (2016), p. 8. 71 The Swedish Corporate Governance Code (2020), p. 2. 72 (Portuguese) Corporate Governance Code (2018), p. 11.

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factors, such as the consideration of stakeholders’ interests,73 the sustainable long-term value creation,74 responsibility towards the society,75 and non-financial reporting.76 Specifically, the Belgian, Portuguese, Spanish, and Luxembourg codes highlight that one of the main drivers leading to the last revision of the code was the inclusion of a long-term and sustainable approach to value creation. The Luxembourg Code, in particular, begins with the announcement of the commitment taken by the Luxembourg Stock Exchange—when it asked for the revision of the code at the beginning of 2017—to promote «investment in the transition towards a more sustainable economy», by integrating CSR principles in the code.77 Even though some codes include CSR/sustainability issues and/or stakeholder interests in their introductory statements, the majority of the analyzed codes still do not consider corporate responsibility towards the society and the environment as a key aspect of corporate governance function. On the contrary, the analysis suggests that stakeholders’ interests—if considered at all—are usually taken into consideration only if not hindering investors’ interests. 6.5.2

CSR/Sustainability

Although the current version of the OECD Code includes some references to CSR issues, such as stakeholder treatment,78 non-financial 73 The 2020 Belgian Code on Corporate Governance (2020), p. 3; (Croatia) Corporate Governance Code (2019), p. 6; The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), 4; The Dutch Corporate Governance Code (2016), 7. 74 Austrian Code of Corporate Governance (2020), p. 9; The 2020 Belgian Code on Corporate Governance (2020), p. 3; The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), 4; The Dutch Corporate Governance Code (2016), 7. 75 Austrian Code of Corporate Governance (2020), p. 9; The Dutch Corporate Governance Code (2016), 7; (Spain) Good Governance Code of Listed Companies (2020), p. 9. 76 The 2020 Belgian Code on Corporate Governance (2020), p. 3; The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), 4. 77 The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), 4. 78 OECD Code (2015), IV.

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disclosure,79 inclusion of environmental and social consideration in board decision-making,80 and Ethics,81 it does not directly address sustainability issues but, instead, refers to other international guidelines and conventions. In particular, it clarifies that factors such as «environmental, anticorruption or ethical concerns» are considered but «are treated more explicitly in a number of other instruments including the OECD Guidelines for Multinational Enterprises, the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions, the UN Guiding Principles on Business and Human Rights, and the ILO Declaration on Fundamental Principles and Rights at Work, which are referenced in the Principles». The 2018 updated version of the UK Code clearly identifies the promotion of the ‘long-term sustainable success’ of the company as a core duty of the board. The UK Code, however, does not include a definition of ‘sustainable success’, a concept that is also mentioned in relation to director re-election82 and remuneration policies and practices,83 nor does specifically address stakeholder, environmental, and social matters. Therefore, its contribution to the integration of sustainability consideration in corporate governance seems rather modest. As to the EU, we found that 16 out of 27 corporate governance codes (from Austria, Belgium, Bulgaria, Czech Republic, Croatia, Germany, Italy, Lithuania, Luxembourg, Malta, The Netherlands, Portugal, Slovakia, Slovenia, Spain, and Sweden) address Corporate Social Responsibility, sustainable value creation or dedicate an entire chapter/principle of the code prescribing the duties of the company towards its stakeholders. In particular, we identified four main approaches: 6.5.2.1 Sustainable Success The Italian and Spanish codes mention—in line with the UK Code— the need for the board of directors to manage the company pursuing its ‘sustainable success’, which is defined by the Italian Code as «the objective that guides the actions of the board of directors and that consists of 79 OECD Code (2015), V. A. 80 OECD Code (2015), VI. D. 6. 81 OECD Code (2015), VI C. 82 UK Code (2018), Provision 18. 83 UK Code (2018), Principle P.

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creating long-term value for the benefit of the shareholders, taking into account the interests of other stakeholders relevant to the company».84 Such criteria should also guide the definition of the compensation policy85 and the activities performed by the internal control system.86 The Spanish Code recommends that the board of directors should «be guided at all times by the company’s best interest, understood as the creation of a profitable business that promotes its sustainable success over time, while maximizing its economic value» but, as the UK Code, does not define what ‘sustainable success’ means.87 However, the Spanish Code requires that the board strives to «reconcile its own interests with the legitimate interests of its employees, suppliers, clients and other stakeholders, as well as with the impact of its activities on the broader community and the natural environment».88 6.5.2.2

Sustainable Development/Value Creation/Sustainable Long-Term Value Codes from Austria, Belgium, Czech Republic, France, Germany, Netherlands, Portugal, and Sweden recommend that companies should be managed in order to ensure a sustainable development/value creation/sustainable long-term value, intended as the maximization of shareholders’ wealth with the permanent consideration of stakeholders’ interests.89 Even though not expressly mentioning sustainability, the French Code recommends the consideration of social and environmental aspects among the criteria to be followed by directors in the performance of their duties, as well as among the conditions to be integrated into directors’ training and compensation.90

84 Italian Corporate Governance Code (2020), Principle I. 85 Italian Corporate Governance Code (2020), Principle XV. 86 Italian Corporate Governance Code (2020), Principle XIII. 87 (Spain) Good Governance Code of Listed Companies (2020), Recommendation 12,

p. 25. 88 Ibidem. 89 Austrian Code of Corporate Governance (2020), Preamble; The 2020 Belgian Code On Corporate Governance (2020), §2.1, 2.2; German Corporate Governance Code (2020), p. 2; The Dutch Corporate Governance Code (2016), §1.1.1; and The Swedish Corporate Governance Code (2020), Principle 3. 90 Corporate governance code of listed corporations (2018), §1, §24.1.1 and §12.1.

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Interestingly, the Dutch Code specifies that the management board should develop a long-term oriented strategy that takes into consideration, inter alia, the interests of the stakeholders but also «the environment, social and employee-related matters, the chain within which the enterprise operates, respect for human rights, and fighting corruption and bribery».91 However, the Dutch Code also explains that, in the event, the company could make short-term adjustments to its long-term strategy— in case of events such as a bankruptcy or takeover—it should expressly clarify why long-term value creation can no longer be a corporate priority. 6.5.2.3 Corporate Social Responsibility (CSR) Codes from Bulgaria, Denmark, Luxembourg, Malta, Slovenia, and Spain include recommendations related to the adoption of CSR initiatives. However, while the Danish Code simply declares the possibility for the board to adopt CSR initiatives92 and the Bulgarian Code mentions the requirement for corporate management to inform stakeholders of CSR and environmental policies adopted,93 the Maltese Code goes further, by recommending that «directors should seek to adhere to accepted principles of Corporate Social Responsibility in their day- to-day management practices of their company»,94 where CSR is defined as the “continuing commitment by business entities to behave ethically and contribute to economic development while improving the quality of life of the work force and their families as well as of the local community and society at large». In such a context, listed companies are encouraged to: (i) adopt «initiatives aimed at augmenting investment in human capital, health and safety issues, and managing change, while adopting environmentally responsible practices related mainly to the management of natural resources used in the production process», (ii) «act as corporate citizens in the local community and work closely with suppliers, customers, employees and public authorities», and (iii) «go through material relating

91 The Dutch Corporate Governance Code (2016), §1.1.1, v) and vi). 92 (Denmark) Recommendations on Corporate Governance (2019), § 2.2. 93 (Bulgarian) National Corporate Governance Code (2016), §42. 94 (Malta) The Code of Principles of Good Corporate Governance, Principle 12.

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to the theme of Corporate Social Responsibility and keep abreast with initiatives being taken in the local and international scenario».95 Codes from Luxembourg and Spain even recommend the definition of a Corporate Social Responsibility policy in order to integrate CSR aspects into corporate strategy that should be adequately published and on which a periodic report should be issued by the company.96 The Spanish Code describes in detail the minimum content of the environmental and CSR policies that should include at least: « (a) the principles, commitments, objectives and strategy regarding shareholders, employees, clients, suppliers, social welfare issues, the environment, diversity, fiscal responsibility, respect for human rights and the prevention of corruption and other illegal conducts; (b) the methods or systems for monitoring compliance with policies, associated risks and their management; (c) the mechanisms for supervising non-financial risk, including that related to ethical aspects and business conduct; (d) channels for stakeholder communication, participation and dialogue; and (e) responsible communication practices that prevent the manipulation of information and protect the company’s honour and integrity».97 As to reporting, the Luxembourg Code recommends that the company publishes CSR performance indicators applicable to its business activities and provides a list of possible relevant indicators to be measured (workforce, staff training, safety, absenteeism, gender balance, subcontracting and relations with suppliers, energy consumption, water consumption, waste treatment, CO2 emissions, adaptation to the consequences of climate change, measures taken to preserve or develop biodiversity).98 6.5.2.4 Stakeholders Codes from Bulgaria, Croatia, Lithuania, Slovakia, and Slovenia also include an entire chapter prescribing the duties of the company towards its stakeholders (see the section below). 95 (Malta) The Code of Principles of Good Corporate Governance, Supporting Principles under Principle 12. 96 The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), Principle 9; and (Spain) Good Governance Code of Listed Companies (2020), III.3.5. 97 (Spain) Good Governance Code of Listed Companies (2020), III.3.5. 98 The X Principles of Corporate Governance of the Luxembourg Stock Exchange

(2017), Guideline under Recommendation 9.4.

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6.5.3

Stakeholders

Employees and other stakeholders are recognized by the OECD Code as important contributors to the long-term success and performance of the company.99 Chapter 4 of the OECD Code is entirely devoted to the stakeholder issue and defines stakeholders as the «different resource providers including investors, employees, creditors, customers and suppliers, and other (stakeholders)». In the revision process performed from the 2004 version to the current version of the code, the chapter has not been altered, except for some minor changes,100 such as the reference to OECD Guidelines for Multinational Enterprises for due diligence procedure,101 the activation, by many countries, of National Contact Points were to bring cases of violation of such guidelines,102 and the reference to the recognition—by international conventions and national norms—of the rights of employees to information, consultation, and negotiation.103 As for the other sections of the chapter—that have been left untouched—the OECD Code requires that companies recognize the rights of stakeholders established by law (e.g., labor, business, commercial, environmental, and insolvency laws) or through mutual agreements, as well as to allow stakeholders to freely communicate and obtain redress for the violation of their rights and for any unethical and illegal practices by corporate officers to the board or to the competent public authorities.104 Moreover, the activation of mechanisms for stakeholder— especially employee—participation is encouraged, provided that sufficient and reliable information is accessible on a timely and regular basis.105 The code provides also some examples of mechanisms for employee participation, such as the employee representation on boards and governance processes allowing employees to share their view on the most relevant

99 OECD Corporate Governance Code (2015), 9. 100 See Trade Union Advisory Committee (TUAC) Secretariat, The review process of

the OECD Principles of Corporate Governance, 24 September 2015. 101 OECD Corporate Governance Code (2015), IV. A. 102 OECD Corporate Governance Code (2015), IV. E. 103 OECD Corporate Governance Code (2015), IV. C. 104 OECD Corporate Governance Code (2015), IV. A, B, E. 105 OECD Corporate Governance Code (2015), IV. C, D.

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decisions.106 Finally, Chapter VI on the responsibilities of the board requires that the board takes into account stakeholder interest in its decisions.107 The UK Code does not broadly address stakeholder interests, nor provide a definition of ‘stakeholder’. The Code mentions such concept only in Principle D—requiring the board to ensure stakeholder engagement and participation—and Provision 5—requiring that the board discloses in the annual report how stakeholders’ interests have been considered in board decision-making and that employees are involved through one or a combination of three methods (the appointment of a director from the workforce, the creation of a formal workforce advisory panel, and the designation of a non-executive officer). In relation to the EU, our study found that 20 (Belgium, Bulgaria, Croatia, Czech Republic, Denmark, France, Germany, Greece, Hungary, Italy, Lithuania, Luxembourg, Malta, Netherlands, Portugal, Romania, Slovakia, Slovenia, Spain, and Sweden) out of 27 corporate governance codes mention stakeholders, out of which 12 (Bulgaria, Croatia, Czech Republic, Greece, Lithuania, Luxembourg, Malta, Netherlands, Slovakia, Slovenia, and Spain) also include a more or less detailed definition of what a ‘stakeholder’ is. On the contrary, codes from Austria, the Republic of Cyprus, Estonia, Finland, Ireland, Latvia, and Poland do not include any reference to the concept of ‘stakeholder’. Most of the definitions provided (Greece, Lithuania, Luxembourg, Malta, Netherlands, and Slovakia) recall the OECD Code definition of stakeholders, just mentioning the list of interest groups that could fall into the definition (employees, clients, investors, suppliers, local community, and regulators). Interestingly, the Spanish Code mentions, in addition to traditional stakeholder categories, also the concept of «impact» of company «activities on the broader community and the natural environment».108 The definitions included in the Bulgaria and Dutch codes do not only include a list of interested parties and groups but also generally refer to the concept of reciprocal, direct and indirect, ‘influence’ between the

106 OECD Corporate Governance Code (2015), IV. C. 107 OECD Corporate Governance Code (2015), VI C. 108 (repres) Good Governance Code of Listed Companies (2020), Recommendation

12.

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company and such groups.109 The same concept also recurs in the Czech Code that defines stakeholders as «those whose interests are o are going to be influenced by the company». Similarly, the Croatian Code refers to the concept of “direct and indirect risks in relation to the company and with regard to the company”.110 On the contrary, Slovenian approach to the concept of ‘stakeholders’ (defined as «interest groups that contribute, either voluntarily or involuntarily, to the ability and activities of companies to create added value, and are therefore also the vehicle of potential gains and risks undertaken by the company»)111 reveals a company-centric approach, as it seems only to consider the influence of ‘interest groups’ on the success of the company, and not the negative/positive impact the corporate activities could produce on them. Codes from Bulgaria, Croatia, Lithuania, Slovakia, and Slovenia include an entire chapter prescribing the duties of the company towards its stakeholders. Such inclusion is sometimes clearly justified by specifying that stakeholders take over certain direct or indirect risks in relation to the company and with regard to the company,112 or that they contribute to the building of competitive and profitable companies113 as «vehicle of potential gains and risks undertaken by the company».114 On the long term, the success of the corporation is therefore considered strictly aligned with stakeholders’ interests.115 In particular, the company is required to: (1) identify the stakeholders who are in the position to influence and impact on company’s sustainable development,116 (2) comply with existing laws protecting stakeholders’ rights,117 (3) ensure transparency and access to information through

109 (Bulgarian) National Corporate Governance Code (2016), §38; The Dutch Corporate Governance Code (2016), p. 8. 110 (Croatian) Corporate Governance Code (2019), p. 23. 111 Slovenian Corporate Governance Code for Listed Companies (2016), p. 7. 112 (Croatian) Corporate Governance Code (2019), p. 23. 113 Corporate Governance Code for Slovakia (2016), p. 17. 114 Slovenian Corporate Governance Code for Listed Companies (2016), p. 7. 115 Corporate Governance Code for Slovakia (2016), p. 17. 116 (Bulgarian) National Corporate Governance Code (2016), §38. 117 (Bulgarian) National Corporate Governance Code (2016), §39; The (Lithuanian)

Corporate Governance Code for the Companies Listed on NASDAQ OMX Vilnius

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constant dialogue and non-financial disclosure,118 (4) ensure that stakeholders can freely communicate their concerns about illegal or unethical practices to the board,119 (5) promote stakeholder participation in corporate decisions (such as employee participation in certain key decisions and/or in company’s share capital, creditor involvement in governance in the context of the company’s insolvency, etc.),120 and (6) report on its relationships with stakeholders.121 In addition to legal obligations, some codes also recommend, in line with the OECD Code, that companies comply with the UN Guiding Principles on Business and Human Rights or the OECD Guidelines for Multinational Enterprises.122 However, such reference is not frequently made, and even where it is recommended that stakeholders’ interests should be taken into consideration by the company, we noticed that, generally, shareholder value maximization is still strongly prioritized over stakeholder interests. The Slovenian Code, for instance, states that «the management and supervisory boards are obliged to act exclusively in the best interest of the company irrespective of the will or wishes of individual shareholders and other stakeholders» and that «the boards act exclusively at their own discretion in the interest of the company and do not communicate with individual shareholders and other stakeholders about their decisions».123 Similarly, the Greek Code requires that «in discharging its role, the board should take into account the interests of key stakeholders such as employees, clients, creditors, and the communities in which the (2010), Principe 9.1; (Croatian) Corporate Governance Code (2019), p. 23; Corporate Governance Code for Slovakia (2016), p. 17. 118 (Bulgarian) National Corporate Governance Code (2016), §42–43, (Czech) Corporate Governance Code based on the OECD Principles (2004), p. 18; The (Lithuanian) Corporate Governance Code for the Companies Listed on NASDAQ OMX Vilnius (2010), Principle 9.3; Slovenian Corporate Governance Code For Listed Companies (2016), p. 8; The (Maltese) Code Of Principles Of Good Corporate Governance, Principle 4. 119 Corporate Governance Code for Slovakia (2016), p. 18, (Czech) Corporate Governance Code based on the OECD Principles (2004), p. 18. 120 The (Lithuanian) Corporate Governance Code for the Companies Listed on NASDAQ OMX Vilnius (2010), Principle 9.2, Corporate Governance Code for Slovakia (2016), p. 17.; Slovenian Corporate Governance Code for Listed Companies (2016), p. 8. 121 Slovenian Corporate Governance Code for Listed Companies (2016), p. 8. 122 Corporate Governance Code for Slovakia (2016), p. 17. 123 Slovenian Corporate Governance Code for Listed Companies (2016), p. 10.

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company operates so long as this does not go against the company’s interests».124 In general, stakeholders’ interests seem to be taken into consideration, not as a core value based on ethical and social/environmental concerns and distinct from the company’s interests, but as a sort of risk factor that should be taken into account in order not to endanger shareholder value on the long term. 6.5.4

Employees

As mentioned above, the OECD Code includes many provisions addressing stakeholder interests. As to employees, the enforcement of mechanisms allowing employee participation should be ensured by the access to information and training for employee representatives.125 As to individual employees, the Code does not include particular provisions, except for the need to ensure a free communication of unethical/illicit conduct by corporate officers.126 Similarly, the UK Code recommends the strengthening of employee engagement, requiring, as already mentioned, the adoption of one or a combination of three specific methods (a director appointed from the workforce; a formal workforce advisory panel; a designated non-executive director).127 Moreover, the Code recommends—similarly to the OECD Code—that some procedures should be established, allowing employees to raise concerns to the board anonymously. As to the EU, the role of employee engagement is mentioned in a more or less detailed way in corporate governance codes depending on the institutional framework of each Member State, especially in relation to the obligation for companies of a certain size to ensure employee representation in the board.128 Except for codes from Croatia, Poland,

124 Hellenic Corporate Governance Code for Listed Companies (2013), p. 30. 125 OECD Code (2015), VI.G. 126 OECD Code (2015), IV.D. 127 UK Code (2018), Provision 5. 128 This is the case for Austria, Croatia, Czech Republic, Germany, Denmark,

Finland, France, Hungary, Luxembourg, Netherlands, Poland, Sweden, Slovenia, Slovak Republic, Spain, Greece, Ireland, and Portugal. See Conchon, A., Board-level employee representation rights in Europe. Facts and trends. Report 121, ETUI (2011). See

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Ireland, and Portugal,129 all other corporate governance codes from countries which recognized some kind of employee representation at the board level mention employees’ right/interests among their principles/recommendations. In addition, some countries with no legislation or other arrangements providing for board-level representation130 mention employees’ rights or interests in their codes of corporate governance. On the contrary, corporate governance codes from Belgium, Bulgaria, Cyprus, Estonia, Italy, and Romania—countries which do not provide employee board representation—do not make specific recommendations in relation to employee rights/interests. In addition to representation in the board, some codes require that appropriate training,131 consultation, communication and reporting tools,132 information,133 and remuneration134 are ensured by the company. As also provided by Directive 2014/95/EU on disclosure of nonfinancial and diversity information, some corporate governance codes135

also: https://www.worker-participation.eu/National-Industrial-Relations/Across-Europe/ Board-level-Representation. 129 It should be noted that—in relation to Poland, Ireland, and Portugal—board level representation is limited to some state-owned or municipally-owned companies. 130 Latvia, Lithuania, Malta. 131 Corporate Governance Code for Slovakia (2016), p. 27; The (Maltese) Code of

Principles Of Good Corporate Governance, Principle 6. 132 German Corporate Governance Code (2019), Recommendation A.2; The Dutch Corporate Governance Code (2016), §2.6.1.; Corporate Governance Code for Slovakia (2016), p. 18; (Lithuanian) The Corporate Governance Code for the Companies Listed on NASDAQ OMX Vilnius (2010), §9.2. 133 (Latvian) Principles of Corporate Governance and Recommendations on Their Implementation (2010), §10.1. 134 In particular, the annual remuneration policy should compare the compensation of the board of directors and managing director to the development of the average remuneration of employees, and the remuneration policy should specify how the terms and conditions of the company’s employees’ salaries and employment relationships have been taken into account. See Finnish Corporate Governance Code 2020 (2020), p. 68; Hellenic Corporate Governance Code for Listed Companies, p. 32; Corporate governance code of listed corporations (2018), § 24.3.3. 135 (Hungarian) Corporate Governance Recommendations, 2018, § 1.6.1; Slovenian Corporate Governance Code For Listed Companies (2016), §29.2; Corporate Governance Code for Slovakia (2016), p. 21.

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require that companies annually publish a non-financial/sustainability report, including also relevant information on employees. 6.5.5

Gender Diversity

The OECD Code refers to gender diversity in Chapter VI, in relation to the board assessment of diversity requirements. In particular, the code invites countries to include mechanisms (such as board quotas, disclosure requirements, and voluntary targets) to enhance gender diversity on boards and in senior management.136 Principle J under the UK Code recommends that board election practices should promote gender diversity, alongside diversity of ethnic background, cognitive and personal strengths.137 The annual reports should include a section concerning how the policy on diversity and inclusion has been implemented by the nomination policy.138 As to the EU, even though in 2012 the EU Commission submitted a proposal for a Directive on improving the gender balance on corporate boards139 —which sets a minimum of 40% of non-executive members of the under-represented sex on company boards—a qualified majority has not been reached in the Council notwithstanding the Parliament strongly supported the introduction of the directive. However, the necessity for an EU intervention to foster gender equality in corporate boards 140 remains strong, especially considered that, according to a report recently published by the EU Commission, over the period 2016–2018, women’s average pay is about 16% lower than that of men and only 6.3% of CEO positions in major publicly listed companies in the EU were held by women.

136 OECD Code (2015), VI.E.4. 137 UK Code (2018), Principle J. 138 UK Code (2018), Provision 23. 139 Proposal for a Directive of the European Parliament and of the Council on

improving the gender balance among non-executive directors of companies listed on stock exchanges and related measures, COM(2012)614 final, available at: https://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2012:0614:FIN:en:PDF. 140 EU Commission, 2019 Report on equality between women and men in the EU, https://ec.europa.eu/info/sites/info/files/aid_development_cooperation_fun damental_rights/annual_report_ge_2019_en_1.pdf.

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Our analysis found that 17 out of 27 of the EU corporate governance codes (codes from Austria, Belgium, Cyprus, Czech Republic, Denmark, Finland, France, Germany, Hungary, Italy, Luxembourg, Netherlands, Poland, Portugal, Romania, Slovenia, Spain, Sweden) recommend that board composition should appropriately represent both genders. However, only the Austrian, Dutch, German, Italian, and Spanish codes specify a mandatory minimum percentage for the representation of the female gender in the board. The Italian Code requires that at least 1/3 of board members141 consist of representatives from the least represented gender.142 The Austrian Code requires that the supervisory board should be made up of at least 30% women and 30% men, provided the supervisory board consists of at least six members, and the employee representatives should comprise at least 20% female and male employees each.143 In the Dutch Code, a reference is made to the legal requirement of at least 30% of male/female diversity in the management board and the supervisory board lapsed as of January 1, 2016.144 Similarly, the German Code 145 requires that the composition of the supervisory board should comply with the legal 30% female quota requirement. Finally, the Spanish Code recommends that female directors represent at least 40% of the total number of members by 2022.146 6.5.6

Sustainability/CSR Committee

The OECD Code does not address the establishment of a CSR/sustainability committee but suggests introducing an Ethics

141 In Italy, even though both one-tier and two-tier governance models are accepted and can be adopted by companies, the prevailing corporate governance structure is the so-called traditional structure, composed by a board of directors (consiglio di amministrazione) and a board of statutory auditors (collegio sindacale), both appointed by the shareholders’ meeting. See Melis, A. (2000). “Corporate Governance in Italy”. Corporate Governance: An International Review, 8(4) (October). Available at SSRN: https://ssrn. com/abstract=238590. 142 (Italian) Corporate Governance Code (2020), Recommendation 8. 143 Austrian Code of Corporate Governance (2020), §52. 144 The Dutch Corporate Governance Code (2016), §2.1.5. 145 German Corporate Governance Code (2020), Principle 11. 146 Spanish) Good Governance Code of Listed Companies (2020), p. 27.

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committee to which unethical/illicit conduct should be reported.147 The UK Code, as well, does not address the issue among its provisions. Among the analyzed codes, only the Luxembourg, Danish, and Spanish corporate governance codes suggest that companies could assign Corporate Social Responsibility functions to a pre-existing committee (such as the audit or nomination committee) or to an ad hoc corporate governance and social responsibility committee.148 The Spanish Code recommends that such committee should, inter alia, « […] b) Monitor the implementation of the general policy regarding the disclosure of economic-financial, non-financial and corporate information, as well as communication with shareholders and investors, proxy advisors and other stakeholders. Similarly, the way in which the entity communicates and relates with small and medium-sized shareholders should be monitored. c) Periodically evaluate the effectiveness of the company’s corporate governance system and environmental and social policy, to confirm that it is fulfilling its mission to promote the corporate interest and catering, as appropriate, to the legitimate interests of remaining stakeholders. d) Ensure the company’s environmental and social practices are in accordance with the established strategy and policy. e) Monitor and evaluate the company’s interaction with its stakeholder groups».149

Outside Europe, such practice is mandated in India, where Section 135 of the Companies Act (2013) requires companies meeting specified criteria150 to establish a Corporate Social Responsibility committee consisting of at least three directors, out of which at least one director shall be an independent director. In particular, such CSR committee shall 147 OECD Code (2015), VI. 6. 148 (Spanish) Good Governance Code of Listed Companies (2020), Recommendation

53; The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), Recommendation 9.3, Guideline 2; (Denmark) Recommendations on Corporate Governance (2019), p. 22. 149 (Spanish) Good Governance Code of Listed Companies (2020), Recommendation

53. 150 «Every company having net worth of rupees five hundred crore or more, or turnover of rupees one thousand crores or more or a net profit of rupees five crores or more during any financial year…», §135, Companies Act (2013).

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formulate and recommend to the board a CSR policy, ensuring that the company spend at least 2% of the average net profit in activities provided for in Schedule VII (such as eradicating hunger, poverty, promoting health care, education, gender equality, and protecting the environment), activities that partially overlap with the SDGs.151 According to a recent study, in 2019, 76% of the top 100 companies by market capitalization fully spent 2% more on CSR activities,152 which represent a striking 100% increase over the last five years. Far from introducing a similar requirement, we recommend that the express attribution of CSR-related activities to a specific—pre-existing of new—committee should be included in corporate governance codes and should become a common practice among EU companies, as this would ensure that sustainability issues are duly taken into consideration at the board level, especially in view of the newly introduced and upcoming legislation on non-financial reporting and sustainable finance (see Sect. 6.3 above). 6.5.7

Compensation and Sustainability

The OECD Code includes some provisions concerning the alignment of compensation with long-term interests,153 but no provision specifically addresses the inclusion of non-financial, social, or environmental criteria among those on which compensation policy should be based. The UK Code recommends that remuneration policies and practices should be designed to support the sustainable success of the company,154 and that workforce engagement has taken place in order to describe how executive compensation aligns with wider company remuneration policy.155 However, similarly to the OECD Code, there is no reference

151 Harpreet, Kaur. (2020). “Achieving Sustainable Development Goals in India”, in Beate Sjåfjell and Christopher M. Bruner (eds.), Cambridge Handbook of Corporate Law, Corporate Governance and Sustainability. Cambridge University Press, 465. 152 See KPMS, India’s CSR Reporting Survey 2019, February 2020, available at: https://home.kpmg/in/en/home/insights/2020/02/india-s-csr-reporting-sur vey-2019.html. 153 OECD Code (2015), VI. D. 4. 154 UK Code (2018), Principle P. 155 UK Code (2018), Provision 41.

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to non-financial factors to be considered in the design of compensation policies. As to the EU, the Shareholder Rights Directive II states that directors’ variable remuneration should be based on both financial and non-financial performance, where applicable.156 However, there is no requirement in relation to what portion of variable remuneration should be linked to as to non-financial performance. As such, the introduction of a mandatory share of remuneration linked to non-financial performance is one of the main issues on which the EU commission required feedback in its consultation document on the renewed sustainable finance strategy.157 Indeed, studies found a connection between sustainability-linked management board compensation and firm ESG performance, 158 but also a possible positive impact between the adoption of sustainability incentives in executive remuneration and firm performance.159 Our analysis on EU codes found that only 11 out of 27 corporate governance codes (Austria, Belgium, Czech Republic, Republic of Cyprus, France, Germany, Italy, Luxembourg, Portugal, Slovenia, and Spain) include a reference to non-financial criteria or to sustainable value creation in the determination of compensation policy. The Luxembourg Code, for example, recommends that «the company shall define, precisely and explicitly, the quantitative and qualitative criteria linked to the CSR aspects when determining the variable part of the remuneration of members of the Executive Management».160 156 Directive 2007/36/EC, as amended by Directive (EU) encouragement of long-term shareholder engagement. See also Commission, Guidelines on the standardised presentation of under Directive 2007/36/EC, as amended by Directive (EU) encouragement of long-term shareholder engagement.

2017/828 as regards the Communication from the the remuneration report 2017/828 as regards the

157 EU Commission, Consultation Document. Consultation on the Renewed Sustainable Finance Strategy, April 2020, Question n. 40. 158 Velte, Patrick. (2016). Sustainable Management Compensation and ESG Performance—The German Case. Problems and Perspectives in Management. 14. https://doi. org/10.21511/ppm.14(4).2016.02; Hong, B., Li, Z., & Minor, D. (2016). “Corporate Governance and Executive Compensation for Corporate Social Responsibility”. Journal of Business Ethics, 136, 199–213. 159 Abdelmotaal, H., & Abdel-Kader, M. (2016). “The Use of Sustainability Incentives in Executive Remuneration Contracts: Firm Characteristics and Impact on the Shareholders’ Returns”. Journal of Applied Accounting Research, 17(3), 311–330. 160 The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), Recommendation 9.3, Guideline 1.

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Similarly, the French Code requires that directors’ compensation should incorporate «one or more criteria related to social and environmental responsibility».161 However, a direct reference to environmental and/or social impact criteria is not common among the other analyzed codes. More frequently, the reference is generically made in relation to non-financial criteria. For instance, Principle 25 of the Spanish corporate governance code requires that «variable payments to executive directors should be linked to predetermined and measurable performance criteria, including criteria of a non-financial nature, which promote the company’s long-term sustainability and success», and Recommendation 58 specifies that variable remuneration items should promote the «long-term sustainability of the company and include non-financial criteria that are relevant for the company’s long-term value creation». However, it is also specified that such criteria include, for example, «compliance with its internal rules and procedures and its risk control and management policies». Similarly, the Italian corporate governance code requires that the compensation policy should be aligned with the pursuit of the corporate “sustainable success”, which, as mentioned before, is defined as the «creation of long-term value for the shareholders, taking into account the interests of the relevant stakeholders».162 In conclusion, the specific reference to environmental and social performance criteria is infrequent among the EU codes, which seems to confirm the lack of clarity concerning the selection and measurability of non-financial targets denounced in relation to the implementation of the Non-Financial Reporting Directive.163 6.5.8

Sustainability Reporting

Chapter V of the OECD Code—addressing corporate transparency and disclosure—includes a strengthened reference to non-financial reporting

161 Corporate governance code of listed corporations (2018), § 24.1.1. 162 Principle XV, Italian Corporate Governance Code (2020). 163 See ESMA, Report Enforcement and regulatory activities of European enforcers in 2019 (April 2020) and Alliance for Corporate Transparency, 2019 Research Report: An analysis of the sustainability reports of 1000 companies pursuant to the EU Non-Financial Reporting Directive (February 2020).

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compared to the previous version of the code. In particular, it encourages companies to disclose material information related to business Ethics, environmental and social issues, human rights, and employee issues. It also mentions the introduction—in some countries—of legal requirements concerning the disclosure of non-financial information by large companies.164 On the contrary, the UK Code does not address nonfinancial/sustainability reporting, but only mentions the duty of the board to describe in the annual report on the sustainability of the business model, without specifying if the concept of sustainability concerns only economic sustainability in the long term or also the social and environmental impact of the company.165 In the EU, the reporting requirement contained in Directive 2014/95/EU—that, as already mentioned in § 2, is going to be amended in order to facilitate sustainable financing and therefore integrate the current EU reform enacted with the launch of the Action Plan—166 has also been integrated into many corporate governance codes. However, only 16 out of 27 codes (from Austria, Republic of Cyprus, Bulgaria, Czech Republic, Denmark, Estonia, Finland, Germany, Italy, Lithuania, Luxembourg, Netherlands, Slovakia, Slovenia, Spain, and Sweden) recommends the reporting of non-financial information or material issues concerning stakeholders. It should be noted that some codes have not been updated recently, which could explain the lack of reference to the Directive and to the disclosure of non-financial information in general. Some codes even went further than the Directive. The Luxembourg Code, for instance, requires that the company should define a Corporate Social Responsibility policy and that CSR aspects are integrated into its strategy.167 Moreover, the code invites companies to align with the

164 OECD Code (2015), V.A. 1-2. 165 UK Code (2018), Provision 1. 166 EU Commission. Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions, Action Plan: Financing Sustainable Growth, COM (2018) 97 final (March 2018). 167 The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), Principle 9 and Recommendation 9.1.

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17 Sustainable Development Goals in their reporting activities.168 The Swedish Code requires that companies make available on their websites the ten most recent years’ sustainability reports, along with auditor’s written statement concerning its assurance activities related to the sustainability report.169 The Slovak Code, in addition to environmental and social information, recommends the disclosure of information on political donations.170 The Dutch Code requires that the management board should align its strategy to a view on long-term value creation, taking into consideration—in addition to matters included in the Directive—also «the chain within which the enterprise operates».171 The sustainability of the supply chain represents, by no means, one of the most critical issues in relation to corporate sustainability, even though the Non-Financial Reporting Directive does not address it directly.172 As mentioned above, sustainability reporting has been recently addressed by the EU legislator, but a revision intervention is going to be soon realized, probably requiring more precise, measurable, and standardized information, as well as verification standards. Nonetheless, the express mention of such a requirement in the context of corporate governance codes would ensure the strengthening of the perceived relevance of the same. 6.5.9

Ethics

The OECD Code includes many provisions addressing Ethics. In particular, Chapter VI states that «the board should apply high ethical standards» as these «are in the long term interests of the company as a means to make it credible and trustworthy».173 As a consequence, the

168 The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), Guideline under Principle 9. 169 The Swedish Corporate Governance Code (2020), Rule 10.4. 170 Corporate Governance Code for Slovakia (2016), Section VI, A.2.i. 171 The Dutch Corporate Governance Code (2016), Best Practice Provision 1.1.1., Section VI. 172 Some requirements are included only in the related guidelines. See Communication from the Commission—guidelines on non-financial reporting (methodology for reporting non-financial information). 173 OECD Code (2015), VI. C.

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same chapter suggests that existence of a company code of Ethics— usually based on professional standards and sometimes broader codes of behavior—could help to ensure that any unethical/illicit behavior is duly reported without fear of negative consequences.174 Moreover, the OECD Code encourages the establishment of ethics programs,175 an audit or ethics committee to which report any concerns about unethical or illegal behavior,176 and the disclosure of policies and performance concerning business ethics.177 The UK Code mentioned Ethics only in passing in relation to the responsibilities of the audit committee that should develop and implement policy on the engagement of the external auditor in supplying non-audit services taking into account the relevant law and ethical guidance.178 As to the EU, 12 out of 27 analyzed codes (Belgium, Bulgaria, Czech Republic, Denmark, France, Germany, Hungary, Latvia, Luxembourg, Malta, the Netherlands, Slovakia, Slovenia, and Spain) include some reference to the notion of Ethics. In particular, 5 codes recommend that a code of conduct/Ethics179 should be adopted by the managing board/board of directors, and that the compliance to such code by employees and directors should be monitored (by the supervisory board or the internal audit function) and ensured.180 The French and Luxembourg codes provide professional, ethical rules for directors, mainly focused on the compliance with conduct duties related to their mandates, such as the respect of confidentiality, attendance

174 OECD Code (2015), VI. 6. 175 OECD Code (2015), VI. 7. 176 OECD Code (2015), VI. 6. 177 OECD Code (2015), V. A. 2. 178 UK Code, Provision 25. 179 The Bulgarian Code defines an ‘ethical code of conduct’ as “a set of moral and ethical norms, principles and standards of conduct”. (Bulgaria) National Corporate Governance Code (2016), p. 4. 180 The 2020 Belgian Code on Corporate Governance (2020), Recommendation 2.18; (Bulgaria) National Corporate Governance Code (2016), p. 4; The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), Recommendation 2.3, Guideline 3; Corporate Governance Code for Slovakia (2016), V, C; The Dutch Corporate Governance Code (2016), § 2.5.2.

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and reporting obligations, and the avoidance of any direct or indirect conflict of interest with the company.181 However, from the overall analysis of the EU codes, the concept of Ethics seems not to be directly connected to the above-mentioned concepts of ‘sustainable value creation’, ‘sustainable success’, ‘CSR’, etc., that have been only recently introduced in the context of the corporate governance codes.

6.6

Final Remarks and Future Steps

The analysis shows that even though some EU corporate governance codes have started including specific references to sustainability-related concepts, some gaps, and weaknesses identified for each of the analyzed aspects reveal that further effort is needed for the full integration of environmental and social issues in corporate governance codes. The results of the study, therefore, confirm the generic nature and inadequacy of sustainability and CSR integration in corporate governance codes already denounced by previous literature.182 However, we could notice that a growing number of codes tend to mention sustainability, CSR, social, and environmental issues, so signaling a growing interest towards the impact of environmental and social factors on business success in the long term. Specifically, some codes, such as the Italian and the Spanish codes, mentioned the new concept of ‘sustainable success’ introduced—but not defined—by the UK Code. Other codes recommend that companies should be managed in order to ensure a sustainable development/value creation/sustainable long-term value, intended as the maximization of shareholders’ wealth with the permanent consideration of stakeholders’ interests. Other codes include recommendations related to the adoption of CSR initiatives. As to the purpose and function of corporate governance, we found that 12 companies out of 27 define the purpose and function of corporate 181 The X Principles of Corporate Governance of the Luxembourg Stock Exchange (2017), Principle 5; Corporate governance code of listed corporations (2018), § 20. 182 See Sjåfjell, B. (2016). “When the Solution Becomes the Problem: The Triple Failure

of Corporate Governance Codes”, in J.J. Du Plessis and C.K. Low (eds.), Corporate Governance Codes for the 21st Century: International Perspectives and Critic, 23–55; and Szabó, D.G., & Sørensen, K.E. (2013). “Integrating Corporate Social Responsibility in Corporate Governance Codes in the EU”. European Business Law Review, 24(6), 781– 828.

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governance, adopting three main approaches. In particular, by adhering to most progressive approach, codes from Bulgaria, Germany, Luxembourg, the Netherlands, Portugal, and Sweden mention the contribution of corporate governance to sustainable development/growth and pay attention to corporate responsibility towards society in defining the purpose of corporate governance. Nevertheless, only a few codes expressly mention CSR/sustainability factors in relation to the main function and objectives of the code. Specifically, the Belgian, Portuguese, Spanish, and Luxembourg codes highlight that one of the main drivers leading to the last revision of the code was the inclusion of a long-term and sustainable approach to value creation. In general, even though some codes include CSR/sustainability issues and/or stakeholder interests in their introductory statements, the majority of the analyzed codes still do not consider corporate responsibility towards the society and the environment as a key aspect of corporate governance function. As to stakeholders, for instance, notwithstanding a high number of corporate governance codes mention the concept of ‘stakeholder’, only a few provide a proper definition and devote specific provisions to the treatment of stakeholders’ interests. While most of the definitions provided recall the OECD Code definition of stakeholders, others refer more generally to the subjects who could impact on/influence or be impacted/influenced by companies activities. However, most of the codes seem to consider stakeholders’ interests only to the extent these could impact on shareholder value in the long term. Such risk-averse approach applied to CSR/sustainability reveals that shareholder primacy rule is far from been overcome, and it is undeniably the same leading the entire sustainable finance reform, as non-financial risks—especially climate-related risks—are considered to be among the most impactful on the future financial performance of listed companies. However, the integration of non-financial risks in the long term is just a small part of what is needed for a truly successful transition to a sustainable economy, as the concept of impact should be considered also in relation to that created by the company on the environment and on society. As to gender diversity, our analysis found that the majority of the EU corporate governance codes recommend that board composition should appropriately represent both genders, but only the Austrian, Dutch, German, Italian, and Spanish codes specify a mandatory minimum percentage for the representation of the female gender in the board.

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With regard to the attribution of CSR function to a specialized committee, only the Luxembourg, Danish, and Spanish corporate governance codes suggest that companies could assign Corporate Social Responsibility functions to a pre-existing committee or to a newly established committee. In this regard, we recommend that the express attribution of CSR-related activities to a specific—pre-existing of new— committee should be included in corporate governance codes and should become a common practice among EU companies, as this would ensure that sustainability issues are duly taken into consideration at the board level, especially in view of the newly introduced and upcoming legislation on non-financial reporting and sustainable finance. In relation to compensation, the analysis found that a minority (only 11 out of 27) of corporate governance codes include a reference to nonfinancial criteria or to sustainable value creation in the determination of compensation policy. As to sustainability reporting, even though the reporting requirements contained Directive 2014/95/EU are effective for more than two years now, only 16 out of 27 codes recommend the reporting of non-financial information or material issues concerning stakeholders, with some codes even going further than the Directive (Luxembourg, Sweden, Netherlands, and Slovak Republic). As to Ethics, 12 out of 27 analyzed codes include some reference to the notion of Ethics and 5 of them recommend that a code of conduct/Ethics should be adopted by the managing board/board of directors, and that the compliance to such code by employees and directors should be ensured. However, from the overall analysis of the EU codes, the concept of Ethics seems not to be directly connected to the above-mentioned concepts of ‘sustainable value creation’, ‘sustainable success’, ‘CSR’, etc. Among the analyzed EU codes, the most ‘sustainability inclusive’— as performing well in all the identified indicators, sometimes going even beyond the OECD Code—is the Luxembourg Code, which—by the way—is the only one that expressly announces in its introduction the commitment by its issuer (the Luxembourg Stock Exchange) to integrate CSR principles in the revised code for promoting responsible and sustainable investing. The Dutch and the Spanish codes follow, while the codes

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issued in Cyprus, Estonia, Ireland,183 and Poland seem the weakest in addressing sustainability/CSR/ethical issues. For their part, the two internationally most influential codes, the OECD Code and the UK Code, undeniably address sustainability-related issues, but cannot be considered as the most advanced and inclusive cases. Hopefully, the upcoming new EU legislation on mandatory human rights and environmental corporate due diligence, as well as the future initiatives on the establishment of a sustainable corporate governance, will lead to a more homogeneous, complete, and coherent approach to the integration of sustainability concerns in corporate governance practices. In this regard, a further analysis of the level of implementation of the codes and of the practices actually enacted by listed companies in relation to code provisions and recommendations integrating sustainability aspects is necessary in order to better understand the real impact of such measures.

183 However, it should be noted that the Irish Corporate Governance Annex just integrates the main applicable corporate governance code in Ireland, i.e., the UK Corporate Governance Code.

PART III

Sustainable Finance and Systemic Risk

CHAPTER 7

Climate Change as a Systemic Risk in Finance: Are Macroprudential Authorities Up to the Task? Seraina Grünewald

7.1

Introduction

Climate change is widely seen as one of the greatest challenges of the twenty-first century. It has and will continue to have major effects on our planet. The UN’s Intergovernmental Panel on Climate change (IPCC) has assessed the scientific evidence supporting the proposition that carbon-intensive activities of humans lead to global warming, rising sea levels and ocean acidification. In the shorter term, these activities

1 Intergovernmental Panel on Climate change (IPCC, 2014), Climate change 2014: Synthesis Report, Contribution of Working Groups I, II and III to the Fifth Assessment Report of the Intergovernmental Panel on Climate change.

S. Grünewald (B) Financial Law Centre (FLC), Radboud University Nijmegen, Nijmegen, The Netherlands e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_7

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may lead to volatile weather patterns, water shortages and increased pollution-driven health costs.1 In two landmark international agreements, the UN 2030 agenda and sustainable development goals and the Paris climate agreement, both concluded in 2015, global leaders pledged, amongst others, to limit global warming to well below 2°C and to pursue efforts to limit it to 1.5°C. There is broad acknowledgement that the financial sector has a central role to play in enabling the transition to an environmentally sustainable economy in line with these climate targets (‘finance for transition’) and in building financial resilience to environmental risks. Article 2 of the Paris climate agreement states: ‘This Agreement in enhancing the implementation of the Convention, including its objective, aims to strengthen the global response to the threat of climate change, in the context of sustainable development and efforts to eradicate poverty, including by: (c) Making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.’

At the same time, banks and other financial institutions are themselves exposed to significant financial risks caused by rising temperatures—risks that may be systemic in nature and not be sufficiently internalised by market players. While the enabling role of the financial sector in the transition to a low-carbon economy and its own exposure to climate-related risks are interrelated themes, it is the latter aspect that this chapter mainly focuses on: What are the specific features of climate-related financial risks (CRFR) that may threaten the stability of the financial system? And what options do macroprudential authorities have in the face of such risks? The chapter proceeds as follows: The next section (7.2) takes stock of the available knowledge on climate change as a source of financial instability, drawing on a growing body of macrofinancial literature and policy work conducted in the area. The chapter then turns to the significant challenges associated with ‘greening’ macroprudential policy by including climate change in macroprudential risk analysis and discusses potential ingredients of a ‘green’ macroprudential policy (7.3). A separate section is devoted to the crucial question of the timing of policy action in the light of the radical uncertainty in relation to the avenues through which climate change affects and may affect in the future the stability of the financial system (7.4). Before it concludes (7.6), the chapter briefly discusses which

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role Central Banks can and should play in the transition to a low-carbon economy (7.5).

7.2

Climate Change as a Source of Financial Instability

It is common knowledge today that climate change affects the financial system through two main channels.2 The first involves physical risks , representing the economic costs and financial losses due to the increasing frequency and severity of climate-related weather events (e.g. storms, floods and heatwaves) and the effects of long-term changes in climate patterns (e.g. ocean acidification and rising sea levels). The second, transition risks , are associated with the uncertain financial impacts that could result from changes in climate policy, technological breakthroughs or limitations as well as shifts in market preferences and social norms during the adjustment to a low-carbon economy.3 While risks from rising temperatures have two main channels, they have many potential impacts on the economy and the financial system in particular. For financial institutions, physical and transition risks can materialise directly, through their exposures to sovereigns, corporations and households that experience climate-related shocks—or indirectly, through the effects of climate change on the wider economy and negative feedback effects within the financial system.4 Physical and transition risks do not represent new categories of financial risks, but can manifest themselves 2 For example, Network for Greening the Financial System (NGFS, 2019), A call for action: Climate change as a source of financial risk, First comprehensive report, April; Network for Greening the Financial System (NGFS, 2018), First Progress Report, October; Batten, Sandra et al. (2016). Let Talk About the Weather: The Impact of Climate Change on Central Banks, Bank of England Staff Working Paper No. 603, May; Carney, Mark. (2015). Breaking the Tragedy of the Horizon—Climate Change and Financial Stability, speech at Lloyd’s of London, 29 September. Some refer to liability risks as a third channel. In this chapter, liability risks are treated as physical risks that may manifest themselves as liability risks. 3 On the effects of the ‘carbon bubble’ on the EU banking sector, Weyzig, Francis. (2014). The Price of Doing Too Little Too Late: The Impact of the Carbon on the European Financial System. Green New Deal Series, Vol. 11, February. 4 For example, Network for Greening the Financial System (NGFS, 2019), A call for action: Climate change as a source of financial risk, First comprehensive report, April, pp. 14, 17; Grippa, Pierpaolo et al. (2019). Climate Change and Financial Risk, IMF Finance & Development, December, p. 27; Bolton, Patrick et al. (2020). The Green

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in terms of known financial risk as follows, with potential spill-over and second-round effects5 : • Credit risks: Physical and transition risks can induce a deterioration in borrowers’ ability to repay their debts and a depreciation of assets used for collateral. • Market risks: A sudden loss in the market value of assets (e.g. due to a change in investors’ perception of profitability of carbon-intensive assets) can potentially lead to fire sales (‘stranded assets’). • Liquidity risks: Banks located in areas hit by a natural disaster may see large and sudden outflows of liquidity. Or more generally, banks and other financial institutions whose balance sheet is hit by credit and/or market risks may be unable to refinance themselves in the short term. • Operational risks: Financial institutions can be affected through their direct exposure to physical risks and see their operations affected (e.g. if a data centre is destroyed by a flood). • Liability risks: Insurances could face higher than expected claim payouts resulting from physical risks. While physical and transition risks are usually assessed separately, due to the complexity involved in each case, they are better understood as being interconnected and part of the same framework.6 Four broad future scenarios of interconnected physical and transition risk can be identified, which depend on the pathway and strength of the corrective transition response7 : (1) Early and measured action to mitigate climate change would limit, but not eliminate, both physical and transition risk (‘soft Swan—Central Banking and Financial Stability in the Age of Climate Change, January, p. 20. 5 Network for Greening the Financial System (NGFS, 2019), A call for action: Climate change as a source of financial risk, First comprehensive report, April, pp. 14, 17; Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, pp. 19–20. On transmission and amplification by the financial system, Financial Stability Board (FSB, 2020), The implications of climate change for financial stability, 23 November, pp. 17–25. 6 Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, p. 18. 7 See Network for Greening the Financial System (NGFS, 2019), A call for action: Climate change as a source of financial risk, First comprehensive report, April, p. 21;

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landing’ scenario). (2) Delayed and weak action would lead to higher and potentially catastrophic physical risk, without necessarily entirely eliminating transition risk (‘hot house earth’ scenario). (3) Delayed action followed by strong action would likely lead to both high physical risk and high transition risk (‘too little too late’ scenario). (4) Sudden, yet sufficient action to meet the climate goals will limit physical risk, but cause high transition risk (‘hard landing’ scenario). Each of these scenarios bears the risk of giving rise to what a study by the Bank for International Settlement (BIS) and the Banque de France refers to as ‘green swan events’.8 These are potentially extremely financially disruptive climate-related events that could be behind the next systemic financial crisis. They exhibit many features of the classical ‘black swan’, on which their notion is based, but they also differ from black swans regarding three key features9 : (1) While there is a high degree of uncertainty regarding the timing and nature of the impacts of climate change on the financial system, there is certainty about the need for ambitious action, as some combination of physical and transition risk is bound to materialise at some point in the future. (2) Climate-induced catastrophes could pose an existential threat to humanity and are therefore yet more serious than other systemic financial crises. (3) Green swan events exhibit complexity of a higher order than black swans, as they could produce chain reactions with fundamentally unpredictable environmental, geopolitical, social and economic outcomes.

7.3

‘Green’ Macroprudential Policy

Central Banks and financial regulators increasingly acknowledge the financial stability implications of climate change.10 It has become a recognised

Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, p. 19. 8 Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January. 9 Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, p. 3. 10 The Network for Greening the Financial System (NGFS), founded in 2017, consists of an ever-growing group of currently 89 member Central Banks and financial supervisors (as of March 19, 2021) and aims to strengthen the role of the financial sector in managing climate-related risks and mobilising capital to enable the low-carbon transition. For an

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policy goal that CRFR be integrated into the frameworks for financial stability monitoring and prudential supervision.11 Efforts so far have mostly focused on raising awareness among financial sector firms of their exposure to CRFR and on improving supervisors’ knowledge base—but much more needs to be done. After discussing the significant challenges associated with implementing a ‘green’ macroprudential approach, the chapter frames CRFR within the analytical framework applied by macroprudential policy makers to ‘standard’, i.e. non-climate-related, systemic risk. 7.3.1

Implementation Challenges

Despite the broadly-acknowledged need for better awareness of and preparation for climate impacts on the financial system, ‘greening’ macroprudential policy comes with significant implementation challenges. A first implementation challenge relates to understanding and measuring the potential impacts of climate change on financial stability. Traditional approaches to risk analysis and management based on historical data and assumptions that shocks are normally distributed are largely useless when it comes to assessing CRFR. CRFR are different from conventional financial risks on many levels12 : They cover unusually long time horizons of overview of initiatives taken with a view to Basel Committee on Banking Supervision (BCBS, 2020), Climate-related financial risks: a survey on current initiatives, April. 11 Network for Greening the Financial System (NGFS, 2019), A call for action: Climate change as a source of financial risk, First comprehensive report, April; and Network for Greening the Financial System (NGFS, 2020), Guide for supervisors—Integrating climaterelated and environmental risks into prudential supervision, Technical document, May; more recently also Financial Stability Board (FSB, 2020), Stocktake of financial authorities’ experience in including physical and transition climate risks as part of their financial stability monitoring, July 22; and Financial Stability Board (FSB, 2020), The implications of climate change for financial stability, 23 November. On research priorities with a view to Network for Greening the Financial System (NGFS, 2020), the macroeconomic and financial stability impacts of climate change—Research priorities, Technical document, June. 12 For example, Battiston/Monasterolo, in: Alessi Lucia (ed.) (2020), JRC Conference and Workshop Report, Joint JRC-EBA workshop on banking regulation and sustainability, p. 46; Network for Greening the Financial System (NGFS, 2019), Macroeconomic and financial stability implications of climate change, Technical supplement to the first comprehensive report, July, p. 3; Chenet, Hugues et al. (2019). Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 2019-13, p. 8.

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several decades; they have barely started to materialise and offer no past record of similar events or developments13 ; they have consequences that are irreversible and cause costs that are potentially infinite or cannot be expressed in monetary terms, respectively; they are endogenous in that the perception of transition risk impacts on the risk itself; and they are non-linear and subject to climate tipping points.14 Even the recently emerged and promoted methodologies of scenario analysis15 and climate stress testing,16 relying on the analysis of prospective scenarios and seeking to set up plausible hypotheses for the future,17

13 See, in particular, Weitzman, Martin L. (2011). Fat-Tailed Uncertainty in the Economics of Catastrophic Climate Change. Review of Environmental Economics and Policy, 5(2), 277: ‘The unprecedented scale and speed of [greenhouse gas] increases brings us into uncharted territory and makes predictions of future climate change very uncertain. Looking ahead a century or two, the levels of atmospheric GHGs that may ultimately be attained (unless decisive measures are undertaken) have likely not existed for tens of millions of years, and the speed of this change may be unique on a time scale of hundreds of millions of years.’ 14 ‘Tipping points’ are commonly understood as critical thresholds at which small

perturbations can lead to large and long-term qualitative changes of the state or future development of a system. See Lenton, Timothy M. et al. (2008). Tipping Elements in the Earth’s Climate System. Proceedings of the National Academy of Sciences of the United States of America, 105(6), 1786–1793. 15 See Network for Greening the Financial System (NGFS, 2020), NGFS climate scenarios for Central Banks and supervisors, June; Network for Greening the Financial System (NGFS, 2020), Guide to climate scenario analysis for Central Banks and supervisors, Technical document, June. On the merits of scenario analysis in a microprudential setup Task Force on Climate-related Financial Disclosures (TCFD, 2017), Final Report, June, pp. 25–30; Task Force on Climate-related Financial Disclosures (TCFD, 2017), The use of scenario analysis in disclosure and climate-related risks and opportunities, June. 16 On climate stress testing Adrian, Tobias et al. (2020), Stress testing at the IMF, Monetary and Capital Markets Department, No. 20/04, pp. 45–47 (Chapter 9). 17 See Battiston/Monasterolo, in: Alessi Lucia (ed.) (2020), JRC Conference and Workshop Report, Joint JRC-EBA workshop on banking regulation and sustainabilityAlessi, pp. 41–43; Network for Greening the Financial System (NGFS, 2019a), A call for action: Climate change as a source of financial risk, First comprehensive report, April, pp. 20– 22, 24–27; Network for Greening the Financial System (NGFS, 2019b), Macroeconomic and financial stability implications of climate change, Technical supplement to the first comprehensive report, July, pp. 27–31.

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may not suffice to guide decision-making. They are inherently incapable of capturing all the complex interactions of natural, technological, societal, regulatory and cultural dynamics that CRFR are subjected to.18 This has led some economists to conclude that we find ourselves in a situation of deep or radical uncertainty19 : Not only do we lack the methodological means to understand the dynamics of CRFR, we may not even be in a position to imagine what effects climate change may have on financial stability. Embracing radical uncertainty requires policymakers to overcome the belief that ‘uncertainty can be confined to the mathematical manipulation of known probabilities’.20 What is needed is nothing less than an ‘epistemological break’21 —a move to alternative, often qualitative approaches aimed at strengthening the resilience and robustness of the financial system, which will be impacted by climate change in one way or another.22 Apart from these epistemological and methodological challenges, there are behavioural challenges that may be in the way of macroprudential policy makers taking timely and sufficient action to address climate-related systemic risk. In macroprudential circles, it is well established that macroprudential actors tend to favour inaction over action when considering

18 Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, pp. 42–46. 19 Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, pp. 23–46; Hugues, C. et al. (2019). Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 2019-13. On climate change uncertainties and their policy implications Pindyck, Robert S. (2020). What We Know and Don’t Know About Climate Change, and Implications for Policy, NBER Working Paper No. 27304, June. 20 King Mervyn. (2017). The End of Alchemy: Money, Banking, and the Future of the Global Economy. W.W. Norton, p. 87. 21 Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, p. 43; Pereira da Silva, Luiz Awazu. (2019). Research on Climate-Related Risks and Financial Stability: An ‘Epistemological Break’?, Remarks at the Conference of the Central Banks and Supervisors Network for Greening the Financial System (NGFS), Paris, 17 April. 22 See Kay John & King Mervyn. (2020). Radical Uncertainty: Decision-Making Beyond the Numbers. W.W. Norton; King Mervyn. (2017). The End of Alchemy: Money, Banking, and the Future of the Global Economy. W.W. Norton.

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the use or macroprudential tools.23 An important explanation for this ‘inaction bias’ is our (still) limited understanding of systemic risk and the macroprudential policy transmission. Another motive for inaction relates to the fact that, while costs of macroprudential measures for market actors are tangible and short term, their benefits are much more uncertain and materialise only in the long term. Measuring the benefits of an avoided crisis is by definition a challenging endeavour. Moreover, just like market actors, policymakers tend to underestimate risks that seem remote and have not materialised in a long time.24 In the context of CRFR, the inaction bias associated with macroprudential policy is yet more pronounced. The radical uncertainties about the nature and dynamics of CRFR and the effects of policy actions on their development are likely reinforcing the tendency of policymakers to delay action by pointing to the need for further data and improved analysis. Moreover, policymakers are faced with an unusually long time horizon when it comes to CRFR—a horizon that by far exceeds the business (2 to 3 years) and financial cycles (10 to 16 years), to which their analysis and policies normally pertain. Mark Carney was the first to refer to the ‘tragedy of the horizon’ to describe the mismatch between the need for policy measures in the short term to mitigate the impacts of climate change on financial stability in the long term.25 However, market players are increasingly aware that the CRFR consequences that they thought lay in the remote future are now much closer. Climate change poses, including for the financial sector, an evident and current danger. This new mind-set of financial sector firms is changing the terms of the tragedy of the horizon: the horizon has moved forward.

23 For example, Houben, Aerdt et al. (2019). “Introduction”, in Aerdt Houben et al. (eds.), Putting Macroprudential Policy to Work, De Nederlandsche Bank, Occasional Studies, Vol. 12–7, 17 January, pp. 11–14; European Systemic Risk Board (ESRB, 2019), The ESRB Handbook on operationalising macro-prudential policy in the banking sector, 17 January, pp. 172–180. From a legal perspective Schammo, Pierre. (2019). “Inaction in Macro-Prudential Supervision: Assessing the EU’s Response”. Journal of Financial Regulation, 5, 1–28. 24 Fundamentally Reinhart Carmen, M., & Rogoff, Kenneth S. (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press. 25 Carney, Mark. (2015). Breaking the Tragedy of the Horizon—Climate Change and Financial Stability, speech at Lloyd’s of London, 29 September.

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Insurers have started to reassess the costs of insuring physical risk; institutional investors, such as pension funds, increasingly re-evaluate their exposure to ‘brown’ assets and CRFR26 ; credit agencies are repricing CRFR27 ; and asset managers are starting to include environmental considerations when structuring their portfolios.28 This is a positive development as it may, to some extent, attach a shadow price to carbon emissions. But it also raises the possibility—in the near future—of a ‘green swan event’.29 7.3.2

Ingredients of a ‘Green’ Macroprudential Policy

Despite these significant implementation challenges, to which the chapter will return when discussing the timing of policy action,30 it is necessary to explore what a ‘green’ macroprudential policy could entail. While CRFR exhibit features different from or exaggerated compared to other systemic risk,31 the ‘standard’ macroprudential framework can be used, with little adaptation, as a starting point to also address CRFR. 26 Bolton/Kacperczyk find that institutional investors are already demanding compensation for their exposure to carbon emission risk, see Bolton, Patrick, & Kacperczyk, Marcin, Do Investors Care About Carbon Risk?, NBER Working Paper No. 26968, April. See, however, International Monetary Fund (IMF, 2020), Global financial stability report, April, pp. 85–102 (Chapter 5), finding that physical risk does not seem to be reflected in global equity valuations. 27 See Financial Stability Board (FSB, 2020), The implications of climate change for financial stability, 23 November, p. 31. 28 In the EU, these developments are of course partially driven by the (binding) legal requirements introduced by Regulation (EU) 2019/2089 of the European Parliament and of the Council of 27 November 2019 amending Regulation (EU) 2016/1011 as regards EU Climate Transition Benchmarks, EU Paris-aligned Benchmarks and sustainabilityrelated disclosures for benchmarks, OJ L 317, 9.12.2019, p. 17 (‘Benchmark Regulation’); Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector, OJ L 317, 9.12.2019, p. 1 (‘Sustainable Finance Disclosure Regulation’); and Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088, OJ L 198, 22.6.2020, p. 13 (‘Taxonomy Regulation’). 29 Pereira da Silva, Luiz Awazu. (2019). Research on Climate-Related Risks and Financial Stability: An ‘Epistemological Break’?, Remarks at the Conference of the Central Banks and Supervisors Network for Greening the Financial System (NGFS), Paris, 17 April. 30 Section 7.4 below. 31 See section 7.2 above.

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A first and obvious macroprudential policy response is the attempt to close existing information gaps and to improve the knowledge base to the extent possible. First, this includes increasing transparency of climate-related exposures of corporate entities and makes such disclosure a legal requirement—a useful starting point obviously being the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).32 Second, this requires the further development of forwardlooking, scenario-based methodologies for risk analysis (so-called climate stress tests) to get a better understanding of the potential dynamics of CRFR—with all the inherent limitations these approaches may have.33 This is different from attempts to create a unified classification system (‘taxonomy’) on what can be considered an environmentally sustainable or ‘green’, ‘neutral’ or ‘brown’ economic activity. The fact that an activity is deemed ‘green’ does not necessarily imply that it is less risky.34 For the time being, CRFR mitigation and adaptation could essentially be tackled with the prudential toolkit that policymakers have at hand. As is done in ‘standard’ macroprudential policy, it is useful to distinguish analytically between the time and cross-sectional dimensions of CRFR and to discuss the specific instruments developed or deployed to address each of these dimensions. The time dimension of systemic risk deals with how aggregate risk in the financial system evolves over time. The cross-sectional (or structural) dimension of systemic risk looks at how aggregate risk is distributed within the financial system at a point in time.35 To each dimension corresponds a source of system-wide financial distress. In the time dimension, the source is the procyclicality of the financial system, i.e. the fact that risk assessments tend to be procyclical and may give rise to outsize financial cycles and business fluctuations. In the cross-sectional dimension, 32 Task Force on Climate-related Financial Disclosures (TCFD, 2017), Final Report, June. For the status of implementation of the TCFD recommendations see Task Force on Climate-related Financial Disclosures (TCFD, 2020), 2020 Status Report, October. 33 On these limitations see section 7.3.1 above. 34 Importantly, some ‘green’ sectors may not succeed in the transition. 35 For example, Galati, Gabriele, & Moessner, Richhild. (2013). “Macroprudential

Policy: A Literature Review”. Journal of Economic Surveys, 27(5), 850–852; Borio, Claudio, & Drehmann, Mathias. (2009). Towards an Operational Framework for Financial Stability: ‘Fuzzy’ Measurement and Its Consequences. In Banco Central de Chile (ed.), Financial Stability, Monetary Policy and Central Banking (also available as BIS Working Paper No. 284).

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the source is common exposures and the interconnectedness of financial institutions and markets, potentially resulting in joint failures as financial institutions are vulnerable to common sources of risk. ‘Standard’ macroprudential policy addresses these sources of risk with different policy strategies. Countercyclical buffers are used to cope with procyclicality: Buffers are built up during the upswing, i.e. as aggregate risk grows, so that they can be drawn on during the downswing, as risk materialises. Common exposures and interlinkages are dealt with by calibrating prudential tools to the (estimated) contribution of each institution to systemic risk. This requires that there is agreement on the acceptable level of risk for the financial system as a whole. 7.3.2.1 Time Dimension of CRFR An initial question is whether CRFR at all exhibit a time dimension. This would require that we can identify a ‘carbon cycle’, i.e. an excessive credit growth in high-carbon industries that feeds into excessive levels of carbon emissions, followed by a sudden correction or downswing. Of course, the carbon cycle has a different horizon and frequency or pattern than the financial cycle, to which ‘standard’ macroprudential policy pertains. It has not become an actual cycle yet, as carbon emissions at the global level have continuously risen at an unprecedented speed since 1950, with differing relative contributions by countries and continents over time.36 However, meeting the climate targets as agreed in the 2015 Paris climate agreement will require substantial reductions in carbon emissions, even if technologies for carbon capture and storage were to improve significantly. Sooner or later, therefore, a correction of the (potentially) excessive credit growth in high-carbon industries is bound to happen. Conceptually, the carbon cycle could be understood as a single, very long-term cycle—although it cannot be entirely excluded that along the low-carbon transition there will be short-term increases in demand for fossil fuels, and therefore ‘dips’ in the carbon cycle, e.g. due to ineffective climate policy or unfulfilled expectations in alternative sources of energy. Three instruments could be used to mitigate specifically the time dimension of CRFR: climate-risk adjusted capital and liquidity requirements; the countercyclical capital buffer (CCyB); and a sectoral leverage

36 See the data available from NASA—Global Climate Change, https://climate.nasa. gov/vital-signs/carbon-dioxide/.

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ratio as well as other (outright) caps on lending to and investments in carbon-intensive industries and assets. Climate-risk adjusted capital requirements represent by far the most discussed policy tool in the context of CRFR.37 All three pillars of the Basel III framework could potentially be ‘greened’, i.e. aligned with the objectives of a low-carbon transition.38 • Under Pillar I (minimum capital requirements), a ‘green supporting factor’ (GSF) or a ‘brown penalizing factor’ (BPF) could give, respectively, lower risk weights to climate-friendly (‘green’) investments or higher risk weights to carbon-intensive investments, thereby allowing for the integration of the added ‘carbon risk’ to overall risk-return assessments. The EU’s High-Level Expert Group on Sustainable Finance (HLEG) contemplated in its final report the adoption of a GSF, or regulatory capital discount, aimed at incentivising bank lending to environmentally sustainable projects and

37 For example, Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, pp. 50-52; Cullen, Jay. (2018). “After ‘HLEG’: EU Banks, Climate Change Abatement and the Precautionary Principle”. Cambridge Yearbook of European Studies, 20, 80–86; Alexander, Kern. (2016). Greening Banking Policy, Input Paper for the G-20 Green Finance Study Group (GFSG); Schoenmaker, Dirk, & van Tilburg, Rens. (2016). “What Role for Financial Supervisors in Addressing Environmental Risks?” Comparative Economic Studies, 58, 317–334; Schoenmaker, Dirk & van Tilburg, Rens. (2016). Financial Risks and Opportunities in the Time of Climate Change, Bruegel Policy Brief 2016/02, April. Critical for the time being Nieto, Maria. (2019). “Banks, Climate Risk and Financial Stability”. Journal of Financial Regulation and Compliance, 27(2), 243–262. 38 See Network for Greening the Financial System (NGFS, 2020), Guide for supervisors—Integrating climate-related and environmental risks into prudential supervision, Technical document, May, pp. 52–57.

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overcoming the ‘green finance gap’.39 Article 501a CRR 40 introduced a GSF that is narrowly targeted at lending to infrastructure project entities contributing to environmental objectives.41 Opponents of a GSF caution against the potentially destabilising impact on banks considering the experience made with the small and mediumsized enterprises (SME) supporting factor.42 Some also question the effectiveness of a GSF in increasing ‘green’ lending.43 Indeed, from a macroprudential point of view, a BPF is the more appropriate 39 High-Level Expert Group on Sustainable Finance (HLEG, 2018), Financing a sustainable European economy, Final report, p. 68. The report explicitly refers to a statement in favour of a GSF made by Commission Vice-President Dombrovskis (see Dombrovskis, Valdis. (2017). “Greening Finance for Sustainable Business”, speech, 12 December, available at: https://ec.europa.eu/commission/presscorner/detail/en/SPE ECH_17_5235). 40 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, OJ L 176, 27.6.2013, p. 1, as amended by Regulation (EU) 2019/876 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No 575/2013 as regards the leverage ratio, the Net Stable Funding Ratio, requirements for own funds and eligible liabilities, counterparty credit risk, market risk, exposures to central counterparties, exposures to collective investment undertakings, large exposures, reporting and disclosure requirements, and Regulation (EU) No 648/2012, OJ L 150, 7.6.2019, p. 1. 41 Article 501a CRR provides that own funds requirements for credit risk shall be multiplied by 0.75, if the exposure complies with all of the requirements set out in Article 501a(1)(a)-(o) CRR. According to lit. o, the obligor must carry out an assessment whether the assets being financed contribute to the following environmental objectives: climate change mitigation; climate change adaptation; sustainable use and protection of water and marine resources; transition to a circular economy, waste prevention and recycling; pollution prevention and control; protection of healthy ecosystems (emphasis added). 42 For example, Cullen, Jay. (2018). “After ‘HLEG’: EU Banks, Climate Change Abatement and the Precautionary Principle”. Cambridge Yearbook of European Studies, 20, 82–84; van Lerven, Frank, & Ryan-Collins, Josh. (2018). Adjusting Banks’ Capital Requirements in Line with Sustainable Finance Objectives: Briefing Note, New Economics Foundation, 28 February; Matikainen, Sini et al. (2017). The Climate Impact of Quantitative Easing, Grantham Research Institute on Climate change and the Environment, Policy Paper, May. 43 Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, p. 53; Thomä, Jakob, & Gibhardt, Kyra. (2019). “Quantifying the Potential Impact of a Green Supporting Factor or Brown Penalty on European Banks and Lending”. Journal of Financial Regulation and Compliance, 27(3), 380–394; Cullen, Jay. (2018). “After ‘HLEG’: EU Banks, Climate Change Abatement and the Precautionary Principle”. Cambridge Yearbook of European Studies, 20, 82–84.

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choice44 : A higher risk weight for loans carrying carbon risks would reflect the real and growing systemic risk of investing in high-carbon activities and may discourage further investment that contributes to the output of carbon dioxide. It would also ensure that banks hold greater buffers to withstand losses from climate-related transition risks. Moreover, and more practically speaking, there is currently less agreement on what counts as ‘green’ (being a very new sector) than what counts as excessively ‘brown’.45 Article 501c CRR mandated the European Banking Authority (EBA) to assess whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified—leaving open whether this be achieved with a GSF or a BPF, if any. • Under Pillar II (internal governance and Supervisory Review and Evaluation Process, SREP), regulators could prescribe capital addons on a case-by-case basis, e.g. if a bank does not adequately monitor and manage CRFR. This would first require that supervisors set new and specific expectations in this regard. Several EU and national competent authorities have already issued guidance on CRFR, including the EBA,46 the U.K.’s Prudential Regulation Authority (PRA),47 the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin),48 the Austrian Finanzmarktaufsicht 44 See also Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, p. 51; D’Orazio, Paola, & Popoyan, Lilit. (2019). “Fostering Green Investments and Tackling Climate-Related Financial Risks: Which Role for Macroprudential Policies?”. Ecological Economics, 160, 29; Chenet, Hugues et al. (2019). Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 2019-13, p. 17. 45 Chenet, Hugues et al. (2019). Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 2019-13, p. 17. With the further development of the framework of the Taxonomy Regulation (n. 28), in particular the adoption of the corresponding Level 2 acts, this may change in the near future. 46 European Banking Authority (EBA, 2019), EBA Action plan on sustainable finance,

6 December. 47 Prudential Regulation Authority (PRA, 2019), Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change, Supervisory Statement 3/19, April. 48 Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin, 2020), Guidance notice on dealing with sustainability risks, 15 January.

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(FMA),49 the Dutch De Nederlandsche Bank (DNB)50 and the European Central Bank (ECB).51 Moreover, Article 98(8) CRD 52 mandates the EBA to assess the potential inclusion of environmental risks, amongst others, into SREP. The EBA has also issued guidelines which introduce specific requirements for ‘green’ lending and encourage institutions to include environmental factors as well as associated risks and opportunities in their risk management policies, credit risk policies and procedures.53 • Finally, under Pillar III (disclosure), supervisors can contribute to improving the pricing of CRFR and to a more efficient allocation of capital by requiring a more systematic and consistent disclosure of these risks.54 The EBA, for example, expects institutions to continue their work on disclosures in line with the Non-Financial Reporting Directive55 and to prioritise the identification of simple metrics that provide transparency on how CRFR are embedded into their business targets, strategies, decision-making processes and risk 49 Finanzmarktaufsicht (FMA, 2020), FMA-Leitfaden zum Umgang mit Nachhaltigkeitsrisiken, 2 July. 50 De Nederlansche Bank (DNB, 2020), Good practice—Integration of climate-related risk considerations into banks’ risk management, 1 April. See also the accompanying Q&A at https://www.toezicht.dnb.nl/3/50-238191.jsp. 51 European Central Bank (ECB, 2020), Guide on climate-related and environmental risks, Supervisory expectations relating to risk management and disclosure, May. 52 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC, OJ L 176, 27.6.2013, p. 338, as amended by Directive (EU) 2019/878 of the European Parliament and of the Council of 20 May 2019 amending Directive 2013/36/EU as regards exempted entities, financial holding companies, mixed financial holding companies, remuneration, supervisory measures and powers and capital conservation measures, OJ L 150, 7.6.2019, p. 263. 53 European Banking Authority (EBA, 2020), Final Report: Guidelines on loan origination and monitoring, 29 May, EBA/GL/2020/06. 54 See also Network for Greening the Financial System (NGFS, 2019), A call for action: Climate change as a source of financial risk, First comprehensive report, April, p. 27: ‘authorities can set out their expectations when it comes to financial firms’ transparency on climate-related issues’. 55 Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups, OJ L 330, 15.11.2014, p. 1.

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management.56 Moreover, Article 449a CRR requires, from 28 June 2022, large institutions with publicly listed issuances to disclose information on ESG risks, including physical risks and transition risks, as defined in the report referred to in Article 98(8) CRD. The EBA is mandated to develop a technical standard implementing these disclosure requirements.57 Some national regulators have already moved forward with a systematic disclosure of CRFR. Article 173 of the French Law on Energy Transition for Green Growth58 requires financial and non-financial firms to disclose the CRFR they are exposed to and how they seek to manage them, increasing awareness among financial firms of how climate change can affect their risk management processes and encouraging the supervisory authorities to observe the developments carefully. Liquidity requirements are of interest as it is suggested that they may unintendedly constrain banks’ willingness to lend to ‘green’ economic activities.59 Both components of liquidity requirements, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) are likely to make long-term financing, including ‘patient’ green investments, more expensive. Countercyclical capital buffers (CCyB) are designed to help banks lean against the build-up phase of systemic vulnerabilities and to serve as a

56 European Banking Authority (EBA, 2019), EBA Action plan on sustainable finance, 6 December, pp. 16–17. 57 Article 434a CRR. The EBA has issued a survey on the matter; see European Banking Authority (EBA, 2020), Survey: Pillar 3 disclosures on ESG risks under Article 449a CRR, 17 September. 58 Loi relative à la transition énergétique pour la croissance verte (2015). 59 For example, Narbel, Patrick. (2013). The Likely Impact of Basel III on a Bank’s

Appetite for Renewable Energy Financing, Norwegian School of Economics Department of Business and Management Science Discussion Paper No. 2013/10, October; Liebreich, Michael, & McCrone, Anguns. (2013). Financial Regulation—Biased Against Clean Energy and green Infrastructure?, Bloomber New Energy Finance, Clean Energy— White Paper, 20, pp. 3–4. See also the policy recommendation to introduce a precise incentive mechanism for the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) to link climate-related and maturity mismatch considerations in European Banking Federation (EBF, 2017), Towards a green finance framework, 28 September, p. 34.

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cushion during the subsequent correction, contributing to a ‘soft landing’.60 In this way, a CCyB could help mitigate excessive credit growth and leverage with respect to carbon-intensive assets, ensuring a smoothedout low-carbon transition process. However, for the CCyB to be effective, it needs to be adequately calibrated and activated on time, i.e. before the cycle starts turning downwards. A sectoral leverage ratio (SLR) would limit a bank’s exposure to a targeted group of carbon-intensive assets by setting a cap on the level of debt financing of such investments.61 SLRs serve as a backstop to riskbased capital requirements by avoiding the overleveraging of a specific sector (here: the carbon-intensive industries) and sustaining an adequate capital base against a particular group of risky assets (here: carbonintensive assets). The impact of a climate-related SLR would be similar to the effects of an outright credit ceiling related to carbon-intensive lending. While the SLR would require banks to back-up their carbonintensive investments with equity, credit ceilings impose an outright limit on lending to carbon-intensive activities or sectors. Minimum credit floors, in contrast, require banks to allocate a predefined fraction of their lending activity to ‘green’ economic activities or sectors.62 Finally, differentiated reserve requirements, a tool that has gone out of fashion in high-income countries, have been deployed or are in the process of being deployed in China and Lebanon in proportion to banks’ lending to ‘green’ sectors.63

60 D’Orazio, Paola, & Popoyan, Lilit. (2019). “Fostering Green Investments and Tackling Climate-Related Financial Risks: Which Role for Macroprudential Policies?” Ecological Economics, 160, 30. 61 D’Orazio, Paola, & Popoyan, Lilit. (2019). “Fostering Green Investments and Tackling Climate-Related Financial Risks: Which Role for Macroprudential Policies?” Ecological Economics, 160, 31. 62 D’Orazio, Paola, & Popoyan, Lilit. (2019). “Fostering Green Investments and Tackling Climate-Related Financial Risks: Which Role for Macroprudential Policies?” Ecological Economics, 160, 32–33. For example, banks and other financial institutions in Bangladesh are required to allocate 5% of their total loan portfolio to ‘green’ sectors (Dikau, Simon, & Ryan-Collins, Josh. (2017). Green Central Banking in Emerging Market and Developing Country Economies, New Economic Foundation, p. 19). 63 D’Orazio, Paola, & Popoyan, Lilit. (2019). “Fostering Green Investments and Tackling Climate-Related Financial Risks: Which Role for Macroprudential Policies?” Ecological Economics, 160, 29–30; see also Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, p. 53.

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7.3.2.2 Cross-Sectional Dimension of CRFR The objective of macroprudential policy tools targeted at the crosssectional dimension of systemic risk is to limit common exposures of and interlinkages between financial institutions and to correct for misaligned incentives exhibited, in particular, by systemically relevant financial institutions (SIFIs). Large exposures limits impose a cap on certain exposures as a percentage of total equity capital. With regard to CRFR, large exposures limits could place quantity-based or price-based constraints on the amount of banks’ exposures to ‘brown’ sectors of the economy and/or sovereigns with elevated environmental risk, thereby limiting the risks associated with the transition to a low-carbon economy.64 The instrument, therefore, includes an allocative feature similar to credit ceilings, albeit relying on the identification of counterparties with a predetermined high participation in carbon-intensive activities instead of a group or type of assets.65 Accordingly, large exposures limits are reporting and disclosure intense, implying high implementation costs. Finally, financial institutions are designated as SIFIs based on a range of indicators, including their size, interconnectedness, substitutability, crossborder activity and complexity. The carbon intensity of their lending and/or investment activity could be added as an additional indicator. Key instruments to counteract misaligned incentives due to the SIFI-status include SIFI capital surcharges and the systemic risk buffer.

7.4

Timing of Policy Action

The crucial question, however, remains the timing of policy action. What are the options of macroprudential policy makers, given that they: (1) tend to agree that CRFR may pose a potentially catastrophic threat to

64 Nieto, Maria. (2019). “Banks, Climate Risk and Financial Stability”. Journal of Financial Regulation and Compliance, 27(2), p. 257; Advisory Scientific Committee (ASC) of the European Systemic Risk Board (ESRB, 2016), Too late, too sudden: Transition to a low-carbon economy and systemic risk, Report No. 6, p. 17; Schoenmaker, Dirk, & van Tilburg, Rens. (2016). “What Role for Financial Supervisors in Addressing Environmental Risks?” Comparative Economic Studies, 58, 317–334; Schoenmaker, Dirk & van Tilburg, Rens. (2016b). Financial Risks and Opportunities in the Time of Climate Change, Bruegel Policy Brief 2016/02, April. 65 D’Orazio, Paola, & Popoyan, Lilit. (2019). “Fostering Green Investments and Tackling Climate-Related Financial Risks: Which Role for Macroprudential Policies?” Ecological Economics, 160, 33.

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financial stability; (2) are confronted with radical uncertainty as to the dynamics of CRFR (the how and the when); and (3) are likely biased towards inaction in the face of such risk?66 First of all, it is clear that a ‘wait and see’ approach is no longer an option. What most policymakers seem to pursue is a ‘wait until we have a better understanding’ approach.67 This appears to be the approach advocated by the Network for Greening the Financial System (NGFS) and also within the EU. In its call for action, the NGFS implied that actions by supervisors and Central Banks be taken in sequences, starting with raising awareness and assessing CRFR and only then moving on to setting supervisory expectations, requiring transparency and, as a last step, mitigating risk through financial resources.68 The EU’s Sustainable Finance Action Plan is focused on measures that increase transparency and develop a ‘common language’, thereby facilitating the redirecting of capital flows towards a low-carbon economy indirectly.69 More direct prudential measures contemplated in the final report of the HLEG,70 in particular a GSF or BPF, have not found their way into concrete legislative proposals yet.71 They appear to be seen as dependent, in particular, on the

66 See sections 7.2 and 7.3.1 above. 67 Critical Chenet, Hugues et al. (2019). Climate-Related Financial Policy in a World

of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 201913; Cullen, Jay. (2018). “After ‘HLEG’: EU Banks, Climate Change Abatement and the Precautionary Principle”. Cambridge Yearbook of European Studies, 20, 61–87. 68 Network for Greening the Financial System (NGFS, 2019a), A call for action: Climate change as a source of financial risk, First comprehensive report, April, pp. 22–28. Building on the approach of the call for action Network for Greening the Financial System (NGFS, 2020), Guide for supervisors—Integrating climate-related and environmental risks into prudential supervision, Technical document, May. 69 Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions, Action Plan: Financing Sustainable Growth, 8 March 2018, COM(2018) 97 final. However, in its consultation on the renewed sustainable finance strategy, the Commission contemplated to scale up the efforts of integrating ESG considerations into the prudential frameworks for banks and insurances. See European Commission (EC, 2020), Consulation document, Consulation on the renewed sustainable finance strategy, 8 April. 70 High-Level Expert Group on Sustainable Finance (HLEG, 2018), Financing a sustainable European economy, Final report. 71 The only (narrow) exception being Article 501a CRR, which applies a GSF (of 0.75) to lending to infrastructure project entities contributing to environmental objectives. The

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further elaboration of the taxonomy framework for climate change activities and are therefore postponed to a more distant future.72 The argument in favour of the ‘wait until we have a better understanding’ approach is that, while it is preferable to act now in light of the climate emergency and its increasingly tangible impact on financial institutions, we lack sufficient ‘intellectual capacity’ to understand the dynamics of CRFR and how they may be affected by policy interventions. The question is: Will sufficient intellectual capacity for policy action ever be reached? A third approach, the ‘take precautionary action’ approach, advocates that targeted policy measures be taken already while efforts are being made to build up a better understanding of the nature and dynamics of CRFR. It is based on the idea that if we know that not acting in the short term will increase the severity of CRFR, we should act to insure the economy against their potentially catastrophic materialisation, even if there are no available models that can predict the probability of such a catastrophic event. In other words, the potential costs of inaction may outweigh the (short-term) costs of adopting less-than-optimal policies. Proponents of such approach contemplate that financial policy and supervision should shape the market to ‘create their preferred scenario’ instead of ‘spending years gathering sufficient information attempting to understand and predict a priori what scenario is occurring and then acting accordingly’.73 The ‘precautionary principle’ is well-established in environmental protection—including climate change mitigation—74 and encourages the

Commission is mandated to report on the impact of this GSF (with the support of EBA) by 28 June 2022. 72 According to Article 501c CCR, the EBA is mandated to assess whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified. It is expected to submit a report on its findings only by 28 June 2025, on the basis of which the Commission may (or may not) submit a legislative proposal. See also European Banking Authority (EBA, 2019), EBA Action plan on sustainable finance, 6 December, p. 13. 73 Chenet, Hugues et al. (2019). Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 2019-13, p. 2. 74 Article 3.3 of the UN Framework Convention on Climate change (UNFCC) of 1992 states: ‘The Parties should take precautionary measures to anticipate, prevent or minimize the causes of climate change and mitigate its adverse effects. Where there are threats of serious or irreversible damage, lack of full scientific certainty should not be used as a reason for postponing such measures, (…).’

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adoption of preventative policies to avert serious or irreversible damage in the face of uncertainty. In the EU, the principle is enshrined in Article 191(2) TFEU75 as a guiding principle of the Union’s policies on the environment, while extending to areas such as consumer policy as well as human, animal and plant health.76 Less acknowledged is the applicability of the precautionary principle in monetary and financial policy, albeit we may have seen monetary and financial policymakers move towards a more precautionary approach in the aftermath of the Great Financial Crisis (GFC). Chenet et al. (2019) corroborate their support of a precautionary approach towards CRFR by pointing to the fact that, in the face of threats to the stability of the financial system, Central Banks adopted nonstandard monetary policy measures on a massive scale, despite significant uncertainties in relation to their effects and potential (undesired) sideeffects.77 However, non-standard monetary policy measures are intended to be of a non-permanent nature and predominantly seen as tools to be deployed on an exceptional basis.78 The argument is perhaps stronger with a view to macroprudential policy, which is by design precautionary.79 Indeed, the ‘take precautionary action’ approach falls squarely within the macroprudential policy framework, which is aimed at increasing the resilience of the financial system against hard-to-predict shocks, including rare and high-impact events, and empowers policymakers to reduce the emergence of instability preemptively. In the light of the different dimensions of systemic risks,80 75 Treaty on the Functioning of the European Union, OJ C 326, 26.10.2012, p. 47. 76 Communication from the Commission on the precautionary principle, 2 February

2000, COM(2000) 1 final, pp. 8-10. For further examples see Chenet, Hugues et al. (2019). Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 2019-13, pp. 12–13; Cullen, Jay. (2018). “After ‘HLEG’: EU Banks, Climate Change Abatement and the Precautionary Principle”. Cambridge Yearbook of European Studies, 20, 78–80. 77 Chenet, Hugues et al. (2019). Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 2019-13, pp. 15– 16. 78 Most Central Banks remain critical of an active ‘leaning against the wind’ with monetary policy. 79 See also Chenet, Hugues et al. (2019). Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 2019-13, pp. 14–15. 80 See section 7.3.2 above.

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macroprudential policy is geared towards (1) dampening the cycle by intervening in the opposite direction of lending and investment activity (‘leaning against the wind’); and (2) offsetting risks arising from complex interconnections within the financial system by increasing the systems’ resilience and reducing the propagation of shocks.81 It is clear that a ‘take precautionary action approach’ towards CRFR comes with significant implementation challenges.82 Given our current state of knowledge, it would be dangerous to assume that we can adopt macroprudential policies to address CRFR based on the outcome of any single risk measure, such as scenario-based stress tests. While there is merit in exploring how closely CRFR can be mapped based on the general analytical framework deployed by macroprudential policy makers, including the distinction between the time and cross-sectional dimension of systemic risk and the policy principles adopted to cope with each dimension,83 this framework is itself still under development when it comes to defining leading indicators.84 At least for the time being, and perhaps even on a more permanent basis, the lack of indicators to calibrate CRFR-oriented macroprudential policy tools must be compensated for by a more qualitative approach. This approach relies on experience and expert judgement rather than data and models. Concepts such as ‘rules of thumb’, ‘bounded rationality’ and ‘learning by doing’ may be instrumental in filtering out information that is of little help and avoiding that complexity is conflated with sophistication.85

81 For example, Bank of England. (2009). The Role of Macroprudential Policy: A

Discussion Paper, November; Borio, Claudio, & Drehmann, Mathias. (2009). Towards an Operational Framework for Financial Stability: ‘Fuzzy’ Measurement and Its Consequences. In Banco Central de Chile (ed.), Financial Stability, Monetary Policy and Central Banking (also available as BIS Working Paper No. 284). 82 Chenet, Hugues et al. (2019). Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 2019-13, pp. 22– 23. 83 See section 7.3.2 above. 84 Borio, Claudio. (2011). “Implementing a Macroprudential Framework: Blending

Boldness and Realism”. Capitalism and Society, 6(1), 1–25. 85 See Chenet, Hugues et al. (2019). Climate-Related Financial Policy in a World of Radical Uncertainty: Towards a Precautionary Approach, UCL Working Paper 2019-13, pp. 22–23. Arguing for simplicity in light of radical uncertainty King Mervyn. (2016). The End of Alchemy: Money, Banking, and the Future of the Global Economy. W.W. Norton, Chapter 4.

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7.5

Which Role for Central Banks?

A related question is which role Central Banks can and should play in the low-carbon transition. To answer the question, it is essential to distinguish between the different functions Central Banks are assigned with.86 The core responsibility of Central Banks is to pursue their monetary policy objective(s) by setting interest rates and the quantity of base money.87 Central Banks typically also play a central role in analysing risks to the stability of the financial system and in activating targeted macroprudential policy measures. Some Central Banks are further tasked with microprudential supervision of the banking sector or even other financial institutions. While there is an important case for integrating CRFR into the framework for microprudential supervision, this chapter focuses on the core functions of Central Banks as monetary and macroprudential policy makers.88 On the one hand, mitigating climate change is seen as the primary responsibility of elected governments, with fiscal tools first in line.89 For many economists, the first-best solution is to adopt a carbon tax to correct for the externalities directly.90 However, as this approach does not seem to be making progress for various reasons, some argue for a role for monetary policy to achieve climate mitigation, even if other tools would be more appropriate. On the other hand, climate change is clearly relevant for monetary policy. Central Banks cannot resort to simply measuring risks and wait for other government agencies to jump into action. This would expose them to the real risk that they will not be able to deliver on 86 Similarly Fisher, Paul, & Alexander, Kern. (2019). Climate Change: The Role for Central Banks, King’s Business School Working Paper No. 2019/6, April. 87 Other core tasks of Central Banks include issuing banknotes; providing clearing and settlement accounts for the banking system; and responsibility for payment systems. 88 The adoption of non-standard monetary policy measures, which pursue financial stability as a second-order or intermediate objective, has blurred the line between monetary and macroprudential policy. 89 For example, Krogstrup, Signe, & Oman, William. (2019). Macroeconomic and Financial Policies for Climate Change Mitigation: A Review of the Literature. IMF Working Paper 19/185, September, amongst many others. 90 For a framework for assessing the social cost of carbon Barnett, Michael et al. (2020). “Pricing Uncertainty Induced by Climate Change”. The Review of Financial Studies, 33(3), 1024–1066.

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their mandates of price and financial stability.91 Rising temperatures and climate change mitigation policies are likely to increase the frequency and severity of supply price shocks, risk and volatility and to affect business cycles.92 More indirectly, CRFR could affect the economy through elevated credit spreads, greater precautionary saving and, in the extreme, a financial crisis93 —factors that affect inflationary pressures. In the worstcase scenario, Central Banks may have to intervene as ‘climate rescuers of last resort’.94 Its precise mandate, degree of independence and scope of discretion in implementing its policies will determine which role each Central Bank can (and should) play in the transition to an environmentally sustainable economy.95 This chapter aims to assess the different views and proposals that are available without referring to a specific Central Bank or legal framework.

91 See Network for Greening the Financial System (NGFS, 2020), Climate change and

monetary policy—Initial takeaways, Technical document, June. 92 See Krogstrup, Signe, & Oman, William. (2019). Macroeconomic and Financial Policies for Climate Change Mitigation: A Review of the Literature. IMF Working Paper 19/185, September, p. 30; Fisher, Paul, & Alexander, Kern. (2019). Climate Change: The Role for Central Banks, King’s Business School Working Paper No. 2019/6, April, p. 8. For potential adaptation policies see, e.g., Fisher & Alexander (2019), pp. 9–11; Coeuré, Benoît. (2018). Monetary policy and climate change, Speech given at a conference on ‘Scaling up Green Finance: The Role of Central Banks,’ organized by the Network for Greening the Financial System, the Deutsche Bundesbank and the Council on Economic Policies, Berlin, November 8; McKibbin, Warwick J. et al. (2017). Climate change and Monetary Policy: Dealing with Disruption, Climate and Energy Economics Discussion Paper, Brookings, Washington DC, November 30. 93 Rudebusch, Glenn D. (2019), Climate Change and the Federal Reserve, FRBSF Economic Letter 2019-09, March 25, p. 3; Krogstrup, Signe, & Oman, William. (2019). Macroeconomic and Financial Policies for Climate Change Mitigation: A Review of the Literature. IMF Working Paper 19/185, September, p. 30; see also Batten, Sandra et al. (2016). Let Talk About the Weather: The Impact of Climate Change on Central Banks, Bank of England Staff Working Paper No. 603, May, pp. 23–27. 94 Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, pp. 9, 47. 95 Central Bank mandates often include the contribution to general economic welfare

additional to price stability (Dikau, Simon, & Volz, Ulrich. [2019]. Central Bank Mandates, Sustainability Objectives and the Promotion of Green Finance, SOAS Department of Economics, Working Paper No. 222, March). For the case of the ECB see Lastra, Rosa, & Alexander, Kern. (2020). The ECB Mandate: Perspectives on Sustainability and Solidarity, Monetary Dialogue Papers, June.

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A study by the BIS and Banque de France suggests that Central Banks become coordinating agents in an endeavour to coordinate fiscal, monetary, prudential and carbon policies and to embed them into broader societal changes such as better integration of sustainability into financial and economic decision-making.96 This is largely in line with the suggestion that there be a role for Central Banks in ‘helping to define the rules of the game’ and ‘acting accordingly, without prejudice to price stability’.97 As benign as this proposal may sound, and with all the merits it has, it runs counter to Central Banks’ typical modus operandi as decision- and policymakers with sole responsibility for specific policy objectives. While, as a result of the GFC, we may have seen Central Banks much more involved in ‘coordinating’ economic policies along with political authorities,98 the coordinating role envisaged here likely implies a stronger, more direct and permanent outside influence on Central Bank policymaking. Potential implications for independence and reputation will depend on the institutional and legal design of such coordinating role, but need to be carefully considered. The literature has pointed to ways in which Central Banks could— to a further or lesser extent—facilitate the low-carbon transition with monetary policy. The redistributive role of monetary policy, which is increasingly recognised and analysed,99 so it is suggested, could be harnessed for ‘secondary’ or supporting objectives, such as climate change mitigation.100 Some have proposed that the climate-related risks in 96 Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, pp. 47–64. 97 Coeuré, Benoît. (2018). Monetary policy and climate change, Speech given at a conference on ‘Scaling up Green Finance: The Role of Central Banks,’ organized by the Network for Greening the Financial System, the Deutsche Bundesbank and the Council on Economic Policies, Berlin, November 8. 98 An ad hoc case in point being the ECB’s involvement in the ‘Troika’ along with the Commission and the International Monetary Fund (IMF). Within macroprudential bodies, Central Bank representatives are also bound to take decisions collectively with Central Bank outsiders (e.g. supervisors, expert individuals, politicians). 99 Koedijk, Kees G. et al. (2018). “Monetary Policy, Macroprudential Regulation and Inequality: An Introduction to the Special Section”. Journal of International Money and Finance, 85, 163–167. 100 Dikau, Simon, & Volz, Ulrich. (2019). Central Bank Mandates, Sustainability Objectives and the Promotion of Green Finance, SOAS Department of Economics, Working Paper No. 222, March; Coeuré, Benoît. (2018). Monetary policy and climate change, Speech given at a conference on ‘Scaling up Green Finance: The Role of Central Banks,’

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Central Banks’ collateral framework could be more adequately assessed and reflected. Similar to the underestimation of climate-related risks by financial markets and institutions, there is evidence that the portfolios purchased in Central Banks’ asset purchase programmes are implicitly biased towards carbon-intensive industries101 —and are therefore not climate neutral.102 Correcting for such ‘carbon bias’, e.g. by developing and applying own risk assessments, can be seen as a way to avoid that Central Banks’ monetary mandate is affected in the medium to long term.103 Moreover, Central Banks could act as catalysts of climaterelated disclosure policies, for example, by refusing to buy securities from companies that fail to disclose climate risks.104 Others suggest taking it one step further by Central Banks actively purchasing low-carbon assets (or eliminating carbon-intensive assets from Central Banks’ portfolios), beyond what is required to adjust risk weights to accurately reflect climate-related risks.105 Proposals concerning ‘green

organized by the Network for Greening the Financial System, the Deutsche Bundesbank and the Council on Economic Policies, Berlin, November 8; Carney, Mark. (2015). Breaking the Tragedy of the Horizon—Climate Change and Financial Stability, speech at Lloyd’s of London, 29 September. 101 Battiston, Stefano, & Irene, Monasterolo. (2019). How Could the ECB’s Monetary Policy Support the Sustainable Finance Transition?, March, available at: https://www.fin exus.uzh.ch/en/news/cspp_sustainable_finance.html; Matikainen, Sini et al. (2017). The Climate Impact of Quantitative Easing, Grantham Research Institute on Climate Change and the Environment, Policy Paper, May. 102 Some Central Banks traditionally adhere to a doctrine of market neutrality, i.e., they seek to minimize distortive effects of their monetary policies on markets’ price discovery mechanisms. The merits of such doctrine, however, are questionable in light of the persistent mispricing of CRFR due to multiple market failures. 103 Similarly Krogstrup, Signe, & Oman, William. (2019). Macroeconomic and Financial Policies for Climate Change Mitigation: A Review of the Literature. IMF Working Paper 19/185, September, p. 31 (‘it is against mandates not to reflect risks appropriately’); Monnin, Pierre. (2018). Central Banks and the Transition to a Low-Carbon Economy, CEP Discussion Note 2018/1, March. 104 Mauderer, Sabine. (2020). Central Banks Have a Part to Play in the Fight Against Climate Change, Financial Times, February 27. 105 For example, van Lerven, Frank, & Ryan-Collins, Josh. (2018). Adjusting Banks’

Capital Requirements in Line with Sustainable Finance Objectives: Briefing Note, New Economics Foundation; Ryan-Collins, Josh et al. (2013). Strategic Quantitative Easing: Stimulating Investment to Rebalance the Economy, New Economics Foundation. On the discussion in the Eurozone De Grauwe, Paul. (2019). Green Money Without Inflation, Council on Economic Policies Blog, March 7.

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quantitative easing’ are more contentious and more difficult to bring in line with a conventional understanding of Central Bank mandates.106 They are best seen as an attempt to define a new role for Central Banks, or at least a reinterpretation of their mandates, through a more explicit and active support of ‘green’ fiscal policy.107 Similarly, a more proactive steering of bank lending and investment to ‘green’ sectors of the economy, e.g. by ensuring better access to funding schemes for commercial banks that invest in low-carbon projects,108 may be viewed as exceeding the conventional realm of Central Banks. A widely-shared view is that Central Banks should lead by example, including by making the carbon footprint of their asset holdings fully transparent109 —in a similar way the private sector is asked to do.110 Moreover, Central Banks may include environmental sustainability considerations in their portfolio management alongside financial returns,111 e.g. by investing some portion of their expanded balance sheet into green bonds (‘impact investing’).112 While Central Banks manage a

106 See also Krogstrup, Signe, & Oman, William. (2019). Macroeconomic and Financial Policies for Climate Change Mitigation: A Review of the Literature. IMF Working Paper 19/185, September, pp. 31–32. 107 Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, p. 47, speak of a ‘third role’ of Central Banks (besides price and financial stability). A recent example for such reinterpreation is the Bank of England, whose mandate was upgraded in early March 2021 to include support to the U.K. government’s strategy to transition to a net zero economy. 108 Aglietta, Michel et al. (2015). A Proposal to Finance Low-Carbon Investment in Europe, La Note D’Analyse No. 4, France Stratégie, Paris. 109 Fisher, Paul, & Alexander, Kern. (2019). Climate Change: The Role for Central

Banks, King’s Business School Working Paper No. 2019/6, April, pp. 14, 16. 110 Specifically on the question of the extent to which the TCFD framework may also be useful for Central Bank disclosures Network for Greening the Financial System (NGFS, 2019), A sustainable and responsible investment guide for Central Banks’ portfolio management, October, pp. 21–22. 111 See the discussion in Bolton, Patrick et al. (2020). The Green Swan—Central Banking and Financial Stability in the Age of Climate Change, January, p. 54. 112 For example, the Green Bond Investment Pools launched by the BIS. Other strategies include: negative screening; best-in-class; ESG integration; and voting and engagement (Network for Greening the Financial System [NGFS, 2019], A sustainable and responsible investment guide for Central Banks’ portfolio management, October, pp. 12–19).

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large number of assets in different portfolios,113 they are different from other institutional investors in that they are bound in their investment practices to their respective policy objectives and need to ensure that their independence is not jeopardised. However, to the extent the asset base invested is unlikely to be adjusted in the future for monetary policy purposes, there is little risk of policy trade-offs and therefore little concern of overstretching the monetary mandate.

7.6

Conclusions

Scientific studies suggest that impacts of climate change on the financial system and the economy at large are no longer a matter for the distant future, but have become increasingly tangible. This chapter has argued that macroprudential policy has a crucial role to play in improving the climate resilience of the financial system. The macroprudential policy framework—while still evolving—must and can adapt to the specificities of CRFR. However, epistemological and methodological as well as behavioural challenges are in the way of timely and effective policy action. CRFR distinguish themselves fundamentally from conventional financial risk, including in terms of time horizon and the irreversibility of their consequences. The desire of macroprudential policy makers to rely in their decision-making on improved risk analysis ignores that we may never be in a position to see through the complexities and interconnections of the climate and financial systems. In fact, we may be even short of imagination when it comes to potential impacts of climate change on the financial system. There is nothing wrong with improving our understanding of the nature and dynamics of CRFR, but it should not lead to inaction that risks irreversible damage from a climate impact that we know is bound to happen sooner or later. Along with other scholars and some policymakers, this chapter therefore suggests that it is worth exploring short-term precautionary measures to improve the preparedness and resilience of the financial system. The implementation of precautionary measures would be driven by heuristics, such as ‘rules of thumbs’ or ‘trial and error’, 113 Typical Central Bank portfolios include: policy portfolios; own portfolios; pension portfolios; and third-party portfolios (Network for Greening the Financial System [NGFS, 2019], A sustainable and responsible investment guide for Central Banks’ portfolio management, October, pp. 7–9).

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rather than deterministic or probabilistic indicators.114 Clearly, more research and policy work is needed to inform these novel decision-making processes. In legal theory, it is well acknowledged that rules guiding the process of decision-making and policy implementation by expert authorities can, to some extent, compensate for a lack of influence of the electorate on the substance of the policy. A similar approach could guide policymaking if agreement on the substance of the policy cannot be reached for lack of conclusive data or underlying analysis. In the light of the fact that macroprudential policy makers (1) tend to agree that CRFR pose a threat to financial stability; (2) are confronted with radical uncertainty as to the dynamics of CRFR; and (3) are likely biased towards inaction in the face of CRFR, a precautionary approach might be the best option they have. Clearly, such approach constitutes a fundamental change—or an ‘epistemological break’. And it is not the only fundamental change ‘green’ macroprudential policy is faced with. The complexities associated with climate change mitigation and adaptation and the sheer immenseness of the task can only be tackled with a mix of coordinated policies. ‘Green’ macroprudential policy must go hand-inhand with other policies, including environmental, land planning, fiscal and monetary policy. The need for a coordinated policy mix will most profoundly affect Central Banks. Their role in the transition to a low-carbon economy is particularly widely debated, and the expectations that are put in these institutions are high. Proposals range from a coordinating function of Central Banks to an active support of ‘green’ fiscal policies with monetary policy instruments. In any case, we will likely see Central Banks transform as a consequence of increased climate change mitigation and adaptation efforts. Since financial stability has been incorporated—explicitly or implicitly—in the mandate of many Central Banks in the aftermath of the GFC, they have become more concerned with CRFR. Existing financial and price stability mandates not only leave room for a ‘greener’ macroprudential and monetary policy, but also require Central Banks to take climate change into account. While the GFC demonstrated that modern

114 The rules of logic tell us that: ‘[i]t is better to be vaguely right than precisely wrong’ (Read Carveth [1914], Logic: Deductive and Inductive, 4th edition, London [Project Gutenberg e-book, 2006], p. 351). King Mervyn. (2016). The End of Alchemy: Money, Banking, and the Future of the Global Economy. W.W. Norton, Chapter 4, famously uses this quote, arguing in favour of simple coping strategies when faced with uncertainty.

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Central Banks do not operate in a political vacuum, their engagement in guiding the transition to a low-carbon economy may expose Central Banks to a much more direct and profound influence from other policymakers, politics and the broader public and may require a rethink of the confines of Central Bank independence. One thing is clear: We are in for a lot of change.

CHAPTER 8

Climate Change as a Threat to Financial Stability: Can Solutions to This Problem Accelerate the Transition to a Low-Carbon Economy? A Critical Review of Policy and Market-Based Approaches Sara Lovisolo

8.1 The Paris Agreement: A Disruptive Legal Framework Focused on Impact The unanimous adoption of the Paris Agreement under the United Nations Framework Convention on Climate Change (UNFCCC) by the governments of 195 countries on 12 December 2015 marked the beginning of a policy-driven revolution aimed at undoing the effects of the market-driven Industrial Revolution that had anchored industrial output

S. Lovisolo (B) European Financial Reporting Advisory Group (EFRAG), Brussels, Belgium e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_8

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to the consumption of fossil fuels.1 The ambition of the “legal instrument” set out in Article 2 is to limit the global average temperature increase to “well below 2 degrees Celsius above pre-industrial levels” and to “pursue efforts to limit the temperature increase to 1.5 degrees Celsius above pre-industrial levels”. This temperature limit is complemented by Article 4.1, which clarifies its implications in terms of global greenhouse gas (GHG) emission reductions or mitigation commitments, with the final goal of achieving “a balance between anthropogenic emissions by sources and removals by sinks of greenhouse gases in the second half of this century”—usually referred to as carbon neutrality or “net zero”— “on the basis of equity, and in the context of sustainable development and efforts to eradicate poverty”. Achieving the objectives of the Paris Agreement furthermore requires the redirection of global financial flows in a way that is “consistent with a pathway towards low GHG emissions and climate-resilient development” (Article 2.1 (c)). The Paris Agreement is therefore a binding legal tool that enshrines in international law a commitment to achieving a specific environmental outcome. And this outcome—a means to the end of avoiding the existential humanitarian catastrophe associated with runaway climate change—has become the benchmark for environmental impact in public policy and finance. The fact that the focus is on an outcome and not on specific actions or inputs from governments makes the agreement particularly powerful, but also “dangerous” in its implications.

8.2 The Paris Agreement as a Threat to Financial Stability On 9 November 2015—and then on 4 December at a press event during the climate conference known as COP21 that was taking place in Paris—the Financial stability Board announced its decision to establish a task force with the aim of developing climate-related disclosures. The announcement2 stated that “policymakers have an interest in ensuring 1 For a historical framing of the Paris Agreement, see Klein, D., Carazo, M. P., Doelle, M., Bulmer, J., & Higham, A. (eds.). (2017). The Paris Agreement on Climate Change: Analysis and Commentary. Oxford University Press. 2 See Financial stability Board. (2015). Proposal for a Disclosure Task Force on Climate-Related Risks, available at https://www.fsb.org/wp-content/uploads/Disclosuretask-force-on-climate-related-risks.pdf.

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that the financial system is resilient to all forms of risk”. Possible climate-related risks fall into three broad categories: – Physical risks: the impacts on insurance liabilities and the value of financial assets that may arise from climate- and weather-related events, such as floods and storms that damage property or disrupt trade. In the financial sector, these losses have consequences most immediately for the insurance sector, but also extend more widely; – Liability risks: the impacts that could arise if parties who have suffered loss or damage from the effects of climate change seek compensation from those they hold responsible. Such claims could come decades in the future, creating liabilities for carbon extractors and emitters and their insurers; – Transition risks: the financial risks which could result from the process of adjustment towards a lower-carbon economy. Changes in policy, technology and physical risks could prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent. The abruptness with which such re-pricing occurs could influence financial stability. The suggestion that changes in policy could lead to an abrupt devaluation of a large range of financial assets or to the phenomenon of “stranded assets”, as the former Governor of the Bank of England and former Chair of the Financial stability Board has warned in an earlier speech,3 and that this could constitute a major financial stability risk was not supported by any evidence. The argument—as outlined in Mark Carney’s “tragedy of the horizon speech”—stated that if global average temperatures should be kept below 2 degrees Celsius above pre-industrial levels, the global economy would have to stay within a carbon budget and the reserves of oil and coal in excess of the carbon budget on which the current evaluation of extractive companies was based would be unburnable, and therefore the associated assets—equities, bonds and loans—would be stranded. While this outcome could be plausible under certain circumstances, how the exposure to stranded assets might lead to financial instability and systemic risk—that is contagion spreading through 3 See Carney, M. (2015). Breaking the Tragedy of the Horizon: Climate Change and Financial Stability, Bank of England, available at https://www.fsb.org/wp-content/upl oads/Breaking-the-Tragedy-of-the-Horizon---climate-change-and-financial-stability.pdf.

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the financial system from one institution to another—was not explained. But the announcement was nevertheless hailed by climate change activists and responsible investors alike as a Copernican revolution in the thinking around finance and climate change that did not require any further proof, but only action. Shifting the conversation from the influence, negative or positive, that the financial system can have on the environment and climate change to the impact that an unorderly transition to a low-carbon economy—mainly driven by policy interventions in the framework of the Paris agreement— drew the attention of the leaders of financial institutions, authorities and governments to a topic that had mainly been the preserve of NGOs.

8.3 Down the Financial Instability Route: Tools and Theoretical Frameworks The Task Force on Climate Related Financial Disclosures (TCFD)4 was set up in January 2016 and its recommendations were published in June 2017, after extensive consultation with the financial sector. As a voluntary framework for climate-related reporting from insurance undertakings, banks, investors and large listed companies, it provides high-level guidance and sector-specific indicators. One of its key recommended disclosures is the use of scenarios to stress-test the resilience to climaterelated risks of financial institutions and listed non-financial companies belonging to certain sectors. The tool fits perfectly well in the regulatory context of the Basel Accords for assessing the resilience of banks to financial shocks. The first attempt at testing the resilience of a financial system to climate-related risks was undertaken by the Dutch National Bank (DNB), where risk modelling was based on the Capital Asset Pricing Model (CAPM). The result of this analysis was that the impact of climaterelated risks on the Dutch financial system was manageable, as “losses for banks range between 1 percent of total stressed assets in the technology shock scenario and 3 percent in the double shock scenario” and “a substantial part of losses is due to the interest rate effect” down to

4 Industry-led, it was chaired by Michael Bloomberg and funded by Bloomberg Philanthropies. It was entirely a private sector effort.

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“holdings in government bonds with a long residual maturity and therefore a high duration”.5 From the perspective of capital charges, the loss would be limited even in the context of the most macroeconomically severe scenario: “the regulatory solvency ratio of Dutch insurers could decrease by up to 16 percentage points in the confidence shock scenario. On average, insurers in the Netherlands have a solvency ratio of about 179%. Since the minimum capital requirement is 100%, a loss of 16 percentage points is relatively small and manageable”.6 While the analysis from the DNB was welcomed as a sign that financial supervisory authorities were starting to take climate change and the Paris Agreement as a serious risk that requires action, it is also clear from the conclusions of the test that the gaps identified were minor and could be addressed by the integration of climate-related risks in the normal risk management process of the bank. As this translates into higher capital charges for riskier assets, and higher interest rates to pay for the higher capital charges, the risk management approach eventually will translate into a higher cost of capital for assets carrying higher risk due to their exposure to climate change.7 An alternative approach—which addresses some of the concerns raised by the DNB as to data availability and accuracy of forecasting—has been put forward by the Banks for International Settlement (BIS) by framing climate change as a “green swan” in a recent publication.8 To avoid downplaying the relevance of climate change as a financial stability risk, the BIS has pushed it back into the distant future and moved it from the domain of risks to the domain of uncertainty: “climate-related risks

5 See Vermeulen, R., Schets, E., Lohuis, M., Kölbl, B., Jansen, D.-J., & Heeringa, W. (2018). An Energy Transition Risk Stress Test for the Financial System of The Netherlands, Dutch National Bank, available at https://www.dnb.nl/binaries/OS_Transition%20risk% 20stress%20test%20versie_web_tcm46-379397.pdf. 6 See Vermeulen, R., Schets, E., Lohuis, M., Kölbl, B., Jansen, D.-J., & Heeringa, W. (2018). An Energy Transition Risk Stress Test for the Financial System of The Netherlands, Dutch National Bank, available at https://www.dnb.nl/binaries/OS_Transition%20risk% 20stress%20test%20versie_web_tcm46-379397.pdf, p. 25. 7 For a discussion of the cost of capital as the key transmission mechanism in the theory of change of sustainable finance; see Lovisolo, S. (2020). “EU Action Plan on Sustainable Finance: Cost of Capital, Impacts and Effectiveness”, Bancaria, January. 8 Bolton, P., Despres, M., Pereira Da Silva, L.A., Samama, F., & Svartzman, R. (2020). The Green Swan: Central Banking and Financial Stability in the Age of Climate Change, BIS, available at https://www.bis.org/publ/othp31.pdf.

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typically fit fat-tailed distributions: both physical and transition risks are characterised by deep uncertainty and nonlinearity, their chances of occurrence are not reflected in past data, and the possibility of extreme values cannot be ruled out”.9 This approach stands clearly in stark contrast with the scenario analysis framework which is based on the notion that future states can be modelled and sensitivity analysis can be carried out also for climate change. The approach adopted by the Intergovernmental Panel on Climate Change (IPCC), the climate-science body of the United Nations, is actually that climate change can be modelled and the economic and environmental outcomes associated with each pathway can be assessed, with probabilities associated with pathways and outcomes—thus firmly keeping climate change in the domain of risk, not uncertainty.10 The BIS, in contast, concludesthat “scenario-based analysis is only a partial solution to apprehend the risks posed by climate change for financial stability. The deep uncertainties involved and the necessary structural transformation of our global socioeconomic system are such that no single model or scenario can provide a full picture of the potential macroeconomic, sectoral and firm-level impacts caused by climate change”.11 Again, while the “green swan” concept has been commended in the responsible finance community as further recognition of the dramatic implications that climate change can unleash on the global economy and the existential threat it poses to humankind, its conclusion fundamentally points policy makers and supervisory authorities in the direction of other,

9 Bolton, P., Despres, M., Pereira Da Silva, L.A., Samama, F., & Svartzman, R. (2020). The Green Swan: Central Banking and Financial Stability in the Age of Climate Change, BIS, available at https://www.bis.org/publ/othp31.pdf, p. 18. 10 IPCC. (2018). Global Warming of 1.5°C: An IPCC Special Report on the Impacts of Global Warming of 1.5°C Above Pre-industrial Levels and Related Global Greenhouse Gas Emission Pathways, in the Context of Strengthening the Global Response to the Threat of Climate Change, Sustainable Development, and Efforts to Eradicate Poverty, available at https://www.ipcc.ch/site/assets/uploads/sites/2/2019/06/SR15_Full_Report_ High_Res.pdf. 11 Bolton, P., Despres, M., Pereira Da Silva, L.A., Samama, F., & Svartzman, R. (2020). The Green Swan: Central Banking and Financial Stability in the Age of Climate Change, BIS, available at https://www.bis.org/publ/othp31.pdf, p. 1.

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non-financial players—other than central banks—for effective solutions to the climate crisis.12 In the meantime, however, financial regulators in various jurisdictions have started to recommend or mandate climate stress-testing to their supervised entities. The European Banking Authority (EBA) launched a voluntary programme of climate risk sensitivity analysis for 2020, while announcing a climate-related disclosure framework would be made available by 2021. In particular, the EBA is expected to “develop common methodologies assessing the effect of economic scenarios on an institution’s financial position taking into account, inter alia, risks stemming from adverse environmental developments and the impact of transition risk stemming from environmental policy changes”.13 In December 2019, the Bank of England published a discussion paper setting out a proposal to use the 2021 biennial exploratory scenario (BES) to incorporate climate-related risks with the objective to “test the resilience of the largest banks, insurers and the financial system to different possible climate pathways and provide a comprehensive assessment of the UK financial system’s exposure to climate-related risks”.14 Finally, the Network for Greening the Financial System (NGFS), a group of central banks and financial supervisors focused on sustainable finance, in June 2020 published five climate scenarios. For each of them, multiple models were used to provide a range of estimates, with a view to “embracing the uncertainty inherent in scenario modelling”15 that so much concerned the proponents of the “green swan” theoretical framework. Only the outcomes of the stress-testing exercises being proposed, and the response that they will elicit from financial institutions, will demonstrate whether a risk approach to climate change is able to drive capital 12 In particular, the report suggests that the only effective solution to the problem is the introduction of a carbon price or tax. For a discussion of the main barriers to the implementation of an effective carbon pricing policy, see ibidem, pp. 6–8 and 72–75. 13 European Banking Authority. (2019). Action Plan on Sustainable Finance, available at https://eba.europa.eu/sites/default/documents/files/document_library//EBA% 20Action%20plan%20on%20sustainable%20finance.pdf. 14 Bank of England. (2019). The 2021 Biennial Exploratory Scenario on the Financial Risks from Climate Change, available at https://www.bankofengland.co.uk/paper/2019/ biennial-exploratory-scenario-climate-change-discussion-paper. 15 Network for Greening the Financial System. (2020). NGFS Climate Scenarios for Central Banks and Supervisors, available at https://www.ngfs.net/sites/default/files/med ias/documents/ngfs_climate_scenarios_final.pdf.

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flows away from assets with significant exposure to climate risks. But it is unlikely that this will lead to transformational changes in the financial system in and of itself.

8.4

Balancing Impact and Financial Stability in the EU Action Plan on Sustainable Finance (2018–2019): A Challenging Task

In March 2018, following the publication of the final report from the High-level Expert Group on Sustainable Finance, the European Commission announced its Action Plan on Financing Sustainable Growth16 (the Action Plan going forward), which encompassed ten high-level priorities supported by granular actions affecting the entire investment value chain, from end investors to listed companies. The Action Plan framed sustainable finance as a balancing act between “two urgent imperatives: (1) improving the contribution of finance to sustainable and inclusive growth by funding society’s long-term needs; (2) strengthening financial stability by incorporating environmental, social and governance (ESG) factors into investment decision-making”. The first imperative is expressed in impact terms, while the second one is concerned with financial stability. This section outlines the challenges posed to policy consistency by the attempt to cater simultaneously to these two imperatives. The first case in point is represented by the attempt made by the Commission to harmonise the impact principles of the Non-financial Reporting Directive (NFRD)17 with the financial stability principles of the TCFD. One of the key actions of the programme was the integration of the TCFD recommendations into the EU regulatory framework, to be achieved by adding a climate-related supplement to the Non-binding Guidelines supporting the Non-financial Reporting Directive, which had been adopted in 2014 and therefore before the Paris Agreement and the publication of the TCFD guidelines. In June 2019, the Commission 16 European Commission, Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions. Action Plan: Financing Sustainable Growth, 8 March 2018. 17 Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings.

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released a communication18 that constitutes an appendix to the Nonbinding Guidelines and only focuses on climate-related disclosures. As outlined by the Technical Expert Group on Sustainable Finance in its report19 to the Commission on which the communication was based, the original spirit of the NFRD was to integrate the customary financial materiality approaches with a “new element to be taken into account when assessing the relevance of non-financial information by referring to information ‘to the extent necessary for an understanding of the impact of (the company’s) activity’”. Making disclosures of the impact of a company on the environment and society legitimate was the main innovation brought to the disclosure regulatory space by the NFRD. When issuing its communication, the Commission was so worried that this innovative “impact” element might be lost when incorporating the TCFD framework, that it further spelled out what materiality means when sustainability disclosures are concerned. It inaugurated the concept of “double materiality” and clarified that “the materiality perspective of the Non-financial Reporting Directive covers both financial materiality and environmental and social materiality, whereas the TCFD has a financial materiality perspective only” (see also Fig. 8.1). These legal qualms are a clear sign of how problematic the “Copernican revolution” brought about by the TCFD can be for policy makers who have to build consensus with a broader range of stakeholders than just investors and providers of capital in general. And it is revealing of the primacy of the impact imperative that each and every indicator recommended by the Commission to substantiate climate-related disclosures is directly linked in the document to European Union environmental and climate policies, thus highlighting the alignment of disclosures to policy objectives, the vast majority of which pursue the European Union’s commitment under the Paris Agreement. A second example is provided by the proposal to establish a “green supporting factor”, similar to the SME supporting factor already included

18 Communication from the Commission, Guidelines on Non-financial Reporting: Supplement on Reporting Climate-Related Information, 24 June 2019. 19 Technical Expert Group on Sustainable Finance. (2019). Report on Climate-Related Disclosures, available at https://ec.europa.eu/info/files/190110-sustainable-finance-tegreport-climate-related-disclosures_en.

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Fig. 8.1 The double materiality perspective of the non-financial reporting directive in the context of reporting climate-related information (Source European Commission, Guidelines on non-financial reporting: Supplement on reporting climate-related information, 24 June 2019)

in the EU Capital Requirement Regulation,20 and announced by the Commission on the occasion of the One Planet Summit in Paris in December 2017, stating that the Commission is “looking positively” at the possible introduction of a “green supporting factor” in prudential rules to boost lending and investments in low-carbon assets.21 Analysis from the High-level Expert Group on Sustainable Finance (HLEG) established by the Commission to advise on how to scale up sustainable finance in Europe immediately signalled how theoretically difficult the proposal was. Clearly, the aim of the proposal was to achieve positive impact: “a green supporting factor could give a strong policy signal to re-engage the banking sector in its lending function for the economy after years of 20 Regulation (EU) 575/2013 (CRR) as amended. The SME supporting factor is introduced in Article 501. 21 High-level Expert Group on Sustainable Finance. (2018). Financing a Sustainable European Economy, available at https://ec.europa.eu/info/sites/info/files/180131-sustai nable-finance-final-report_en.pdf.

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tightening capital regulation. It would also reinstate an explicit purpose for banking in the current context, namely the pro-active pursuit of the EU’s sustainability and climate objectives, which go hand in hand with sustainable economic, social and environmental developments and for which large-scale investment and lending is necessary”.22 However, the HLEG continued, “financial stability is a prerequisite for sustainability; to safeguard both, capital requirements must remain risk-based. This means that several steps are needed to establish whether the basis for a risk-based change to capital requirements is in place”. Hence, based on this caveat, the Commission did not directly introduce the green supporting factor as a proposal in its Action Plan, but only tasked the European Banking Authority with carrying out research to assess the appropriateness of such supporting factor.23 The Commission is now persuaded that the introduction of a “green supporting factor” “calls for a better reflection of risks associated with climate and other environmental factors in prudential regulation with a careful calibration that would not jeopardise the credibility and effectiveness of the current EU prudential framework and its risk-based nature”.24 Whereas in the previous example, it was the focus on financial stability of the TCFD framework that risked jeopardising the impact nature of the NFRD, here on the contrary it is the impact objective of the green supporting factor that is framed as putting financial stability at risk. Another test bed for the difficult marriage between impact and financial stability is the identification of sustainability indicators for banks as part of Pillar 3 disclosures in the context of the Second EU Capital Requirement 22 Ibidem, p. 68—emphasis added. 23 See European Banking Authority. (2019). Action Plan on Sustainable Finance, avail-

able at https://eba.europa.eu/sites/default/documents/files/document_library//EBA% 20Action%20plan%20on%20sustainable%20finance.pdf, p. 7: the EBA is required “to assess whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified (as a component of Pillar 1 capital requirements). In particular, the EBA must assess: methodologies for the assessment of the effective riskiness of exposures related to assets and activities associated substantially with environmental and/or social objectives compared with the riskiness of other exposures; the development of appropriate criteria for the assessment of physical risks and transition risks; and the potential effects of a dedicated prudential treatment of exposures associated substantially with environmental and/or social objectives and activities on financial stability and bank lending in the Union”. 24 European Commission, Action Plan: Financing Sustainable Growth, 8 March 2018, p. 9. Emphasis added.

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Fig. 8.2 Direct and indirect effects of the choice of alternative KPIs in bank climate-disclosures (Source Lovisolo 2019)

Regulation (CRR II).25 The EBA will specify ESG indicators in a regulatory technical standard, with focus on physical and transition risks.26 While this exercise is still underway at the time of writing, the challenges posed by the availability—on the basis of global disclosure standards and market best practice—of indicators for climate-related risks and opportunities that aim for impact (such as the exposure of a bank’s loan book to green assets) and of risk-based indicators (such as the exposure of a loan book to assets in geographies with high risk of climate-related disasters). Trade-offs between financial stability and impact can be spotted at the micro-level for each possible indicator, in the same vein as the discussion on the “green supporting factor”. Without getting into too much technical detail around the individual possible indicators here,27 it is worth flagging that the fundamental question is again whether pursuing impact might eventually and indirectly lead to financial stability, and the pursuit of financial stability (as in the context of the TCFD framework) might eventually and indirectly lead to impact outcomes—and through which transmission mechanism or channels (see Fig. 8.2 for a visual representation of the analysis). We will see in the next section how the emergence of alternative regulatory frameworks—decidedly bent on impact and no longer reliant 25 Regulation (EU) 2019/876 (CRR2). 26 See European Banking Authority (2019), p. 12. 27 For a more detailed examination, see Lovisolo, S. (2019). “Climate-Related Indica-

tors for Banks: What Transmission Mechanism?”, in Proceedings from JRC-EBA Workshop on Banking Regulation and Sustainability, European Commission Joint Research Centre (JRC), 18–19 November 2019, available at https://publications.jrc.ec.europa.eu/reposi tory/bitstream/JRC119403/jrc_eba_workshop_-_report_final_version.pdf.

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on the notion of materiality as an informing principle—is reshaping the public and private sector discourse on the theory of change of sustainable finance, probably making the debate on financial stability a relic of the past.

8.5 Back to Impact: Emerging Regulatory Frameworks from the European Union New approaches to the integration of sustainability consideration in the financial services value chain have emerged from two key European Union regulations that form part of the Action Plan: the Taxonomy and the Disclosures regulations.28 The Disclosure Regulation is particularly important as it legally defines for the first time responsible investment, and it does so in impact terms: “‘sustainable investment’ means an investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities” (Article 2, emphasis added). The Taxonomy Regulation, by setting out a list of economic activities that significantly contribute to environmental objectives—and the associated technical screening criteria—further specifies what impact means and how it is achieved in the real economy. While significant contribution to an environmental or social objective is not required in the definition of responsible investment provided by the Disclosure Regulation, what both regulations share is the notion of “do no significant harm”. The Disclosure regulation states that “to ensure the coherent and consistent application of this Regulation, it is necessary to lay 28 Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment; and Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector, respectively.

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down a harmonised definition of ‘sustainable investment’ which provides that the investee companies follow good governance practices and the precautionary principle of ‘do no significant harm’ is ensured, so that neither the environmental nor the social objective is significantly harmed” (Recital 17, emphasis added). The Taxonomy Regulation clarifies that an economic activity should be eligible for inclusion in the EU Taxonomy if it significantly contributes to at least one of six stated environmental objectives, and it does “no significant harm” to any of the other five objectives, setting out “do no significant harm” criteria for each sector (these will be specified alongside the significant contribution screening criteria in the delegated acts, which will be based on the technical advice of the Technical Expert Group on Sustainable Finance29 ). The combination of (significant) contribution and the “do no significant harm” principle decouples sustainable finance from materiality and financial stability considerations, anchoring investment decisions (and conversely, disclosures) not to financial considerations but to benchmarks that are science-based first and then policy-driven. In the European Union, the benchmark is set by the EU Green Deal, i.e. by the commitment—agreed by EU Member States in December 2019—to achieve carbon neutrality for the European economy by 2050, and the EU Taxonomy is framed as the key tool of the Sustainable Europe Investment Plan announced in January 2020 in support of the EU Green Deal.30 The Taxonomy Regulation requires listed companies, banks and insurance undertakings31 to disclose their exposure to the green economy as defined by the EU Taxonomy, regardless of any materiality considerations. A further application of the EU Taxonomy and the “do no significant harm” principle regards the green recovery package—which included

29 Technical Expert Group on Sustainable Finance. (2020). Taxonomy Report Technical Annex, available at https://ec.europa.eu/info/files/200309-sustainable-finance-teg-finalreport-taxonomy-annexes_en. 30 See European Commission, Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions: The European Green Deal, 11 December 2019, available at https://ec.europa.eu/info/sites/info/files/european-green-deal-com munication_en.pdf. 31 The organisations falling within the scope of the NFRD, i.e. currently those with more than 500 employees.

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the new recovery instrument “Next Generation EU” worth e750bn32 — adopted by the European Commission on 27 May 2020 to respond to the economic implications of the 2020 COVID-19 pandemic. The package refers to a “Green Oath to do no harm” aimed at insuring that public investments drawn to accelerate the economic recovery are in line with the long-term objectives of the EU Green Deal. A similar approach—which distances itself from the financial stability principle as outlined by the TCFD—has been recently embraced for the first time by a few leading banks—often in response to shareholder pressure. Barclays, for example, had its “net-zero ambitions” approved at its annual general meeting in May 2020. In a statement to shareholders,33 the bank’s chairman commented: “This [resolution] commits the group to a strategy with targets for alignment of its entire financing portfolio to the goals of the Paris Agreement and I believe that this represents a substantial and necessary step on the journey to Barclays becoming one of the leading banks globally in addressing climate change”. In February 2020, the Royal Bank of Scotland announced that it will “stop lending and offering underwriting services to major oil and gas producers that do not have credible transition plans in line with Paris climate agreement targets, which aim to limit global heating to below 2 degree Celsius”. It also pledged to fully phase out coal financing by 2030 and is aiming to “at least halve” the climate impact of its lending activity by the end of the decade.34 The above examples of lending policies are in line with an impact approach—even a “do no significant harm” approach in the case of the phasing out of coal financing—rather than a financial stability or risk management framework.

32 See European Commission, The EU Budget Powering the Recovery Plan for Europe,

May 2020, available at https://ec.europa.eu/info/sites/info/files/factsheet_1_en.pdf. 33 Available at https://home.barclays/content/dam/home-barclays/documents/inv estor-relations/reports-and-events/AGM2019/RNS%20-%20Barclays%202020%20AGM% 20statements.pdf. 34 See The Guardian, 14 February 2020, available at https://www.theguardian.com/ business/2020/feb/14/rbs-will-stop-lending-to-energy-firms-without-climate-crisis-plan.

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8.6

Conclusions

The theory of change that posits the transition to a low-carbon economy as a threat to financial stability has been extremely successful since 2015 in mobilizing financial sector leadership and thinking in response to climate change. However, the transmission mechanism linking exposure to stranded assets with financial instability or systemic risk has not been clarified or modelled yet. Tools for the financial sector that are consistent with this risk management approach are still under development—such as scenarios to be used as a basis for climate stress testing. Therefore, the “threat to financial stability” theory might backfire where evidence is gathered that can falsify it. For example, if climate stress testing systematically confirms that banks are already well capitalised to address climate change risks and no action is required on their part, then a business-as-usual approach will be encouraged rather than urgent action to contrast the climate crisis. This article argues that emerging approaches or theories of change based on the impact of the financial sector on the real economy and the fight against climate change—such as those most recently sponsored by the European Union—stand better chances of driving consistent action from the financial sector in the pursuit of environmental outcomes in the framework of the Paris Agreement over the long term. The Paris Agreement commits governments to achieving a positive outcome. Supporting public policy and market-based frameworks in the financial sector should align to this overarching goal in aiming for a defined outcome by adopting an impact rather than a risk management approach. Risk management approaches could contribute to achieving impact in an indirect way—e.g. through the reduction of the cost of capital for sustainable assets—but the transmission mechanism from risk measures to impact is uncertain. Given the scale of the climate crisis the global economy is faced with, policy makers cannot afford false starts.

CHAPTER 9

Which Role for the Prudential Supervision of Banks in Sustainable Finance? Antonio Luca Riso

9.1

Introduction

Although there is no unique definition, in the EU context it may be relevant to recall that for the European Banking Authority (EBA) “Sustainable finance can be broadly understood as financing and related institutional and market arrangements that contribute to the achievement of strong, sustainable, balanced and inclusive growth, through supporting directly and indirectly the framework of the Sustainable Development Goals”,1 while for the Commission it also refers to the process of taking due account of environmental and social considerations in investment

1 European Banking Authority (2019), Action Plan on Sustainable Finance.

A. L. Riso (B) European Central Bank, Frankfurt, Germany e-mail: [email protected]

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_9

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decision-making.2 Environmental, social and governance (ESG) factors represent the three main pillars of sustainability, and it is becoming clearer and clearer how ESG factors may have a (positive or negative) impact on the financial performance or solvency of an entity,3 whose analysis lies at the heart of what we mean by “sustainable finance”. Among the other factors, environmental factors, and specifically environmentalrelated risks—intended as “risks posed by the exposure of financial firms and/or the financial sector to activities that may potentially cause or be affected by environmental degradation and actions taken to address these environmental challenges”—have traditionally been at the core of sustainable finance.4 This chapter focuses on a subset of environmental-related risks, i.e. climate-related risks—intended as those risks posed by the exposure of financial firms and/or the financial sector to physical or transition risks caused by or related to climate change and that could potentially impact the safety and soundness of individual financial institutions and have broader financial stability implications for the banking system.5 For the purposes of this analysis, recourse is made to a specific viewpoint, i.e. that of prudential supervision of the banking sector (whose supervised entities will be referred to as “banks” or “institutions”), which is uniquely positioned to mobilise capital to the green economy—especially in the EU—and in particular with regard to lending and investments in connection to renewable and clean energy projects and funding for infrastructure

2 European Commission (2018), “Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions - Action Plan: Financing Sustainable Growth (COM/2018/097 final)”. 3 European Banking Authority (2020), “Discussion Paper—On Management and

Supervision of ESG Risks for Credit Institutions and Investment Firms”. 4 Network for Greening the Financial System (2020), “Overview of Environmental Risk Analysis by Financial Institutions”. 5 Network for Greening the Financial System (2020), “Overview of Environmental Risk Analysis by Financial Institutions”; Basel Committee on Banking Supervision (2020), “Climate-related financial risks: a survey on current initiatives”.

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finance,6 which is of primary importance in the fight to climate change.7 This contribution to the debate aims to discuss how prudential supervision, in spite of several constraints and limits which need to be taken into account and highlighted, can effectively contribute to pursue the objective of sustainability in finance, and what has been done in this regard in the European Union. In line with the general focus of the book, the scope of the analysis is limited to the European Union—which unfortunately leaves out the experience of non-Western supervisors which present original features, also possible due to the specificities of the underlying financial systems.8 Moreover, although numerous national supervisors have been very active in carrying out policies in the field of environmental sustainability, reference to these practices will be episodic and anecdotal, due to the deliberate choice of privileging an analysis of the steps undertaken by the EBA and the European Central Bank (ECB), which are the two institutions dealing with prudential supervision of the banking sector within the EU at cross-border level, from a regulatory and supervisory perspective, respectively. The next section will start the analysis by a review of why environmental and climate-related risks matter from the perspective of prudential supervision. The following section focuses on the difficulties to comprehend and evaluate these risks from a prudential perspective, given the current stage of our knowledge. Next, the scope and limitations of prudential supervisors’ mandates are examined, against the background of the mentioned considerations and constraints. Finally, an overview is presented of how the supervisory expectations and review process should

6 Campiglio E., Dafermos Y., Monnin P., Ryan-Collins J., Schotten G., Tanaka M. (2018). “Climate Change Challenges for Central Banks and Financial Regulators”. Nature Climate Change, 8, 462–468; Alexander (2016), “Greening Banking Policy”, available at http://unepinquiry.org/wp-content/uploads/2016/09/10_Greening_Banking_Policy. pdf (accessed in September 2020). 7 European Banking Authority (2019), “Report on undue short-term pressure from the financial sector on corporations”. 8 Sustainable Banking Network (2019), “Global Progress Report of the Sustainable

Banking Network Innovations in Policy and Industry Actions in Emerging Markets”; Sustainable Banking Network (2020), “Necessary Ambition: How Low-Income Countries Are Adopting Sustainable Finance to Address Poverty, Climate Change, and Other Urgent Challenges”; Cambridge University (2014), “Stability and Sustainability in Banking Reform – Are Environmental Risks missing in Basel III?”.

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be conducted, in the current understanding of the EBA and the ECB, before concluding.

9.2 Climate-Related Risks and Prudential Supervision Although any contribution is necessary and welcome in the collective effort of contributing to climate change—of which also the act of reading and writing this book may be seen as a part, si parva licet —the real question that should be asked to everyone given the urgency and gravity9 of climate change is whether we are doing enough in this regard, and prudential supervision should not be exempted from being requested an answer.10 This section analyses the impact of climate change on the risks within the remit of the prudential supervisors’ competence, the inadequacy of current time-frames to capture these risks, and more generally the relation of these risks with the prudential framework. 9.2.1

The Risks Connected to Climate Change

To be able to answer the question of whether prudential supervision is doing enough to contribute to the collective effort required to effectively fight the challenges of climate change, first the problem at stake needs to be identified, to then consider whether prudential supervision is to any extent part of the problem and, even more importantly, whether it could be part of the solution, or in other words what should be the contribution of prudential supervision and prudential supervisors. Although the contributions of the two are closely interlinked, it may be worth noting that there is not a complete overlap, as there are objectives which can be pursued only through changes in prudential rules, and others that prudential supervisors may pursue also under the existing framework (this also relates to the discussion of what supervisors could do, i.e. what is

9 See European Parliament resolution of 28 November 2019 on the climate and environment emergency (2019/2930(RSP)). 10 Elderson, F. (2019). “Are we doing enough? Keynote speech by Mr Frank Elderson, Executive Director of Supervision of the Netherlands Bank, at the European Insurance and Occupational Pensions Authority (EIOPA) 9th Annual Conference, Frankfurt am Main, 19 November 2019”, available at https://www.bis.org/review/r191122j.htm.

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allowed under their current mandates, which is going to be analysed later). The challenges that climate change raises for our economic and financial system, and more broadly even for our civilisation and humankind, are extensively analysed also in other parts of this book. Nonetheless, it may be worth to briefly review the main elements of the issue at stake against the background of the particular mission and viewpoint of prudential supervisors. Although climate change has more prominently risen to the top of the global policy agenda only recently, a United Nations Framework Convention on Climate Change is already in force since 1994, following the 1992 Rio Convention and building up on the successful precedent of the Montreal Protocol of 1987. Binding emission reduction targets for Greenhouse Gases (GHG) have been agreed by several jurisdictions, including the European Union, in the context of the 1997 Kyoto Protocol first—which among other things introduced international emission trading which within the European Union is mirrored by the EU emissions trading system11 —and more recently in the context of the 2015 Paris Agreement, whose main aim is to hold global temperature below 2°C (and possibly below 1.5 degrees) above pre-industrial levels, but also making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.12 These objectives are underpinned by a broad consensus in the scientific community on the interrelations between anthropogenic greenhouse gas emissions and climate change, and the wider effects of the latter, as illustrated in the five assessment cycles (the sixth is ongoing) undertaken by the Intergovernmental Panel on Climate Change (IPCC) since its establishment in

11 See Commission Regulation EU No 389/2013 establishing a Union Registry pursuant to Directive 2003/87/EC of the European Parliament and of the Council, Decisions No 280/2004/EC and No 406/2009/EC of the European Parliament and of the Council and repealing Commission Regulations (EU) No 920/2010 and No 1193/2011. 12 See Article 2 of the Paris Agreement, in particular paragraph 1(a) and (c).

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1988.13 The binding nature of the international commitments undertaken by numerous jurisdictions (unless the binding feature of those commitments is disputed) allows to deem highly likely that several measures will be adopted at different levels—although probably also at different paces and in a relatively uncoordinated manner in the various involved jurisdictions—to deliver on the objectives of the Paris agreement. The adoption of these measures represents a risk for the financial system typically (but not only)14 because exposures to counterparties may be impaired and result in losses as a consequence of the fact that the assets and/or collateral of counterparties become ‘stranded assets’.15 Similarly, the compelling scientific evidence16 on which those commitments are based prospects the material risk that the effects of a rise in temperature may directly or indirectly result in the impairment of assets and businesses of financial entities and their counterparties, and ultimately

13 Intergovernmental Panel on Climate Change (2014), “Climate Change 2014 Synthesis Report. Contribution of Working Groups I, II and III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change”, available at https://www. ipcc.ch/site/assets/uploads/2018/02/SYR_AR5_FINAL_full.pdf (accessed in September 2020); Intergovernmental Panel on Climate Change (2018), “Global warming of 1.5°C. An IPCC Special Report on the impacts of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas emission pathways, in the context of strengthening the global response to the threat of climate change, sustainable development, and efforts to eradicate poverty”, available at https://www.ipcc.ch/site/assets/uploads/sites/ 2/2019/06/SR15_Full_Report_High_Res.pdf (accessed in September 2020). 14 There is, e.g. an operational risk element connected to the possibilities that banks’

assets and infrastructures are directly affected by the adverse effects of climate change. See below, Sect. 9.5.4. 15 Organisation for Economic Cooperation and Development (2015), “Divestment and Stranded Assets in the Low-carbon Transition- Background paper for the 32nd Round Table on Sustainable Development 28 October 2015 OECD Headquarters, Paris”, edited by Baron, Richard and Fischer, David; European Systemic Risk Board (2020), “Positively green: Measuring climate change risks to financial stability”; European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”. 16 Some still question in full or part the general consensus in the scientific community, or point to the fact that the possible negative side-effects of the strategies pursued to achieve a reduction in Greenhouse Gases (GHG) reduction may actually overcompensate the benefits achieved (Vidal O., Goffé B., Arndt N. (2013), “Metals for a low-carbon society”. Nature Geoscience 6,894–896; Mariutti E., (2020) “La grande eresia: la rivoluzione verde è un’enorme fake news?”. Econopoly https://www.econopoly.ilsole 24ore.com/2020/11/11/rivoluzione-verde-fake-news/?uuid=96_VO67c4cb. Accessed in November 2020).

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put in question the foundations of our civilisation or even human life on this planet.17 Most commentators agree indeed on the fact that two main channels of transmission of climate-related risk can be identified,18 which are, respectively, labelled as ‘physical risks’—i.e. those risks which arise from events which are directly related to climate change (floods, rising sea level) and which can directly impair the value of banks’ assets or collateral, or indirectly, e.g. by impairing business conditions for the real economy— and ‘transition risks’—i.e. risks resulting from the adjustment towards a lower carbon economy prompted by drivers such as changes in climate policy,19 technological advances or shifts in public sentiment, preference and expectations,20 or also reputational and legal risks due to the inability to avoid or minimise adverse impacts on the climate.21 Clearly, there is an inverse relationship between these two categories of risks, in the sense that a timely adoption of effective policies to contrast climate change would decrease the risks connected to the effects of climate change, and at the same time increase the risk that the current evaluations of many sector

17 “If there are 1 million species on the way out with the sixth mass extinction the real question is whether Homo Sapiens are going to be part of the next wave of extinction”, as it has been effectively put by H. Bruyninckx, executive director of the European Environment Agency in his contribution to the hearing of the European Parliament Committee on Environment, Public Health and Food Safety, available at https://multimedia.europarl.europa.eu/en/committee-on-enviro nment-public-health-and-food-safety_20210114-0900-COMMITTEE-ENVI_vd (accessed in January 2021). 18 Some identify a third transmission channel distinct from the other two, e.g. “liability risks”: e.g. Carney M. (2015), “Breaking the Tragedy of the Horizon – climate change and financial stability”. https://www.bankofengland.co.uk/-/media/boe/files/speech/ 2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-stability.pdf?la= en&hash=7C67E785651862457D99511147C7424FF5EA0C1A Accessed in September 2020. Most commentators tend however to include liability risks in the broader category of “physical risks”; ex multis: Network Green Financial System (2018), “First progress report”; European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”; European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”; European Systemic Risk Board (2020), “Positively green: Measuring climate change risks to financial stability”. 19 Network for Greening the Financial System (2018), “First progress report”. 20 Network for Greening the Financial System (2018), “First progress report”. 21 European Commission (2017), “Communication from the Commission — Guide-

lines on non-financial reporting (methodology for reporting non-financial information (C/2017/4234)”.

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of our economies are suddenly affected by decisive public action, while vice versa late or less decisive public action would smoothen the cliff for business models which are viable under the current regulatory framework (and would not, or would be less so under a different one), and at the same time maximise the risk of long-lasting and devastating consequences of climate change.22 9.2.2

The Tragedy of the Horizon and the Question of Short-Termism

The trade-off between the two options should leave little doubt as to the need to act decisively and without delay. At the same time, it needs to be acknowledged that this trade-off implies important redistribution effects within our current societies and also across generations.23 Also, the global and systemic nature of the problem is such that not necessarily the benefits of effective and timely actions are mainly enjoyed by those who undertake those actions, who in turn may suffer the negative consequences of the inaction of others. This is a well-known collective action problem known as ‘tragedy of the commons’.24 Mark Carney,

22 European Systemic Risk Board (2016), “Too late, too sudden: Transition to a lowcarbon economy and systemic risk”, Report of the Advisory Scientific Committee No 6 / February 2016, available at https://www.bis.org/review/r200804g.htm (accessed in September 2020). 23 Aglietta, M., Espagne, É. (2016). “Climate and Finance Systemic Risks, More Than an Analogy? The Climate Fragility Hypothesis”, available at http://www.cepii.fr/PDF_ PUB/wp/2016/wp2016-10.pdf; Ashford, N.A. (2007), “The Legacy of the Precautionary Principle In US Law: The Rise of Cost Benefit Analysis and Risk Assessment as Undermining Factors in Health, Safety and Environmental Protection”, in De Sadeleer N. (ed.), Implementing the Precautionary Principle Approaches from the Nordic Countries, EU and USA, 352–378; European Commission (2000), “Communication from the Commission on the Precautionary Principle. COM(2000) 1 Final.”; Haldane, A. (2013). “Why Institutions Matter (More Than Ever)”, available at https://www.bankofengland. co.uk/speech/2013/why-institutions-matter-now-more-than-ever (accessed in September 2020). 24 Forster Lloyd, W. (1832), “Two Lectures on the Checks to Population”, available at https://en.wikisource.org/wiki/Two_Lectures_on_the_Checks_to_Population (accessed in September 2020); Hardin, G. (1968), “The Tragedy of the Commons”. Science, 162, 1243–1248; Elinor Olstrom won however the Nobel Prize in 2009 for showing that when natural resources are jointly used by their users, in time, rules are established for how these are to be cared for and used in a way that is both economically and ecologically sustainable, although her studies were conducted in small, local communities.

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at the time Governor of the Bank of England, coined for the specific context of climate change the expression ‘tragedy of the horizon’, as “the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix means beyond”, including the time horizon of monetary policy extends (2–3 years), credit rating agencies (3–5 years) and financial stability (up to a decade).25 These time-horizons are further shortened by the shareholder value dominance on equity targets.26 Banks in particular tend to measure and manage risks within a short time frame, and their internal models seldom look beyond the next 12 months.27 Sustainability risks such as those related to climate change tend to have a time horizon of a generation (25 years) or more, which is significantly longer also than the duration of the business cycle (5–7 years) and of the credit cycle (10 years or more).28 Against this background, the question has been raised whether prudential supervision plays a role in skewing the time horizon of finance towards short-termism, and whether it could contribute to fight such short-termism. Beyond risks, also projects aimed at fighting (or adapting to) climate change tend to have a longer maturity than average, as they often are complex infrastructural project to which funds are channelled through project finance. Some of the reforms introduced in the Basel framework after the Great Financial Crisis of 2008 (s.c. Basel III) have raised criticism in particular because they provide incentives to reduce the duration of loans, both 25 Carney, M. (2015), “Breaking the Tragedy of the Horizon—Climate Change and Financial Stability”, available at https://www.bankofengland.co.uk/-/media/boe/ files/speech/2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-sta bility.pdf?la=en&hash=7C67E785651862457D99511147C7424FF5EA0C1A (accessed in September 2020). 26 Aglietta, M., Espagne, É. (2016). “Climate and Finance Systemic Risks, More Than an Analogy? The Climate Fragility Hypothesis”, available at http://www.cepii. fr/PDF_PUB/wp/2016/wp2016-10.pdf; Riso, A.L., Lackhoff, K. (2020), “Dividend Recommendation”, in Lackhoff K. (ed.), Banking Supervision and Covid-19. Nomos Verlag. 27 Enria, A. (2020), “ECB Banking Supervision’s Approach to Climate Risks— Keynote Speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the European Central Bank Climate and Environmental Risks Webinar”, available at https://www.bankingsupervision.europa.eu/press/speeches/date/2020/html/ssm.sp2 00617~74d8539eda.en.html (accessed in September 2020). 28 Alexander, S.K., Fisher, P. (2018), “Banking Regulation and Sustainability”, available at http://dx.doi.org/10.2139/ssrn.3299351 (accessed in September 2020).

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due to the lower risk weighting of short-term corporate loans compared to longer-term non-recourse project finance loans,29 and to the liquidity requirements which penalise the misalignment between the maturity of items on the assets and liabilities side (liabilities being generally more of a shorter-term nature) of banks’ balance sheets.30 The EBA, in a report which has been charged to deliver on the matter,31 has however found that there is limited short-termism which could be labelled as ‘undue’, although it also acknowledged that forms of short-termism apply to the banks themselves—profitability pressure, accounting rules, time-horizon of certain prudential requirements such as the Internal Capital Adequacy Assessment Process (ICAAP) or funding plans—to corporates as a consequence of the pressure exerted on them by banks, and to sustainable finance as a whole as sustainability factors are not considered in the treatment of funding.32 Although the Basel framework is well-designed to address various sources of risks for banks, including sustainability risks, climate change could be considered as an opportunity to broaden the horizons of the prudential framework to combine the current shortterm risk management tools with other tools to understand and manage longer-term risks.33 29 Cambridge University (2014), “Stability and Sustainability in Banking Reform—Are Environmental Risks Missing in Basel III?”. 30 D’Orazio, P., Popoyan, L. (2018), “Fostering Green Investments and Tackling Climate Related Financial Risks: Which Role for Macroprudential Policies?” Ruhr Economic Papers, No. 778, available at http://dx.doi.org/10.4419/86788906 (accessed in September 2020); Weitzman, M. (2013), “The Geo-Engineered Planet”. In PalaciosHuerta I. (ed.), One Hundred Years, 145–164. 31 In February 2019, the EBA received a call for advice from the Commission, as part of the Commission’s action plan on sustainable finance, see European Commission (2018), “Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions - Action Plan: Financing Sustainable Growth (COM/2018/097 final)”. 32 European Banking Authority (2019), “Report on undue short-term pressure from the financial sector on corporations”. 33 Enria, A. (2020), “ECB Banking Supervision’s Approach to Climate Risks— Keynote Speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the European Central Bank Climate and Environmental Risks Webinar”, available at https://www.bankingsupervision.europa.eu/press/speeches/date/2020/html/ssm.sp2 00617~74d8539eda.en.html (accessed in September 2020); Alexander, S.K., Fisher, P. (2018), “Banking Regulation and Sustainability”, available at http://dx.doi.org/10. 2139/ssrn.3299351 (accessed in September 2020).

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The Relationship Between Climate-Related Risks and the Prudential Framework

The size of the challenges which climate change implies for our societies at large is such that—as it has effectively been maintained—the risks for the financial sector may broadly speaking fall into three categories: risks stemming from disregard, from delay and from deficiency.34 Environmental and climate-related risks can be seen from a prudential perspective as the negative materialisation of environmental factors in the form of financial risks posed by banks’ exposures to counterparties that may be affected by (or contribute to) climate change.35 Looking at climate-related risks through the lenses of the prudential framework, the main question is whether and to what extent the latter is fit to understand and manage climate-related risks, or whether it needs to be changed for this purpose. A closely related question (one may say: the other side of the same question, which will be dealt with in more detail in the following paragraph) is whether, looking at the prudential framework through the lenses of sustainable finance, the prudential framework is fit enough to allow for the development of sustainable finance and thereby achieve a shift in the use of the resources of the financial sector towards the s.c. green economy and to serve the purpose of climate-change adaptation and mitigation, in line with the broader objective of the fight to climate change. The EU has approached the issue of climate change as an issue that can and should be solved by the market, in line with a general trend of environmental policies to shift from hierarchic governance to network and market governance.36 The cornerstone of this approach has been the establishment of a carbon emissions pricing scheme which has in turn resulted in policies mainly focussing on the demand rather than on the supply of credit, as it has been the case instead in emerging economies where there is a higher degree of control on the supply and allocation of 34 Lagarde, C. (2020), “Climate Change and the Financial Sector—Speech by Christine Lagarde, President of the ECB, at the launch of the COP 26 Private Finance Agenda”, available at https://www.ecb.europa.eu/press/key/date/2020/html/ecb.sp2 00227_1~5eac0ce39a.en.html (accessed in September 2020). 35 European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”. 36 Bouwma, I., Gerritsen, A., Kamphorst, D., Kistenkas, F. (2015), “Policy Instruments and Modes of Governance in Environmental Policies of the European Union”, available at https://edepot.wur.nl/373629 (accessed in September 2020).

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credit.37 The assumption that the market may deliver a solution to the management of climate-related risks is based on the model of the rational investor, and that the market, as an ‘epistemic device’, can evaluate and price any eventuality and risk, given full information.38 In this context, mispricing of climate-related risks may be mainly attributed to informational market failures stemming on the one hand from the absence of a clear, consistent and transparent globally agreed taxonomy (i.e. a list of criteria to identify activities that contribute to the achievement of sustainable objectives) and disclosure requirements, and on the other hand from the failure of market participants to correctly and fully price externalities and tail events that fall outside the historical distribution of outcomes.39 An approach based on the rational investor model and efficient market hypothesis has been however criticised by those who see the radical uncertainty inherently connected to climate change as precluding the capacity of financial markets to define common knowledge of fundamental values, and therefore the possibility to treat climate change as a negative externality, against which the society can insure itself: according to this view,

37 The ECB, the Federal Reserve (FED), the Bank of England (BoE), the Bank of Japan (BoJ) and other central banks of s.c. ‘advanced economies’ have preferred to use in the most recent decades the reference interest rate as main monetary policy instrument, allowing a better control on the interbank lending rate. The use of reserves by the central bank as a constraint to certain types of lending would be incompatible with the objective of stable interbank lending rates, as these depend on the central bank’s ability to satisfy any demand of reserves from the banking market, especially in case of liquidity stress: see Campiglio, E., Dafermos, Y., Monnin, P., Ryan-Collins, J., Schotten, G., & Tanaka, M. (2018), “Climate Change Challenges for Central Banks and Financial Regulators”. Nature Climate Change, 8, 462–468). See also Cullen, J. (2018), “After ‘HLEG’: EU Banks, Climate Change Abatement and the Precautionary Principle”. Cambridge Yearbook of European Legal Studies, 20, 61–87. 38 Cullen, J. (2018), “After ‘HLEG’: EU Banks, Climate Change Abatement and the Precautionary Principle”. Cambridge Yearbook of European Legal Studies, 20, 61–87. 39 Schnabel, I. (2020), “When Markets Fail—The Need for Collective Action in Tackling Climate Change—Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at the European Sustainable Finance Summit, Frankfurt am Main, 28 September 2020”, available at https://www.ecb.europa.eu/press/key/date/2020/html/ ecb.sp200928_1~268b0b672f.en.html (accessed in September 2020).

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possible negative future outcomes should be eliminated rather than internalised, since the whole distribution of potential damages should be considered, rather than their average probability.40 The options available to deal with climate-related risks in the field of prudential supervision may be seen as different steps of a continuum, going from the development of methodologies and tools to allowing a better understanding and management of the risks in question, the provision of incentives for banks to disclose the extent to which their exposures are affected by climate-related risks, and the implementation of prudential policy,41 which in turn can take the form of, e.g. specific capital surcharges based on the carbon intensity of individual exposures or large exposure limits applied to the overall investment in assets which are deemed highly vulnerable to climate-related risks,42 or an outright ban of certain activities. The role of prudential regulation is usually justified in economic theory by the existence of market failures arising from informational failures and competitive distortions, which in the absence of public interventions may result in the misallocation of capital to unsustainable economic activities, and may be seen as an application of the theory of the second best.43 Adequately representing climate-related risks in the balance sheets of banks allows an accurate pricing of these risks and is therefore consistent with the traditional approach to risks of prudential supervisions.44 40 Aglietta, M., Espagne, É. (2016). “Climate and Finance Systemic Risks, More Than an Analogy? The Climate Fragility Hypothesis”, available at http://www.cepii.fr/PDF_ PUB/wp/2016/wp2016-10.pdf (accessed in September 2020). 41 Campiglio, E. (2016). “Beyond Carbon Pricing: The Role of Banking and Monetary Policy in Financing the Transition to a Low-Carbon Economy”. Ecological Economics, 121, 220–230. 42 European Systemic Risk Board (2016), “Too late, too sudden: Transition to a lowcarbon economy and systemic risk”, Report of the Advisory Scientific Committee No 6 / February 2016, available at https://www.bis.org/review/r200804g.htm (accessed in September 2020). 43 Alexander, S.K. (2016), “Greening Banking Policy”, available at http://unepin quiry.org/wp-content/uploads/2016/09/10_Greening_Banking_Policy.pdf (accessed in September 2020); Volz, U. (2017), “On the Role of Central Banks in Enhancing Green Finance”, available at http://unepinquiry.org/wp-content/uploads/2017/02/On_the_ Role_of_Central_Banks_in_Enhancing_Green_Finance.pdf (accessed in September 2020). 44 Enria, A. (2020), “ECB Banking Supervision’s Approach to Climate Risks— Keynote Speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the European Central Bank Climate and Environmental Risks Webinar”, available

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Capital requirements have a large impact on the lending capacity of banks, and thereby on the possibility for corporates to carry out the investments needed to address climate-related risks as a consequence of a deterioration in their ability to borrow,45 and a change in the risk weighting of ‘green exposures’ has thus been advocated for, e.g. in the form of a green supporting factor (GSF) to favour green investments and loans.46 In response to that, caution has been called for by many influential voices when considering to adjust the capital framework for banks,47 or it has been suggested to give precedence to those options which would penalise exposures (by recurring to a s.c. ‘dirty penalising factor’, DPF) to sectors which are more prone to be affected by climate-related change, rather foreseeing for ‘green’ exposures more beneficial risk weights, which may however not be necessarily warranted from a prudential viewpoint,48 while some argue that actually climate-related risks may be considered at https://www.bankingsupervision.europa.eu/press/speeches/date/2020/html/ssm.sp2 00617~74d8539eda.en.html (accessed in September 2020). 45 Fraisse, H., Lé, M., Thesmar, D. (2017), “The Real Effects of Bank Capital Requirements”, ESRB Working Paper Series No 47/June 2017; Volz, U. (2017), “On the Role of Central Banks in Enhancing Green Finance”, available at http://unepinquiry.org/wp-content/uploads/2017/02/On_the_Role_of_Cent ral_Banks_in_Enhancing_Green_Finance.pdf (accessed in September 2020). 46 High Level Expert Group on Sustainable Finance (2018), “Financing a Sustainable European Economy. Final Report 2018 by the High-Level Expert Group on Sustainable Finance”; Dombrovskis, V. (2019), “Keynote Speech of VicePresident Valdis Dombrovskis on Challenges and Impacts of Implementing Basel III”, available at https://ec.europa.eu/commission/presscorner/detail/en/SPEECH_19_6269 (accessed in September 2020). 47 Carney, M. (2015), “Breaking the Tragedy of the Horizon—Climate Change and Financial Stability”, available at https://www.bankofengland.co.uk/-/media/boe/ files/speech/2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-sta bility.pdf?la=en&hash=7C67E785651862457D99511147C7424FF5EA0C1A (accessed in September 2020); Alexander, S.K., Fisher, P. (2018). “Banking Regulation and Sustainability”, available at http://dx.doi.org/10.2139/ssrn.3299351 (accessed in September 2020). 48 European Central Bank (2020), “Eurosystem reply to the European Commission’s public consultations on the Renewed Sustainable Finance Strategy and the revision of the Non-Financial Reporting Directive”; Boot, A., & Schoenmaker, D. (2018), “Climate Change Adds to Risk for Banks, but EU Lending Proposals Will Do More Harm Than Good”, Bruegel, available at https://www.bruegel.org/2018/01/climate-changeadds-to-risk-for-banks-but-eu-lending-proposals-will-do-more-harm-than-good/ (accessed in September 2020); Matikainen, S. (2017). “Green Doesn’t Mean Risk-Free: Why We Should Be Cautious About a Green Supporting Factor in the EU”, available

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under the current internal rating-based approach standards.49 While a DPF may aim at increasing minimum capital requirements to cover any unexpected losses due to climate risks (consistently with the general purpose of the prudential framework), higher capital requirements might not be sufficient to promote change in bank behaviours,50 and even more importantly (from a prudential perspective) their calibration would be affected by the huge uncertainty which exists with regard to the quantification of climate-related risks.51 Both a GSF and a DPF require as a precondition a taxonomy to distinguish green from carbon-intensive assets, since this would enhance transparency as to which activities respectively contribute to a transition to a greener economy and which ones are more exposed to climate and environmental risks.52 In this context, harmonisation and consistency across the various jurisdictions should be pursued, but more data and information would be needed to build a robust framework for the assessment of climate-related risks.53 Against this background, the adoption of an

at https://www.lse.ac.uk/granthaminstitute/news/eu-green-supporting-factor-bank-risk/ (accessed in September 2020). 49 Network for Greening the Financial System (2020), “A Status Report on Financial Institutions’ Experiences from working with green, non-green and brown financial assets and a potential risk differential”. 50 Given certain premises and the existence of certain constraints, it has been interestingly noted that certain assets on the banks’ balance sheets could behave similarly to “Giffen Good”, i.e. banks may actually have an incentive to hold more of these goods when their capital requirements risk weighting increases, see Corrias, R., & Neumann, T. (2015), “Are Mortgages Like Potatoes? Unintended Consequences in a World of Many Constraints”, available at https://bankunderground.co.uk/2015/07/30/are-mortgages-like-potatoes-uni ntended-consequences-in-a-world-of-many-constraints/#more-393 (accessed in September 2020). 51 Nieto, M.J. (2019), “Banks, Climate Risk and Financial Stability”, Journal of Financial Regulation and Compliance, 27(2), 243–262. 52 Bank for International Settlements (2020), “The green swan Central banking and financial stability in the age of climate change”; Network for Greening the Financial System (2018), “First progress report”; Network for Greening the Financial System (2019), “A call for action Climate change as a source of financial risk”. 53 Network for Greening the Financial System (2019), “A call for action Climate change as a source of financial risk”; Basel Committee on Banking Supervision (2020), “Climaterelated financial risks: a survey on current initiatives”.

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official taxonomy at EU level54 has been welcome as a step in the right direction in this context, it has also been noted that it would need to be complemented by a ‘carbon-intensive’ taxonomy.55

9.3

Epistemic Aspects of Climate-Related and Environmental Risks

A correct understanding of the factual circumstances affected by climate change and the risks which it generates is a precondition for the correct performance of their functions by prudential supervisors. This section therefore analyses in more detail the problems faced by prudential supervisors which are connected to the fact that we are still at an early stage of the necessary development of expertise and knowledge in this area. In the first place the scarcity of reliable data will be examined, then the existing tools for identifying and evaluating environmental and climaterelated risks will be illustrated, while at the end of the section the broader impact of uncertainty on the understanding by prudential supervisors of their role and mission is considered. 9.3.1

The Scarcity of Data

One of the main difficulties in the development of a risk analysis framework for climate-related risks stems from thedisclosure difficulty to correctly quantify these risks and identify the related transmission channels. Informational inefficiencies, mainly due to incomplete, insufficient and inconsistent, impair the financial markets’ ability to price the probability of climate-related risks, thereby also compromising the possibility to use past performance of greener firms to predict future developments—to the extent that climate risk does not appear to be fully reflected in asset prices so far.56 However, financial institutions should be very concerned 54 Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088 (the s.c. Taxonomy Regulation). 55 European Central Bank (2020), “Eurosystem reply to the European Commission’s public consultations on the Renewed Sustainable Finance Strategy and the revision of the Non-Financial Reporting Directive”. 56 European Systemic Risk Board (2020), “Positively green: Measuring climate change risks to financial stability”. First, very limited attempts to conduct backward-looking

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with the need to recalibrate and adapt their processes to properly reflect risks; otherwise, the risks are that markets (or supervisors) may suddenly do it for them.57 Being able to analyse and predict the way environmental factors affect (positively or negatively) banks’ (and more generally financial institutions’) counterparties is of crucial importance for assessing the soundness of financial institutions, because to the extent that these factors impact negatively counterparties (i.e. these factors are environmental or climate-related risks), they can materialise as prudential risks and affect the performance of banks (and other financial institutions) to different degrees, depending on a number of factors such as the type and size of assets and liabilities held, the business sector and activity of the counterparties as well as their geographical location.58 A framework for environmental risks analysis and management typically involves four steps: risk identification, measurement of risk exposure, risk assessment and risk mitigation.59 Clearly, it is extremely difficult to develop and implement such a framework if the first of the steps which it implies is hampered by the unavailability of reliable information and data. For the sake of completeness, it should however be mentioned that several other barriers exist (calling therefore for the intervention of regulators) to a wider adoption by financial institutions of Environmental Risk Assessments (ERA), i.e. practices which are aimed at identifying, pricing and managing climate-related (and more broadly environmental) risks, including a lack of clear and consistent policy signals, limited methodologies and relevant data capacity limitations within financial institutions,60

studies on a potential risk differential between brown and green assets failed to reach strong conclusions: Network for Greening the Financial System (2020), “A Status Report on Financial Institutions’ Experiences from working with green, non-green and brown financial assets and a potential risk differential”. 57 Elderson, F. (2019), “We All Play a Vital Role, Keynote Speech by Mr Frank Elderson, Executive Director of Supervision of the Netherlands Bank, at the International Capital Markets Conference, Frankfurt am Main, 30 August 2019”, available at https://www.bis.org/review/r190904c.htm (accessed in September 2020). 58 European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”. 59 Network for Greening the Financial System (2020), “Overview of Environmental Risk Analysis by Financial Institutions”. 60 G20 Green Finance Study Group (2017), “G20 Green Finance Synthesis Report”.

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limited capacity to develop ERA methodologies, lack of awareness of environmental risks and appreciation of their relevance.61 9.3.2

The Quest for the Identification of Climate-Related and Environmental Risks

The lack of appropriate disclosure renders publicly available environmental-related data (i.e. those data which are provided and reported by non-financial entities) even more important for the purposes of risk analysis and management, and has therefore prompted the community of prudential supervisors (alongside central banks) to acknowledge the need to build in-house capacity in this regard, and cooperate also with other stakeholders to develop a shared understanding of how climaterelated factors affect financial risks.62 The lack of or difficulty to access data such as physical asset level environmental data, water stress, natural disaster probabilities, energy demand shifts, changes in technology or consumption patterns, use and availability of renewable resources, costs of pollution and environmental remediation, limits the ability of banks and financial markets at large to analyse and manage environmental risk exposure, and at the same time hinders the reallocation of resources towards “greener” investment opportunities.63 The efforts to establish an enhanced disclosure framework at global level, building on the Recommendations of the TFCD,64 will be of fundamental importance to achieve more standardisation and overcome the lack of harmonised data which is one of the main obstacles to define the “greenness” of an asset, together with the limitations and inconsistencies

61 Network for Greening the Financial System (2020), “Overview of Environmental Risk Analysis by Financial Institutions”. 62 Network for Greening the Financial System (2019), “A call for action Climate change as a source of financial risk”; De Nederlandse Bank N.V. (2017), “Waterproof - An exploration of climate-related risks for the Dutch financial sector”. 63 G20 Green Finance Study Group (2017), “G20 Green Finance Synthesis Report”. 64 Task Force on Climate-Related Financial Disclosure (2017), “Recommendations of

the Task Force on Climate-Related Financial Disclosure”.

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of current taxonomies.65 An enhanced disclosure of the carbon intensity of non-financial firms will allow reassessing the exposures of financial institutions against this value.66 The importance of the issue has not been disregarded by the EU institutions, as witnessed by the requirement introduced since 2018 for large public interest entities to disclose material information on key environmental, social and governance aspects and how risks stemming from them are managed,67 as well as the consideration given to the possible need for adaptations of the International Financial Reporting Standards (IFRS) framework68 where needed to grant flexibility.69 In parallel, financial institutions are becoming themselves progressively subject to mandatory disclosure requirements, including in the EU.70 Unless and until when disclosure improves, market discipline is unlikely to provide incentives to address climate-related risks, and therefore taxonomies can play a crucial role in this respect.71 The development of a unified EU classification system has been identified as a cornerstone 65 Network on Greening the Financial System (2020), “A Status Report on Financial Institutions’ Experiences from working with green, non- green and brown financial assets and a potential risk differential”. 66 European Systemic Risk Board (2016), “Too late, too sudden: Transition to a low-

carbon economy and systemic risk”, Report of the Advisory Scientific Committee No 6 / February 2016, available at https://www.bis.org/review/r200804g.htm (accessed in September 2020). 67 Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups (the s.c. non-financial reporting directive). 68 See European Parliament resolution of 6 October 2016 on International Financial Reporting Standards: IFRS 9 (2016/2898(RSP). 69 European Commission (2018), “Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions - Action Plan: Financing Sustainable Growth (COM/2018/097 final)”. 70 Basel Committee on Banking Supervision (2020), “Climate-related financial risks: a survey on current initiatives”; See, e.g. new Article 449a Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and amending Regulation (EU) No 648/2012 (CRR). 71 De Guindos, L. (2019), “Implications of the Transition to a Low-Carbon Economy for the Euro Area Financial System—Speech by Luis de Guindos, VicePresident of the ECB, at the European Savings and Retail Banking Group Conference, Creating Sustainable Financial Structures by Putting Citizens First”, available at

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of the EU Action Plan for Financing Sustainable Growth,72 also as a first step towards developing in the future-specific labels and standards facilitating the reallocation of resources within the market while at the same time protecting market integrity and trust. The EU taxonomy73 is implemented via a set of granular criteria for economic activities being considered as sustainable.74 9.3.3

Methodological Approaches to Risks Evaluation

Taxonomies and other indicators can be extremely useful to identify climate-related and environmental risks, especially in this phase where our knowledge of the matter is still limited. However, risk identification is only a part of the process, which needs to be completed with a second stage, whereby these risks, once identified, are evaluated and assessed. For this purpose, at least three different methodologies exist, each one with benefits and shortcomings.75 A first method, which is known as ‘portfolio alignment’, relies on the use of tools to benchmark in quantitative or qualitative terms to display the extent to which the composition and structure of a portfolio as a whole is in line with certain policy objectives. This method therefore probably is the one which can best serve the purpose of implementing targets relating to the fight to climate change. At the same time, since it targets the portfolio as a whole, it may include assets which greatly differ in the contribution which they provide to the achievement of the pursued targets (provided that the negative effects of some assets are offset by the positive effects of others). Even more importantly, this method does not capture the relationship between climate-related risks and traditional https://www.ecb.europa.eu/press/key/date/2019/html/ecb.sp191121_1~af63c4de7d. en.html (accessed in September 2020). 72 European Commission (2018), “Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions - Action Plan: Financing Sustainable Growth (COM/2018/097 final)”. 73 The adoption of EU taxonomy Regulation is a key milestone in defining legally sustainable activities. 74 European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”. 75 European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”.

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prudential categories, e.g. by attempting to quantify (for each asset) the probability of default (PD) or the loss given default (LGD). A second method is the s.c. ‘exposure method’, which has the benefit of simplicity, in that it is based on an assessment of the materiality of the impact of ESG risks on each exposure and does not require any assumptions on future developments of the surrounding environment. This assessment can be delivered by banks themselves but also by specialised rating agencies. Its reliability crucially depends on the availability of (granular) data, but while the quality and quantity of these data can increase over time, a shortcoming which is built in this methodology is that it is mostly backward looking by design, and it would therefore not be well-suited for assessing the potential effects of future shocks. A third method, somewhat in between the first two, is the s.c. ‘risk framework method’, whereby the design of future scenarios is the forward looking component, while the rest of the exercise is fundamentally backward looking, as it is based on the impact of these future scenarios on current exposures. The most important limitation of this methodology is that it does not necessarily ensure at any point in time a specific contribution by banks to the delivery of global targets (differently e.g. from the portfolio alignment methodology). Within the risk framework method, stress testing in particular has been prospected and explored as a promising tool to improve the understanding of climate-related risks.76 Although the granularity of data available represents, as mentioned, the most important limitation to the effectivity of these exercises, also the difficulty in designing a scenario should not be underestimated.77 While the hypothesis of a late and 76 European Systemic Risk Board (2016), “Too late, too sudden: Transition to a low-carbon economy and systemic risk”, Report of the Advisory Scientific Committee No 6 / February 2016, available at https://www.bis.org/review/r200804g.htm (accessed in September 2020); De Nederlandse Bank N.V. (2017), “Waterproof - An exploration of climate-related risks for the Dutch financial sector”; Bank of England (2019), “The 2021 biennial exploratory scenario on the financial risks from climate change – Discussion Paper”, available at https://www.bankofengland.co.uk/-/media/boe/files/paper/2019/ the-2021-biennial-exploratory-scenario-on-the-financial-risks-from-climate-change.pdf?la= en&hash=73D06B913C73472D0DF21F18DB71C2F454148C80 (accessed in September 2020); Basel Committee on Banking Supervision (2020), “Climate-related financial risks: a survey on current initiatives”; Bank for International Settlements (2020), “The green swan Central banking and financial stability in the age of climate change”. 77 De Guindos, L. (2019), “Implications of the Transition to a Low-Carbon Economy for the Euro Area Financial System—Speech by Luis de Guindos, Vice-President of the

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sudden transition may be considered as a plausible starting point,78 the difficulty to establish assumptions under uncertainty in relation to factors such as the time horizon, the discount rate, the evolution of policies and technologies should not be underestimated, also given the lack of historical precedents and the possibility of major and irreversible changes—therefore knowledge building and exchange of views and information among relevant stakeholders are once again a factor of primary importance.79 An element which could facilitate the deployment of this methodology is that stress tests are already foreseen in the EU framework under the Capital Requirement Directive (CRD) as a an element in the prudential supervisors’ toolkit to determine whether the arrangements, strategies, processes and mechanisms implemented by institutions and the own funds and liquidity held by them ensure a sound management and coverage of their risks.80 9.3.4

The Level of Uncertainty: A Role for the Precautionary Principle?

The emphasis on the need to gather data is used as an argument by those who argue the need to provide evidence supporting certain courses of policy action with regard to the management of climate-related risks is used as an argument, as well as by those who invoke the application of the precautionary principle in the field of prudential regulation to cope with climate-change risks. The precautionary principle is indeed ECB, at the European Savings and Retail Banking Group Conference, Creating Sustainable Financial Structures by Putting Citizens First”, available at https://www.ecb.europa.eu/ press/key/date/2019/html/ecb.sp191121_1~af63c4de7d.en.html (accessed in September 2020); Giuzio, M., Krusec, D., Levels, A., Melo, A-S., Mikkonen, K., & Radulova, P. (2019), “Climate Change and Financial Stability”, ECB Financial Stability Review, May. 78 European Systemic Risk Board (2016), “Too late, too sudden: Transition to a lowcarbon economy and systemic risk”, Report of the Advisory Scientific Committee No 6 / February 2016, available at https://www.bis.org/review/r200804g.htm (accessed in September 2020). 79 Network on Greening the Financial System (2018), “First progress report”; De Nederlandse Bank N.V. (DNB 2017), “Waterproof - An exploration of climate-related risks for the Dutch financial sector”. 80 Articles 97 and 100 of Directive EU/2013/36 of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (CRD).

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the founding principle on which the EU policy on the environment is based in accordance with Article 191 Treaty on the Functioning of the European Union (TFEU), and the Commission already in 2000 clarified that in its opinion the scope of application of this principle should not be considered as limited to this Union policy only.81 In line with the principle of precaution, prudential regulators and supervisors should be alert of the limitations of their knowledge, and in situations where it is rather challenging for regulators and supervisors to pursue an evidence-based approach in relation to extremely rare events with extreme consequences—the s.c. black swans—certain activities could and should be prohibited by default, while financial institutions would have the burden of proof as to their compatibility with a sound management of climate-related risks.82 From an epistemic point of view, climate change would put in question the foundations on which the legitimacy of technical authority such as prudential supervisors is grounded,83 i.e. the mandate to deal with specific risks based on a specific expertise, or at least their current modus operandi. This is due to the fact that the nature of risks that they are mandated to supervise has to some extent shifted from risks (where events are uncertain but probabilities are known) towards uncertainty (where probabilities are unknown),84 or according to another classification, from uncertainty (where the precise identification of a probability distribution is difficult due to a lack of information, contrasting evidence or unclear causality nexuses) towards indeterminacy (the area of the ‘known unknown’) or 81 European Commission (2000), “Communication from the Commission on the Precautionary Principle. COM(2000) 1 Final”. 82 Cullen, J. (2018), “After ‘HLEG’: EU Banks, Climate Change Abatement and the Precautionary Principle”. Cambridge Yearbook of European Legal Studies, 20, 61–87; I. Webb, D. Baumslag R. Read (2017), “How should regulators deal with uncertainty? Insights from the Precautionary Principle”, available at https://bankunderground.co.uk/2017/01/27/how-should-regulators-deal-withuncertainty-insights-from-the-precautionary-principle/ (accessed in September 2020). 83 On the need for epistemological breaks, see Svartzman, R., Bolton, P., Despres, M., Pereira Da Silva, L. A., Samama, F. (2020), “Central Banks, Financial Stability and Policy Coordination in the Age of Climate Uncertainty: A Three-Layered Analytical and Operational Framework”. Climate Policy. 84 Majone, G. (2002), “What Price Safety? The Precautionary Principle and Its Policy Implications”. Journal of Common Market Studies, 40(1), 89–109; Sunstein, C. (2003), “Beyond the Precautionary Principle”. University of Pennsylvania Law Review, 151, 1003– 1058.

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even ignorance (the area of the ‘unknown unknown’).85 In those cases where no uncertainty exists, an application of the precautionary principle to decision-making is the s.c. minimax, according to which among the various policy options available that (or those) whose worst case is the least bad should be identified and preferred.86 Proponents of the tradeoff methodology maintain that the cost-benefit analysis, as the intellectual device generally used in the design of public policies, would by design be inadequate to allow a proper comprehension of the problems at stake and to inform an appropriate course of action in that regard. In particular, cost-benefit analysis is accused of delivering results which, while optimising the cost aspects, may be blatantly inconsistent with the ranking of priorities and values which are set at the beginning of the decision-making process. An additional shortcoming of the cost-benefits analysis is that it would hide the distributional effects of the various policy options, and in the context of the redistribution of costs across generations, would be inherently biased against future generations, due to the discounted present value of future benefits. The other face of the same coin is that the consistency of a simple, bi-dimensional model such as the cost-benefits analysis is replaced by a multi-layered and multifaced complex framework which complicates both decision-making and communication to the public, since accounting synthesis is to be replaced by accountability efforts, as it has been effectively summarised.87 The complexity of an analytical and more comprehensive framework raises however risks of inconsistency, given that the application of the precautionary principle renders it more difficult to be conservative in a consistent manner in the situations of uncertainty which lie at the core of risk regulation, and that the latter is incompatible with an aim of 85 Ashford, N.A. (2007), “The Legacy of the Precautionary Principle in US Law: The Rise of Cost Benefit Analysis and Risk Assessment as Undermining Factors in Health, Safety and Environmental Protection”, in De Sadeleer N. (ed.), Implementing the Precautionary Principle Approaches from the Nordic Countries, EU and USA, 352–378. 86 Majone, G. (2002), “What Price Safety? The Precautionary Principle and Its Policy Implications”. Journal of Common Market Studies, 40(1), 89–109; Sunstein, C. (2003). “Beyond the Precautionary Principle”. University of Pennsylvania Law Review, 151, 1003– 1058. 87 Ashford, N.A. (2007), “The Legacy of the Precautionary Principle In US Law: The Rise of Cost Benefit Analysis and Risk Assessment as Undermining Factors in Health, Safety and Environmental Protection”, in De Sadeleer N. (ed.), Implementing the Precautionary Principle Approaches from the Nordic Countries, EU and USA, 352–378.

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zero risk which could be used to prohibit probably any human activity— although unbounded losses (of the kind generated by a serious and irreversible damage, such as the one that climate change could bring about) break down the traditional tools of decision theory.88 In the view of the Commission, indeed the application of the principle of precaution should not aim at zero risk nor lead to the adoption of disproportionate measures, and as pertaining to the domain or risk management rather than that of risk assessment, it should be based on a scientific assessment as comprehensive as possible so as not to limit the number of options available to the decision-maker.89 In reality it should indeed be highlighted that as science progresses, and our knowledge of climate-related risks improves, many of these risks which are now in the area of uncertainty are going to shift over time from the area of uncertainty to that of proper risks—or according to another classification, from the area of indeterminacy to that of uncertainty—thereby reducing the scope of application of the precautionary principle.90

9.4

The Mandate of Prudential Supervisors

The question of the mandate of prudential supervisors is of crucial importance to consider the delicate issue of the delimitation of technocratic competences vis á vis the prerogatives of elected politicians in democratic regimes, the actual possibilities for prudential supervisors to act within the limits of their current scope of competences, and the possible need for changes to address resulting shortcoming. These three issues are considered below in this order. 9.4.1

The Thin Divide Between Politics and Policies

A discussion on the application of the principle of precaution to and by prudential supervisors when dealing with climate-related risks inevitably 88 Majone, G. (2002), “What Price Safety? The Precautionary Principle and Its Policy Implications”. Journal of Common Market Studies, 40(1), 89–109. 89 European Commission (2000), “Communication from the Commission on the Precautionary Principle. COM(2000) 1 Final.”. 90 Sunstein, C. (2003), “Beyond the Precautionary Principle”. University of Pennsylvania Law Review, 151, 1003–1058.

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leads to a wider discussion on the limits and scope of their mandate, and what, pursuant to the latter, prudential authorities are allowed to do to effectively tackle climate-related risks and at the same time pursue the development of sustainable finance. The fact that these elements are clearly interrelated, but not identical nor completely overlapping, is a first element which needs to be highlighted in this context. An even more important consideration from a constitutional viewpoint is that if measures addressing climate change are inherently redistributive in nature, the task to adopt them should rest with democratically elected governments which are generally competent to adopt fiscal measures, while authorities with responsibilities for the soundness of the financial sector should only play a supporting role and in particular ensure that the financial system is resilient to any transition hastened by those decisions, and is able to finance the transition efficiently.91 In democratic societies, technocracies are exceptions to the general principle that the vote of the people is the source of legitimation of public power.92 Such an exception is allowed because certain problems require specific and specialised technical expertise which go beyond day-to-day politics and need to be protected from the latter. This is also to address the short-term bias of elected politicians, who by necessity focus on the time horizon of the electoral cycle, while certain issues require the development and implementation of long-term policies. Considerations which have been illustrated above such as the lack of reliable data, the need to develop appropriate methodologies and the

91 European Central Bank (2020), “Eurosystem reply to the European Commission’s public consultations on the Renewed Sustainable Finance Strategy and the revision of the Non-Financial Reporting Directive”; Carney, M. (2015), “Breaking the Tragedy of the Horizon—Climate Change and Financial Stability”, available at https://www.bankof england.co.uk/-/media/boe/files/speech/2015/breaking-the-tragedy-of-the-horizon-cli mate-change-and-financial-stability.pdf?la=en&hash=7C67E785651862457D99511147C 7424FF5EA0C1A (accessed in September 2020). 92 Riso, A.L., Zagouras, G. (2020), “Single Supervisory Mechanism (SSM)”, in Grieser S.G. and Heemann M. (eds.), Europäisches Bankaufsichtsrecht, 71–110; Zilioli, C., Riso, A.L. (2018), “New Tasks and Central Bank Independence: the Eurosystem Experience”, in Lastra R. M. and Conti-Brown P. (eds.), Research Handbook on Central Banking, 155–183; Haldane, A. (2013), “Why Institutions Matter (More Than Ever)”, available at https://www.bankofengland.co.uk/speech/2013/why-instituti ons-matter-now-more-than-ever (accessed in September 2020); Zulianello, M., Ceccobelli, D. (2020), “Don’t Call It Climate Populism: On Greta Thunberg’s Technocratic Ecocentrism”. The Political Quarterly, 91(3), 623–631.

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uncertainty as to whether the approach to risk mitigation should or should not be informed by the principle of precaution are all elements which may undermine the argument that technical institutions are better equipped at dealing with these problems than elected politicians by virtue of their technical expertise, and therefore particular caution would be necessary regarding the use of this argument at least as long as these issues are not settled. On the other hand, climate change is clearly a phenomenon which requires policies with a long-term horizon, and these policies in turn trigger inevitable trade-offs between the present generations, which are by definition better represented in the electoral process and which benefit of market evaluations which understate risks for the future, and future generations which would benefit of risk-mitigation measures and from the intervention of independent institutions. The management of climate-related risks is no exception to this kind of dynamics and has an inherent redistributive component (across generations) which relates to the time horizon aspects. In turn, policies aiming at mitigating climate (changes and) risks are inherently redistributive not only because they aim at frontloading the costs of climate change to the benefit of future generations (and hence at least in part to the expense of current ones), but also because they can render economically viable and accelerate technological changes and accompany shifts in market preferences determining who will be the winners and losers of tomorrow among the economic actors of today. The adoption and implementation of these policies therefore constitute for those economic actors a risk which can be included under the label of “transition risk”, as discussed above. There may therefore be a logical contradiction if the same authorities which are mandated to control certain categories of risks (including transition risks) are also (among) the main sources of those risks: as a minimum there would be a conflict of interests between the two functions (control of transition risks and enactment of policies in support of sustainable finance which underlie that risk), and the probabilities of dominance of one on the other would be too high. The insufficiency of financial incentives to reduce emissions can be considered as part of the slow pace of transition to a low carbon economy so far, and it is therefore not unconceivable that discretionary government spending may at some point be used to stimulate “green” demand,

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beyond the use of carbon pricing to penalise polluters.93 The relationship between governments and the financial system (and the authorities that regulate and supervise the latter) is also important in so that while the real economy cannot shift enough without the help of the financial sector, the latter cannot act fast without the help of governments, which in particular includes the adoption of long-term and unambiguous legislation to create clarity on the strategy to tackle climate change.94 In turn an early start of governments in the adoption and implementation of their plans increases the likelihood of a smoother transition and therefore lower transition (but also physical) risks.95 9.4.2

The Current Scope of Prudential Mandates

While the above considerations may give some indications with a view to delimit what prudential supervisors cannot or should not do, in particular in their relationship with governments, they fall short of providing clarity on what prudential supervisors can or should do to respond to the challenges of climate changes. The lack of clarity, or at least the inexistence of a consensus on what the mandate of prudential authorities should be in this regard is confirmed by a survey recently conducted among those prudential authorities by the Basel Committee on Banking Supervision (BCBS), according to which a large majority of them does not have an explicit mandate with regard to climate-related risks—although most of

93 Elderson, F. (2020), “We Should Aim for a 1.5 Degree Economy When Designing the Recovery Path—Speech by Mr Frank Elderson, Executive Director of Supervision of the Netherlands Bank, at the OECD Committee on Financial Markets Webinar, 1 July 2020.”, available at https://www.bis.org/review/r200804g.htm (accessed in September 2020). 94 Elderson, F. (2019), “We All Play a Vital Role Keynote Speech by Mr Frank Elderson, Executive Director of Supervision of the Netherlands Bank, at the International Capital Markets Conference, Frankfurt am Main, 30 August 2019”, available at https://www.bis. org/review/r190904c.htm (accessed in September 2020). 95 European Systemic Risk Board (2016), “Too Late, Too Sudden: Transition to a LowCarbon Economy and Systemic Risk”, Report of the Advisory Scientific Committee No 6 / February 2016, available at https://www.bis.org/review/r200804g.htm (accessed in September 2020).

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them also considered that these risks fall implicitly within their existing regulatory and supervisory framework.96 The contours of this discussion are partly blurred by the fact that the functions of prudential supervisors and central banks are often hosted within the same institution, therefore some of the considerations which are made for central banks also apply to prudential supervisors, at least to some extent. Certainly prudential supervisors, like central banks, can and should play a role of catalysts in the transition of the financial system towards sustainability. The Bank for International Settlements (BIS) has described this catalyst function with five Cs: “contribute to coordination to combat climate change”, a function which is seen as stretching to the contribution to the necessary adaptations of prudential regulation.97 The most difficult question to answer relates to what prudential supervisors are allowed or mandated to do beyond acting as an advisor and a facilitator in such a catalyst function. Although it cannot be excluded that governments entrust prudential supervisors with a more active role in this field as a result of and as a reaction to a market failure in the allocation of credit, the risk of a disproportion and mismatch between the number of objectives and tools available98 should be highlighted, as well as the (already mentioned) possible concerns for vesting too much power—and quasifiscal competences—with unaccountable institutions.99 In addition, these considerations do not help in answering what can or should be done as long as the objective to contribute to the transition of the financial system is included in the mandate of supervisors. To address these questions and concerns it is therefore necessary to briefly consider what the original mandate and objectives of prudential supervisors are.

96 Basel Committee on Banking Supervision (2020), “Climate-related financial risks: a survey on current initiatives”. 97 Bank for International Settlements (2020), “The green swan – Central banking and

financial stability in the age of climate change”. 98 See also on this Tinbergen, J. (1952), “On the Theory of Economic Policy”, in particular Chapter IV. 99 Volz, U. (2017), “On the Role of Central Banks in Enhancing Green Finance”, available at http://unepinquiry.org/wp-content/uploads/2017/02/On_the_Role_of_C entral_Banks_in_Enhancing_Green_Finance.pdf (accessed in September 2020).

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Within the Basel Framework,100 the Core Principles for Effective Banking Supervision (Core Principles) should be the starting point of the search for an answer to these questions, as they are the de facto minimum standard for sound prudential regulation and supervision of banks and banking systems.101 According to Principle 1, which deals with the objectives of prudential supervisors, “the primary objective of banking supervision is to promote the safety and soundness of banks and the banking system” and “if the banking supervisor is assigned broader responsibilities, these are subordinate to the primary objective and do not conflict with it.”102 On the other hand, according to Principle 8,103 supervisors are expected to develop and maintain a forward-looking assessment of the risk profile of individual banks and banking groups, proportionate to their systemic importance; identify, assess and address risks emanating from banks and the banking system as a whole, and in conjunction with other relevant authorities, identify, monitor and assesses the build-up of risks, trends and concentrations within and across the banking system as a whole. It seems possible to read these principles as meaning that within their traditional mandates—i.e. without prejudice to the possibility that prudential supervisors’ objectives are expanded to include specific tasks relating to the fight to climate change—prudential supervisors can and should cater for climate-related risks to the extent that they represent a threat for the safety and soundness of individual banks or of the banking system as a whole, and in doing so they can and should have a forward-looking approach in their assessment of these risks. 9.4.3

Towards an Evolution of Prudential Supervisors’ Mandates?

In the light of the above considerations, it is clear that (a) the traditional mandates of supervisors would probably benefit of clarifications or proper amendments, to allow supervisors to provide an effective contribution in 100 Basel Committee on Banking Supervision (2019), “Core Principles for Effective Banking Supervision”. 101 Basel Committee on Banking Supervision (2019), “Core Principles for Effective Banking Supervision”, BCP 01.1. 102 Basel Committee on Banking Supervision (2019), “Core Principles for Effective Banking Supervision”, BCP 01.65. 103 Basel Committee on Banking Supervision (2019), “Core Principles for Effective Banking Supervision”, BCP 01.79.

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the field of sustainable finance, yet (b) under the current mandates, the possibility for supervisors to provide a meaningful contribution is not at all precluded, and there is a broad margin for an extensive interpretation of supervisors’ mandates in this respect. Any further consideration on the topic requires by necessity an analysis of the specific legal framework of which the legal mandate is part: it is also worth remembering in this regard that the Core Principles are a typical example of ‘soft law’ and there is therefore some inevitable degree of difference in the way they are implemented by each jurisdiction. In the EU, the role and mandates of banking supervisors are to a vast extent harmonised within the context of the CRD/CRR framework, yet (also due to the abovementioned lack of harmonisation in the first instance at international level) this is one of those cases where differences exist at national level as to the way supervisors interpret their mandates, or in relation to the set of powers and responsibilities provided to them under national law. A thorough analysis of the mandates of banking supervisors in the EU in relation to sustainable finance would therefore require a comparative study of national frameworks which is outside the scope of this work, for the purpose of which the analysis of the supervisory expectations and review, as currently undertaken, will be mostly limited to the EBA and the ECB in the next paragraphs. While the EBA is not a banking supervisor in a narrow sense, its governance includes the banking supervisors of all EU Member States, and its role in developing the regulatory framework for prudential supervision in turn indirectly contributes to define the mandate of banking supervisors. On the other hand the ECB, after the establishment of the Single Supervisory Mechanism (SSM), falls squarely (also) within the definition of banking supervisor, yet is characterised by a series of distinctive features that set it apart from the others: besides the obvious observation that it is the only supervisor whose competences refer to more than a Member State, for our purposes it should be highlighted that— being an EU institution—it is bound by the principal of conferral, hence the tasks which are attributed to it need to have an ultimate coverage in the Treaties. This in turn means that its mandate may be less flexible than that of national supervisors, which can be amended by national law. At the same

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time, this is only partly the case, because the ECB mission104 as a banking supervisor is to apply the EU regulatory framework in the field of prudential supervision, and for this purpose it has the powers and obligations that supervisors have under the relevant EU regulatory framework.105 In this regard, it should also be noted that the Court of Justice seems inclined to recognise to the ECB a broad discretion when carrying out its supervisory tasks, including ‘the possibility of taking into account future events capable of altering [the banks’] risk profile’.106 On the other hand, although Article 25 SSMR lays out a separation of objectives between supervisory and central bank functions—i.e. the ECB should not pursue objectives which are (exclusively) related to its monetary policy mandate when carrying out its supervisory tasks—any risk of conflicting objectives should be solved in the light of the hierarchy established by the Treaties.107 Article 127 TFEU requires108 the European System of Central Banks (ESCB) to act (i) in accordance with the principle of an open market 104 On the definition of the ECB competence in the field of banking supervision by reference and on the basis of its tasks, see Riso, A.L. (2021), “A Prime for the SSM Before the Court: The L-Bank Case”, in Zilioli C. and Wojcik K.-P. (eds.), Judicial Review in the Banking Union. Elgar. 105 See Articles 4(3) and 9(1) Council Regulation (EU) No 1024/2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions (SSMR). 106 See Judgement of 13 December 2017, Crédit Mutuel Arkéa, T-52/16, ECLI:EU:T:2017:902, paragraph 175; Biermann, B. (2019). “Sustainable Capital: Prudential Supervision on Climate Risk for Banks”, in Beekhoven van den Boezem F.J., Jansen C. and Schuijling B. (eds.), Sustainability and Financial Markets, 129–162. 107 Riso, A.L., & Zagouras, G. (2020). “Single Supervisory Mechanism (SSM)”, in

Grieser S.G. and Heemann M. (eds.), Europäisches Bankaufsichtsrecht, 71–110; Zilioli, C., Riso, A.L. (2018), “New Tasks and Central Bank Independence: the Eurosystem Experience”, in Lastra and R.M. and Conti-Brown P. (eds.), Research Handbook on Central Banking, 155–183. 108 With regard to the ECB’s mandate under the Treaty, it should be highlighted that Article 127 TFEU mandates the ESCB to support the “general economic policies in the Union TEU with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3”. In turn, Article 3 TEU includes “a high level of protection and improvement of the quality of the environment” among the Union’s objectives, and pursuant to Article 11 TFEU “environmental protection requirements must be integrated into the definition and implementation of the Union’s policies and activities, in particular with a view to promoting sustainable development”. Whether the principle of an open market economy should instead be seen as a hard requirement or a generic statement of principle is debated in the literature: see Malfrère, F. (2018). “Introduction to the Panel

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economy with free competition, (ii) favouring an efficient allocation of resources, (iii) and in compliance with the principles set out in Article 119 TFEU. The wording of Article 127 TFEU suggests that not necessarily the principle of an open market economy with free competition leads to an efficient allocation of resources,109 therefore if this is not the case, it is for the ESCB to reconcile the two elements of the requirement.110 The principle of an open market economy should not, however, be disguised for the requirement to pursue a ‘market neutrality’111 which on the Relevance of the Principle of an Open Market Economy for Monetary Policy”. ECB Legal Conference 2018, 21–25, at 22. 109 It has been argued, however, that even the primary objective of price stability should be seen as functional to the efficient allocation of resources performed by an open market economy with free competition, and the latter would therefore trump even the primary objective of price stability. According to this reading, pursuing the primary (or another) objective should not imply a departure from the open economy model, even to achieve a social market economy (although the latter is expressly mentioned in Article 3(3) TEU). 110 Fischer, Y. (2019), “Global Warming: Does the ECB Mandate Legally Authorise a ‘Green Monetary Policy’?”, in Beekhoven van den Boezem F.J., Jansen C., and Schuijling B. (eds.), Sustainability and Financial Markets, 163–198. It has been argued that “In normal circumstances an open market economy with free competition favours an efficient allocation of resources. The ESCB should therefore not use monetary policy measures that violate that principle. Such were the circumstances under which the Treaty was written, and under which the euro area functioned during its first decade. However, there may be circumstances under which the assumption of a functioning open market economy with free competition breaks down […]. Arguably, under circumstances where markets fail, the premise of the principle of an open market economy with free competition – i.e. that it favours an efficient allocation of resources – no longer holds. Perhaps then, under such circumstances, monetary policy measures that would normally be at odds with the principle of an open market economy with free competition become acceptable”, Hopman, C. (2018). “Monetary Policy and the Principle of an Open Market Economy with Free Competition”, ECB Legal Conference 2018, 36–43, at 40. 111 For a different view see: Weidmann, J. (2020), “Combating Climate Change—What Central Banks Can and Cannot Do”, Speech at the European Banking Congress, available at https://www.bundesbank.de/en/press/speeches/combating-climate-change-whatcentral-banks-can-and-cannot-do-851528 (accessed in January 2020); Mersch, Y. (2018). “Climate Change and Central Banking”—Speech by Mr. Yves Mersch, Member of the Executive Board of the European Central Bank, at the Workshop discussion “Sustainability is becoming mainstream”, Frankfurt am Main, 27 November 2018, available at https://www.bis.org/review/r181128b.htm (accessed in September 2020). Although the discussion mainly relates to the ECB tasks as a central bank, it may be worth observing that if the open market economy principle may trump the primary objective of price stability as the proponents of this reading of the principle argue, a fortiori it might be possible for the supporters of this line of thought to argue that this principle may also trump secondary objectives, including those pursued in the performance of other

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would in re exclude the possibility of any intervention of central banks and supervisors alike, in the same way an objective observation is not really possible in Schrödinger’s cat paradox.112 Against this background, of particular importance are the specific mandates which have been recently conferred upon the EBA by the legislator,113 in particular with regard to the potential inclusion of ESG risks in the review and evaluation performed by competent authorities114 —which may lead to an expansion of the mandate of prudential supervisors in practice—and the possibility to introduce a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives115 —whose effect may be more ambiguous because it would provide more solid grounds to act, but at the same time reduce the scope for discretion of prudential supervisors in specific cases. More generally, the EBA’s mandate—which could be considered as a meta-mandate in relation to the mandates of banking supervisors, given the impact it has on the supervisors mandates, for the reasons illustrated above—has been recently enriched by the legislators with the task to take

ECB tasks, such as its supervisory tasks. It is also worth highlighting that this reading of the open market economy principle also sees such principle as incompatible with the ‘social market economy’ referred to in Article 3(3) TEU, whose aims include “a high level of protection and improvement of the quality of the environment”: accordingly, the Eurosystem (but why not the SSM by extension if the latter is also bound by Article 127 TFEU?) would thus be subject to an overarching principle (the open market economy) different from and incompatible with the overarching principle applicable to the Union as a whole (the social market economy). See Kaiser, K. (2018), “The Objective of Price Stability and the Principle of an Open Market Economy: What Trumps?” ECB Legal Conference 2018, 26–30. 112 See Schnabel, I. (2020). “When Markets Fail—The Need for Collective Action in Tackling Climate Change”. See also Colesanti Senni, C., Monnin, P. (2020), “Central Bank Market Neutrality Is a Myth”, available at https://www.cepweb.org/central-bankmarket-neutrality-is-a-myth/ (accessed in January 2020); Riso, A.L. (2015), “An Analysis of the OMT Case from an EU Law Perspective”. In The ECB’s Outright Monetary Transactions in Courts, edited by Siekmann H., Vig V. and Wieland V., IMFS Interdisciplinary Studies in Monetary and Financial Stability, 1, 19–29. 113 The new provisions in the CRD and CRR have been introduced by Directive (EU) 2019/878 of 20 May 2019 and Regulation (EU) 2019/876 of the Council of 20 May 2019 respectively. 114 Article 98(8) CRD. 115 Article 501c CRR.

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into account “sustainable business models and the integration of environmental, social and governance related factors”.116 This change may prelude to more attention on the side of the EBA for sustainable finance aspects when designing provisions in the level 2 regulatory framework, or contributing to develop parts of the regulatory framework also at level 1 (e.g. in the context of its advisory functions).

9.5

Supervisory Expectations and Supervisory Review

In the following paragraphs current practices in the areas of supervisory expectations and review are examined, based on the analysis conducted by the NGFS, the EBA and the ECB, respectively. While the Network for Greening the Financial System (NGFS) carries out a descriptive review of practices undertaken by prudential supervisors at global level, the EBA has adopted a report which has a prescriptive nature, in that its aim is to coordina te the way competent authorities in the EU adopt supervisory expectations and conduct their supervisory reviews. The ECB document which is analysed alongside the others is instead an actual set of supervisory expectations by a specific prudential supervisor. When specific reference is therefore made to one of these documents, such reference is reported so that the reader can appreciate these differences in the original context of the documents of which these elements were parts. At the same time, the decision to analyse all these elements in parallel is due to the fact that this is an area in rapid development and in fact descriptive elements resulting from the NGFS report are actually underpinned by concrete supervisory expectations, and the normative propositions of the EBA are going to be embedded in their practice by EU supervisors; therefore, it is probably only a matter of time, before that these propositions are assembled together as parts of a consistent system of principles presiding over this area.

116 Articles 1(3) and 8(1a)(c) Regulation (EU) No 1093/2010 (the EBA Regulation), as amended by Regulation (EU) 2019/2175 of 18 December 2019.

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9.5.1

General Principles on Supervisory Expectations and Supervisory Review

In the Basel framework for prudential supervision, supervisors are expected to evaluate the banks’ assessment of their capital needs relative to risks—in particular in areas which are external to the bank, or which are not taken into account or fully covered by Pillar 1—while being at the same time expected to consider alternative options to increased capital (such as strengthening risk management, applying internal limits, strengthening the level of provisions and reserves, and improving internal controls) to address these risks.117 In the EU context, pursuant to Article 97 CRD, competent authorities have a mandate to review the arrangements, strategies, processes and mechanisms implemented by the institutions to comply with prudential requirements, and evaluate risks to which institutions are or might be exposed, as well as risks that each institution poses to the financial system—in relation to which explicit reference is now made to potential environmental-related systemic risk118 —and risks revealed by stress tests. Such review and evaluation focuses on several risk categories, including in particular the exposure to and management of concentration risk by supervised entities, the geographical location of exposures, the business model of the supervised entity and the assessment of systemic risk.119 To ensure EU-wide consistency in the way such supervisory review is conducted, the EBA has been mandated to develop guidelines,120 which have structured the supervisory review and evaluation process (SREP) around four pillars: the (i) business model analysis, and the assessment of

117 Basel Committee on Banking Supervision (2019), “Core Principles for Effective Banking Supervision”, in particular BCBS SRP 10 and BCBS SRP 30 with regard to risk management. 118 Pursuant to Article 97(1) CRD, for the evaluation of the risks which an institution poses to the financial system account should be taken of the identification and measurement of systemic risk under Article 23 of Regulation (EU) No 1093/2010. The latter has been in turn amended by Regulation (EU) 2019/2175, to include environmental risk in the systemic risk whose potential to increase in a situation of stress should be evaluated. 119 See Article 98(1) CRD, in particular (b), (h), (i), (j). 120 See Article 107 CRD and European Banking Authority (2014), “Guidelines for

common procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing (EBA/GL/2014/13)”.

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(ii) governance (also including ICAAP121 and ILAAP122 ) and (iii) capital and (iv) liquidity risks. The reference to risks which are not fully covered in the framework under Pillar 1 has the potential to be used to expand in practice the areas covered by the supervisors’ mandate without specific changes to the framework (provided that the new areas imply an element of risk that can be framed within the existing categories included in the supervisory review). Also against this background, one of the recommendations of the NGFS to supervisors is to develop strategies to integrate these risks into their work123 , in a first stage by raising awareness internally (e.g. through training of staff and set-up of dedicated structures within the organisations) and externally (e.g. through supervisory dialogue, organisation of and participation to conferences, seminars, debates fora, dissemination of publications or other contributions to the public debate), to then move in a second stage to setting supervisory expectations to be shared with supervised entities.124 These supervisory expectations, as emerging from the practice so far, are developing mainly in five areas, which to some extent reflect the traditional areas covered in the SREP (strategy/business model, governance, risk management) and for the rest relate to a tool which is instrumental to SREP (stress testing), and to the communication to the market (disclosure) as an implicit alternative to harder tools which supervisors may deploy, but whose consideration is still at an early stage currently.125

121 Internal Capital Adequacy Assessment Process, i.e. the process for the identifica-

tion, measurement, management and monitoring of internal capital implemented by the institution pursuant to Article 73 CRD. 122 Internal Liquidity Adequacy Assessment Process, i.e. the process for the identi-

fication, measurement, management and monitoring of liquidity implemented by the institution pursuant to Article 86 CRD. 123 It needs to be reiterated that this should happen alongside integrating climate-related and environmental risks into the mandate of prudential supervisors. 124 Network for Greening the Financial System (2020), “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision”. 125 Network for Greening the Financial System (2020), “Guide for Supervisors Inte-

grating climate-related and environmental risks into prudential supervision”; European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”; European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”.

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9.5.2

Business Models and Strategy

The most evident vulnerability which banks would need to address is probably the banks’ typical current time horizon for business planning, which should be extended beyond the present standard of three to five years,126 so that the implications of potential changes on the business environment could be fully understood and strategies to cope with these changes could be developed.127 Although specific adjustments of the legislative framework would be needed to underpin the extension of the business planning, designing business strategies which are more aware of climate-related and environmental risks may be possible, based e.g. on scenario analysis, and portfolio alignment with market-based principles or the EU taxonomy, and complemented by the engagement with counterparties (as this could reduce their PD and LGD, and thereby losses on the bank’s balance sheet, as a consequence of the materialisation of climate-related and environmental risks) and other stakeholders, and the development of sustainable finance products.128 Prudential supervisors, as illustrated by the ECB’ example, will expect that the banks identify and monitor129 the impact of climate change on the business environment in which they operate—including macroeconomic variables, the competitive landscape, policy and regulation, technology, societal/demographic developments and geopolitical trends130 —and properly document the

126 European Banking Authority (2019), “Report on undue short-term pressure from the financial sector on corporations”. 127 Network for Greening the Financial System (2020), “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision”; European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”; European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”. 128 European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”. 129 See also European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, paragraph 30. 130 See European Banking Authority (2014), “Guidelines for common procedures and

methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing (EBA/GL/2014/13)”, paragraph 64–65; see also European Banking Authority (2018), “Guidelines on the revised common procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing (EBA/GL/2018/03)”, paragraphs 59 and 60 under Principle 4.

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materiality assessment of these risks, taking into account up-to-date scientific insights and relevant policy initiatives and developments131 (also on the basis of scenario analysis132 ) and having in mind possible longterm effects on the bank’s financial interests and solvency.133 To support their own execution capabilities in relation to these strategies, banks should consider setting and monitoring clear key performance indicators (KPIs).134 9.5.3

Governance and Risk Appetite

Alongside KPIs, also the development of key risk indicators135 (KRIs) is encouraged by supervisors to allow for an effective oversight of

131 For an analysis of the potential prudential impact of the tightening of energy effi-

ciency standards for credit institutions, see also, e.g. Bank of England (2018), “Prudential Regulation Authority report”, Box 3, “Transition in thinking: the impact of climate change on the UK banking sector”. 132 Task Force on Climate-related Financial Disclosures (2017), “Technical supplement: The Use of Scenario Analysis in Disclosure of Climate-related Risks and Opportunities”; Network for Greening the Financial System (2020), “Requirements for scenario analysis”. 133 European Banking Authority (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”; see European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, article 23; see also European Banking Authority (2014), “Guidelines for common procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing (EBA/GL/2014/13)”; see also European Banking Authority (2018), “Guidelines on the revised common procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing (EBA/GL/2018/03)”, paragraphs 25, 32 and 34 under Principles 2 and 4. 134 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”; Network for Greening the Financial System (2020) “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision”; see European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, paragraphs 136 and 139. 135 See European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 3.3 and 6. See also European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, paragraphs 24 and 28, on the oversight role and the achievement of its objectives.

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risks, together with the adoption of forward-looking risk appetite frameworks136 (RAFs) considering the material risks137 to which each bank is exposed in line with the strategic planning horizon set out in the business strategy, clearly outlying appropriate limits for the level of climate-related and environmental risks that the bank is willing to accept, and appropriate follow-up actions in case these limits are breached.138 The proper execution of business strategies (and of the changes to business models required to cope with the challenges presented by climate-related risks) presupposes institutional arrangements which are fit and suitable to operationalise strategic decisions in the day-to-day activity of the banks. Sound governance arrangements are a cornerstone of banks’ prudent management and supervision, and in this context the role of the management body and the allocation of responsibilities within the latter have a fundamental importance in the effective oversight of climate-related and environmental risks139 : various models are possible, whereby specific responsibilities are assigned, e.g. to a senior executive, a board member or a (existing or ESG-related) board committee,140 but in all cases the 136 See European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectations 4.1 and 4.2. For a general understanding of the RAF’s function, see also European Banking Authority (EBA 2016), “Guidelines on ICAAP and ILAAP information collected for SREP purposes (EBA/GL/2016/10)”; SSM supervisory statement on governance and risk appetite and Financial Stability Board (2013), “Principles for An Effective Risk Appetite Framework”. 137 See also European Banking Authority (2018), “Guidelines on the revised common procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing (EBA/GL/2018/03)”, paragraph 100. 138 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”. The ECB expects banks to develop quantitative metrics to monitor and report their exposures in the longer run, although qualitative metrics may be used as an interim step. See also European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, paragraph 138. 139 See Article 74 CRD and European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, in particular paragraphs 23, 30 and 131. 140 As noted by the NGFS, a possible development in the future is that appropriate

knowledge, skills and expertise in relation to climate-related and environmental risks may be integrated in the fit and proper assessment of board members appointments, see Network for Greening the Financial System (2020), “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision”. According to the EBA, it should already be the case that Members of the specialized committees on

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management board should be involved in setting, approving and overseeing the business strategy process, and should take decisions on a sound and well-informed basis,141 also to ensure that work on these risks is prioritised in the organisation.142 Each bank’s management board should in turn make sure that reporting lines and the allocation of responsibilities within the organisation are clear, well defined, coherent, enforceable and duly documented.143 In this context, the identification and management of climate-related and environmental risks should be fully embedded at each level of the internal control framework, following the three lines of defence model: (1) business lines and units taking risk should have the primary responsibility to identify, assess and monitor climate-related and environmental risks relevant e.g. for the creditworthiness of clients throughout the whole life-cycle of the activity, including by conducting proper due diligence144 on climate-related and environmental risks and incorporating these risks in credit policies already at the point of loan

ESG risks should have appropriate knowledge, skills and expertise concerning ESG risks and assist the management body in its supervisory function with regard to the extent to which institutions’ activities are exposed to ESG risks, see European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”. 141 See European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”, expectation 3.2, and European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, paragraphs 23, 28, 33, 95, as well as Principle 1 (i) and Principle 2 (iii) and (v), and European Banking Authority (2018), “Guidelines on the revised common procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing (EBA/GL/2018/03)”, paragraphs 32 and 34. 142 Network for Greening the Financial System (2020), “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision”; European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”. 143 See European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 3.1; see also European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, paragraph 67. 144 See also OECD (2019), “Guidelines for Multinational Enterprises‘’ and OECD, 2019, “Due Diligence for Responsible Corporate Lending and Securities Underwriting – Key considerations for banks implementing the OECD Guidelines for Multinational Enterprises”.

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origination,145 develop sustainable credit facilities and inform counterparties of how their investments can be aligned with the bank’s risk appetite; (2) independent risk control functions should have appropriate financial and human resources as well as the powers to effectively perform their role and ensure that the climate-related and environmental risks are properly reflected and incorporated in prudential risk categories146 ; and (3) the independent internal audit function should have sufficient expertise and knowledge to be able to review the risk management framework, by considering external developments, changes in the risk profile and in products and/or business lines, and understand and challenge specific decisions.147 These organisational arrangements should be adequately supported by IT systems to enable the collection and processing of data and an appropriate and timely internal reporting,148 as well as appropriate staff training.149 Finally, appropriate remuneration policies should be in place to align incentives within the organisation with the long-term

145 See also European Banking Authority (2020), “Guidelines on loan origination and monitoring (EBA/GL/2020/06)”, in particular sections 4.3.5 and 4.3.6. 146 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 5.2; see also European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, paragraphs 155 and 160. Compliance functions should additionally advice the management body on compliance with applicable law and regulation: see European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 5.4; and European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, paragraph 192. 147 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 5.4; European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”, paragraph 139. 148 See European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 6; see also European Central Bank (2018), “Guide to the internal capital adequacy assessment process (ICAAP)”, paragraphs 29 and 30 under Principle 2; European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”; and European Banking Authority (2018), “Guidelines on the revised common procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing (EBA/GL/2018/03)”, Section 5.8. 149 Network on Greening the Financial System (2020), “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision”.

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business goals, and the overall business strategy and risk appetite of each bank.150 9.5.4

Risk Management

A sound risk management framework requires policies and procedures to be in place to identify, assess, monitor, report and manage material risks,151 which in the case of climate-related and environmental risks can be approached as drivers of established prudential risks such as credit, market and operational risk. These policies and processes need to be underpinned by sufficient, reliable and appropriate data, for which banks are expected to develop in time proper metrics and methodologies,152 while the outcome of this activity needs to be adequately reflected in the capital adequacy of each bank,153 and policies themselves need to be subject to periodic reviews.154 In the case of banks, credit risk management clearly has a peculiar importance: in the EU, prudential supervisors have an explicit mandate to ensure that credit is granted on the basis of sound and well-defined criteria and that the process for approving,

150 Network for Greening the Financial System (2020), “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision”; European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”; European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”. 151 See Article 73 CRD. See also European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, paragraphs 136 and 137. See also European Central Bank (2018), “Guide to the internal capital adequacy assessment process (ICAAP)”, paragraphs 32 and 34 under Principle 2 (ii). 152 The ECB highlights that risks should not be excluded because of the difficulty to quantify them or because data are not available. See European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 7.2. 153 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 7.5, ECB; European Central Bank (2018), “Guide to the internal capital adequacy assessment process (ICAAP)”, paragraph 60. 154 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 7.6; European Central Bank (2018), “Guide to the internal capital adequacy assessment process (ICAAP)”, paragraph 18 under Principle 1 (iii).

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amending, renewing, and re-financing credits is clearly established.155 Banks should make sure that all stages of the credit granting process incorporate climate-related and environment risks, and that these are reflected in the assessment of the borrower’s default risk.156 The materialisation of climate-related and environmental risks can indeed impact all main components of credit and counterparty risk,157 such as the probability of default (PD), e.g. because the shift in market preferences reduces demands on certain products, the exposure at default (EAD), e.g. because counterparties may draw on their credit lines to respond to sudden shocks, and the loss given default (LGD), as the value of stranded assets provided as collateral will decrease (at some point suddenly) in a transition scenario, determining lower recovery values.158 Banks are therefore expected to monitor and manage the credit risk in their portfolio through sectoral and geographical concentration analyses, exposure limits, deleveraging, stress testing and scenario analysis.159 The bank’s risk appetite should be reflected in the credit policies (as well in the ICAAP and ILAAP), including the pricing framework and the possibility that the latter is underpinned by specific funding (on more favourable terms)

155 See Article 79 CRD. 156 European Central Bank (2020), “Guide on climate-related and environmental risks.

Supervisory expectations relating to risk management and disclosure”, expectation 8.1; European Banking Authority (2020), “EBA Guidelines on loan origination and monitoring (EBA/GL/2020/06)”, paragraph 57; European Central Bank (2018), “Guide to the internal capital adequacy assessment process (ICAAP)”, principles 2 (ii) and (iii). 157 Although it is worth noting commonly used traditional credit risk indicators, such as probability of default (PD) and loss given default (LGD) are primarily based on historical data, which in most cases, do not reflect expected impact of environmental or social factors. The assessment of climate-related and environmental risks may thus have to build on different metrics, see European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”. 158 The ECB expects banks to consider granular elements such as e.g. the physical location of assets and the energy efficiency in the case of real estate, and to incorporate these considerations both in the evaluation of collateral, and in its periodic review; European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 8.3. 159 See European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 8.4.

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supporting environmentally sustainable assets.160 In the area of market risk, where prudential supervisors are mandated to ensure that banks have policies and processes in place for the identification, measurement and management of all material sources and effects of market risks,161 banks are expected to consider the possible impact of climate-related and environmental risk on their current market positions or future investments, taking into account how environmental and climate-related risks could lead to potential shifts in supply and demand for financial instruments (e.g. securities, derivatives), products and services, with a consequent impact on their value, and to conduct rigorous programmes of stress testing.162 An appropriate organisational framework should clarify the responsibilities for deciding, implementing, monitoring and reporting the impact of ESG risks on the market portfolio of each bank, and portfolio diversification should be considered as a possible option for market risk mitigation.163 Prudential supervisors are also mandated to ensure that banks have policies and processes to evaluate and manage the exposure to operational risk,164 which in turn can be driven by climate-related and environmental risks, in particular via reputational risk and liability risk that can arise as a result of a bank’s activities.165 A further element that banks should not omit to consider is that they can be directly (rather than 160 See Article 76(3) CRD as well as European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectations 8.5 and 8.6; European Banking Authority (2020), “EBA Guidelines on loan origination and monitoring”, paragraphs 189, 187, 190, 200 and 201. 161 See Article 83 CRD and European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 10; see also European Central Bank (2018), “Guide to the internal capital adequacy assessment process (ICAAP)”, principles 2 and 7. 162 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”. 163 European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”. 164 See Article 85 CRD and European Banking Authority (2018), “Guidelines on the revised common procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing (EBA/GL/2018/03)”, paragraph 255. 165 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 9.2; Banks that provide portfolio management or financial advice will also have to comply with the disclosure requirements laid down in Regulation (EU) 2019/2088 of the European

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indirectly, through their counterparties) exposed to climate-related and environmental risks and should therefore assess the impact of physical risks on their operations, including outsourced activities and IT services.166 Corrective measures to mitigate operational risk such as insurance policies should also be considered in this context.167 Prudential supervisors also need to ensure that banks have robust strategies, policies, processes and systems for the identification, measurement, management and monitoring of liquidity risk over an appropriate set of time horizons to ensure they maintain adequate liquidity buffers.168 Climate-related and environmental risks can also drive liquidity risk, directly, e.g. via increased liquidity needs of counterparties affected by the materialisation of physical risks,169 or indirectly, e.g. due to shocks having an impact on the banks’ability to refinance themselvers, either as a consequence of the deterioration of their own balance sheets, or as a consequence of tensions on the interbank market triggered by these shocks.170 Although scenario analysis and stress testing are conceptually distinct from risk management in a stricter sense, they are extremely useful tools to help to dispel the current uncertainty surrounding the magnitude and sectoral and geographical distribution of financial damages and losses connected to climate-related and environmental risks; therefore banks are expected to develop methodologies and tools, such as stress testing and scenario analysis, that can be used to identify, monitor and assess risks both in the

Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector. 166 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 9.1; European Banking Authority (2019), “Guidelines on outsourcing (EBA/GL/2019/02)”, paragraph 31 under Section 4. 167 European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”. 168 See Article 86(1) CRD. 169 See also Bundesanstalt für Finanzmarktaufsicht (2020), “Guidance Notice on

Dealing with Sustainability Risks”, p. 18. 170 European Central Bank (2020) “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”. See also Bank for International Settlement (2020), “The green swan – Central banking and financial stability in the age of climate change”, p. 28.

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short and in the longer term.171 A tailored and in-depth review of banks’ vulnerabilities should be conducted through stress testing in the context of ICAAP172 and the appropriateness of these methodologies should be reviewed in particular by banks with material exposures to climate-related and environmental risks.173 9.5.5

Disclosure

Public disclosure is generally considered a tool which enhances market efficiency by ensuring that market participants have adequate insight into the risk exposures, risk assessment processes and capital adequacy of financial institutions, thereby exerting pressure on banks to efficiently manage their risks. Against this background, supervisors increasingly expect that banks disclose information and metrics on the climate-related and environmental risks they are exposed to, such as, e.g. breakdown of environmental risks by business line or geographical location, scope 1, 2 or 3 GHG emissions and KPIs and KRIs used for strategy setting and risk-management,174 and in some cases to refer to international initiative such as e.g. the recommendations of the Task Force on Climaterelated Financial Disclosures (TFCD)175 or the supplement on reporting climate-related information to the European Commission’s Guidelines on non-financial reporting.176 The adoption of the Taxonomy Regulation in

171 Network on Greening the Financial System (2020), “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision”. 172 See European Banking Authority (2017), “Guidelines on internal governance (EBA/GL/2017/11)”, paragraphs 140 et seq.; and European Banking Authority (2016), “Guidelines on ICAAP and ILAAP information collected for SREP purposes (EBA/GL/2016/10)”, Chapters 5.4 and 6.5. 173 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 11. 174 See European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectations 13.5 and 13.6. 175 Task Force on Climate-related Financial Disclosures (2017), “Recommendations of the Task Force on Climate-Related Financial Disclosure”. 176 European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 13.4. See also Network for Greening the Financial System (2020), “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision”.

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the EU should help disclosure in the future, as it will enable a certain consistency in the information disclosed by different institutions.177 From 28 June 2022, large institutions which have issued securities that are admitted to trading on a regulated market of any Member State will be subject to the obligation to disclose information on ESG risks.178 Until then, and also thereafter especially for those banks which are not included in the scope of this disclosure obligation, it should be reminded that under the CRR banks are required to disclose information that is material (and not proprietary or confidential) when limiting to strictly required information disclosure would not convey the risk profile comprehensively to market participants.179 Although there is no threshold for assessing the materiality of information in relation to climate-related and environmental risks, banks should document the reasons underpinning the evaluation of these risks as immaterial.180 Supervisory expectations need however still to be receipted by banks: from a recent analysis conducted by the ECB on a vast range of institutions it emerges that none of them meets the supervisory expectations which the ECB itself shared with the public. Only a limited number of institutions discloses information on the materiality assessment or a clear mapping of how climate-related and environmental risk would impact on prudential risk categories, less than a third discloses information on the impact of these risks on the business model, just above a third discloses some information on metrics and targets, and only half of the institutions provide information on the board’s oversight of climate-related risks.181

177 Trippel, E. (2020), “How Green Is Green Enough? The Changing Landscape of Financing a Sustainable European Economy”. ERA Forum, 21, 155–170. 178 See Article 449a CRR. 179 See Article 431(3) CRR. 180 See European Central Bank (2020), “Guide on climate-related and environmental risks. Supervisory expectations relating to risk management and disclosure”, expectation 13.2. See also European Banking Authority (2014), “Guidelines on materiality, proprietary, and confidentiality and on disclosure frequency on materiality, proprietary and confidentiality and on disclosure frequency under Articles 432(1), 432(2) and 433 of Regulation (EU) No 575/2013 (EBA/GL/2014/14)”, paragraph 19. 181 European Central Bank (2020), “ECB report on institutions’ climate-related and environmental risk disclosures”.

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Follow-Up to Supervisory Expectations—Supervisory Techniques and Tools

While the analysis of the ECB with regard to banks’ compliance with its supervisory expectations in the area of disclosure is quite illustrative of the degree of preparedness of financial institutions in the face of repeated proclaims on the matter, its otherwise clear and extensive supervisory expectations are less explicit on the reaction which is due in cases of non-compliance with these expectations. On the one hand, this apparent “omission” can be explained by the fact that the general rules on supervisory powers apply, and the ECB supervisory expectations may be qualified as a voluntary limitation of the ECB’s discretion in the use of its powers, in that it creates legitimate expectations in the banks.182 On the other hand, this can also be explained by the fact that—while supervisory powers could be used at any time when the necessary preconditions as provided by the law are fulfilled—supervisory expectations are a step in a process which is aimed at gradually pushing banks towards compliance, rather than primarily targeting forms of enforcement which may be of lesser benefit and impact for the purpose of promoting a broader paradigm shift in the financial system. Moreover, it should also be considered that the discussion about the possibility to enrich the supervisory toolbox with specific, targeted powers and mandates which would supplement those currently existing is still ongoing, and at EU level the EBA has been mandated to both consider the possible inclusion of ESG risks in the SREP framework, and to report on the possible need to intervene on pillar 1 requirements, which in turn would have an impact on supervisors’ competence, given that in the context of the SREP, the latter is primarily targeted at pillar 2, which in turn is mainly aimed at covering risks which are not fully covered by pillar 1. Left aside further considerations de jure condendo, de jure condito supervisors have already an appropriate range of supervisory techniques

182 In other words, following the line of argumentation underlying the ECB supervisory expectations, i.e. that climate-related and environmental factors are drivers of prudential risks, the ECB has already—as any other supervisors—the possibility to use all powers which are granted to prudential supervisors to handle prudential risks. Against these background supervisory, expectations may thus be seen as an ex ante assessment built around standards, compliance with which should generally reassure banks (unless specific circumstances occur) that their risk profile does not raise concerns, and the use of supervisory powers should not be warranted.

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and tools at their disposal to implement their supervisory approach and act at an early stage to address unsafe and unsound practices or activities that could pose risks to banks or to the banking system.183 In the EU framework, climate-related and environmental risks can be embedded in the various components of the SREP process, which revolves around four areas of analysis,184 and whose outcome can take the wide range of qualitative, quantitative or other supervisory measures (or ultimately early intervention measures),185 including, e.g. a discussion with the board of the concerned institutions to ensure adequate follow-up to the identified shortcomings, requiring institutions to strengthen risk management and internal control systems, procedures and processes, to integrate climaterelated and environmental risks into ICAAP, to reduce the level of risk, ultimately imposing limitations on carrying out certain categories of transactions or operations, up to setting limitations to the distribution of profits or imposing capital add-ons.186 As mentioned above, the EBA has been mandated to assess the potential inclusion in the review and evaluation performed by competent authorities of ESG risks, ultimately with the possibility to issue guidelines regarding the uniform inclusion of ESG risks in the SREP.187 The preliminary findings of the EBA in this regard are of course of particular interest.188 The specific time horizon of climate-related and environmental risks may be one of the main factors requiring an adaptation of the current SREP framework: capital requirements set in Pillar 2 are estimated 183 See Core principles 8, 9 and 11. 184 Business model analysis, assessment of internal governance and internal controls,

assessment of risks to capital and of risks to liquidity. See Articles 97 and 98 CRD, and European Banking Authority (2014), “Guidelines for common procedures and methodologies for the supervisory review and evaluation process (SREP) and supervisory stress testing (EBA/GL/2014/13)”. 185 See Articles 104, 105 and 106 CRD. See also European Banking Authority (2015), “Guidelines on triggers for use of early intervention measures pursuant to Article 27(4) of Directive 2014/59/EU (EBA/GL/2015/03)” and European Banking Authority (2020), “Discussion paper - Application of early intervention measures in the European Union according to Articles 27-29 of the BRRD”. 186 Network for Greening the Financial System (2020), “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision”. 187 Article 98(8) CRD, as amended by Directive (EU) 2019/878. 188 European Banking Authority (2020), “Discussion Paper—On Management and

Supervision of ESG Risks for Credit Institutions and Investment Firms”.

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to cover primarily the unexpected losses over a 12-month period, and capital guidance (P2G) is based on stressed conditions over a forwardlooking horizon of at least two years; therefore, EBA advices to assess the sustainability and viability of banks’ business models over a much longer time frame (even up to ten year), bearing in mind that the forwardlooking assessment of longer-term resilience could, e.g. become a new area of business model analysis. More generally, the EBA concurs with the view that ESG risks materialise in the form of existing prudential risks, and should thus be embedded in the existing supervisory review process. Although the EBA intends to issue guidelines for this purpose, it has also advocated for the need to introduce specific provisions on ESG risks directly in the CRD.189

9.6

Conclusion

The inclusion of climate-related and environmental risks in the scope of prudential supervision is still a relatively new concept at an early stage of its development. Although conceptually the potential impact of climate change and ensuing shocks on the stability of the financial system and of individual institutions is rather clear, important limitations still exist with regard to the possibility to properly measure this phenomenon, given the lack or scarcity of reliable data, and the existence of methodological constraints. Also in the light of these limitations, it has been found that an extension of the mandate of prudential supervisors would be warranted to clarify how climate-related and environmental risks should be included in their activities. However, the possibilities to act under the existing mandates have been highlighted, and existing practices of EU authorities in terms of supervisory expectations and review have been analysed. Going back to the initial question, as to whether prudential supervisors are doing enough to contribute to the fight to climate change, the present contribution probably does not provide sufficient elements to give a definitive answer, and from many elements it may actually be possible to argue that prudential supervisors may indeed do more—yet, an emerging trend is that prudential supervisors have started engaging in the topic, and this is excellent news while waiting for further developments in the future. 189 European Banking Authority (2020), “Discussion Paper—On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms”.

PART IV

Sustainable Finance and Financial Markets

CHAPTER 10

Sustainable Finance: An Overview of ESG in the Financial Markets Marieke Driessen

10.1

Introduction

Sustainable finance has been around for years.1 After publication of the EU Action Plan for Sustainable finance (Action Plan) by the European Commission in March 2018, sustainable finance rose to the top of the EU legislative agenda for the financial markets, as well as the regulatory

1 By way of example, in November 2008, the World Bank issued its first green bond, whereby the proceeds of the bond issuance were dedicated to a certain kind of project, based on eligibility criteria for projects and featured a second opinion provider (CICERO) to assess whether a particular project would make a positive impact on the environment. See: https://www.worldbank.org/en/news/feature/2018/11/27/from-evolutionto-revolution-10-years-of-green-bonds.

M. Driessen (B) Financial Markets Group, Stibbe N.V., Amsterdam, The Netherlands e-mail: [email protected]

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_10

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and supervisory agenda of EU and national supervisors and competent authorities of the financial sector.2 In this chapter, Sect. 10.2 provides an overview of various sustainable and ESG products that have been a feature of the international financial markets, such as green, ESG and sustainability-linked loans and bonds. Section 10.3 discusses the current legal framework in which these financial products are issued, with a focus on EU-level legislation, including the EU Taxonomy regulation and the EU Sustainable Finance Disclosure Regulation. Section 10.4 considers legal and regulatory developments on the horizon, such as the Green bonds Standard and Climate benchmarks. Section 10.5 concludes with a few remarks on general trends in ESG and sustainable finance developments in the financial markets.

10.2

ESG Products in the Financial Markets

10.2.1

Meaning and Standards of ESG/Sustainable Finance Generally

In recent years, the financial markets have seen the launch of a number of financial products that were promoted in the attendant press releases as the “first ever” green, social, sustainability-linked, ESG-linked, climate change, inclusion or other bond or loan of a certain type.3 At first glance, the distinctions and similarities between such products—and the terminology used—are not always clear. This has led to accusations by investors, regulators, supervisors and special interest groups, directed at financial market participants, of “greenwashing” financial products they issue, use or invest in, whereby greenwashing is meant to refer to the use of terminology that sounds more “green” or environmentally sustainable

2 Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions (8 March 2018), Action Plan: Financing Sustainable Growth, COM/2018/097. 3 Many financial market participants with the ambition to be at the forefront of sustainable finance claim to have developed the first ever financial transaction of a certain type, resulting in claims to have acted on so-called “market firsts” for a company of a certain type, in a certain jurisdiction or with a certain characteristic. The Climate Bonds Initiative keeps a database of transactions that earmark proceeds for climate or environmental projects and have been labelled as ‘green’ by the issuer. See: https://www.climatebonds. net/cbi/pub/data/bonds.

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than the products are in substance.4 That has led some financial market participants to refer to their products in shades of green when discussing a particular financial markets product.5 In general and as things stand now, the financial markets distinguish between (a) financial products that are dedicated to types of projects with (some degree of) ESG signature and (b) financial products that are meant to support the issuers/borrowers of the products in their ambitions in (some degree of) ESG. For example, a bond or a loan the proceeds of which (i.e. the monies borrowed by the issuer of the bond or by the borrower(s) under the loan) are to be used to finance a certain “green” or “social” project (e.g. construction or renovation of environmentally friendly buildings, means of transport, energy plants or construction of social housing) are commonly referred to as “green bonds/loans” or “social bonds/loans”, respectively. Where the use of proceeds of a bond issuance or a loan is less relevant (e.g. the bond/loan may be used for general corporate purposes of the issuer/borrower), but the funding is concerned with the behaviour of that issuer or borrower more generally (e.g. taking initiatives to make itself, its supply chain and/or its output more environmentally friendly), such bonds or loans are commonly referred to as “sustainability-linked” or “ESG-linked” bonds or loans. Typically, in such debt products, the interest payable by, or other restrictions on, the issuer or borrower will be lower where certain “scores” or behaviours on sustainability or ESG factors are achieved. It is important to note that the creation and characterisation of such financial products are not prescribed by mandatory or binding legislative or regulatory instruments. There is currently no law, decree or other legislative instrument requiring that certain financial market participants use such forms of green, social or sustainability-linked financing. The practice has developed as a result of voluntary action of financial market participants (issuers/borrowers, investors, financial institutions

4 For example, investors complain that some green financial products are little more than marketing, as they intend to finance, e.g., through green bonds, a company in a determinedly brown sector. See, e.g.: https://www.ft.com/content/c4cefa40-f4ab-11e9b018-3ef8794b17c6. 5 For example, the Dutch Minister of Finance claimed that the green bonds issued by the Dutch government in 2019 would be dark green. See: https://english.dsta.nl/news/ news/2019/04/08/issuance-20-year-sovereign-green-bond-on-21-may-2019.

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structuring transactions) to contribute to sustainable growth, whether on the basis of the United Nations’ Sustainable Development Goals (SDG),6 the Paris Agreement7 or otherwise. Clearly, as the financial markets develop sustainable finance products, the benefit from consistency in terminology and standards would increase. Several market and industry associations have taken up this task, issuing their own guidelines on best practices for the use of terminology and other standards in sustainable finance transactions. In the realm of debt finance, the Climate Bonds Initiative (CBI) has established the Climate Bonds Standard and Certification Scheme, based on its own “Climate Bonds Taxonomy”, which is a FairTradelike labelling scheme for bonds and loans that are consistent with the 2 degrees Celsius warming limit in the Paris Agreement.8 The International Capital Markets Association (ICMA) issued Green Bond Principles (GBP),9 Social Bond Principles (SBP),10 Sustainability Bond Guidelines (SBG)11 and Sustainability-linked Bond Principles

6 The 2030 Agenda for Sustainable Development, adopted by all United Nations Member States in 2015, provides a shared blueprint for peace and prosperity for people and the planet through 17 Sustainable Development Goals (SDGs). 7 The Paris Agreement under the United Nations Framework Convention on Climate Change adopted on 12 December 2015 relates to one SDG specifically, i.e. Goal 13 which calls for urgent action to combat climate change and its impacts. The Paris Agreement officially entered into force on 4 November 2016, after 55 countries accounting for 55 per cent of the total global greenhouse gas emissions, deposited their instruments of ratification, acceptance or approval with the UN Secretary-General. As of June 2020, 195 signatories and 189 countries have joined the Paris Agreement. 8 CBI, Climate Bonds Standard and Certification Scheme, available at: https://www.cli matebonds.net/. 9 ICMA (June 2018), Green Bond Principles, available at: https://www.ICMAgroup. org/assets/documents/Regulatory/Green-Bonds/Green-Bonds-Principles-June-2018270520.pdf. 10 ICMA (June 2020), Social Bond Principles, available at: https://www.ICMAgr oup.org/assets/documents/Regulatory/Green-Bonds/June-2020/Social-Bond-Principle sJune-2020-090620.pdf. 11 ICMA (June 2018), Sustainable Bond Guidelines, available at: https://www.ICMAgr oup.org/assets/documents/Regulatory/Green-Bonds/Sustainability-Bonds-GuidelinesJune-2018-270520.pdf.

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(SLBP)12 to ensure that products labelled as such feature common characteristics. ICMA also sought to order the use of terminology in the international capital markets by issuing high-level definitions.13 By way of example, according to ICMA, “Sustainable finance” is understood to incorporate climate, green and social finance with further sustainability considerations in relation to economic stability of the relevant issuer and the financial system.14 In the realm of project finance, project-related bridge and corporate loans and advisory, financial institutions have signed up to the Equator Principles (EPs) of the Equator Principles Association (EPA), as a result of which they are committed to determining, assessing and managing environmental and social risk in projects, which is intended to provide a minimum standard for due diligence and monitoring to support responsible risk decision-making. The member financial institutions have committed to implementing the EPs in their internal environmental and social policies, procedures and standards for financing projects and not to provide financing to projects where the client will not, or is unable to, comply with the EPs.15 10.2.2

Green, Social and Sustainability(-Linked) Loans and Bonds

In 2019, the volume of sustainable debt issued globally in any one year hit a record USD 465 billion globally (of which green bonds constituting more than half with USD 271 billion issued in 2019), so that the all-time,

12 ICMA (June 2020), Sustainability-linked Bond Principles, available at: https://www. ICMAgroup.org/assets/documents/Regulatory/Green-Bonds/June-2020/SustainabilityLinked-Bond-PrinciplesJune-2020-100620.pdf. 13 For example, ICMA (May 2020), Sustainable Finance, High-level Definitions, available at: www.ICMAgroup.org/assets/documents/Regulatory/Green-Bonds/SustainableFinance-High-Level-Definitions-May-2020-110520.pdf. 14 ICMA, Sustainable Finance, High Level Definitions, page 5, available at: www. ICMAgroup.org/assets/documents/Regulatory/Green-Bonds/Sustainable-Finance-HighLevel-Definitions-May-2020-110520.pdf. 15 Currently 108 Equator Principles Financial Institutions (EPFIs) in 38 countries have officially adopted the EPs, covering the majority of international project finance debt within developed and emerging markets, see: https://equator-principles.com/about/. The Equator Principles were last updated in July 2020, see: https://equator-principles.com/ wp-content/uploads/2020/05/The-Equator-Principles-July-2020-v2.pdf.

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cumulative issuance of sustainable debt reached USD 1.17 trillion by 31 December 2019.16 Many such products are based on voluntarily adopted principles or standards, such as the before mentioned Green Bond Principles (GBP),17 Social Bond Principles (SBP),18 Sustainability Bond Guidelines (SBG)19 and Sustainability-linked Bond Principles (SLBP)20 developed by ICMA. In short, the GBP, SBP and SBG regulate: 1. the use of proceeds: the proceeds of the securities issued are to be used for financing or refinancing green projects or objectives (in the case of green bonds), the financing or refinancing of social projects which produce positive social outcomes (in the case of social bonds) or to finance or re-finance a combination of both green and social projects (in the case of sustainable bonds). These projects and/or objectives are to be assessed and quantified by the issuer of the bonds; 2. the issuer’s framework for the process for selection of projects and the evaluation thereof, which include the process itself, eligibility and/or exclusion criteria for which proceeds may or may not be used, as well as green, social or sustainability standards/certifications; 3. the management of proceeds by the issuer: since money is fungible, the issuer is to have in place a process of tracking the expenditure of funds in its accounts; 16 All figures as reported by Bloomberg research company BloombergNEF, see: https://about.bnef.com/blog/sustainable-debt-sees-record-issuance-at-465bn-in-2019up-78-from-2018/. 17 ICMA (June 2018), Green Bond Principles, available at: https://www.ICMAgroup. org/assets/documents/Regulatory/Green-Bonds/Green-Bonds-Principles-June-2018270520.pdf. 18 ICMA (June 2020), Social Bond Principles, available at: https://www.ICMAgr oup.org/assets/documents/Regulatory/Green-Bonds/June-2020/Social-Bond-Principle sJune-2020-090620.pdf. 19 ICMA (June 2018), Sustainable Bond Guidelines, available at: https://www.ICMAgr oup.org/assets/documents/Regulatory/Green-Bonds/Sustainability-Bonds-GuidelinesJune-2018-270520.pdf. 20 ICMA (June 2020), Sustainability-linked Bond Principles, available at: https://www. ICMAgroup.org/assets/documents/Regulatory/Green-Bonds/June-2020/SustainabilityLinked-Bond-PrinciplesJune-2020-100620.pdf.

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4. the reporting on progress against the criteria above, for example in annual reports. The GBP and SGP also recommend that there is third-party verification (i.e. an external review) of the issuer’s green and social bond framework and reporting. This can come in the form of an opinion, certification, scoring and/or rating. In the loan markets, similar distinctions between loans for green/ESG purposes or projects on the one hand and borrowers’ ESG frameworks for ESG behaviours on the other hand have evolved between Green Loan Principles (GLP) and Sustainability-linked Loan Principles (SLLP) issued by the Loan Market Association (LMA), the Asia Pacific Loan Market Association (APLMA) and the Loan Syndications & Trading Association (LSTA), thereby helping to develop a global market for green and sustainability-linked loan products.21 The table below sets out the main differences and similarities in relation to ESG financial products. Differences and similarities in ESG financial productsa Green, social and sustainability loan/bonds: Use of proceeds determines classification. Proceeds to be used to finance or refinance Green Projects or objectives assessed and quantified by issuer

Process applies for project evaluation and selection (process, eligibility/exclusion criteria, green standards/certifications) Management of proceeds applies (tracking funds, auditor/third party)

Sustainability-linked loan/bonds: Use of proceeds not determining classification Instead, focus on relationship to Borrower’s overall Corporate Social Responsibility (CSR) strategy: • proceeds may be used for general corporate purposes • pricing linked to ESG/sustainability performance of the borrower’s business (as a whole, e.g. ESG score, or against certain criteria) Substantive target setting and measuring the sustainability of the Borrower Management of proceeds not applicable (continued)

21 LMA (May 2020), Global Loan Market Associations Launch New Guidance Documents to Support the Green Loan Principles and the Sustainability Linked Loan Principles, available at: https://www.lma.eu.com/news-publications/press-releases?id=176.

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(continued) Differences and similarities in ESG financial productsa Reporting (annual report) applies Third-party verification (external review of green bond framework, reporting, opinion, certification, scoring, rating) is recommended, not required

Reporting applies Review/Third-party oversight generally required

a Author’s own elaboration

10.2.3

ESG Market Infrastructure

In addition to financial products or issuers/borrowers being assessed according to ESG criteria, a number of stock exchanges have sought to create ESG listings, trading platforms and indices. For example, the Luxembourg Stock Exchange (LSE) created the Luxembourg Green Exchange LGX, which is dedicated exclusively to sustainable financial instruments, including green, social, sustainable and ESG securities provided that issuers provide full disclosure and fulfil reporting obligations.22 Other investment firms and exchanges have created indices, in which they have included issuers that meet certain ESG criteria, for example the Dow Jones Sustainability World Index.23 Investors willing to invest in sustainable finance instruments also flock to ESG investment funds, which may consist of sustainable finance securities or issuers with projects that meet ESG criteria as formulated by the relevant funds. Again, these funds do so on a voluntary basis to meet market demand, and are not under a legal obligation to do so, nor are they bound to any terminology or standards used in the market, so they apply their own standards. Credit rating agencies have also begun to issue ratings with green and ESG factors, with each rating agency applying its own criteria. Generally, 22 https://www.bourse.lu/green. 23 The Dow Jones Sustainability World Index is constituted of companies that are weighted in accordance with ESG characteristics, including Carbon to Value Invested, Carbon to Revenue, Weighted Average Carbon Intensity and Fossil Fuel Reserve Emissions. See: https://www.spglobal.com/spdji/en/indices/equity/dow-jones-sustainabilityworld-index/#data.

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ESG factors are considered in credit rating analyses in relation to country risk assessments, risk position and corporate governance.24

10.3 The Legal Framework Applicable to ESG in the Financial Markets The current status of ESG in the financial markets is based mainly on the principles, guidelines and initiatives of voluntary application to financial market participants, as described in paragraph II. There are provisions in existing legislative instruments that accommodate and seek to promote such application. These include corporate governance rules and principles generally and for the financial sector specifically, as well as risk management and prudential rules which have been subject to ESG favourable supervisory practices. The EU Framework Regulation and Sustainable Finance Disclosure Regulation are a direct intervention in the financial sector designed to actively promote and accelerate sustainable finance. 10.3.1

Corporate Governance

Corporate governance rules promoting the long-term interests of companies and their stakeholders have been understood as implying—and in some cases explicitly provide for—consideration of impact of companies on climate and environment-related aspects.25 At an EU level, the Shareholders Engagement Directive encourages long-term shareholder engagement, so as to favour sustainable finance and ESG goals. In particular, the Shareholders Engagement Directive requires member states to impose on equity investors in publicly listed companies the requirement to disclose their investment strategies.26 The directive considers shareholder engagement as “one of the levers that 24 S&P Global, ESG in Credit Ratings, see: https://www.spglobal.com/ratings/en/

products-benefits/products/esg-in-credit-ratings; Moody’s, ESG & Climate Risk, see: https://esg.moodys.io/insights-analysis#insights-MIS. 25 For a detailed discussion, see Chapter 5 by A. M. Pacces. 26 Directive (EU) 2017/828 of the European Parliament and of the Council of 17

May 2017 amending Directive 2007/36/EC as regards the encouragement of long-term shareholder engagement (investment strategies).

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can help improve the financial and non-financial performance of companies, including as regards environmental, social and governance factors, in particular as referred to in the Principles for Responsible Investment, supported by the United Nations ”.27 For EU financial institutions, corporate governance rules set out in capital requirements legislation has been a basis for environmentally responsible conduct.28 10.3.2

Supervisory Practices

In addition to corporate governance matters, supervisory practices of relevant competent authorities have embedded ESG in existing legislation in relation to (i) risk management, and (ii) prudential supervision, the idea being that climate risks facing financial institutions or their clients need to be considered, managed and provided for in capital buffers.29 The Network for Greening the Financial System (NGFS)30 supports a smooth transition towards a low-carbon economy. On 17 April 2019, the NGFS published its first report with recommendations on how central banks and supervisors can foster a greener financial system.31 By way of example, the ECB has adopted key areas of focus on ESGrelated issues: (i) climate change is taken into account in the ECB’s macroeconomic models, forecasting methods, and risk assessments, (ii) as supervisor it engages with banks to raise awareness of risks emerging from climate change so that these risks are managed appropriately, (iii) monetary policy is executed with a view to ESG (e.g. as part of the ECB’s 27 Recital 15 of the Shareholders Engagement Directive. 28 Capital requirements are set out in the Capital Requirements Directive (Direc-

tive 2013/36/EU) and the Capital Requirements Regulation (Regulation (EU) No 575/2013) and legislative instruments pursuant thereto. CRD/CRR refer to sustainability of policies and practices of financial institutions, underlining long-term considerations. 29 The ECB has made clear that climate scenario analysis and stress testing should explicitly feed into banks’ capital adequacy to help drive the European Green Deal. The US, meanwhile, shows no sign of introducing climate-risk stress tests for its banks. See: https://www.fitchratings.com/research/banks/climate-stress-tests-will-eventu ally-influence-bank-capital-10-09-2020. 30 NGFS members include central banks and financial supervisors from all five continents. 31 For a further discussion of the role of supervisors in the financial markets, see Chapter 9 by A. L. Riso.

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asset purchase programmes, the ECB has invested in green bonds), and (iv) financial stability experts measure and assess the risks posed to the financial system by climate change.32 The ECB and ESMA have also focussed on credit rating agencies taking more and improved action for the measurement, disclosure and incorporation of ESG factors in credit ratings. The aim is for credit rating agencies to disclose more detailed information as regards the analysis and data they use, as well as the assumptions they make, when assessing the relevance of climate change risk for credit ratings.33 By way of another example, on 3 April 2019, the Dutch Authority for the Financial Markets and the French Autorité des Marchés Financiers (AMF) published a Position Paper on their supervisory practices for prospectuses for green bonds.34 The stated goal was for investors in green bonds to make an informed investment decision while allowing the green bond market to develop. The regulators imposed minimum requirements on the information in prospectuses by issuers choosing to issue “green” bonds. The prospectus for green bonds should include additional information regarding: – – – –

use of proceeds; selection of funded projects; management of proceeds; and the intention of the issuer to comply with green bond standards; to publish a reporting on the use of the green bond proceeds; and to mandate a third-party verification.

32 ECB, Climate Change and the ECB, see: https://www.ecb.europa.eu/ecb/orga/cli mate/html/index.en.html. 33 ESMA (July 2019), Final Report Guidelines on Disclosure Requirements Applicable to Credit Ratings, available at: https://www.esma.europa.eu/sites/default/files/library/ esma33-9-320_final_report_guidelines_on_disclosure_requirements_applicable_to_credit_ rating_agencies.pdf. 34 AFM (April 2019), Sustainable Finance: The AFM and AMF Publish a Common Position on the Content of the Prospectus for Green Bonds, see: https://www.afm.nl/en/ nieuws/2019/apr/transparantie-prospectus-groene-obligaties.

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10.3.3

Non-financial Reporting

Non-financial reporting, e.g. in annual accounts, on ESG factors has been a requirement of corporate law and audit rules and regulations for years. For example, in the UK, the Companies Act 2006 includes Section 172(1) which requires all companies qualifying as large under the Companies Act 2006 and certain medium-sized companies to report—in their “Section 172 reporting”— on climate and environmental matters. In the EU, large companies35 are required to disclose certain nonfinancial information on the way they operate and manage social and environmental challenges with the aim of (i) helping investors, consumers, policy makers and other stakeholders to evaluate the non-financial performance of large companies and (ii) encouraging these companies to develop a responsible approach to business. The non-financial reporting directive (NFRD) lays down the rules on disclosure of non-financial and diversity information by large companies, which have applied since 2018.36 Under the NFRD, large companies have to publish reports on the policies they implement in relation to: environmental protection, social responsibility and treatment of employees, respect for human rights, anticorruption and bribery and diversity on company boards (in terms of age, gender, educational and professional background). In June 2017 and June 2019, the European Commission published guidelines that, in essence, request companies to disclose more ESG and climate-related information.37 In December 2019, as part of the European Green Deal, the European Commission committed to reviewing the NFRD to achieve two objectives: (i) to improve disclosure of climate and environmental data 35 The EU rules on non-financial reporting apply to large public-interest companies with more than 500 employees. This covers approximately 6,000 large companies and groups across the EU, including listed companies, banks, insurance companies and other companies designated by national authorities as public-interest entities. See: https://ec.europa.eu/info/business-economy-euro/company-reporting-and-aud iting/company-reporting/non-financial-reporting_en. 36 Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups. 37 The European Commission guidelines on non-financial reporting, first published on 26 June 2017 (last update on: 18 June 2019), available at: https://ec.europa.eu/info/ publications/non-financial-reporting-guidelines_en#climate.

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by companies to better inform investors about the sustainability of their investments, and (ii) to give effect to changes required by the new Sustainable Finance Disclosure Regulation and the Framework Regulation.38 It launched a consultation to review the most significant problems with reporting on ESG factors in non-financial information to date: non-financial information reported by companies is deficient in terms of comparability, reliability and relevance, and many reporting companies experience significant problems with requests for non-financial information, for example from rating agencies or NGOs. A common standard of reporting on ESG and auditing thereof could be imposed in the future to address the identified problems.39 10.3.4

Taxonomy Regulation

As part of its Action Plan, the European Commission adopted a proposal for a Regulation on the establishment of a framework to facilitate sustainable investment (the Framework Regulation or Taxonomy regulation) in May 2018.40 The Taxonomy regulation is in effect since 22 June 2020. The Taxonomy regulation establishes a classification system (or taxonomy) to establish market clarity on what economic activities should be considered “sustainable”. The European Commission considers this necessary due to the range of interpretations by member states as to what counts as a sustainable investment. Standardising the concept of environmentally sustainable investment across the EU is, therefore, expected to both facilitate investment in environmentally sustainable economic activities, and enable economic operators to attract investment from abroad more easily.41 It is important to note that the Taxonomy regulation does not impose rules on the financial sector outright, but is rather an instrument to be

38 See below in paragraphs 4 and 5. 39 EC, Consultation Non-financial Reporting by Large Companies (updated rules),

available at: https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/ 12129-Revision-of-Non-Financial-Reporting-Directive/public-consultation. 40 Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088. 41 The Taxonomy regulation is discussed in more detail in Chapter 11 by Ch. V. Gortsos.

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used if another legislative instrument has imposed rules that need to be complied with from an ESG perspective. 10.3.5

Sustainable Finance Disclosure Regulation

In May 2018, the European Commission adopted a proposal for a regulation on disclosures relating to sustainable investments and sustainability risks (the Sustainable Finance Disclosure Regulation).42 The Sustainable Finance Disclosure Regulation entered into force on 29 December 2019 and will apply from 10 March 2021. The purpose of the Sustainable Finance Disclosure Regulation is to impose transparency and disclosure requirements on (a) financial market participants, (b) insurance intermediaries providing insurance advice on insurance-based investment products (IBIPs) and (c) financial advisors concerning the integration of sustainability risks in the investment decision-making process and advisory processes, so that end-investors in financial products can make informed investment choices. In short, the Sustainable Finance Disclosure Regulation requires firms to: i. publish written policies on the integration of sustainability risks in their investment decision-making process; ii. make pre-contractual disclosures on how they incorporate sustainability risks in their businesses; iii. comply with pre-contractual transparency rules on sustainable investments; iv. publish a description of the sustainable investments target and information on the methodologies used to assess, evaluate and monitor the effectiveness of investments; and v. describe in periodical reports the specification of the impacts of sustainable investments by means of relevant sustainability indicators, and ensure that all the information published on their websites

42 Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector.

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is kept up-to-date, including a clear explanation of any amendments to the published information.43 The Sustainable Finance Disclosure Regulation is not intended to regulate market access for these financial market participants and financial advisors. It does, however, govern the way their activities are carried out. Accordingly, the Sustainable Finance Disclosure Regulation has a direct impact on the activities of, for example, investment funds and financial advisers. Where those entities need to comply with the requirements of the Sustainable Finance Disclosure Regulation, they may need to procure information from other parties that are not directly caught by it. For example, an investment fund in the renewable energy sector that is subject to the Sustainable Finance Disclosure Regulation will need information from the issuers of its investments in order to compile relevant information on the sustainability indicators on which it will need to provide information in periodical reports under the Sustainable Finance Disclosure Regulation. This means that a wide range of entities that are not subject to financial markets regulation and are not in scope of the Sustainable Finance Disclosure Regulation, such as corporate issuers, will be faced with requirements imposed on them by their lenders, investors and other parties to comply with elements of the Sustainable Finance Disclosure Regulation, as if it applies to them directly. The expectation is, and this is already a reality in practice, that financial market participants who are in scope of the Sustainable Finance Disclosure Regulation—whether directly such as investment firms, or indirectly such as banks—impose information covenants on their clients in relation to ESG to ensure their own compliance with the Sustainable Finance Disclosure Regulation.44

43 The Sustainable Finance Disclosure Regulation is discussed in more detail in Chapter 12 by D. Busch. 44 For example, banks have started to impose general information undertakings in loan documentation that the borrower will provide ESG relevant information at request.

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10.4 Upcoming Legislative and Regulatory Developments 10.4.1

EU Green Bond Standard

On 12 June 2020, the European Commission launched a public consultation on the creation of a European standard for green bonds.45 The European Commission notes that there is no uniform green bond standard within the EU as yet and that this has created barriers in the financial markets.46 The Commission proposes the establishment of a uniform standard for EU Green bonds, which is to reduce uncertainty about what constitutes “green” investment (by linking the standard to the Framework Regulation), to standardise costly and complex verification and reporting processes; and to establish an official standard to which potential green/ESG incentives could be linked. It has been a topic of discussion for some time whether any EU Green Bond Standard would be mandatory or of voluntary application for financial market participants. Mandatory application could have the adverse effect of financial market participants (such as issuers and investors) using other financial instruments (e.g. SDG-linked instruments) that are not subject to mandatory standards, thus defeating the overall purpose of the Action Plan to stimulate green investments. From the consultation it appears that current thinking at the European Commission is that voluntary application of the EU Green Bond Standards is best; issuers who wish to issue green investment products can continue to do so, whereas investors who wish to issue products in accordance with the EU Green Bond Standard can make use of the advantages that the standard would offer in terms of recognition and understanding in the market, standardised processes and incentives met. 10.4.2

EU Climate Benchmarks

The EU Benchmark Regulation provides a regulatory framework for benchmarks at the EU level to ensure the proper functioning of the EU

45 The consultation period ends on 2 October 2020. 46 EC, Targeted Consultation Document. Establishment of an EU Green Bond Standard,

see: https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_fin ance/documents/2020-eu-green-bond-standard-consultation-document_en.pdf.

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financial markets and a high level of consumer and investor protection.47 The general idea is that benchmarks and indices (such as EURIBOR, LIBOR or other, e.g. green, benchmarks) used in financial instruments and financial contracts or used to measure the performance of investment funds are appropriately administered, contributed to and used by financial market participants. The Benchmark Regulation was amended by the introduction of a regulatory framework which lays down minimum requirements at the EU level for EU Climate Transition Benchmarks and EU Parisaligned Benchmarks. Accordingly, financial instruments that reference EU climate transition and alignment with the Paris Agreement should meet minimum requirements as to their administration, contribution thereto and use thereof. Such benchmarks should not significantly harm other environmental, social and governance (ESG) objectives. The EU Climate benchmarks Regulation48 entered into effect on 10 December 2019 and was supplemented by two delegated regulations, which have been adopted on 17 July 2020, but have not yet entered into effect.49 The regulations include minimum standards for benchmarks that are labelled “EU Climate Transition Benchmarks” and “EU Paris-aligned Benchmarks”, as well as rules on disclosure in benchmark statements how ESG factors are provided and published, so as to increase the comparability of benchmarks with regard to ESG factors. The delegated acts set out the minimum content of the ESG factors to be disclosed as well as the standard formats for the presentation of that information. 47 Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014 (Text with EEA relevance). 48 Regulation (EU) 2019/2089 of the European Parliament and of the Council of 27 November 2019 amending Regulation (EU) 2016/1011 as regards EU Climate Transition Benchmarks, EU Paris-aligned Benchmarks and sustainability-related disclosures for benchmarks. 49 Commission Delegated Regulation supplementing Regulation (EU) 2016/1011 of the European Parliament and of the Council as regards minimum standards for EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks; and Commission Delegated Regulation supplementing Regulation (EU) 2016/1011 of the European Parliament and of the Council as regards the explanation in the benchmark statement of how environmental, social and governance factors are reflected in each benchmark provided and published.

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The difficulty of the EU Climate benchmarks Regulation already being effective, but the delegated regulations not yet, gives rise to legal uncertainty for benchmark administrators and contributors, as they cannot adequately determine their content and/or whether they are compliant with the regulations. This also gives rise to legal uncertainty for competent authorities tasked with supervision and enforcement of the regulations. Accordingly, ESMA issued a no-action letter on 29 April 2020 that competent authorities should not prioritise any supervisory or enforcement action in relation to certain requirements of the EU Climate benchmarks Regulation, until the delegated acts apply.50 10.4.3

Amendments to Existing Financial Markets Legislation

In addition to the proposals outlined pursuant to the Action Plan, in July 2018 the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA) were mandated by the European Commission to provide technical advice on potential amendments to, or the introduction of, delegated acts regarding the integration of sustainability risks and sustainability factors under various sector-specific directives and regulations. As a result, the following EU-level rules and regulations are under review to promote ESG objectives. 10.4.3.1 MIFID II Amendments In view of the EU’s ESG ambitions, several amendments are underway affecting the investment services industry. MIFID II51 introduced a number of requirements applicable to financial market participants providing investment services, including in relation to their own governance, product manufacturing and distribution (“product governance”) and transparency. These rules are amended and integrated to ensure that sustainability and ESG become part of the DNA of investment firms.

50 ESMA (29 April 2020), No Action Letter, available at: https://www.esma.europa.eu/ sites/default/files/library/esma41-137-1300_esmar_article_9a3_opinion_-_bmr_nca.pdf. 51 The Markets in Financial Instruments (MiFID II) Directive 2014/65/EU and the Markets in Financial Instruments (MiFIR) Regulation (EU) No 600/2014.

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A Draft Commission Delegated Directive proposes to integrate sustainability factors and preferences into product governance obligations.52 The draft directive was consulted on, but has not yet been adopted. The general purpose of the draft directive is to support the Action Plan’s goals of seeking to ensure investors have clear information on the social and environmental risks and opportunities attached to their investments and to shift capital flows away from activities with negative social and environmental consequences, and direct them towards socially responsible ones. The draft requires fund managers to properly inform investors about the environmental, social and governance risks involved in their investment. Simultaneously, two draft Commission Delegated Regulations were consulted on in relation to (a) integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms,53 and (b) the integration of ESG considerations and preferences into the investment advice and portfolio management.54 10.4.3.2 Investments and Insurance (UCITS, AIFMD, IDD) Funds and funds managers subject to UCITS and AIFMD55 will also see amendments and additions to the rules applying to them to incorporate sustainability risks and factors into their organisation, operations, product governance processes, investment advice and portfolio management. The following draft legal instruments will be imposed on the sector:

52 Draft Commission Delegated Directive amending Delegated Directive (EU) 2017/593 as regards the integration of sustainability factors and preferences into the product governance obligations. 53 Draft Commission Delegated Regulation amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms. 54 Draft Commission Delegated Regulation amending Delegated Regulation (EU) 2017/565 as regards the integration of Environmental, Social and Governance (ESG) considerations and preferences into the investment advice and portfolio management. 55 Commission Directive 2010/43/EU of 1 July 2010 implementing Directive 2009/65/EC of the European Parliament and of the Council as regards organisational requirements, conflicts of interest, conduct of business, risk management and content of the agreement between a depositary and a management company (UCITS) and Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 (AIFMD), respectively.

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i. Draft Commission Delegated Directive amending Directive 2010/43/EU as regards the sustainability risks and sustainability factors to be taken into account for UCITS; ii. Draft Commission Delegated Regulation amending Delegated Regulation (EU) No 231/2013 as regards the sustainability risks and sustainability factors to be taken into account by Alternative Investment Fund Managers under AIFMD; iii. Draft Commission Delegated Regulation amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms under MIFID II; iv. Draft Commission Delegated Directive amending Delegated Regulation Directive (EU) 2017/593 as regards the integration of sustainability factors and preferences into the product governance obligations of investment firms under MIFID II; v. Draft Commission Delegated Regulation amending Delegated Regulation Directive (EU) 2017/565 as regards the integration of ESG considerations and preferences into investment management advice and portfolio management. As and when these draft directives and regulations (which have been consulted upon) are adopted, they will affect the organisation of investment firms, their procedures, their risk management, the responsibility of their senior management, their handling of conflicting interests and due diligence. Also, investment firms are required to have resources and expertise to assess sustainability risks. In addition, the draft directives and regulations impose on investment firms a mandatory assessment of sustainability and ESG preferences of their clients and reporting thereon, taking into account the client’s sustainability preferences (and other factors), and any assessment of the target market for financial products must also by reference to ESG factors. For the insurance sector, similar changes are forthcoming under the Draft Commission Delegated Regulation requiring integration of ESG

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considerations and preferences into the investment advice for insurancebased investment products.56 10.4.4

Future Amendments

The European Commission intends to accelerate the allocation of capital towards sustainable investments and, as part of the European Green Deal, launched a Renewed Sustainable finance Strategy consultation.57 The consultation concluded that the financial and industrial sectors will be subject to large-scale transformation and massive investment and that this transformation is not occurring fast enough. Accordingly, the Renewed Sustainable finance Strategy focusses predominantly on three areas: 1. Strengthening the foundations for sustainable investment by creating an enabling framework, with appropriate tools and structures. Long-term development and sustainability-related challenges and opportunities should be the focus of corporate and financial entities. 2. The impact of the frameworks and tools should be maximised in order to “finance green”. 3. Climate and environmental risks will need to be fully managed and integrated into financial institutions and the financial system as a whole, while ensuring social risks are duly taken into account where relevant. It is expected that further legal and regulatory initiatives will be on their way to the financial markets.

56 Draft Commission Delegated Regulation amending Delegated Regulation (EU) 2017/2359 as regards the integration of ESG considerations and preferences into the investment advice for insurance-based investment products. 57 EC, Consultation Document. Consultation on the Renewed Sustainable Finance Strategy, see: https://ec.europa.eu/info/sites/info/files/business_economy_euro/ban king_and_finance/documents/2020-sustainable-finance-strategy-consultation-document_ en.pdf.

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10.5 Concluding Remarks on the Impact of Legislative Developments on the Financial Markets As discussed in this chapter, the financial markets have focussed on sustainable finance already for many years, without a legal and regulatory framework imposing such focus on them. Sustainable finance instruments developed and market practices became identifiable, with industry associations such as ICMA and the LMA providing principles and guidelines to help market participants forward in their ESG ambitions. The EU legislator has taken inspiration from current market practices and seeks to accelerate the move to “green finance” by elevating existing market principles and guidelines to legal requirements applicable to all throughout the European Union (e.g. the EU Green Bond Standard is clearly inspired by ICMA principles for green, social and sustainability bonds). In addition, regulated entities in the financial markets are asked to make ESG part of their DNA by new legal requirements in a comprehensive package of EU-level directives and regulations for the financial sector with the aim that ESG is part of every financial market participant’s operations, governance, products and clients. From client onboarding, and identifying the client’s investment preferences, to advisory, disclosure and reporting on the ESG impact of (potential) investments, to corporate governance and product governance of financial sector entities, the EU rules and regulations will affect the financial markets significantly. Simultaneously, regulators and supervisors are pro-actively making and executing policies that support the transition to sustainable finance by issuing guidance, focussing on climate risk management in prudential supervision and taking enforcement measures that favour ESG principles. Also non-regulated entities will feel the impact of the legal and regulatory burden for the financial sector, as they are asked to provide information, undertakings and reporting in an effort to “green financing” in the EU. In conclusion, then, ESG was already and will remain a main driver for developments in the financial markets relevant to all financial market participants.

CHAPTER 11

The Taxonomy Regulation: More Important Than Just as an Element of the Capital Markets Union Christos V. Gortsos

11.1 Subject Matter and Scope of the Regulation---Environmental Objectives 11.1.1

Subject Matter

11.1.1.1 Introductory Remarks On 18 June 2020, the European Parliament and the Council adopted in accordance with the ordinary legislative procedure1 Regulation (EU) 1 TFEU, Article 289(1). 2 OJ L 198, 22.6.2020, pp. 13–43.

The cut-off date for information included therein is 31 March 2021. C. V. Gortsos (B) Law School of the National and Kapodistrian University of Athens, Athens, Greece © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_11

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2020/852 “on the establishment of a framework to facilitate sustainable investment and amending Regulation (EU) 2019/2088”2 (the “Taxonomy regulation”, TR ). This legislative act was adopted on the basis of Article 114 TFEU, entered into force on 12 July 2020,3 is binding in its entirety and directly applicable in all Member States4 and is consistent with the principles of subsidiarity and proportionality.5 It constitutes, along with the legislative act it amends, namely Regulation (EU) 2019/2088 of the same institutions of 27 November 2019 “on sustainability-related disclosures in the financial services sector”,6 (commonly referred to as the “Sustainable Finance Disclosure Regulation”, SFDR ) and Regulation (EU) 2019/2089 of the same institutions of 27 November 2019 (as well) “amending Regulation (EU) 2016/1011 as regards EU Climate Transition Benchmarks, EU Parisaligned Benchmarks and sustainability-related disclosures for benchmarks”7 (the “Low Carbon Benchmarks Regulation”), the “regulatory trilogy” implementing the (European) Commission’s 2015 Action Plan “on Building a Capital Markets Union”8 (CMU) in relation to sustainable finance.9

3 TR, Article 27(1). 4 Ibid., last sentence. 5 Ibid., recital (60). 6 OJ L 317, 9.12.2019, pp. 1–16. 7 OJ L 317, 9.12.2019, pp. 17–27. 8 COM/2015/468 final, available at: https://ec.europa.eu/info/publications/midterm-review-capital-markets-union-action-plan_en. 9 ‘Sustainable finance’ can be defined as the aggregate of financing and related institutional and market arrangements that contribute to the achievement of strong, sustainable, balanced and inclusive growth, through supporting directly and indirectly the framework of the Sustainable Development Goals (SDGs) (see G20 Sustainable Finance Study Group (2018). Synthesis Report, July, available at: http://www.g20.utoronto.ca/2018/ g20_sustainable_finance_synthesis_report.pdf. It is also noted that the establishment of an internal market that works for the sustainable development of the EU, based, inter alia, on balanced economic growth and a high level of protection and the improvement of the quality of the environment, is laid down in Article 3(3) TEU (on this Article, see by means of mere indication U. Becker (2019). Artikel 3 des EUV, in Schwarze, J., Becker, U., Hatje, A. und J. Schoo (2019, Hrsg.): EU -Kommentar, 4. Auflage, Nomos Verlagsgesellshaft, Baden-Baden, pp. 53–59. Sustainability and the transition to a safe, climate-neutral, climate-resilient, more resource-efficient and circular economy are crucial to ensuring the long-term competitiveness of the EU economy (TR, recital (4)).

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(2) It is noted in this respect that the Commission Communication of 8 June 2017 on the “Mid-Term Review of the [CMU] Action Plan”10 set nine priority actions concerning seven issue-areas, which should constitute the basis for the foundation of the CMU by 2019.11 Priority action (6) of this Review concerned a concrete follow-up to the recommendations of the High-Level Expert Group (HLEG) on Sustainable Finance, which was set up by the Commission in December 2016 with the mandate to develop an overarching and comprehensive EU strategy on sustainable finance,12 addressing climate-related and environmental risks.13 In this respect, the Commission submitted proposals aimed at improving

10 COM(2017) 292 final, available at: https://ec.europa.eu/info/sites/info/files/com munication-CMU-mid-term-review-june2017_en.pdf. 11 The consolidated set of measures is laid down in the Annex to the Communication. The Commission’s Q&As on this Review are available at: http://europa.eu/rapid/pressrelease_MEMO-17-1528_en.htm. On the evolution of the CMU project, see the various contributions in Busch, D., Avgouleas, E. and G. Ferrarini (2018, editors). Capital Markets Union in Europe, Oxford EU Financial Regulation Series. UK: Oxford University Press; Lannoo, K. and A. Thomadakis (2019). Rebranding Capital Markets Union: A Market Finance Action Plan. CEPS-ECMI Task Force Report, Centre for European Policy Studies (available at: https://www.ceps.eu/wp-content/uploads/2019/06/RebrandingCapital-Markets-Union.pdf), the Final Report of the High-Level Forum on the Capital Markets Union of June 2020 “A New Vision for Europe’s Capital Markets” (available at: https://ec.europa.eu/info/files/200610-CMU-high-level-forum-final-report_en), and the Special Report 25/2020 of the European Court of Auditors of 11 November “Capital Markets Union—Slow Start Towards an Ambitious Goal” (available at: https://www. eca.europa.eu/en/Pages/DocItem.aspx?did=57011). The most recent Action Plan on this field, amidst the current pandemic crisis, is contained in the Commission Communication of 24 September 2020 “A Capital Markets Union for People and Businesses—New Action Plan” (COM(2020) 590 final, available at: https://ec.europa.eu/info/publicati ons/200924-capital-markets-union-action-plan_en). The measures to support, inter alia, a green recovery, are contained in Section 1 (pp. 7–10, Actions 1–6). 12 Its Report of 31 January 2018, titled “Financing a Sustainable European Economy”,

called for the creation of a technically robust classification system at EU level to establish clarity on which activities qualify as ‘green’ or ‘sustainable’ (TR, recital (5)) (available at: https://ec.europa.eu/info/sites/info/files/180131-sustainable-finance-final-report_en. pdf). On the work of the HLEG, see Alexander, K. (2019). Principles of Banking Regulation. UK: Cambridge University Press, pp. 366–369. 13 On

these risks, which combine two main risk drivers (i.e., physical and transition risk), see by means of indication European Central Bank (2020): “Guide on Climate-Related and Environmental Risks: Supervisory Expectations relating to Risk Management and Disclosure”, 27 November, pp. 10–15 (available at: https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.202011finalguideoncli mate-relatedandenvironmentalrisks~58213f6564.en.pdf).

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disclosure and integrating sustainability as well as environmental, social and governance (ESG) considerations fully in rating methodologies and supervisory processes, as well as in the investment mandates of institutional investors and asset managers. It also committed to develop an approach for taking sustainability considerations into account in upcoming legislative reviews of financial legislation.14 (3) The TR builds on the work of the HLEG and is also substantially based on the Report of the Technical Expert Group on Sustainable Finance (TEG) set up by the Commission in line with its legislative proposals of May 201815 to assist it in developing, inter alia, the socalled EU taxonomy. This is a unified EU (green) classification system to determine if an economic activity is environmentally sustainable, which was published in March 2020.16 Of particular relevance in this context is also the Commission Communication of 8 March 2018 on an “Action Plan on Financing Sustainable Growth”,17 Action 1 which calls for the establishment of the EU taxonomy.18

14 In this respect, inter alia, all three Regulations governing the European Supervisory Authorities (ESAs, namely the EBA, the ESMA and the EIOPA) were amended by virtue of Regulation (EU) 2019/2175 of the European Parliament and of the Council of 18 December 2019 (OJ L 334, 27.12.2019, pp. 1–145), which clarifies and strengthens their existing powers, while also attributing new powers to them in targeted areas, including the taking into account of sustainable business models and the integration of environmental, social and governance (ESG) factors when acting within its scope of action and carrying out its tasks [Article 1(3)]. See further below, under 11.6.2. 15 See at: https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sus tainable-finance_en#implementing. 16 On the TEG, see at: https://ec.europa.eu/info/publications/sustainable-financetechnical-expert-group_en. Its Report provides recommendations relating to the TR’s overarching design, as well as guidance on making disclosures using the taxonomy. It is supplemented by a technical annex containing technical screening criteria (TSC) for 70 climate change mitigation and 68 climate change adaptation activities, including criteria for do no significant harm to other environmental objectives, as well as a methodology section to support the recommendations on the TSC (see under 11.1.3 below). The Report is available at: https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_fin ance/documents/200309-sustainable-finance-teg-final-report-taxonomy_en.pdf. 17 COM/2018/097 final (available at: https://eur-lex.europa.eu/legal-content/EN/ TXT/?uri=CELEX%3A52018DC0097). 18 A main objective set out therein is the reorientation of capital flows towards sustainable investments to achieve sustainable and inclusive growth and, in that respect, the most important and urgent action envisaged is the establishment of a unified classification system

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11.1.1.2

The Considerations Set Out in the Regulation on Harmonisation of Rules, the Disclosure Framework and Private Sector Initiatives (1) In accordance with its title, the TR establishes “a framework to facilitate sustainable investment ”. In this respect, it is considered that a necessary condition to enable the development of future EU policies in support of sustainable finance, including EU-wide standards for environmentally sustainable financial products and the eventual establishment of labels that formally recognise compliance therewith (“eco-labels”), is the establishment of a classification system for environmentally sustainable economic activities at EU level, which could also serve as the basis for other economic and regulatory measures.19 Hence, uniform legal requirements for determining the degree of investments’ environmental sustainability, based on uniform (as well) criteria for environmentally sustainable economic activities, are necessary as a reference to facilitate investments’ shift towards such economic activities.20 (2) Within this conceptual framework, the TR sets out the criteria for determining whether an economic activity qualifies as environmentally sustainable for the purposes of establishing the degree to which an investment is environmentally sustainable as well.21 The harmonisation (at EU level) of these criteria aims at both removing barriers to the functioning of the internal market with regard to raising funds for sustainability projects and preventing the future emergence of barriers to such projects. The expectation is that such a harmonisation will allow economic operators “to find it easier to raise funding across borders for their environmentally sustainable activities, as their economic activities could be compared

for sustainable activities. Since the shift of capital flows towards more sustainable activities must be underpinned by a holistic understanding of the environmental sustainability of activities and investments, the Action Plan considers that, as a first step, clear guidance on activities that qualify as contributing to environmental objectives would help inform investors about the investments funding environmentally sustainable economic activities, while further guidance on activities contributing to other sustainability objectives (e.g., social ones) might be developed at a later stage (TR, recital (6)). 19 See also below, under 11.6.2. 20 TR, recital (16). 21 Ibid., Article 1(1).

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against uniform criteria in order to be selected as underlying assets for environmentally sustainable investments ” and, hence, facilitate cross-border sustainable investment in the EU.22 (3) In accordance with recital (10), “in view of the scale of the challenge and the costs associated with inaction or delayed action, the financial system should be gradually adapted in order to support the sustainable functioning of the economy. To that end, sustainable finance needs to become mainstream and consideration needs to be given to the sustainability impact of financial products and services ”. The channelling of private investments (capital flows) towards sustainable investments is considered (correctly so) as a precondition for achieving the Sustainable Development Goals (SDGs), as laid down in the 2015 United Nations (UN) global sustainable development framework (“The 2030 Agenda for Sustainable Development”23 ), which covers sustainability’s three dimensions, namely economic, social and environmental. An effective way for achieving this is to make available financial products which pursue environmentally sustainable objectives.24 Member States and the EU should (be required to) use a common concept of environmentally sustainable investment when introducing requirements at national and EU level regarding financial market participants or issuers for the purpose of labelling financial products or corporate bonds that are marketed as environmentally sustainable in order to promote the functioning of the internal market.25 National requirements that financial market participants or issuers have to comply with in order to market financial products or corporate bonds as environmentally sustainable should build on the above-mentioned uniform criteria for environmentally sustainable economic activities to avoid market fragmentation and harm to the interests of consumers and investors as a

22 Ibid., recital (12). 23 Available at: https://sustainabledevelopment.un.org/content/documents/212

52030%20Agenda%20for%20Sustainable%20Development%20web.pdf. 24 TR, recital (11), first sentence. See also Bose, S., Dong, G. and A. Simpson (2019). The Financial Ecosystem: The Role of Finance in Achieving Sustainability. Palgrave Studies in Impact Finance. Cham, Switzerland: Palgrave Macmillan. 25 On the current situation concerning national labelling schemes in place and the need to establish uniform criteria to incentivise economic operators to access cross-border capital markets for the purposes of sustainable investment, seethe considerations in recital (11), fourth to last sentences.

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result of diverging notions.26 In that respect, the term “environmentally sustainable investment” is defined to mean an investment in one or more economic activities that qualify as environmentally sustainable under the TR.27 (4) Apart from setting out the criteria for determining whether an economic activity qualifies as environmentally sustainable for the purposes of establishing the degree to which an investment is environmentally sustainable, the TR lays down a disclosure framework, which supplements the disclosure requirements laid down in the SFDR.28 By setting requirements for marketing financial products or corporate bonds as environmentally sustainable investments, including requirements set by Member States and the EU to allow financial market participants and issuers to use national labels, it aims at enhancing investor confidence and awareness of the environmental impact of these financial products or corporate bonds and at creating visibility. It also intends to alleviate the burden on investors’ own due diligence with regard to products’ environmental sustainability and address concerns of “greenwashing”, i.e., the practice of gaining an unfair competitive advantage by inaccurately marketing a financial product as environmentally friendly or “green”, when in fact basic environmental standards have not been met.29 (5) It is finally worth noting that in the context of achieving the SDGs in the EU, the creation, inter alia, of a European Fund for Strategic Investment has been effective in contributing to the channelling of private funds towards sustainable investments alongside public

26 Ibid., recital (14), first and second sentences. 27 In this respect and from a global perspective, see also the Report of 29 June 2017 by

the Task Force on Climate-related Financial Disclosures (TCFD) of the Financial Stability Board (FSB), which provides recommendations for consistent, comparable, reliable, clear and efficient climate-related financial disclosures by companies (“Recommendations of the Task Force on Climate-related Financial Disclosures”, available at: https://www.fsb.org/ wp-content/uploads/P290617-5.pdf). 28 TR, recital (55), first sentence [see also below under 11.4.1 (2)]. In accordance with its Article 1, the objective of that legislative act is to lay down harmonised rules for financial market participants and financial advisers on transparency with regard to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability-related information with respect to financial products. That legislative act is analysed in Chapter 11 (Busch, D. Sustainability Disclosure in the Financial Sector). 29 Ibid., recital (11), second and third sentences.

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spending.30 Furthermore, recital (8) considers that, in accordance with Decision No 1386/2013/EU of the European Parliament and of the Council of 20 November 2013 “on a General Union Environment Action Programme to 2020 ‘Living well, within the limits of our planet”,31 private sector funding for climate-related and environmental expenditure should also be increased. This could in particular be achieved by initiating incentives and methodologies that stimulate companies to measure the environmental costs of their business and profits derived from using environmental services. 11.1.2

Scope

On the basis of the above-mentioned considerations, the system of rules laid down in the TR is anchored in the definition of six specific environmental objectives32 ; these constitute the benchmark on the basis of which an economic activity can (be assessed to) qualify as environmentally sustainable33 and, consequently, the degree to which a financial investment is environmentally sustainable is established. The field of application of this legislative act covers34 :

30 Regulation (EU) 2015/1017 of the European Parliament and of the Council of 25 June 2015 “On the European Fund for Strategic Investments, the European Investment Advisory Hub and the European Investment Project Portal (…)—The European Fund for Strategic Investments” (OJ L 169, 1.7.2015, pp. 1–38) specifies a 40% climate investment target for infrastructure and innovation projects under the Fund [see recitals (2), (9) and (17)]. 31 OJ L 354, 28.12.2013, pp. 171–200. 32 See just below, under 11.1.3. 33 See under 11.2 below. 34 TR, Article 1(2), points (a)–(c), respectively and recital (14), third sentence.

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first, any legislative or other measures adopted by Member States or by the EU that set out requirements for financial market participants35 or issuers36 in respect of financial products37 or corporate bonds that are made available as environmentally sustainable; second, financial market participants that make available (environmentally sustainable) financial products; and third, undertakings which are subject to the obligation to publish a non-financial statement or a consolidated non-financial statement pursuant to Articles 19a or 29a, respectively, of Directive 2013/34/EU of the European Parliament and of the Council. of 26 June 2013 “on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings (…)”38 and issue environmentally sustainable corporate bonds. 11.1.3

Environmental Objectives

For the purpose of determining the environmental sustainability of a given economic activity, and on the basis of the recommendations contained in

35 The term ‘financial market participant’ is defined with reference to Article 2, point (1) SFDR and includes a manufacturer of a pension product to which a Member State has decided to apply that legislative act in accordance with Article 16 thereof [Ibid., Article 2, point (2)]. 36 The term ‘issuer’ is defined with reference to Article 2, point (h) of the Prospectus Regulation (Regulation (EU) 2017/1129 of the European Parliament and of the Council of 14 June 2017, OJ L 168, 30.6.2017, pp. 12–82) [Ibid., Article 2, point (4)]. 37 The term ‘financial product’ is defined [Ibid., Article 2, point (3)] with reference to Article 2, point (12) SFDR, meaning all of the following: a portfolio which is managed in accordance with Article 2, point (6); an alternative investment fund (AIF); an ‘insurancebased investment product’(IBIP); a pension product; a pension scheme; an undertaking for collective investment in transferable securities (UCITS); or a ‘pan-European Personal Pension Product’ (PEPP). It is noted that bank lending is not covered either by this definition or by the TR (and the SFDR) in general. 38 OJ L 182, 29.6.2013, pp. 19–76. Articles 19a and 29a were inserted into that legislative act by Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 (OJ L 330, 15.11.2014, pp. 1–9, the ‘EU Non-Financial Reporting Directive’).

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(above-mentioned) TEG’s final Report, the TR contains an exhaustive list of six environmental objectives. These are the following39 : First, climate change mitigation, meaning the process of holding the increase in the global average temperature to well below 2°C and pursuing efforts to limit it to 1,5°C above pre-industrial levels, as laid down in the Paris Agreement.40 This environmental objective should be interpreted in accordance with relevant EU law, including Directive 2009/31/EC of the European Parliament and of the Council of 23 April 2009 “on the geological storage of carbon dioxide (…)”.41 Second, climate change adaptation, meaning the process of adjustment to actual and expected climate change and its impacts.42 This objective should be interpreted in accordance with relevant EU law and the Sendai Framework for Disaster Risk Reduction 2015–2030.43 39 TR, Article 9 and recital (23). According to recital (7) given the systemic nature of global environmental challenges, environmental sustainability should be approached on a systemic and forward-looking basis, addressing growing negative trends, such as climate change, the loss of biodiversity, the global overconsumption of resources, food scarcity, ozone depletion, ocean acidification, the deterioration of the fresh water system, and land system change as well as the appearance of new threats, such as hazardous chemicals and their combined effects. 40 Ibid., Article 2, point (5). The Paris Agreement was approved in the EU by Council Decision (EU) 2016/1841 of 5 October 2016 “on the conclusion, on behalf of the European Union, of the Paris Agreement adopted under the UN Framework Convention on Climate Change” (OJ L 282, 19.10.2016, pp. 1–3). Article 2(1), point (c) of the Paris Agreement aims to strengthen the response to climate change by making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development, inter alia. In that context, on 12 December 2019, the European Council adopted conclusions on climate change, in light of which the TR represents a key step towards the objective of achieving a climate-neutral EU by 2050 (TR, recital (3)). 41 OJ L 140, 5.6.2009, pp. 114–135; Ibid., recital (24), third sentence. 42 Ibid., Article 2, point (5). 43 Ibid., recital (25), second sentence. The Sendai Framework, which was adopted at the Third UN World Conference in Sendai, Japan, on 18 March 2015, is the outcome of stakeholder consultations initiated in March 2012 and inter-governmental negotiations from July 2014 until March 2015, supported by the UN Office for Disaster Risk Reduction at the request of the UN General Assembly; its text is available at: https://www. preventionweb.net/files/43291_sendaiframeworkfordrren.pdf. On this Framework, see, by means of mere indication, Aitsi-Selmi, A., Blanchard, K. and V. Murray (2016):

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Third, sustainable use and protection of water and marine resources.44 Fourth, transition to a “circular economy”; circular economy means an economic system whereby the value of products, materials and other economic resources is maintained for as long as possible, enhancing their efficient use in production and consumption, thereby reducing the environmental impact of their use, minimising waste and the release of hazardous substances at all stages of their life cycle, including through the application of the waste hierarchy.45 Fifth, pollution prevention and control; the term “pollution” has a threefold meaning46 : (i) the direct or indirect introduction of pollutants47 into air, water or land as a result of human activity; (ii) in the context of the marine environment, pollution as defined in Article 3, point (8) of Directive 2008/56/EC of the European Parliament and of the Council of 17 June 2008 “establishing

Ensuring Science Is Useful, Usable and Used in Global Disaster Risk Reduction and Sustainable Development: A View Through the Sendai Framework Lens. Palgrave Communications, Vol. 2, available at: https://ssrn.com/abstract=2780391. 44 This environmental objective should be interpreted in accordance with the sectoral legislative acts laid down in recital (26) and the Commission Communications of 18 July 2007 on “Addressing the challenge of water scarcity and droughts in the European Union”, of 14 November 2012 on “A Blueprint to Safeguard Europe’s Water Resources” and of 11 March 2019 on “European Union Strategic Approach to Pharmaceuticals in the Environment”. 45 Ibid., Article 2, point (9). ‘Waste hierarchy’ has the meaning laid down in Article 4 of Directive 2008/98/EC of the European Parliament and of the Council of 19 November 2008 “on waste and repealing certain Directives” (the Waste Framework Directive, OJ L 312, 22.11.2008, pp. 3–30) [Ibid., Article 2, point (8)]. This environmental objective should be interpreted in accordance with relevant EU law in the areas of the circular economy, waste and chemicals, and with the Commission Communications of 2 December 2015 on “Closing the Loop—An EU Action Plan for the Circular Economy” and of 16 January 2018 on “A European Strategy for Plastics in a Circular Economy” [Ibid., recital (27)]. 46 Ibid., Article 2, point (12). 47 ‘Pollutant’ means a substance, vibration, heat, noise, light or other contaminant

present in air, water or land which may be harmful to human health or the environment, which may result in damage to material property, or which may impair or interfere with amenities and other legitimate uses of the environment [Ibid., Article 2, point (10)].

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a framework for community action in the field of marine environmental policy” (the Marine Strategy Framework Directive)48 ; and (iii) in the context of the water environment, pollution as defined in Article 2, point (33) of Directive 2000/60/EC of the same institutions of 23 October 2000 “establishing a framework for Community action in the field of water policy”.49 Finally, protection and restoration of biodiversity and ecosystems(healthy ecosystem). In this respect: “biodiversity” means the variability among living organisms arising from all sources including terrestrial, marine and other aquatic ecosystems and the ecological complexes of which they are part and includes diversity within species, between species and of ecosystems; and “ecosystem” means a dynamic complex of plant, animal, and micro-organism communities and their non-living environment interacting as a functional unit.50

11.2 Criteria for Determining Whether Economic Activities Qualify as Environmentally Sustainable 11.2.1

General Overview

(1) In accordance with recital (34), for each of the above-mentioned environmental objectives, the TR should lay down uniform criteria for determining whether economic activities substantially contribute to it, including the avoidance of significant harm to it. The objective is to avoid that investments qualify as environmentally sustainable where the economic activities benefitting from those cause harm to the environment to an extent that outweighs their contribution to an environmental

48 OJ L 164, 25.6.2008, pp. 19–40. 49 OJ L 327, 22.12.2000, pp. 1–73. This environmental objective should be interpreted

in accordance with the sectoral legislative acts set out in recital (29) TR. 50 Ibid., Article 2, points (15) and (13), respectively. The term ‘ecosystem services’ is defined to mean the direct and indirect contributions of ecosystems to the economic, social, cultural and other benefits that people derive from those [Ibid., Article 2, point (14)]. This environmental objective should be interpreted in accordance with the sectoral legislative acts and the Commission Communications set out in recital (30).

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objective. Such criteria should take into account the life cycle of the products and services provided by each economic activity in addition to the environmental impact of the economic activity itself, including taking into account evidence from existing life cycle assessments, in particular by considering their production, use and end of life. (2) In accordance with these considerations, for the purposes of establishing the degree to which an investment is environmentally sustainable, an economic activity qualifies as environmentally sustainable if four criteria are met cumulatively:51 first, it substantially contributes to (at least) one or more environmental objectives in accordance with Articles 10–1652 ; hence, a direct link is established between the environmental objectives and the substantial contribution of economic activities to each of them; second, it does not significantly harm any other environmental objective in accordance with Article 1753 ; third, it is carried out in compliance with the safeguards laid down in Article 1854 ; and fourth, it complies with applicable technical screening criteria (TSC) set out in the Commission’s delegated acts, which supplement the TR.55 (3) These criteria must be applied by Member States and the EU in order to determine whether an economic activity qualifies as environmentally sustainable for the purposes of any measure setting out requirements for financial market participants or issuers in respect of financial products or corporate bonds made available as environmentally sustainable.56

51 Ibid., Article 3. 52 See just below, under 11.2.2. 53 See below, under 11.2.3. 54 See below, under 11.2.4. 55 See under 11.3 below. 56 TR, Article 4. This provision does not apply to certificate-based tax incentive schemes, which existed prior to the entry into force of the TR and set out requirements for financial products that aim to finance sustainable projects, without prejudice to the respective competences of the EU and the Member States with respect to tax provisions, as set out by the Treaties [Ibid., Article 27(3) and recital (58)].

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11.2.2

Substantial Contribution to Environmental Objectives

11.2.2.1 Substantial Contribution to Climate Change Mitigation Means for Meeting This Criterion (1) An economic activity meets this criterion where it substantially contributes to the stabilisation of greenhouse gas concentrations in the atmosphere,57 at a level which prevents dangerous anthropogenic interference with the climate system consistent with the long-term temperature goal of the Paris Agreement of limiting the global temperature increase to 1.5 degrees Celsius above pre-industrial levels. This can be achieved either by avoiding or reducing greenhouse gas concentrations or by enhancing greenhouse gas removals, through process or product innovations, via any of the following means: first, by generating, transmitting, storing, distributing or using renewable energy (e.g., through extension of the grid) in accordance with Directive (EU) 2018/2001 of the European Parliament and of the Council of 11 December 2018 “on the promotion of the use of energy from renewable sources”58 ; second, by improving energy efficiency,59 except for power generation activities60 ; third, by increasing clean or climate-neutral mobility, as well as the by use of environmentally safe carbon capture and utilisation (CCU) and carbon capture and storage (CCS) technologies, which deliver a net reduction in greenhouse gas emissions; fourth, by switching to the use of sustainably sourced renewable materials; 57 The definition of the term ‘greenhouse gas’ is made with reference to Annex I to Regulation (EU) No 525/2013 of the European Parliament and of the Council of 21 May 2013 “on a mechanism for monitoring and reporting greenhouse gas emissions and for reporting other information at national and Union level relevant to climate change (…)” (OJ L 165, 18.6.2013, pp. 13–40) [Ibid., Article 2, point (7)]. 58 OJ L 328, 21.12.2018, pp. 82–209. 59 ‘Energy efficiency’ means the more efficient use of energy at all the stages of the

energy chain from production to final consumption (TR, Article 2, point (17)). For the purposes of the TR, this term is used in a broad sense and should be construed by taking into several sectoral legislative acts of the European Parliament and of the Council as well as the implementing measures adopted by the Commission [Ibid., recital (33)]. 60 On this, see below, under 11.3.2 (2).

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fifth by strengthening land carbon sinks (e.g., through avoiding deforestation and forest degradation, restoration of forests, sustainable management and restoration of croplands, grasslands and wetlands, afforestation, and regenerative agriculture); sixth, by establishing energy infrastructure required for enabling the decarbonisation of energy systems; furthermore, by producing clean and efficient fuels from renewable or carbon-neutral sources; or finally, by enabling any of the above activities in accordance with Article 16.61 Enabling and Transitional Activities (1) An economic activity qualifies as contributing substantially to this (or any other62 ) environmental objective by directly enabling other activities to make a substantial contribution to one or more of those objectives as well. Such “enabling activities” should not lead to a lock-in of assets that undermine long-term environmental goals (considering their economic lifetime) and should have a substantial positive environmental impact on the basis of life cycle considerations.63 (2) An economic activity for which there is no technologically and economically feasible low-carbon alternative is considered to qualify as contributing substantially to climate change mitigation if it supports the transition to a climate-neutral economy consistent with a pathway to limit the temperature increase to 1.5°C above pre-industrial levels (e.g., by phasing out greenhouse gas emissions, in particular emissions from solid fossil fuels) and, in addition, meets the following conditions: has greenhouse gas emission levels corresponding to the best performance in the sector or industry; does not hamper the development and deployment of low-carbon alternatives; and does not lead to a lock-in of carbon-intensive assets, considering their economic lifetime (“transitional activity”).64

61 TR, Article 10(1) and recital (24), first and second sentences. 62 See below, under 11.2.2.3, 11.2.2.4, 11.2.2.5, 11.2.2.6. 63 TR, Article 16 and recital (42). 64 For this purpose and for the establishment of TSC pursuant to Article 19 (see under

11.3 below), the Commission must assess the potential contribution and feasibility of all relevant existing technologies [Ibid., Article 10(2)].

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11.2.2.2 Substantial Contribution to Climate Change Adaptation An economic activity meets this criterion in two (alternative) cases: first, if it includes adaptation solutions, which either substantially reduce the risk of the adverse impact of the current and expected future climate on that economic activity or substantially reduce that adverse impact, without increasing the risk of an adverse impact on people, nature or assets. Such solutions must be assessed and ranked in order of priority using the best available climate projections and, at a minimum, prevent or reduce either the location-specific and context-specific adverse impact of climate change on the economic activity; or the potential adverse impact of climate change on the environment within which the economic activity takes place; or second, if it provides adaptation solutions which satisfy the conditions set out in Article 16 and, in addition, contribute substantially to preventing or reducing the risk of the adverse impact of the current and the expected future climate on people, nature or assets, without increasing the risk of an adverse impact on them.65 11.2.2.3

Substantial Contribution to the Sustainable Use and Protection of Water and Marine Resources An economic activity meets this criterion if it substantially contributes either to achieving the “good status”66 of bodies of water (including bodies of surface water and groundwater) or to preventing the deterioration of bodies of water that already have good status, or to achieving the “good environmental status” of marine waters67 or to preventing the deterioration of marine waters that are already in good environmental status. This can be achieved by means of any of the following (including through enabling activities): 65 Ibid., Article 11(1)–(2) and recital (25), first sentence. 66 ‘Good status’ means the following: for surface water, having both ‘good ecological

status’, as defined in Article 2, point (22) of Directive 2000/60/EC and ‘good surface water chemical status’, as defined in Article 2, point (24) thereof; and for groundwater, having both ‘good groundwater chemical status’, as defined in Article 2, point (25) of Directive 2000/60/EC and ‘good quantitative status’, as defined in Article 2, point (28) thereof [Ibid., Article 2, point (22)]. In this respect, the terms ‘surface water’ and ‘groundwater’ have the meaning as defined in Article 2, points (1) and (2), respectively of Directive 2000/60/EC [Ibid., Article 2, points (19)–(20)]. 67 ‘Good environmental status’ has the meaning as defined in Article 3, point (5) of Directive 2008/56/EC and ‘marine waters’ the meaning as defined in Article 3 point (1) thereof [Ibid., Article 2, points (21) and (18), respectively].

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first, by protecting the environment from the adverse effects of urban and industrial waste-water discharges, including from contaminants of emerging concern, such as pharmaceuticals and microplastics, e.g., by ensuring the adequate collection, treatment and discharge of urban and industrial waste-waters; second, by protecting human health from the adverse impact of any contamination of water intended for human consumption, ensuring that it is free from any micro-organisms, parasites and substances that constitute a potential danger to human health as well as increasing people’s access to clean drinking water; third, by improving water management and efficiency (e.g., by protecting and enhancing the status of aquatic ecosystems), by promoting the sustainable use of water through the long-term protection of available water resources (inter alia, through water reuse), by ensuring the progressive reduction of pollutant emissions into surface water and groundwater, by contributing to mitigating the effects of floods and droughts, or by any other activity protecting or improving the qualitative and quantitative status of water bodies; or fourth, by ensuring the sustainable use of marine ecosystem services or by contributing to the good environmental status of marine waters (e.g., by protecting, preserving or restoring the marine environment) and by preventing or reducing inputs in the marine environment.68 11.2.2.4

Substantial Contribution to the Transition to a Circular Economy An economic activity qualifies as substantially contributing to the transition to a circular economy, including waste prevention, re-use and recycling, by any of the following means (including through enabling activities): first, it uses natural resources (such as sustainably sourced bio-based and other raw materials) in production more efficiently, including by reducing the use of primary raw materials or increasing the use of

68 Ibid., Article 12(1).

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by-products and secondary raw materials or by resource and energy efficiency measures; second, it increases the durability, reparability, upgradability, reusability and recyclability of products (including the recyclability of individual materials contained in them); the use of secondary raw materials and their quality, including by high-quality recycling of waste; the preparation for the re-use and recycling of waste; and the development of the waste management infrastructure needed for prevention, preparing for re-use and recycling, while ensuring that the recovered materials are recycled as high-quality secondary raw material input in production (avoiding thus downcycling); third, it substantially reduces the content of hazardous substances and substitutes substances of very high concern in materials and products throughout their life cycle, in accordance with the objectives set out in EU law, including by replacing such substances with safer alternatives and ensuring traceability; fourth, it prolongs the use of products, including through reuse, design for longevity, repurposing, disassembly, remanufacturing, upgrades and repair, and sharing them; or fifth, it prevents or reduces waste generation, including the generation of waste from the extraction of minerals and waste from the construction and demolition of buildings, minimises the incineration of waste and avoids the disposal of waste (including landfilling), in accordance with the principles of the waste hierarchy, or it avoids and reduces litter.69 11.2.2.5

Substantial Contribution to Pollution Prevention and Control An economic activity meets this criterion: first, by preventing or (if that is not practicable) reducing pollutant emissions into air, water or land, other than greenhouse gasses, or by preventing or minimising any adverse impact on human health and the environment of the production, use or disposal of chemicals; second, by improving levels of air, water or soil70

69 Ibid., Article 13(1) and recital (28). 70 ‘Soil’ means the top layer of the earth’s crust situated between the bedrock and the

surface, composed of mineral particles, organic matter, water, air and living organisms [Ibid., Article 2, point (11)].

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quality in the areas where the economic activity takes place, while also minimising any adverse impact on human health and the environment or the risk thereof; third, by cleaning up litter and other pollution; or finally, through enabling activities.71 11.2.2.6

Substantial Contribution to the Protection and Restoration of Biodiversity and Ecosystems An economic activity meets this criterion where it substantially contributes to protecting, conserving or restoring biodiversity or to achieving the good condition of ecosystems72 or to protecting ecosystems already in good condition by any of the following means: first, by nature and biodiversity conservation (including by achieving favourable conservation status of natural and semi-natural habitats and species or preventing their deterioration where they already have favourable conservation status) and by protecting and restoring terrestrial, marine and other aquatic ecosystems in order to improve their condition and enhance their capacity to provide ecosystem services; second, by sustainable land use and management, including adequate protection of soil biodiversity, land degradation neutrality and the remediation of contaminated sites; third, by sustainable agricultural practices (including those contributing to the enhancement of biodiversity or to the halting or prevention of the degradation of soils and other ecosystems, deforestation and habitat loss), as well as by sustainable forest management73 ; or finally, through enabling activities.74 11.2.3

No Significant Harm to Any Other Environmental Objective

(1) An economic activity must also meet the “do no significant harm” principle, referred to in Article 2, point (17) SFDR , by virtue of which an activity substantially contributing to one of the environmental

71 Ibid., Article 14(1). 72 ‘Good condition’ means, in relation to an ecosystem, that this is in good phys-

ical, chemical and biological condition or is of a good physical, chemical and biological quality with self-reproduction or self-restoration capability, in which species composition, ecosystem structure and ecological functions are not impaired [Ibid., Article 2, point (16)]. 73 The term ‘sustainable forest management’ should be construed by taking into account the factors laid down in recital (32). 74 Ibid., Article 15(1) and recital (31).

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objectives must also do no significant harm to any of the other objectives. Hence, an economic activity should not qualify as environmentally sustainable if it causes more harm to the environment than the benefits it brings. Taking thus into account the life cycle of products and services provided by an economic activity, including evidence from existing life cycle assessments, an economic activity is considered to significantly harm: the first environmental objective (climate change mitigation), where it leads to significant greenhouse gas emissions; the second objective (climate change adaptation), where it leads to an increased adverse impact on the current and expected future climate, on the activity itself or on people, nature or assets; the third objective (sustainable use and protection of water and marine resources), where it is detrimental either to the good status or the good ecological potential of bodies of water,75 including surface water and groundwater, or to the good environmental status of marine waters; the fourth objective (circular economy), where: first, it leads to significant inefficiencies in the use of materials or in the direct or indirect use of natural resources such as non-renewable energy sources, raw materials, water and land at one or more stages of products’ life cycle; second, it leads to a significant increase in waste generation, incineration or disposal, with the exception of the incineration of non-recyclable hazardous waste; or third, the long-term disposal of waste may cause significant and long-term harm to the environment; the fifth objective (pollution prevention and control), where it leads to a significant increase in the emissions of pollutants into air, water or land, as compared with the situation before the activity started; and the sixth objective (protection and restoration of biodiversity and ecosystems), where it is significantly detrimental to the good condition and resilience of ecosystems or detrimental to the conservation status of habitats and species, including those of EU interest.76 (2) In the course of assessing an economic activity against the above criteria, both the environmental impact of the activity itself and the environmental impact of the products and services provided by it throughout

75 The term ‘good ecological potential’ is defined with reference to Article 2, point (23) of Directive 2000/60/EC [Ibid., Article 2, point (23)]. 76 Ibid., Article 17(1), with reference to Article 3, point (b).

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their life cycle must be taken into account, by considering the production, use and end of life of those products and services.77 11.2.4

Compliance with Minimum Safeguards

Taking into account the joint commitment of the European Parliament, the Council and the Commission to pursuing the principles enshrined in the European Pillar of Social Rights in support of sustainable and inclusive growth,78 and recognising the relevance of international minimum human and labour rights and standards, economic activities qualify as environmentally sustainable upon the condition that they are also compliant with the “minimum safeguards” referred to in Article 18 TR.79 These are procedures implemented by undertakings carrying out economic activities in order to ensure consistency with the OECD “Guidelines for Multinational Enterprises” and the UN “Guiding Principles on Business and Human Rights”,80 including the 1988 “Declaration on Fundamental Principles and Rights at Work” of the International Labour Organisation (ILO),81 the 8 fundamental conventions of the ILO 1998 (defining human and labour rights to be respected by undertakings), and the “International Bill of Human Rights”.82 When implementing these procedures, undertakings must adhere to the “do no significant harm” principle and take into account the regulatory technical standards (RTSs) adopted pursuant to the SFDR.83 77 Ibid., Article 17(2). 78 See at: https://ec.europa.eu/commission/priorities/deeper-and-fairer-economic-

and-monetary-union/european-pillar-social-rights/european-pillar-social-rights-20-princi ples_en. 79 TR, Article 3, point (c). 80 Available at: https://www.oecd.org/corporate/mne. 81 Available at: https://www.ilo.org/declaration/lang--en/index.htm. 82 TR, Article 18(1) and recital (35), first and second sentences. The International Bill

of Human Rights was adopted and proclaimed by UN General Assembly Resolution 217 A (III) of 10 December 1948 (available at: https://www.ohchr.org/Documents/Public ations/Compilation1.1en.pdf). Several of these international standards are enshrined in the Charter of Fundamental Rights of the EU. The minimum safeguards are without prejudice to the application of more stringent requirements related to environmental, health, safety and social sustainability as set out in EU law, where applicable [Ibid., recital (35), third and fourth sentences]. 83 Ibid., Article 18(2) and recital (35), last sentence.

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11.3 In Particular: Requirements for Technical Screening Criteria (TSC) 11.3.1

The Considerations Set Out in the Regulation

(1) In order to determine whether an economic activity qualifies as sustainable, the Commission must adopt delegated acts establishing TSC pursuant to Articles 10(3), 11(3), 12(2), 13(2), 14(2) and 15(2) TR.84 With regard to these criteria, the following considerations are set out in the recitals85 : First, given the specific technical details needed to assess the environmental impact of an economic activity and the fast-changing nature of both science and technology, the TSC should be regularly adapted to reflect such changes. In addition, in order to ensure that they are up to date, based on scientific evidence and input from experts as well as relevant stakeholders, the conditions for “substantial contribution” and “significant harm” should be specified with more granularity for different economic activities. Accordingly, the Commission must establish granular and calibrated TCS for the different economic activities, based on technical input from the Platform on Sustainable Finance.86 Second, given that the potential capacity to contribute to one or more environmental objectives can vary across sectors, the TSC should ensure that relevant economic activities within a specific sector can qualify as environmentally sustainable and are treated equally if they equally contribute to one or more environmental objectives. However, within each sector, they should not unfairly disadvantage certain economic activities over others if all contribute to the environmental objectives to the same extent. Third, in order to avoid overly burdensome compliance costs on economic operators, the TSC must provide for sufficient legal clarity, be practicable and easy to apply, while, in order to avoid unnecessary administrative burden, verification of compliance therewith within reasonable cost-of-compliance boundaries should also be granted. 84 See below, under 11.3.2. 85 TR, recitals (38), (45) and (47)–(48). 86 On this Platform, referred to in Article 20, see below, under 11.5.1.1.

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Furthermore, if sufficiently practicable and necessary, the TSC could require carrying out a life cycle assessment. Finally, in order to ensure that private investments are channelled towards economic activities that make the greatest positive impact on the environmental objectives, the Commission should prioritise the establishment of TSC for economic activities that potentially contribute most to such objectives. (2) In establishing and updating the TSC for the environmental objective of climate change mitigation, the Commission should take into account and provide incentives for the ongoing and necessary transition towards a climate-neutral economy in accordance with Article 10(2). In addition to the use of climate-neutral energy and more investments in already low-carbon economic activities and sectors, the transition requires substantial reductions in greenhouse gas emissions in other economic activities and sectors for which there are not any technologically and economically feasible low-carbon alternatives. These transitional economic activities should qualify as contributing substantially to climate change mitigation if their greenhouse gas emissions are substantially lower than the sector or industry average, do not hamper the development and deployment of low-carbon alternatives and do not lead to a lock-in of assets incompatible with the objective of climate-neutrality, considering the economic lifetime of those assets. Furthermore, the TSC should ensure the existence of a credible path towards climate-neutrality and should be adjusted accordingly at regular intervals.87 (3) Finally, appropriate TSC must be established for the transport sector, including for mobile assets, which should take into account that this sector, including international shipping, contributes close to 26% of total greenhouse gas emissions in the EU. As stated in the 2018 “Action Plan on Financing Sustainable Growth”88 the transport sector represents about 30% of the additional annual investment needed for sustainable development in the EU, e.g., to increase electrification or to support the transition to cleaner modes of transport by promoting modal shift and better traffic management.89 87 TR, recital (41). 88 See above, under 11.1.1.1 (2). 89 TR, recital (49).

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11.3.2

The Provisions of Article 19

(1) On the basis of the above considerations, TSC must meet the following requirements:90 a. identify the most relevant potential contributions to the given environmental objective, while respecting the principle of technological neutrality, considering both the short- and long-term impact of a given economic activity; b. specify the minimum requirements to be met in order to avoid significant harm to any of the environmental objectives, considering both the short- and long-term impact of each economic activity; c. be quantitative and, to the extent possible, contain thresholds; otherwise be qualitative; d. where appropriate, build upon EU labelling and certification schemes, methodologies for assessing environmental footprint, and statistical classification systems, and take into account any relevant existing EU legislation; e. to the extent feasible, use existing sustainability indicators as proposed by the European Parliament in its Resolution of 29 May 2018 on sustainable finance and referred to in Article 4(6) SFDR , in order to ensure the reliability, consistency and comparability of sustainability-related disclosures in the financial services sector; f. be based on conclusive available scientific evidence and if scientific evaluation does not allow for a risk to be determined with sufficient certainty, the precautionary principle should apply in accordance with Article 191 TFEU91 ; g. take into account the life cycle, including evidence from existing assessments, by considering the environmental impact of both the economic activity itself and of the products and services provided by that economic activity, in particular by considering the production, use and end of life of those products and services;

90 Ibid., Article 19(1). 91 On this requirement, see also recital (40), third and fourth sentences. On Article

191 TFEU, see by means of mere indication A. Käller (2019).Artikel 191 des AEUV, in Schwarze, J., Becker, U., Hatje, A. und J. Schoo (2019, Hrsg.): EU -Kommentar, 4. Auflage, Nomos Verlagsgesellshaft, Baden-Baden, pp. 2436–2452 (with extensive further references to primary and secondary sources).

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h. take into account the nature and scale of the economic activity, including whether it is an enabling or a transitional one as referred to in Articles 16 and 10(2)92 ; i. take into account the potential market impact of the transition to a more sustainable economy, including the risk of certain assets becoming stranded as a result of such transition and that of creating inconsistent incentives for investing sustainably; j. cover all relevant economic activities within a specific sector and ensure that those are treated equally if they equally contribute towards the environmental objectives in order to avoid distorting competition in the market; and k. be easy to use and set in a manner facilitating the verification of their compliance. (2) The TSC must also: include criteria for activities related to the clean energy transition consistent with a pathway to limit the temperature increase to 1,5 C above pre-industrial levels (in particular energy efficiency and renewable energy) to the extent that these substantially contribute to any of the environmental objectives; ensure that power generation activities using solid fossil fuels do not qualify as environmentally sustainable93 ; and include criteria for activities related to the switch to clean or climate-neutral mobility (e.g., through modal shift, efficiency measures and alternative fuels, to the extent that these substantially contribute to any environmental objective).94 11.3.3

Specific Provisions

(1) Articles 10–15 contain specific provisions with regard to the TSC provided therein. In particular, the Commission must adopt a delegated act in accordance with Article 23 to supplement: first, Article 10(1)– (2) by establishing TSC for determining the conditions under which a specific economic activity qualifies as contributing substantially to climate change mitigation; second, Article 11(1)–(2) by establishing TSC for

92 On these Articles, see above, under 11.2.2.1. The TSC must clearly indicate that fact that the economic activity belongs to one of these categories. 93 On this aspect, see also above, under 11.2.2.1 (1). 94 TR, Article 19(2), (3) and (4), respectively.

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determining the conditions under which a specific economic activity qualifies as contributing substantially to climate change adaptation; third, Article 12(1) by establishing TSC for determining the conditions under which a specific economic activity qualifies as contributing substantially to sustainable use and protection of water and marine resources; fourth, Article 13(1) by establishing TSC for determining the conditions under which a specific economic activity qualifies as contributing substantially to the transition to a circular economy; fifth, Article 14(1) by establishing TSC for determining the conditions under which a specific economic activity qualifies as contributing substantially to pollution prevention and control; and sixth, Article 15(1) by establishing TSC for determining the conditions under which a specific economic activity qualifies as contributing substantially to the protection and restoration of biodiversity and ecosystems.95 (2) In all cases, the delegated act must also supplement Article 1796 by establishing, for each relevant environmental objective, TSC for determining whether an economic activity causes significant harm to one or more of those objectives.97 11.3.4

Obligations Imposed on the Commission

(1) When establishing and updating the TSC, the Commission should assess whether their establishment would give rise to stranded assets, result in inconsistent incentives or have any other adverse impact on financial markets.98 It must also take into account: first, Regulations (EC) No 1221/2009 of the European Parliament and of the Council of 25 November 2009 “on the voluntary participation by organisations in a Community eco-management and audit scheme (EMAS) (…)”, and (EC) No 66/2010 “on the EU

95 Ibid., Articles 10(3), point (a), 11(3), point (a), 12(2), point (a), 13(2), point (a), 14(2), point (a) and 15(2), point (a). 96 See above, under 11.2.3. 97 TR, Articles 10(3), point (b), 11(3), point (b), 12(2), point (b), 13(2), point (b),

14(2), point (b) and 15(2), point (b). 98 Ibid., recital (46).

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Ecolabel”,99 its Recommendation 2013/179/EU of 9 April 2013 “on the use of common methods to measure and communicate the life-cycle environmental performance of products and organisations”100 and its Communication of 16 July 2018 on “Public procurement for a better environment”101 ; second, the statistical classifications in the environmental goods and services sector in order to avoid inconsistencies with existing classifications of economic activities for other purposes102 ; third, existing environmental indicators and reporting frameworks, developed (inter alia) by itself and the European Environment Agency, as well as existing international standards, such as those developed (inter alia) by the OECD; and finally, the specificities of the infrastructure sector, as well as environmental, social and economic externalities within a cost-benefit analysis, taking into account several related sectoral Directives of the European Parliament and of the Council,103 standards and current methodology, as well as the work of international organisations, such as the OECD; the TSC should promote appropriate governance frameworks integrating environmental, social and governance (ESG) factors as referred to in the UN-supported Principles for

99 OJ L 342, 22.12.2009, pp. 1–45 and OJ L 27, 30.1.2010, pp. 1–19, respectively. 100 OJ L 124, 4.5.2013, pp. 1–210. 101 COM (2008) 400. 102 These include the classification of environmental protection activities (CEPA) and

resource management activities (CReMA) pursuant to Regulation (EU) No 538/2014 of the European Parliament and of the Council of 16 April 2014 “amending Regulation (EU) No 691/2011 on European environmental economic accounts” (OJ L 158, 27.5.2014, pp. 113–124). 103 Directive 2001/42/EC of 27 June 2001 “on the assessment of the effects of certain plans and programmes on the environment” (OJ L 197, 21.7.2001, pp. 30–37), Directive 2011/92/EU of 13 December 2011 “on the assessment of the effects of certain public and private projects on the environment” (OJ L 26, 28.1.2012, pp. 1– 21), and Directives 2014/23/EU, 2014/24/EU and 2014/25/EU of 26 February 2014 “on the award of concession contracts”, “on public procurement (…)” and “on procurement by entities operating in the water, energy, transport and postal services (…)” (OJ L 94, 28.3.2014, pp. 1–64, 65–242 and 243–374, respectively).

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Responsible Investment (PRI)104 at all stages of a project’s life cycle.105 (2) Prior to adopting the above-mentioned delegated acts, the Commission must consult the Platform on Sustainable Finance regarding the TSC. The TSC referred to in Articles 10–15 must each be adopted in one delegated act, taking into account the requirements of Article 19.106 It must also regularly review the TSC and, where appropriate, amend the relevant delegated acts in line with scientific and technological developments.107

11.4 Disclosure Requirements for Environmentally Sustainable Investments 11.4.1

Considerations and Relationship to the SFDR

(1) In order to avoid harming investor interests and as already noted,108 the TR introduces specific disclosure requirements for environmentally sustainable investments. In this respect, recital (18) makes the following considerations:

104 The PRI is a leading proponent of responsible investment, working to understand the investment implications of ESG factors and to support its international network of investor signatories in incorporating these factors into their investment and ownership decisions. It acts in the long-term interests of its signatories, as well as of the financial markets and economies in which they operate (see at: https://www.unpri.org). 105 TR, recitals (43)–(44) and (46). 106 Ibid., Articles 10(4)–(5), 11(4)–(5), 12(3)–(4), 13(3)–(4), 14(3)–(4) and 15(3)–(4);

on Article 19, see above, under 11.3.2. 107 Ibid., Article 19(5), first sentence. In that context, before amending or replacing a delegated act, the Commission must assess the implementation of those criteria taking into account the outcome of their application by financial market participants and their impact on capital markets, including on the channelling of investment into environmentally sustainable economic activities. To ensure that economic activities as referred to in Article 10(2) remain on a credible transition pathway consistent with a climate-neutral economy, the Commission must review the TSC for those activities at least every three years and, where appropriate, amend the delegated act referred to in Article 10(3) in line with scientific and technological developments [Ibid., Article 19(5), second and third sentences]. 108 See above, under 11.1.1.2.

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First, fund managers and institutional investors that make available financial products should disclose how and to what extent they use the criteria for environmentally sustainable economic activities to determine the environmental sustainability of their investments.109 The information disclosed should enable investors to understand the proportion of the investments underlying the financial product in environmentally sustainable economic activities as a percentage of all investments underlying it, thereby enabling them to understand the degree of investments’ environmental sustainability. Second, if these investments are in economic activities that contribute to environmental objectives, the information to be disclosed should specify the objective or objectives to which these investments contribute, as well as how and to what extent they fund environmentally sustainable economic activities. The information should also include details on the respective proportions of enabling and transitional activities. Third, the information that needs to be disclosed should be specified by the Commission and should enable national competent authorities (NCAs) to easily verify compliance with that disclosure obligation and to enforce such compliance in accordance with applicable national law. Finally, in cases where financial market participants do not take the criteria for environmentally sustainable investments into account, they should provide a statement to that end. In order to avoid the circumvention of the disclosure obligation, this should also apply where financial products are marketed as promoting environmental characteristics, including financial products that have as their objective environmental protection in a broad sense. (2) The disclosure obligations laid down in the TR supplement the rules on sustainability-related disclosures laid down in the SFDR. In particular, in order to enhance transparency and to provide an objective point of comparison by financial market participants to end investors on the proportion of investments that fund environmentally sustainable

109 On this aspect, see also the analytical considerations in recital (13).

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economic activities, the TR supplements the rules on disclosures (transparency) in pre-contractual disclosures and in periodic reports laid down in the SFDR.110 (3) In exceptional cases relating to economic activities carried out by undertakings not required to disclose information under the TR and for which complete, reliable and timely information cannot be obtained, financial market participants can make complementary assessments and estimates on the basis of information obtained from other sources. In order to ensure that the disclosure to end investors is clear and not misleading, financial market participants should clearly explain the basis for their conclusions and the reasons for having to make such complementary assessments and estimates.111 11.4.2

The Provisions of Articles 5–7

11.4.2.1

Disclosure of Environmentally Sustainable Investments in Pre-contractual Disclosures and in Periodic Reports When a financial product as referred to in Article 9(1), (2) or (3) SFDR 112 invests in an economic activity that contributes to an environmental objective within the meaning of Article 2, point (17) thereof, the information to be disclosed in accordance with Articles 6(3) and 11(2) thereof must include the following:

110 It is noted that the definition of ‘sustainable investment’ in the SFDR includes investments in economic activities that contribute to an environmental objective which, inter alia, should include those into ‘environmentally sustainable economic activities’ within the meaning of the TR. Moreover, the SFDR only considers an investment to be a sustainable investment if it does not significantly harm any environmental or social objective as set out therein [Ibid., recital (19)]. 111 Ibid., recital (21). Economic operators not covered by the TR may be encouraged to publish and disclose information on their websites on a voluntary basis on the environmentally sustainable economic activities they carry out, which will assist financial market participants to easily identify which economic operators carry out environmentally sustainable economic activities and facilitate the latter to raise funds for their environmentally sustainable activities [Ibid., recital (15)]. 112 Article 9(1) SFDR refers to financial products whose objective is sustainable investment and contain an index designated as a reference benchmark; Article 9(2) refers to financial products with the same objective but no index has been designated as a reference benchmark; and Article 9(3) refers to financial products whose objective is a reduction in carbon emissions.

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first, the information on the environmental objective(s) to which the investment underlying the financial product contributes; and second, a description of how and to what extent the investments underlying the financial product are in economic activities qualifying as environmentally sustainable pursuant to Article 3 TR, which must specify the proportion of investments in environmentally sustainable economic activities selected for the financial product, including details on the proportions of enabling and transitional activities referred to in Articles 16 and 10(2),113 respectively, as a percentage of all investments selected for that product.114 11.4.2.2

Disclosure of Financial Products that Promote Environmental Characteristics in Pre-contractual Disclosures and in Periodic Reports The (just) above-mentioned Article 5 TR is also applicable, mutatis mutandis, where a financial product as referred to in Article 8(1)SFDR 115 promotes environmental characteristics. For “nonsustainable” products the TR also introduces in this case a requirement to include a statement confirming that the investments underlying the product do not fully take into account the EU criteria for environmentally sustainable economic activities. Hence, the information to be disclosed in accordance with Articles 6(3) and 11(2)SFDR must be accompanied by the following statement: “The “do no significant harm” principle applies only to those investments underlying the financial product that take into account the EU criteria for environmentally sustainable economic activities. The investments underlying the remaining portion of this financial product do not take into account the EU criteria for environmentally sustainable economic activities”.116

113 On these Articles, see above, under 11.2.2.1 (1), in finem, and (2). 114 TR, Article 5. 115 Article 8(1) SFDR refers to financial products which promote, inter alia, environmental or social characteristics, or a combination thereof, provided that the companies in which the investments are made follow good governance practices. 116 TR, Article 6.

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11.4.2.3

Transparency of Other Financial Products in Pre-contractual Disclosures and in Periodic Reports If a financial product is not subject to any of the above-mentioned (under 11.4.2.1 and 11.4.2.2) SFDR Articles, the information to be disclosed in accordance with the provisions of sectoral legislation referred to in Articles 6(3) and 11(2) thereof must be accompanied by the following statement: “The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities ”.117 11.4.3

Competent Authorities—Measures and Penalties

(1) The monitoring of financial market participants’ compliance with the requirements laid down in Articles 5–7 TR has been assigned to the NCAs referred to in Article 14(1) SFDR . These must have all the necessary supervisory and investigatory powers for the exercise of their functions under the TR, cooperate and provide each other, without undue delay, with such information as is relevant for the purposes of carrying out their duties.118 (2) Furthermore, in order to enforce compliance, Member States must lay down rules on effective, proportionate and dissuasive measures and penalties applicable to infringements of Articles 5–7 TR.119 NCAs and the ESAs should exercise the product intervention powers laid down in three relevant Regulations of the European Parliament and of the Council120 also with respect to mis-selling practices or misleading disclosures of sustainability-related information, including the information required under the TR.121

117 Ibid., Article 7. 118 Ibid., Article 21 and recital (55), second sentence. 119 Ibid., Article 22 and recital (55), third sentence. 120 Notably: Regulation (EU) No 600/2014 of 15 May 2014 “On Markets in Finan-

cial Instruments (…)” (OJ L 173, 12.6.2014, pp. 84–138, MiFIR ); Regulation (EU) No 1286/2014 of 26 November 2014 “On Key Information Documents for Packaged Retail and Insurance-based Investment Products (PRIIPs)” (OJ L 352, 9.12.2014, pp. 1– 23); and Regulation (EU) 2019/1238 of 20 June 2019 “On a Pan-European Personal Pension Product (PEPP)” (OJ L 198, 25.7.2019, pp. 1–63). 121 TR, recital (55), fourth sentence.

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The Provisions of Article 8 on Non-financial Reporting

(1) The TR imposes additional requirements on undertakings, which are covered by the field of application of Directive (2013/34/EU). In particular, any undertaking which is subject to an obligation to publish non-financial information pursuant to Articles 19a or 29a of that legislative act must include in its non-financial statement or consolidated non-financial statement information on how and to what extent its activities are associated with economic activities qualifying as environmentally sustainable under (the above-mentioned) Articles 3 and 9 TR.122 The information to be disclosed, which is considered as useful to investors interested in companies whose products and services contribute substantially to any of the environmental objectives, contains two pillars: first, the proportion of turnover derived from products or services associated with economic activities that qualify as environmentally sustainable; and second, the proportion of capital expenditure (CapEx) and of operating expenditure (OpEx) related to assets or processes associated with environmentally sustainable economic activities.123 (2) By 1 June 2021, the Commission must adopt a delegated act specifying the content and presentation of the information to be disclosed in accordance with the above-mentioned, including the methodology to be used in order to comply with them, taking into account the specificities of both financial and non-financial undertakings and the TSC established.124

122 This requirement is based on Commission Communication of 20 June 2019 “Guidelines on non-financial reporting: Supplement on reporting climate-related information”, which recommends that certain large companies report on certain climate-related key performance indicators (KPIs) on the basis of the TR framework [Ibid., recital (22), first sentence]. 123 Ibid., Article 8(1)–(2). If an undertaking publishes non-financial information pursuant to the above-mentioned Articles 19a or 29a in a separate report pursuant to Articles 19a(4) or 29a(4), this information must be published in that separate report [Ibid., Article 8(3)]. Smaller companies may voluntarily decide to publish such information as well [Ibid., recital (22), last sentence]. 124 Ibid., Article 8(4).

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11.5

Other Provisions

11.5.1

Advisory Bodies

11.5.1.1 The Platform on Sustainable Finance Rationale, Composition, Constitution (1) When developing the TSC, the Commission should carry out appropriate consultations in line with the Better Regulation Agenda,125 while the process for their establishment and updating should involve relevant stakeholders and build on the advice of experts who have proven knowledge and experience in the relevant areas.126 Based on these considerations, the Commission should set up a multi-stakeholder “Platform on Sustainable Finance” (the Platform), which is, indeed, operational since October 2020.127 (2) The Platform is chaired by the Commission128 and is composed, in a balanced manner, of experts representing both the public and private sector as well as the civil society: public-sector experts include representatives of the European Environmental Agency, the European Supervisory Authorities (ESAs), the European Investment Bank (EIB) and the EU Agency for Fundamental Rights; private sector experts include representatives of financial and non-financial market participants and business sectors, representing relevant industries, and persons with accounting and reporting expertise; and experts representing civil society include experts in the field of environmental, social, labour and governance issues. Further members of the Platform are experts appointed in a personal capacity, with proven knowledge and experience in the areas covered by the TR, as well as of experts representing academia, including persons with global expertise.129 (3) The Platform is constituted in accordance with the horizontal rules on the creation and operation of Commission expert groups, including with regard to the selection process, which should aim to ensure a high level of expertise, geographical and gender balance, as well as a balanced representation of relevant know-how, taking into account the 125 See below, under 11.5.2. 126 TR, recital (50), first and second sentences. 127 See at: https://ec.europa.eu/info/publications/sustainable-finance-platform_en. 128 TR, Article 20(4), first sentence. 129 Ibid., Article 20(1) and recital (50), fourth–seventh sentences.

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Platform’s specific tasks. During the selection process, the Commission should perform an assessment in accordance with those horizontal rules to determine whether potential conflicts of interest exist and should take appropriate measures to resolve any such conflicts. In that context, the Commission may invite experts with specific expertise on an ad hoc basis.130 The minutes of the Platform’s meetings and other relevant documents must be published on the Commission’s website. In order to ensure the efficient and sustainable organisation of its work and meeting practices and to enable broad participation and efficient interaction within the groups, their subgroups, the Commission and stakeholders, the Platform should consider, where appropriate, the increased use of digital, including virtual, technologies.131 Role (1) The main role of the Platform is to advise the Commission on the development, analysis and review of TSC, including the potential impact of such criteria on the valuation of assets that qualify as environmentally sustainable assets under existing market practices, and on the potential need to update them. Its advisory role is further extended to the following issues: where appropriate, on the possible role of sustainability accounting and reporting standards in supporting the application of the TSC; on the possible need to develop further measures to improve data availability and quality; on the usability of the TSC in future EU policy initiatives aimed at facilitating sustainable investment, taking into account the objective of avoiding undue administrative burdens; on the possible need to amend the TR; on the evaluation and development of sustainable finance policies, including with regard to policy coherence issues; on addressing other sustainability objectives, including social objectives; and on the application of Article 18 (on the functioning of minimum safeguards132 ) and the need to supplement the requirements thereof. Furthermore, the Platform must analyse the impact of the TSC in terms of potential costs and benefits of their application; assist the Commission in analysing requests from stakeholders to develop or revise TSC for a given economic activity;

130 Ibid., Article 20(4), first and second sentences, and recital (51). 131 Ibid., Article 20(5) and recital (56). 132 See above, under 11.2.4.

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as well as monitor and regularly report to the Commission on trends at EU and Member State level regarding capital flows into sustainable investment.133 It must take into account the views of a wide range of stakeholders and carry out its tasks in accordance with the transparency principle.134 (2) In order to help the Commission in evaluating the appropriateness of complementing or updating the TSC, financial market participants are encouraged to inform it if they consider that an economic activity that does not meet the TSC, or for which such criteria have not yet been established, should qualify as environmentally sustainable.135 11.5.1.2

Formalisation of the Member State Expert Group on Sustainable Finance The TR provides that the (existing) “Member State Expert Group on Sustainable Finance” (i.e., the TEG)136 should be vested a formal status and, inter alia, advise the Commission on the appropriateness of the TSC and the approach taken by the Platform regarding their development pursuant to Article 19. For this purpose, the Commission must keep the Member States informed through regular meetings of that Group in order to facilitate an exchange of views between them on a timely basis, in particular as regards the main output of the Platform, such as new TSC, material updates thereof or draft reports.137 11.5.2

Exercise of the Delegation

(1) In order to specify the requirements set out in the TR, and in particular to establish and update for different economic activities granular and calibrated TSC for what constitutes “substantial contribution” and “significant harm” to the environmental objectives, the power to adopt delegated acts (in accordance with Article 290 TFEU) in respect

133 TR, Article 20(2) and recital (52). 134 Ibid., Article 20(3). 135 Ibid., Article 20(6) and recital (50), last sentence. 136 See above, under 11.1.1.1 (2). 137 TR, Article 24 and recital (53). As in the case of the Platform, the increased use of digital, including virtual, technologies should be considered, where appropriate [Ibid., recital (56)].

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of the content and presentation of the information referred to in Article 8(4),138 as well as in respect of the TSC laid down in Articles 10(3), 11(3), 12(2), 13(2), 14(2) and 15(2)139 has been conferred on the Commission for an indeterminate period from 12 July 2020. This delegation of powers may be revoked at any time by the European Parliament or by the Council, by a decision putting an end to the delegation of specified therein, taking effect on the day following its publication in the OJ or at a later date specified therein and not affecting the validity of any delegated acts already in force.140 (2) The Commission must notify any delegated act adopted simultaneously to the European Parliament and to the Council; such delegated act will enter into force only if no objection has been expressed by either of these two EU institutions within a period of four months of notification of that act to them or if, before the expiry of that period, both these EU institutions have informed the Commission that they will not object. That period can be extended by two months at the initiative of the European Parliament or of the Council.141 11.5.3

Amendments to the SFDR

(1) In order to ensure consistency between the two fundamental EU sustainability-related legislative acts, the TR amends the SFDR , inserting, inter alia, an obligation for the ESAs to jointly develop RTSs further specifying the details of the content and presentation of the information in relation to the “do no significant harm” principle; draft

138 See above, under 11.4.3 (2). 139 See above, under 11.3.3. 140 TR, Article 23(1)–(3) and recital (54), first sentence. The Commission must gather

all necessary expertise, prior to the adoption and during the development of delegated acts, including through the consultation of the experts of the Expert Group on Sustainable Finance. Before adopting a delegated act, it must act in accordance with the principles and procedures laid down in the Interinstitutional Agreement of 13 April 2016 “on Better Law-Making” (OJ L 123, 12.5.2016, pp. 1-14). In particular, to ensure equal participation in the preparation of delegated acts, the European Parliament and the Council should receive all documents at the same time as Member States’ experts, and their experts should systematically have access to meetings of Commission expert groups dealing with the preparation of delegated acts [Ibid., Article 23(4) and recital (54), second and third sentences]. 141 Ibid., Article 23(5)–(6).

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RTSs should have been submitted to the Commission by 30 December 2020.142 These must be consistent with the content, methodologies and presentation of the sustainability indicators in relation to adverse impacts as referred to in the SFDR; they must also be compliant with the principles enshrined in the European Pillar of Social Rights, the OECD Guidelines for Multinational Enterprises, the UN Guiding Principles on Business and Human Rights, including the ILO Declaration on Fundamental Principles and Rights at Work, the eight fundamental conventions of the ILO and the International Bill of Human Rights.143 (2) The SFDR has been further amended to mandate the ESAs to develop, through the Joint Committee, draft RTSs to supplement the rules on transparency of the promotion of environmental characteristics and of environmentally sustainable investments in pre-contractual disclosures and in periodic reports.144 11.5.4

Review Clause

(1) By 13 July 2022, and subsequently every three years thereafter, the Commission must publish a Report on the application of the TR, evaluating the following aspects145 : first, the progress in its implementation with regard to the development of TSC for environmentally sustainable economic activities; second, the possible need to revise and complement the criteria set out in Article 3 for an economic activity to qualify as environmentally sustainable; 142 Ibid., Article 25 and recital (36), first sentence. These were submitted on 2

February 2021 (available at: https://www.eiopa.europa.eu/sites/default/files/publicati ons/reports/jc-2021-03-joint-esas-final-report-on-rts-under-sfdr.pdf?source=search). 143 Ibid., recital (36), second and third sentences; see also above, under 11.2.4. 144 Ibid., Article 25 and recital (37). These draft DRS were submitted on 15 March

2021 (available at: https://www.eiopa.europa.eu/sites/default/files/publications/con sultations/jc-2021-22-joint-consultation-paper-on-taxonomyrelated-sustainability-disclo sures.pdf). On the Joint Committee, see Gortsos, Ch.V. (2020). European Central Banking Law—The Role of the European Central Bank and National Central Banks under European Law. Palgrave Macmillan Studies in Banking and Financial Institutions. Cham, Switzerland: Palgrave Macmillan Springer, p. 127; see also at: https://esas-jointcommittee.europa.eu. 145 Ibid., Article 26(1) and recital (59).

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third, the use of the definition of environmentally sustainable investment both in EU law and at Member State level, including the provisions required for setting up verification mechanisms of compliance with the criteria set out in the TR; fourth, the effectiveness of the application of the TSC in channelling private investments into environmentally sustainable economic activities and in particular as regards capital flows, including equity, into private enterprises and other legal entities, both through financial products covered by the TR and other financial products; fifth, the access by financial market participants covered by the TR and by investors to reliable, timely and verifiable information and data regarding private enterprises and other legal entities, including investee companies within and outside its scope and, in both cases, as regards equity and debt capital, taking into account the associated administrative burden, as well as the procedures for the verification of the data necessary for determining the degree of alignment with the TSC and to ensure compliance with those procedures; and finally, the application of Articles 21–22 on NCAs, measures and penalties.146 (2) The Commission must also publish, by 31 December 2021, a report describing the necessary provisions in order to meet the following goals: extend the TR’s scope beyond environmentally sustainable economic activities; cover economic activities that do not have a significant impact on environmental sustainability and significantly harm it, as well as a review of the appropriateness of specific disclosure requirements related to transitional and enabling activities; and also cover social objectives. Furthermore, by 13 July 2022, it must assess the effectiveness of the advisory procedures for the development of the TSC established under the TR.147 11.5.5

Start of Application

(1) The Commission delegated acts on the first two climate-related objectives (i.e., climate change mitigation and adaptation) should have 146 On Articles 21–22, see above, under 11.4.3. 147 TR, Article 26(2)–(3).

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been adopted by 31 December 2020 and will apply from 1 January 2022.148 Those on the other four environmental objectives will have to be adopted by the Commission by 31 December 2021 and will apply from 1 January 2023.149 (2) In order to allow relevant actors to familiarise themselves with the criteria for qualification as environmentally sustainable economic activities and to prepare for their application, the disclosure obligations set out in the TR will apply 12 months after the establishment of the relevant TSC, depending on the environmental objective they relate to. In particular, Articles 4–7 and 8(1)–(3) will apply in respect of the first two climaterelated objectives from 1 January 2022; and in respect of the other four environmental objectives from 1 January 2023.150

11.6

Concluding Remarks 11.6.1

A Summary

(1) The Taxonomy regulation (TR), adopted in 2019, is a key milestone in defining legally sustainable activities. It should be viewed within the context of the climate and energy targets set by the EU for 2030 in order to become climate-neutral by 2050, and constitutes, along with the Sustainable Finance Disclosure Regulation (SFDR) and the Low Carbon Benchmarks Regulation, the regulatory “trilogy” implementing the CMU Action Plan in relation to sustainable finance. It substantially builds on the 2020 Report of the Technical Expert Group on Sustainable Finance (TEG), which developed the “EU taxonomy” classification system to determine whether an economic activity can qualify as environmentally sustainable.151 The system of its rules is anchored in the

148 Ibid., Articles 10(6) and 11(6). The Draft Delegated Act on climate change mitigation and climate change adaptation were published on November 20, containing a draft Delegated Regulation, Annex I on the climate change mitigation environmental objective (233 pages) and Annex II on the climate change adaptation objective (281 pages); available at: https://ec.europa.eu/info/law/better-regulation/have-your-say/initia tives/12302-Climate-change-mitigation-and-adaptation-taxonomy#ISC_WORKFLOW. As of March 2021, however, they had not yet been adopted. 149 Ibid., Articles 12(5), 13(5), 14(5) and 15(5). 150 Ibid., Article 27(2), first sub-paragraph and recital (57). 151 See above, under 11.1.1.1.

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definition of six specific environmental objectives,152 which constitute the benchmark on the basis of which an economic activity can be assessed to qualify as environmentally sustainable and, hence, the degree to which a financial investment is environmentally sustainable is established. For this latter purpose, an economic activity qualifies as environmentally sustainable if it substantially contributes to one or more environmental objectives, does not significantly harm any other environmental objective, is carried out in compliance with specific safeguards153 and complies with applicable technical screening criteria (TSC), as set out in the delegated acts to be adopted by the Commission pursuant to the TR.154 When developing the TSC, the Commission is assisted by the advisory Platform on Sustainable Finance, composed of experts representing the public sector, the private sector and the civil society. It is also advised by the Expert Group on Sustainable Finance on the appropriateness of the TSC and the approach taken by the Platform regarding their development.155 The delegated acts will be adopted in two stages: those on climate change mitigation and adaptation by 31 December 2020 (and will apply from 1 January 2022) and those on the other four objectives by 31 December 2021 (to apply from 1 January 2023).156 (2) The TR applies to any measures adopted by Member States or by the EU setting out requirements for financial market participants or issuers in respect of financial products or corporate bonds that are made available as environmentally sustainable, to financial market participants that make available environmentally sustainable financial products and to undertakings which are subject to the obligation to publish a nonfinancial statement or a consolidated non-financial statement pursuant to the EU Non-Financial Reporting Directive and issue environmentally sustainable corporate bonds. In order to avoid harming investor interests, it introduces specific disclosure requirements for marketing financial products or corporate bonds as environmentally sustainable investments. These obligations supplement the sustainability-related disclosure rules of the SFDR in pre-contractual disclosures and in periodic reports; in this 152 See above, under 11.1.3. 153 See above, under 11.2.2, 11.2.3, 11.2.4 respectively. 154 See above, under 11.3 and 11.5.2. 155 See above, under 11.5.1. 156 See above, under 11.5.1 and 11.5.5 (1).

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respect, firms will have to consider the impact that the new rules will have at both entity and product level.157 Furthermore, in order to ensure consistency between the two TR and the SFDR, the former amends the latter.158 (3) It is finally noted that the TR contains a review clause, on the basis of which, by 13 July 2022, the Commission must publish a Report on its application, evaluating, inter alia, the progress in its implementation with regard to the development of TSC for environmentally sustainable economic activities, the potential need to revise and complement the TSC set out for an economic activity to qualify as environmentally sustainable and the effectiveness of the application of the TSC in channelling private investments into such economic activities. Furthermore, and most importantly, by 31 December 2021, the Commission must publish a Report describing the necessary provisions in order to extend the TR’s scope beyond environmentally sustainable economic activities and cover both economic activities that do not have a significant impact on environmental sustainability and significantly harm it, as well as social objectives.159 11.6.2

The Impact on Credit Institutions’ Management and Supervision of ESG Risks

(1) The significance of the impact of the TR is not confined to the firms which are directly covered by its scope and the disclosure requirements imposed on them. The EU taxonomy classification system, which constitutes the core of this legislative act, will be taken over in other sources of EU financial regulation, which apply to credit institutions, investment firms and investment fund managers, as well as insurance companies.160 Even though the TR in itself is a legal instrument setting out disclosure requirements only and does not directly apply to the lending activities of credit institutions, its impact on the latter activity is significant indirectly

157 See above, under 11.4. 158 See above, under 11.5.3. 159 See above, under 11.5.4. 160 See by means of mere indication Alexander, K. and P.G. Fisher (2018). Banking Regulation and Sustainability. available at https://ssrn.com/abstract=3299351 and Alexander, K. (2019). op. cit., pp. 357–364.

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through Guides developed by the European Central Bank (ECB)161 and to be developed by the European Banking Authority (EBA). (2) Among other related initiatives,162 on 30 October 2020, the EBA issued a discussion paper “On management and supervision of ESG risks for credit institutions and investment firms (EBA/DP/2020/03)”.163 Its purpose is to define and develop assessment criteria for “ESG factors” that may impact the financial performance and solvency of credit institutions (and investment firms) through their counterparties, as well as to present the EBA’s understanding on the relevance of “ESG risks” for a sound functioning of the financial sector.164 On the basis of the comments to be collected from stakeholders, the EBA will adopt and submit (expectedly in June 2021) its final Report,165 which will have:

161 See the ECB “Guide on climate-related and environmental risks: Supervisory expectations relating to risk management and disclosure” of 27 November 2020 (referred to above, under 11.1.1.1 (2)). 162 E.g., “EBA Action Plan on Sustainable Finance”, 6 December 2019, available at: https://eba.europa.eu/sites/default/documents/files/document_library//EBA% 20Action%20plan%2on%20sustainable%20finance.pdf. 163 Available at: https://eba.europa.eu/financial-innovation-and-fintech/sustainable-fin ance/discussion-paper-management-and-supervision-esg-risks-credit-institutions-and-invest ment-firms-0. 164 ESG factors are defined as environmental, social or governance characteristics, that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual (EBA/DP/2020/03, para. 30). ESG risks are defined to mean the risks of any negative financial impact to an institution stemming from the current or prospective impacts of ESG factors on its counterparties and materialise themselves through their impact on prudential risk categories (Ibid., para. 38). These include, but are not confined to, the climate-related and environmental risks, as defined in the abovementioned ECB 2020 Guide (Ibid., para. 8, point a). ESG factors, ESG risks and their transmission channels are discussed in detail in Chapter 4 (pp. 20–47), while Chapter 5 (pp. 48–77) develops on quantitative and qualitative indicators, metrics and methods to assess ESG risks. Annex 1 (pp. 141–153) contains a non-exhaustive list of ESG factors, indicators and metrics. 165 The legal bases of this Report are Article 98(8) of Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 “on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms (…)”(CRD IV, OJ L 176, 27.6.2013, pp. 338–436), which was inserted by Article 1, point 29(d) of Directive (EU) 2019/878 of the same institutions of 7 June 2019 amending the CRD IV (CRD V, OJ 150, 7.6.2019, pp. 253–295), and Article 35 of Directive (EU) 2019/2034 of the same institutions of 27 November 2019 “on the prudential supervision of investment firms” (IFD, OJ L 314, 5.12.2019, pp. 64–114).

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first, to elaborate on the arrangements, processes, mechanisms and strategies to be implemented by credit institutions (and investment firms) to identify, assess and manage ESG risks, embedding them in their internal governance and risk management frameworks in a proportionate manner; and second, to assess, under the provisions of the so-called “Pillar 2” of the framework governing the micro-prudential regulation and supervision of credit institutions (and investment firms), the inclusion of ESG factors and EFG risks in the review and evaluation performed by competent (supervisory) authorities (including the ECB for significant credit institutions within the Single Supervisory Mechanism (SSM)).166 The taxonomy framework, as laid down in the TR, will, inter alia, be used as one of the benchmarks in this respect.167 (3) For the sake of completeness, it is noted that the EBA is required to take related action also with regard to the two other Pillars of the regulatory framework. In particular (and taking into account only the provisions relating to credit institutions): first, in accordance with Article 501c of Regulation (EU) No 575/2013of the European Parliament and of the Council of 26 June 2013 “on prudential requirements for credit institutions and investment firms (…)”168 (CRR ), which was inserted by Article 1 of Regulation (EU) 2019/876 of the same institutions of 7 June 2019 amending the CRR169 (CRR II), it must assess whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified as a component of Pillar 1 capital requirements; and 166 EBA/DP/2020/03, Chapter 6 (pp. 78–117) on the management of ESG risks by credit institutions and investment firms and Chapter 7 (pp. 118–140) on ESG factors and ESG risks in supervision, respectively. Chapter 7 elaborates, in particular, on the effective way to proportionately reflect ESG risks in the supervisory review for credit institutions and makes several related policy recommendations. 167 The frequency of references to the TR in the discussion paper (15 times) is notable. 168 OJ L 176, 27.6.2013, pp. 1–337. 169 OJ 150, 7.6.2019, pp. 1–225.

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second, Article 449a CRR provides that large credit institutions with publicly listed issuances must, under the Pillar 3 provisions, disclose information on ESG risks, including physical and transition risks; in this respect, the EBA must develop a technical standard implementing this disclosure requirement.170

170 CRR, Article 434a.

CHAPTER 12

Sustainability Disclosure in the EU Financial Sector Danny Busch

12.1

Introduction

On 8 March 2018, the European Commission launched its Action Plan on Sustainable Finance (‘Action Plan’).1 The Action Plan aims to: (i) reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth; (ii) manage financial risks stemming from climate change, resource depletion, environmental degradation and

1 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 2.

D. Busch (B) Financial Law Centre (FLC), Radboud University Nijmegen, Nijmegen, The Netherlands e-mail: [email protected]

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_12

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social issues; and (iii) foster transparency and long-termism in financial and economic activity.2 In the Action Plan, these aims are translated into ten concrete actions, including (1) strengthening sustainability-related disclosures and (2) clarifying sustainability-related fiduciary duties.3 Of course, the EU financial services sector has been the subject of detailed harmonised regulatory disclosure rules and harmonised regulatory fiduciary duties for many years, but until very recently harmonised regulatory sustainability-related (i) disclosure rules and (ii) fiduciary duties were lacking or in any event underdeveloped. The recently adopted regulation on sustainability-related disclosures in the financial services sector (the ‘Sustainable Finance Disclosure Regulation’ or ‘SFDR’) aims to fill this gap by subjecting several players in the EU financial services sector to a harmonised set of regulatory sustainability-related (i) disclosure rules and (ii) fiduciary duties.4 The bulk of these new rules will apply from 10 March 2021.5

2 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), p. 3. 3 European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March 2018), pp. 4–11. 4 Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector [2019] OJ EU L 317/1, as amended by Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088 [2020] OJ EU L 198/13. References to Articles of Regulation (EU) 2019/2088 which did not result in amendments of the Sustainable Finance Disclosure Regulation itself, will be referred to as the ‘Taxonomy regulation’. A consolidated version of the Sustainable Finance Disclosure Regulation is available at https://eur-lex.europa.eu/legal-content/EN/TXT/?uri= CELEX%3A02019R2088-20200712. 5 Art. 20 (2) SFDR. By way of derogation from Art. 20 (2) (i) Art. 4(6) and (7), Art. 8(3), Art. 9(5), Art. 10(2), Art. 11(4) and Art. 13(2) will apply from 29 December 2019 (these provisions all concern the ESAs’ power to draw up relevant RTS’s and the Commission’s power to adopt them); (ii) Art. 2a, 8(4), 9(6) and 11(5) will apply from 12 July 2020 (these provisions all concern the ESAs’ power to draw up relevant RTS’s and the Commission’s power to adopt them); (iii) Art. 8(2a) and 9(4a) will apply from 1 January 2022 or 1 January 2023, as applicable (these provisions concern information on the various ‘environmental objectives’); (iv) Art. 11(1) to (3) will apply from 1 January 2022 (these provisions concern transparency of the promotion of environmental or social characteristics and of ‘sustainable investments’ in periodic reports).

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According to Recital (9) SFDR, harmonised sustainability-related disclosure rules are necessary, essentially because the alternative is not workable. After all, divergent national disclosure standards and marketbased practices (i) make it very difficult to compare different financial products (ii) create an uneven playing field for such products and for distribution channels and (iii) erect additional barriers within the internal market. Such divergences could also be confusing for end investors and could distort their investment decisions. Recital (10) SFDR states that the legislation aims to reduce information asymmetries in principal–agent relationships with regard to (i) the integration of sustainability risks (ii) the consideration of adverse sustainability impacts and (iii) the promotion of environmental or social characteristics as well as sustainable investment by means of pre-contractual and ongoing disclosures to end investors, acting as principals, by financial market participants or financial advisers, acting as agents on behalf of principals.6 Against this backdrop, the Sustainable Finance Disclosure Regulation lays down harmonised rules for (i) financial market participants and (ii) financial advisers on transparency with regard to (a) the integration of sustainability risks and (b) the consideration of adverse sustainability impacts, both in their processes and in the provision of sustainabilityrelated information with respect to financial products.7 The aim of this chapter is twofold. On the one hand, it explores the main features of the Sustainable Finance Disclosure Regulation. On the other hand, it tries to assess whether the Sustainable Finance Disclosure Regulation is likely to succeed in harmonising sustainability-related (i) disclosure rules and (ii) fiduciary duties, not only across Member States, but also across financial products and distribution channels. The chapter is structured as follows. First, some key terms and definitions are discussed (Sect. 12.2), followed by a treatment of the main rules on (1) sustainability disclosure at entity level (Sect. 12.3), (2) pre-contractual sustainability disclosure at product level (Sect. 12.4), 6 Please note that I quoted Recital (10) as very slightly reformulated in Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16), on p. 6. 7 Art. 1 SFDR.

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(3) sustainability disclosure at product level on websites (Sect. 12.5) and (4) sustainability disclosure at product level in periodic reports (Sect. 12.6). Subsequently, the relationship between sustainability disclosure and marketing communications is addressed (Sect. 12.7), followed by some remarks on competent financial supervisors (Sect. 12.8). In Sect. 12.9, it is assessed whether the Sustainable Finance Disclosure Regulation is likely to succeed in harmonising sustainability-related (i) disclosure rules and (ii) fiduciary duties. Finally, Sect. 12.10 zooms out and puts the Sustainable Finance Disclosure Regulation in a broader perspective.

12.2

Key Terms & Definitions 12.2.1

General

The Sustainable Finance Disclosure Regulation uses its own vocabulary. To properly grasp the broad scope and content of the new rules, we must first assess the meaning of the key terms and definitions used in the Sustainable Finance Disclosure Regulation. 12.2.2

Financial Market Participants

‘Financial market participants’ are defined as (1) insurance undertakings which make available insurance-based investment products (IBIPs)8 ; (2) investment firms and credit institutions providing individual portfolio

8 Art. 2(1) (a) read in conjunction with Art. 2(2) and Art. 2(3) SFDR.

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management9 ; (3) managers of collective investment schemes10 ; and (4) several entities involved in pension products.11 12.2.3

Financial Advisers

‘Financial advisers’ are defined as (1) insurance intermediaries and insurance undertakings providing insurance advice with regard to IBIPs12 ; (2)

9 Art. 2(1) (b) (investment firms as defined in Art. 2(5)) and (j) (credit institutions), both read in conjunction with Art. 2(6) SFDR. In practice, the following question has arisen. For portfolios, or other types of tailored financial products managed in accordance with mandates given by clients on a discretionary client-by-client basis, do the disclosure requirements in the Sustainable Finance Disclosure Regulation apply at the level of the portfolio only or can they apply at the level of standardised portfolio solutions? See further the letter dated 7 January 2021 from the joint ESAs to the European Commission (JC 2021 02). 10 Art. 2(1) (e) (alternative investment fund managers (AIFMs), as defined in Art. 2(4)) (g) (managers of venture capital funds, EuVECA) (h) (managers of social entrepreneurship funds, EuSEF) and (i) (a management company of an undertaking for collective investment in transferable securities, UCITS management companies, as defined in Art. 2(10)) SFDR. An ‘AIFM’ is further defined in Art. 2(4) SFDR with reference to Article 4(1)(b) of Directive 2011/61/EU (the Alternative Investment Fund Managers Directive (AIFMD)). Therefore, the SFDR applies to AIFMs in general by virtue of the reference to Article 4(1)(b) AIFMD. The following questions have arisen in practice. (i) Does the SFDR therefore apply to registered (sometimes referred to as sub-threshold) AIFMs referred to in Art. 3(2) AIFMD? (ii) Does SFDR apply to non-EU AIFMs, for example, when they market a sustainable EU Alternative Investment Fund under a National Private Placement Regime? See the letter dated 7 January 2021 from the joint ESAs to the European Commission (JC 2021 02). 11 Art. 2(1) (c) (institutions for occupational retirement provision (IORPs), as defined in Art. 2(7)) (d) (manufacturers of pension products as defined in Art. 2(8)) and (f) (providers of pan-European Personal Pension Products (PEPPs), as defined in Art. 2(9)) SFDR. NB: Member States may decide (Member State option) to apply the Sustainable Finance Disclosure Regulation to manufacturers of pension products operating ‘national social security schemes’ which are covered by Regulations (EC) No 883/2004 and (EC) No 987/2009. In such cases, manufacturers of pension products as referred to in Art. 2(1)(d) SFDR includes manufacturers of pension products operating national social security schemes and of pension products referred to in Art. 2(8) SFDR. In such case, the definition of pension product in Art. 2(8) SFDR is deemed to include pension products with regard to national social security schemes. See Art. 16(1) SFDR. Member States must notify the Commission and the ESAs of any decision taken pursuant to Art. 16(1) SFDR (Art. 16(2) SFDR). 12 Art. 2(11) (a) and (b) (insurance intermediaries as defined in Art. 2(20) and insurance undertakings as defined in Art. 2(2) providing insurance advice as defined in Art. 2(21)

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investment firms and credit institutions providing investment advice13 ; and (3) managers of collective investment schemes providing investment advice.14 12.2.4

Financial Product

‘Financial product’ is defined as (a) an individually managed portfolio15 ; (b) a collective investment scheme16 ; (c) an insurance-based investment

with regard to IBIPs as defined in Art. 2(3)) SFDR. NB: the Sustainable Finance Regulation does not apply to insurance intermediaries providing insurance advice with regard to IBIPs that employ fewer than three persons, irrespective of their legal form, including natural persons (Art. 17(1) SFDR). Member States may however decide (Member State option) to nevertheless apply the Sustainable Finance Disclosure Regulation in such cases (Art. 17(2) SFDR). Member States must notify the Commission and the ESAs of any such decision (Art. 17(3) SFDR). 13 Art. 2(11) (c) and (d) (credit institutions and investment firms as defined in Art. 2(5)

providing investment advice as defined in Art. 2(16)) SFDR. NB: the Sustainable Finance Regulation does not apply to investment firms providing investment advice that employ fewer than three persons, irrespective of their legal form, including natural persons (Art. 17(1) SFDR). Member States may nevertheless decide (Member State option) to apply the Sustainable Finance Disclosure Regulation in such cases (Art. 17(2) SFDR). Member States must notify the Commission and the ESAs of any such decision (Art. 17(3) SFDR). 14 Art. 2(11) (e) and (f) (alternative investment fund managers (AIFMs) as defined in Art. 2(4) and UCITS management companies as defined in Art. 2(10) providing investment advice as defined in Art. 2(16)) SFDR. 15 Art. 2(12) (a) read in conjunction with Art. 2(6) SFDR. 16 Art. 2(12) (a) and (f) (alternative investment funds (AIFs) as defined in Art. 2(13)

and UCITS as defined in Art. 2(13)) SFDR.

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product (IBIP)17 ; (d) a pension product or pension scheme18 ; and (e) a pan-European Personal Pension Product (PEPP).19 12.2.5

Sustainability Risk

‘Sustainability risk’ is defined as an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment.20 12.2.6

Sustainability Factors

‘Sustainability factors’ is defined as environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters.21 12.2.7

Sustainable Investment

12.2.7.1 General ‘Sustainable investment’ is defined as: 1. an investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on;

17 Art. 2(12) (c) read in conjunction with Art. 2(3) SFDR. 18 Art. 2(12) (d) and (e) (pension product as defined in Art. 2(8) and pension schemes

as defined in Art. 2(14)) SFDR. NB: Member States may decide (Member State option) to apply the Sustainable Finance Disclosure Regulation to manufacturers of pension products operating ‘national social security schemes’ which are covered by Regulations (EC) No 883/2004 and (EC) No 987/2009. In such cases, manufacturers of pension products as referred to in Art. 2(1)(d) SFDR includes manufacturers of pension products operating national social security schemes and of pension products referred to in Art. 2(8) SFDR. In such case, the definition of pension product in Art. 2(8) SFDR is deemed to include pension products operating national social security schemes. See Art. 16(1) SFDR. Member States must notify the Commission and the ESAs of any decision taken pursuant to Art. 16(1) SFDR (Art. 16(2) SFDR). 19 Art. 2(9) SFDR. 20 Art. 2(22) SFDR. 21 Art. 2(24) SFDR.

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a. the use of energy, renewable energy, raw materials, water and land; b. the production of waste; c. greenhouse gas emissions, and d. biodiversity and the circular economy, or 2. an investment in an economic activity that contributes to a social objective, in particular; a. an investment that contributes to tackling inequality, or b. an investment that fosters social cohesion, social integration and labour relations, or c. an investment in human capital or economically or socially disadvantaged communities. provided (i) that the investments set out in (1) and (2) above ‘do not significantly harm’ any of those environmental and social objectives and (ii) that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance.22 12.2.7.2

‘Level 2’ Regulation: The Principle of ‘Do Not Significantly Harm’ The principle of ‘do not significant harm’ will be fleshed out in greater detail in regulatory technical standards (RTSs) to be adopted by the Commission and drawn up jointly by the European Securities and Markets Authority (ESMA), the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA) (jointly referred to as the ‘European Supervisory Authorities’ or ‘ESAs’). More precisely, the ESAs must jointly develop draft RTSs to specify the details of (i) the content and (ii) the presentation of the information in relation to the principle of ‘do not significant harm’ referred to in the definition of ‘sustainable investment’ set out in Sect. 12.2.7 above (by 30 December 2020, 1 June 2021 or 1 June 2022, as applicable23‚24 ). 22 Art. 2(17) SFDR. 23 But see Sect. 12.9.6. 24 Art. 2a(1) SFDR. The RTSs on the principle of ‘do no significant harm’ must be consistent with the RTSs on (a) the content (b) the methodologies and (c) the

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Relevant Concepts Used in the Taxonomy Regulation

12.2.8.1 Environmental Objectives As will be seen further below, certain concepts used in the Taxonomy Regulation are also relevant for the proper application of the Sustainable Finance Disclosure Regulation.25 The relevant concepts will be explained below. First of all, in the Taxonomy Regulation, the following objectives are designated as ‘environmental objectives’: a. climate change mitigation; b. climate change adaptation; c. the sustainable use and protection of water and marine resources; d. the transition to a circular economy; e. pollution prevention and control; f. the protection and restoration of biodiversity and ecosystems.26 The Taxonomy Regulation sets out in broad outline when an economic activity (i) ‘contributes substantially’ to one or more of the above ‘environmental objectives’ or (ii) is considered to ‘significantly harm’ one or more of the above ‘environmental objectives’. In delegated acts to be adopted by the European Commission (by 31 December 2020 or presentation in respect of the sustainability indicators in relation to the adverse impacts (Art. 2a(1) SFDR). See Sect. 12.3.3.1(iv), for a treatment of the RTSs on (a) the content (b) the methodologies and (c) the presentation in respect of the sustainability indicators in relation to the adverse impacts. See also Art. 2a(2) and Art. 8(4) SFDR. Power is delegated to the Commission to supplement the SFDR by adopting the relevant RTSs in accordance with Art. 10 to 14 of Regulations (EU) No 1093/2010 (EU) No 1094/2010 and (EU) No 1095/2010 (Art. 2a(3) and Art. 8(4) SFDR). On 23 April 2020, the ESAs published a consultation paper setting out the RTSs they propose in this regard: Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). Market parties could respond until 1 September 2020. The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03). 25 Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088 [2020] OJ EU L 198/13 (‘Taxonomy regulation’). That Taxonomy Regulation is analysed in the contribution by C.V. Gortsos in this book. 26 Art. 9 Taxonomy regulation.

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2021, as applicable, and to be applied from 1 January 2022 or 2023 onwards, as applicable), ‘technical screening criteria’ will be established for determining the exact conditions under which an economic activity (i) ‘contributes substantially’ to one or more of the above ‘environmental objectives’ or (ii) is considered to ‘significantly harm’ one or more of the above ‘environmental objectives’.27 Before adopting the relevant delegated acts, the Commission will need to consult the ‘Platform on Sustainable Finance’. The platform is composed of people from a wide range of sectors including civil society, industry and academia. The platform will reach out to a wide range of stakeholders through both public consultations and targeted outreach. In addition, the Directorate General for Financial Stability, Financial Services and Capital Markets Union (DG FISMA) directly appointed representatives from seven public entities, namely the European Environment Agency, the European Investment Bank, the European Investment Fund, the ESAs and the European Agency for Fundamental Rights.28 12.2.8.2

‘Do not Significantly Harm’ Versus ‘Significant Harm to Environmental Objectives’ The exact link between the concept of ‘do not significantly harm’ under the Sustainable Finance Disclosure Regulation29 and the concept of ‘significant harm to environmental objectives’ under the Taxonomy Regulation30 is unfortunately not entirely clear and should be clarified by the Commission. See also the following remark in the Joint Consultation Paper of the ESAs:

27 Art. 3, 10–17 and 19 Taxonomy regulation. See for the draft delegated regulation regarding the technical screening criteria for determining the conditions under which an economic activity qualifies as contributing substantially to (a) climate change mitigation or (b) climate change adaptation, and for determining whether that economic activity causes no significant harm to any of the other environmental objectives (published on 20 November 2020): https://ec.europa.eu/info/law/better-regulation/have-your-say/ini tiatives/12302-Climate-change-mitigation-and-adaptation-taxonomy#ISC_WORKFLOW. 28 Art. 20 Taxonomy regulation. See for the tasks and composition of the Platform on Sustainable Finance: https://ec.europa.eu/info/publications/sustainable-finance-platfo rm_en. 29 See Art. 2(1)(17) SFDR, on which see Sect. 12.2.7.2. 30 See Art.17 Taxonomy regulation.

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The ESAs acknowledge the strong link between the concept of “do not significantly harm” under SFDR and the same notion under the [T]axonomy [R]egulation applied to environmental activities. For example, the detailed technical screening criteria for “do not significantly harm” under the [T]axonomy [R]egulation would be useful input for firms’ assessment of “do not significantly harm” where SFDR products make environmentally sustainable investments in economic objectives. However, the definition of sustainable investments in Article 2(17) SFDR includes both environmental and social objectives, while the [T]axonomy [R]egulation is only limited to environmental objectives. Furthermore, the disclosure of principal adverse impact and significant harm may involve different uses of the same indicators. For these reasons, the ESAs believe the Commission should consider studying the feasibility of clarifying the relation between the concepts of “do not significantly harm” and principal adverse impact in the future.31

12.2.8.3 Minimum Safeguards Furthermore, according to the Taxonomy Regulation, ‘minimum safeguards’ are procedures implemented by an ‘undertaking’32 that is carrying out an economic activity to ensure the alignment with (i) the OECD Guidelines for Multinational Enterprises and (ii) the UN Guiding Principles on Business and Human Rights, including the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work and the International Bill of Human Rights.33 When implementing the procedures set out in the previous sentence, ‘undertakings’ must adhere to the principle of ‘do no significant harm’ referred to in Sect. 12.2.7.2 above.34

31 See p. 9 of the Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03). 32 The term ‘undertaking’ is not defined in the Taxonomy Regulation. I assume the term includes ‘financial market participants’ and ‘financial advisers’ as defined in Art. 2(1) and 2(11) SFDR. See on the terms ‘financial market participants’ and ‘financial advisers’ Sects. 12.2.2 and 12.3. 33 Art. 18(1) Taxonomy Regulation. 34 Art. 18(2) Taxonomy Regulation read in conjunction with Art. 2(17) SFDR.

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12.2.8.4 Environmentally Sustainable Economic Activities Finally, according to the Taxonomy regulation, an economic activity qualifies as ‘environmentally sustainable’ where that economic activity: a. contributes substantially to one or more of the ‘environmental objectives’ set out in Sect. 12.2.8.1 above; b. does not significantly harm any of the ‘environmental objectives’ set out in Sect. 12.2.8.2 above; c. is carried out in compliance with the ‘minimum safeguards’ set out in Sect. 12.2.8.3 above; and d. complies with ‘technical screening criteria’ that have been established by the Commission (see Sect. 12.2.8.1, last paragraph above).35

12.3

Sustainability Disclosures at Entity Level 12.3.1

General

Now that we have a basic understanding of the key terms and definitions used in the Sustainable Finance Disclosure Regulation, we can move on to the substantive rules themselves. The first type of sustainability disclosure set out in the Sustainable Finance Disclosure Regulation is explored in this Sect. 12.3 and applies at entity level. 12.3.2

Transparency of Sustainability Risk Policies on the Website

Both financial market participants and financial advisers must publish on their websites information about their policies on the integration of ‘sustainability risks’36 in their investment decision-making process (financial market participants) and in their investment advice or insurance advice (financial advisers).37 35 Art. 3 Taxonomy regulation. 36 ‘Sustainability risk’ is defined as an environmental, social or governance event or

condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment (Art. 2(22) SFDR, see Sect. 12.2.5). 37 Art. 3(1) (financial market participants) and (2) (financial advisers) SFDR. Financial market participants that qualify as IORPs must publish and maintain the information

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They must ensure that this information is kept up to date. Where a financial market participant or financial adviser amends such information, a clear explanation of such amendment must be published on the same website.38 12.3.3

Transparency of Principal Adverse Sustainability Impacts on the Website

12.3.3.1 Financial Market Participants (i) Comply… Where they consider principal adverse impacts of investment decisions on ‘sustainability factors’,39 financial market participants must publish and maintain on their websites a statement on due diligence policies with respect to those impacts, taking due account of (i) their size, the nature and scale of their activities and (ii) the types of financial products they make available.40 Financial market participants must publish at least the following information on their websites: a. information about their policies on the identification and prioritisation of principal adverse sustainability impacts and indicators; b. a description of the principal adverse sustainability impacts and of any actions in relation thereto taken or, where relevant, planned;

referred to in Art. 3(1) in accordance with point (f) of Article 36(2) of Directive (EU) 2016/2341 (IORP Directive), see Art. 15(1) SFDR. Financial advisers that qualify as insurance intermediaries must communicate the information referred to in Art. 3(2) SFDR in accordance with Art. 23 of Directive (EU) 2016/97 (IDD), see Art. 15(2) SFDR. 38 Art. 12(1) (financial market participants) and (2) (financial advisers) SFDR. 39 ‘Sustainability factors’ is defined as environmental, social and employee matters,

respect for human rights, anti-corruption and anti-bribery matters (Art. 2(24) SFDR, see Sect. 12.2.6). 40 Art. 4(1), opening words, and (a) SFDR. Financial market participants that qualify as IORPs must publish and maintain the information referred to in Art. 4(1), opening words, and (a) SFDR in accordance with point (f) of Article 36(2) of Directive (EU) 2016/2341 (IORP Directive), see Art. 15(1) SFDR.

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c. brief summaries of engagement policies in accordance with the Directive on the exercise of certain rights of shareholders in listed companies,41 where applicable; d. a reference to their adherence to responsible business conduct codes and internationally recognised standards for due diligence and reporting and, where relevant, the degree of their alignment with the objectives of the Paris Agreement.42 (ii) … or Explain Where they do not consider adverse impacts of investment decisions on ‘sustainability factors’,43 financial market participants must publish and maintain on their websites clear reasons for why they do not do so, including, where relevant, information on whether and when they intend to consider such adverse impacts (‘comply or explain’).44 (iii) Financial Market Participants Above a Certain Size In view of the above, financial market participants in principle have a choice not to consider adverse impacts of investment decisions on ‘sustainability factors’‚45 provided that they give reasons for it. However, from 30 June 2021 onwards, financial market participants exceeding (i) on their own balance sheet dates or (ii) where they are parent undertakings of a large group,46 on their group balance sheet dates, the criterion of the average number of 500 employees during the financial year, must 41 See Art. 3 g (Engagement Policy) of Directive 2007/36/EC of the European Parliament and of the Council of 11 July 2007 on the exercise of certain rights of shareholders in listed companies [2007] OJ EU L184/17, as amended by (1) Directive 2014/59/EU [2014] OJ EU L173/90 and (2) Directive (EU) 2017/828 [2017] OJ EU L131/1. 42 Art. 4(2) SFDR. 43 ‘Sustainability factors’ is defined as environmental, social and employee matters,

respect for human rights, anti-corruption and anti-bribery matters (Art. 2(24) SFDR, see Sect. 12.2.6). 44 Art. (4)(1), opening words, and (b) SFDR. Financial market participants that qualify as IORPs must publish and maintain the information referred to in Art. 4(1), opening words, and (b) SFDR in accordance with point (f) of Article 36(2) of Directive (EU) 2016/2341 (IORP Directive), see Art. 15(1) SFDR. 45 ‘Sustainability factors’ is defined as environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters (Art. 2(24) SFDR, see Sect. 12.2.6). 46 As referred to in Article 3(7) of Directive 2013/34/EU.

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always consider adverse impacts of investment decisions on ‘sustainability factors’.47 (iv) ‘Level 2’ Regulation The disclosure rules set out above will be fleshed out in greater detail in RTSs to be adopted by the Commission and drawn up jointly by the ESAs. More precisely, the ESAs must jointly develop draft RTSs48 on the (a) content (b) methodologies and (c) presentation of information in respect of the sustainability indicators in relation to adverse impacts (i) on the climate and other environment-related adverse impacts (by 30 December 202049‚50 ); and (ii) in the field of social and employee matters, respect for human rights, anti-corruption and anti-bribery matters (by 30 December 2021).51

47 Art. 4(3) and (4) SFDR. ‘Sustainability factors’ is defined as environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters (Art. 2(24) SFDR, see Sect. 12.2.6). In practice, the following questions have arisen in this connection. (i) Must the calculation of the 500-employee threshold to the parent undertaking of a large group be applied to both EU and non-EU entities of the group without distinction as to the place of establishment of the group and/or subsidiary? (ii) Does the due diligence statement include impacts of the parent undertaking only or must it include the impacts of the group at a consolidated level? See the letter dated 7 January 2021 from the joint ESAs to the European Commission (JC 2021 02). 48 In accordance with Articles 10 to 14 of Regulations (EU) No 1093/2010, (EU) No 1094/2010 and (EU) No 1095/2010. 49 But see Sect. 12.9.6. 50 The ESAs must, where relevant, seek input from the European Environment Agency

and the Joint Research Centre of the European Commission, see Art. 4(6), second paragraph, SFDR. 51 Art. 4 (6) and (7) SFDR. Power is delegated to the Commission to supplement this Regulation by adopting the relevant RTSs in accordance with Articles 10 to 14 of Regulations (EU) No 1093/2010, (EU) No 1094/2010 and (EU) No 1095/2010. On 23 April 2020, the ESAs published a consultation paper setting out the RTSs they propose in this regard: Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). Market parties could respond until 1 September 2020. The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03).

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(v) The Data Challenge One aspect of great practical importance deserves explicit attention in this chapter. The relevant draft RTS jointly proposed by the ESAs stipulates that the ‘adverse sustainability impacts statement’ must be published in a certain prescribed format.52 It also sets out that this statement consists of the following sections, titled: a. ‘Summary’; b. ‘Description of principal adverse sustainability impacts’; c. ‘Description of policies to identify and prioritise principal adverse sustainability impacts’; d. ‘Description of actions to address principal adverse sustainability impacts’; e. ‘Engagement policies’; and f. ‘References to international standards’.53 The relevant draft RTS goes on by stating that the section ‘Description of policies to identify and prioritise principal adverse sustainability impacts’ (point (c), above) must contain a description (1) of the policies of the financial market participant on the assessment process to identify and prioritise principal adverse impacts on sustainability factors (2) of the indicators used and (3) of how those policies are maintained and applied, including at least the following: i. the date of approval of the policies by the governing body of the financial market participant; 52 See (i) Art. 4(2) at p. 28 and (ii) Table 1 of Annex 1 at pp. 53–63, of the Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03), see (i) Art. 4(2) at p. 23 and (ii) Table 1 of Annex 1 at pp. 59–66. 53 See Art. 4(2) at p. 28 of the Joint Consultation Paper, ESG Disclosures, Draft regu-

latory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03), see Art. 4(2) at p. 23.

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ii. the allocation of responsibility for the implementation of the policies within organisational strategies and procedures; iii. a description of the methodologies to assess each principal adverse impact and, in particular, how those methodologies take into account the probability of occurrence and severity of adverse impacts, including their potentially irremediable character; iv. an explanation of any associated margin of error within those methodologies; and v. a description of the data sources used.54 Where information relating to any of the indicators used is not readily available, the section ‘Description of policies to identify and prioritise principal adverse sustainability impacts’ (point (c), above) must also contain details of the best efforts used to obtain the information either directly from investee companies, or by carrying out additional research, cooperating with third party data providers or external experts or making reasonable assumptions.55 At this early stage, the data required to calculate adverse impacts according to the relevant indicators will often not be readily available and cannot be obtained directly from investee companies, which means that the entities subject to the Sustainable Finance Disclosure Regulation will often be dependent on third-party data providers claiming to have access to the required information.56 54 See Art. 7(1) at pp. 29–30 of the Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03), see Art. 7(1) at p. 25. 55 See Art. 7(2) at p. 30 of the Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03), see Art. 7(2) at p. 25. In the final report, Art. 7(2) has been rephrased somewhat. In the main text, I followed the rephrased version of Art. 7(2). 56 In a similar vein: Securities and Markets Stakeholder Group, SMSG advice to the ESA’s Joint Consultation Paper on ESG Disclosures (draft regulatory technical standards with regard to the content, methodologies and presentation pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation EU

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12.3.3.2 Financial Advisers (i) Comply… Financial advisers must likewise publish and maintain on their websites information on whether they consider in their investment or insurance advice the principal adverse impacts on ‘sustainability factors’,57 taking due account of (i) their size, the nature and scale of their activities, and (ii) the types of financial products they advise on.58 (ii) …or Explain Where they do not consider adverse impacts of investment decisions on ‘sustainability factors’59 in their investment or insurance advice, financial market participants must publish and maintain on their websites information on why they do not do so, including, where relevant, information on whether and when they intend to consider such adverse impacts (‘comply or explain’).60 In view of the above and unlike financial market participants above a certain size (see previous paragraph), financial advisers always have a choice not to consider adverse impacts of investment decisions on ‘sustainability factors’61 in their investment or insurance advice.

2019/2088 (14 September 2020) (ESMA22-106-2858), pp. 3–4. See Position https:// www.afm.nl/en/nieuws/2020/december/reguleer-aanbieders-duurzaamheidsdata. 57 ‘Sustainability factors’ is defined as environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters (Art. 2(24) SFDR, see Sect. 12.2.6). 58 Art. 4(5), opening words, and sub (a) SFDR. Financial advisers that qualify as insurance intermediaries must communicate the information referred to in Art. 4(5), opening words, and sub (a) SFDR in accordance with Art. 23 of Directive (EU) 2016/97 (IDD), see Art. 15(2) SFDR. 59 ‘Sustainability factors’ is defined as environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters (Art. 2(24) SFDR, see Sect. 12.2.6). 60 Art. 4(5), opening words, and sub (b) SFDR. Financial advisers that qualify as insurance intermediaries must communicate the information referred to in Art. 4(5), opening words, and sub (b) SFDR in accordance with Art. 23 of Directive (EU) 2016/97 (IDD), see Art. 15(2) SFDR. 61 ‘Sustainability factors’ is defined as environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters (Art. 2(24) SFDR, see Sect. 12.2.6).

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(iii) ‘Level 2’ Regulation The disclosure rules set out above will be fleshed out in greater detail in regulatory technical standards (RTSs) to be adopted by the Commission and drawn up jointly by ESAs.62 See for more detail Sect. 12.3.3.1(iv) above. 12.3.4

Transparency of Remuneration Policies in Relation to the Integration of Sustainability Risks

Both financial market participants and financial advisers must (i) include in their remuneration policies information on how those policies are consistent with the integration of ‘sustainability risks’63 and (ii) publish that information on their websites.64 This information must be included in remuneration policies that financial market participants and financial advisers are required to establish and maintain in accordance with applicable sectoral legislation.65 They must ensure that this information is kept up to date. Where a financial market participant or financial adviser amends such information, a clear explanation of such amendment must be published on the same website.66

62 See Art. 4(6) and (7) SFDR. On 23 April 2020, the ESAs published a consultation paper setting out the RTSs they propose in this regard: Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). Market parties could respond until 1 September 2020. The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03). 63 ‘Sustainability risk’ is defined as an environmental, social or governance event or

condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment (Art. 2(22) SFDR, see Sect. 12.2.5). 64 Art. 5(1) SFDR. Financial market participants that qualify as IORPs must publish and maintain the information referred to in Art. 5(1) SFDR in accordance with point (f) of Article 36(2) of Directive (EU) 2016/2341 (IORP Directive), see Art. 15(1) SFDR. Financial advisers that qualify as insurance intermediaries must communicate the information referred to in Art. 5(1) SFDR in accordance with Art. 23 of Directive (EU) 2016/97 (IDD), see Art. 15(2) SFDR. 65 In particular Directives 2009/76/EC (UCITS); 2009/138/EC (Solvency II); 2011/61/EU (AIFMD); 2013/36/EU (CRD IV); 2014/65/EU (MiFID II); (EU) 2016/97 (IDD); and (EU) 2016/2341 (IORPs), see Art. 5(2) SFDR. 66 Art. 12(1) (financial market participants) and (2) (financial advisers) SFDR.

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12.4

Pre-contractual Sustainability Disclosures at Product Level 12.4.1

General

The second type of sustainability disclosure set out in the Sustainable Finance Disclosure Regulation is explored in this Sect. 12.4 and concerns pre-contractual sustainability disclosures at product level. 12.4.2

Financial Market Participants and Financial Advisers

12.4.2.1 Comply… Both financial market participants and financial advisers must provide precontractual disclosures on: I. the manner in which ‘sustainability risks’67 are integrated into their investment decisions (financial market participants) or into their investment or insurance advice (financial advisers); and II. the results of the assessment of the likely impacts of ‘sustainability risks’68 on the returns of the financial products they make available (financial market participants) or advise on (financial advisers).69 12.4.2.2 …or Explain Where financial market participants or financial advisers deem ‘sustainability risks’ not to be relevant, the descriptions must include a clear and concise explanation of the reasons (‘comply or explain’).70 67 ‘Sustainability risk’ is defined as an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment (Art. 2(22) SFDR, see Sect. 12.2.5). 68 Ibid. 69 Art. 6(1), opening words, sub (a) and (b) (financial market participants) and Art. 6(2), opening words, sub (a) and (b) (financial advisers) SFDR. Financial market participants that qualify as IORPs must publish and maintain the information referred to in Art. 6(1), opening words, sub (a) and (b) SFDR in accordance with point (f) of Article 36(2) of Directive (EU) 2016/2341 (IORP Directive), see Art. 15(1) SFDR. Financial advisers that qualify as insurance intermediaries must communicate the information referred to in Art. 6(2), opening words, sub (a) and (b) SFDR in accordance with Art. 23 of Directive (EU) 2016/97 (IDD), see Art. 15(2) SFDR. 70 Art. 6(1), second paragraph (financial market participants) and Art. 6(2), second paragraph (financial advisers) SFDR. Financial market participants that qualify as IORPs

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12.4.2.3

Disclosure in Accordance with Applicable Sectoral Legislation The pre-contractual information must be disclosed to end investors in accordance with the applicable sectoral legislation, through an extremely broad spectrum of pre-contractual disclosure instruments, ranging from elaborate documents such as prospectuses to very concise documents such as key information documents (KIDs).71 12.4.3

Financial Market Participants

12.4.3.1 General For financial market participants, the pre-contractual disclosure duties set out in Sect. 12.4.2 above are fleshed out in greater detail, both in the Sustainable Finance Disclosure Regulation itself and in RTSs to be adopted.

must publish and maintain the information referred to in Art. 6(1), second paragraph SFDR in accordance with point (f) of Article 36(2) of Directive (EU) 2016/2341 (IORP Directive), see Art. 15(1) SFDR. Financial advisers that qualify as insurance intermediaries must communicate the information referred to in Art. 6(2), second paragraph, SFDR in accordance with Art. 23 of Directive (EU) 2016/97 (IDD), see Art. 15(2) SFDR. 71 See Art. 6(3) SFDR: for (a) AIFMs, in the disclosures to investors referred to in Art. 23(1) of Directive 2011/61/EU; (b) insurance undertakings, in the provision of information referred to in Art. 185(2) of Directive 2009/138/EC or, where relevant, in accordance with Art. 29(1) of Directive (EU) 2016/97; (c) IORPs, in the provision of information referred to in Art. 41 of Directive (EU) 2016/2341; (d) managers of qualifying venture capital funds, in the provision of information referred to in Art. 13(1) of Regulation (EU) No 345/2013; (e) managers of qualifying social entrepreneurship funds, in the provision of information referred to in Art. 14(1) of Regulation (EU) No 346/2013; (f) manufacturers of pension products, in writing in good time before a retail investor is bound by a contract relating to a pension product; (g) UCITS management companies, in the prospectus referred to in Article 69 of Directive 2009/65/EC; (h) investment firms which provide portfolio management or provide investment advice, in accordance with Art. 24 (4) of Directive 2014/65/EU; (i) credit institutions which provide portfolio management or provide investment advice, in accordance with Art. 24(4) of Directive 2014/65/EU; (j) insurance intermediaries and insurance undertakings which provide insurance advice with regard to IBIPs and for insurance intermediaries which provide insurance advice with regard to pension products exposed to market fluctuations, in accordance with Art. 29(1) of Directive (EU) 2016/97; (k) AIFMs of ELTIFs, in the prospectus referred to in Art. 23 of Regulation (EU) 2015/760; and (l) PEPP providers, in the PEPP key information document referred to in Art. 26 of Regulation (EU) 2019/1238.

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12.4.3.2

Pre-contractual Transparency on Whether a Financial Product Has an Adverse Sustainability Impact (i) Comply… First, for financial market participants who chose to (or must) provide transparency of adverse sustainability impacts at entity level,72 the precontractual disclosures set out in Sect. 12.4.2 above must by 30 December 2022 include for each financial product: I. a clear and reasoned explanation of whether, and, if so, how a financial product considers principal adverse impacts on ‘sustainability factors’73 ; II. a statement that information on principal adverse impacts on ‘sustainability factors’74 is available in the information to be disclosed in the periodic reports.75 (ii) or Explain Financial market participants, who chose (and may choose) not to provide transparency of adverse sustainability impacts at entity level,76 must include for each financial product a statement that the financial market participant does not consider the adverse impacts of investment decisions on sustainability factors and the reasons (‘comply or explain’).77

72 See Sect. 12.3.3.1. 73 ‘Sustainability factors’ is defined as environmental, social and employee matters,

respect for human rights, anti-corruption and anti-bribery matters (Art. 2(24) SFDR, see Sect. 12.2.6). 74 Ibid. 75 Art. 7(1), opening words, and sub (a) and sub (b) SFDR. Financial market participants that qualify as IORPs must publish and maintain the information referred to in Art. 7(1), opening words, sub (a) and (b) SFDR in accordance with point (f) of Article 36(2) of Directive (EU) 2016/2341 (IORP Directive), see Art. 15(1) SFDR. 76 See Sect. 12.3.3.1. 77 Art. 7(2) SFDR. Financial market participants that qualify as IORPs must publish

and maintain the information referred to in Art. 7(2) SFDR in accordance with point (f) of Article 36(2) of Directive (EU) 2016/2341 (IORP Directive), see Art. 15(1) SFDR.

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Pre-contractual Transparency on Whether a Financial Product Promotes Environmental and/or Social Characteristics

(i) General Second, where a financial product promotes environmental characteristics and/or social characteristics (in practice also referred to as ‘light green’ or ‘Article 8’ products78 ), financial market participants must include in the pre-contractual disclosures set out in Sect. 12.4.2 above: a. information on how those characteristics are met; b. if an index has been designated as a reference benchmark, information on whether and how this index is consistent with those characteristics.79 In addition, where a financial product promotes environmental characteristics, financial market participants must include in the pre-contractual disclosures set out in Sect. 12.4.2 above: a. the information on the ‘environmental objective’ or ‘environmental objectives’80 to which the investment underlying the financial product contributes; and b. a description of how and to what extent the investments underlying the financial product are in economic activities that qualify as ‘environmentally sustainable’81 ; this description must specify the proportion of investments in ‘environmentally sustainable economic activities’82 selected for the financial product, including details

78 See B. Bierens, Hoofdstuk 6: De bancaire zorgplicht, klimaatverandering en het Europese ‘Actieplan: duurzame groei financieren’, in: D. Busch et al. (eds), Zorgplicht in de financiële sector, Kluwer, Deventer 2020, § 3.2(e). 79 Art. 8(1), opening words, and sub (a) and (b) SFDR. 80 The following objectives are designated as ‘environmental objectives’: (a) climate

change mitigation; (b) climate change adaptation; (c) the sustainable use and protection of water and marine resources; (d) the transition to a circular economy; (e) pollution prevention and control; (f) the protection and restoration of biodiversity and ecosystems (Art. 9 Taxonomy regulation), see Sect. 12.2.8.1. 81 See on this term Art. 3 Taxonomy Regulation, on which see Sect. 12.2.8.3. 82 As defined in Art. 3 Taxonomy Regulation, on which see Sect. 12.2.8.3.

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on the proportions of enabling and transitional activities, as a percentage of all investments selected for the financial product.83 Also, where a financial product promotes environmental characteristics, financial market participants must accompany the pre-contractual disclosures set out in Sect. 12.4.2 above with the following statement: ‘The ‘do no significant harm’ principle84 applies only to those investments underlying the financial product that take into account the EU criteria for environmentally sustainable economic activities. The investments underlying the remaining portion of this financial product do not take into account the EU criteria for environmentally sustainable economic activities’.85‚86

Finally, where a financial product is not subject to pre-contractual transparency on whether a financial product (i) promotes environmental characteristics or (ii) has ‘sustainable investment’87 as its objective,88 the pre-contractual information to be disclosed to end investors must be accompanied by the following statement: The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities’.89

83 Art. 6, paragraph 1, Taxonomy Regulation, read in conjunction with Art. 5

Taxonomy regulation. See, to the same effect, Art. 8(2a) SFDR. 84 The ‘do no significant harm’ principle is an element in the definition of ‘sustainable investment’ set out in Art. 1(17) SFDR and to be fleshed out in relevant RTSs. See Sects. 12.2.7.1 and 12.2.7.2. 85 ‘Environmentally sustainable economic activities’ as defined in Art. 3 Taxonomy Regulation, on which see Sect. 12.2.8.3. 86 Art. 6, second paragraph onwards, Taxonomy Regulation. See, to the same effect, Art. 8(2a) SFDR. 87 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 88 See Art. 9(1), (2) and (3) SFDR, discussed in Sects. 12.4.3.4(i) and (ii). 89 Art. 7 Taxonomy Regulation. In practice, several questions have arisen with regard

to the application of Art. 8 SFDR. (i) Can the name of a product, which may include words like ‘sustainable’, ‘sustainability’ or ‘ESG’ be considered to qualify a product to be promoting an environmental or social characteristic or to be having sustainable investment as its objective? (ii) While a financial product to which Article 8 applies does not need to explicitly promote itself as targeting sustainable investments (within the meaning of Article

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(ii) Methodology Used for the Relevant Indices Financial market participants must include in the pre-contractual information set out in Sect. 12.4.2 above an indication of where the methodology used for the calculation of the index can be found.90 (iii) ‘Level 2’ Regulation The disclosure rules set out above will be fleshed out in greater detail in RTSs to be adopted by the Commission and drawn up jointly by the ESAs. More precisely, the ESAs must jointly develop draft RTSs to specify the details of the (a) content and (b) presentation of the above information to be disclosed (by 30 December 2020, 1 June 2021 or 1 June 2022, as applicable91 ). When developing the draft RTSs, they must take into account (i) various types of financial products, their characteristics and the differences between them, as well as (ii) the objective that disclosures must be accurate, fair, clear, not misleading, simple and concise.92 2(17) SFDR), would a reference to taking into account a sustainability factor or sustainability risk in the investment decision be sufficient for Article 8 to apply? If the answer is yes, how can financial market participants that disclose mandatory information according to Article 6(1) or Article 7(1) SFDR ensure that this is not automatically considered as ‘promoting environmental or social characteristics’. (iii) Must a product to which Article 8 applies invest a minimum share of its investments to attain its designated environmental or social characteristic in order to be considered to be promoting environmental or social characteristics? (iv) In the absence of active advertising of an environmental or social characteristic of the product, would an intrinsic characteristic of the product, such as a sectoral exclusion (e.g. tobacco) which is not advertised, also qualify as “promotion”? (v) In addition, would complying with a national legal obligation, which applies to the financial market participant, such as a ban on investment in cluster munitions, also bring the product into the scope of Article 8? See the letter dated 7 January 2021 from the joint ESAs to the European Commission (JC 2021 02). 90 Art. 8(2) SFDR. 91 But see Sect. 12.9.6. 92 Art. 8(3) and (4) SFDR. Power is delegated to the Commission to supplement the Sustainable Finance Disclosure Regulation by adopting the relevant RTSs in accordance with Articles 10 to 14 of Regulations (EU) No 1093/2010, (EU) No 1094/2010 and (EU) No 1095/2010. On 23 April 2020, the ESAs published a consultation paper setting out the RTSs they propose in this regard: Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). Market parties could respond until 1 September 2020. The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03). See also: ESAs Survey on templates for Environmental and/or Social financial products under SFDR (21 September

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12.4.3.4

Pre-contractual Transparency on Whether a Financial Product Has Sustainable Investment as Its Objective

(i) General Third, where a financial product has ‘sustainable investment’93 as its objective (in practice also referred to as ‘dark green’ or ‘Article 9’ products94 ) and an index has been designated as a reference benchmark, financial market participants must accompany the pre-contractual disclosures set out in Sect. 12.4.2 above with: a. information on how the designated index is aligned with that objective; b. an explanation as to why and how the designated index aligned with that objective differs from a broad market index.95 Where a financial product has ‘sustainable investment’96 as its objective and no index has been designated as a reference benchmark, financial market participants must include in the pre-contractual disclosures set out in Sect. 12.4.2 above an explanation on how that objective is to be attained.97 Where a financial product which has ‘sustainable investment’98 as its objective, invests in an economic activity that contributes to an environmental objective within the meaning of the definition of ‘sustainable investment’ set out in Art. 2(17) SFDR,99 financial market participants must include in the information set out in Sect. 12.4.2 above: 2020) (https://ec.europa.eu/eusurvey/runner/ESGtemplatesSFDR), on which see the critical advice of the Securities and Markets Stakeholder Group: SMSG advice on the ESAs’ Survey on templates for Environmental and/or Social financial products under SFDR (23 October 2020) (ESMA22-106-2993), inter alia suggesting that the templates are too long (p. 1). 93 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 94 See B. Bierens, Hoofdstuk 6: De bancaire zorgplicht, klimaatverandering en het

Europese ‘Actieplan: duurzame groei financieren’, in: D. Busch et al. (eds), Zorgplicht in de financiële sector, Kluwer, Deventer 2020, § 3.2(e). 95 Art. 9(1) SFDR. 96 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 97 Art. 9(2) SFDR. 98 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 99 See on the definition of ‘sustainable investment’ Sect. 12.2.7.

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a. the information on the ‘environmental objective’ or ‘environmental objectives’100 to which the investment underlying the financial product contributes; and b. a description of how and to what extent the investments underlying the financial product are in economic activities that qualify as ‘environmentally sustainable’101 ; this description must specify the proportion of investments in ‘environmentally sustainable economic activities’102 selected for the financial product, including details on the proportions of enabling and transitional activities, as a percentage of all investments selected for the financial product.103 Pursuant to the Taxonomy Regulation, where a financial product is not subject to pre-contractual transparency on whether a financial product (i) promotes environmental characteristics104 or (ii) has ‘sustainable investment’105 as its objective, the pre-contractual information to be disclosed to end investors must be accompanied by the following statement: ‘The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities’.106‚107 100 The following objectives are designated as ‘environmental objectives’: (a) climate change mitigation; (b) climate change adaptation; (c) the sustainable use and protection of water and marine resources; (d) the transition to a circular economy; (e) pollution prevention and control; (f) the protection and restoration of biodiversity and ecosystems (Art. 9 Taxonomy regulation), see Sect. 12.2.8.1. 101 See on this term Art. 3 Taxonomy regulation, on which see Sect. 12.2.8.3. 102 As defined in Art. 3 Taxonomy regulation, on which see Sect. 12.2.8.3. 103 Art. 9(4a) SFDR read in conjunction with Art. 5 Taxonomy regulation. 104 See Art. 8(1) SFDR, discussed in Sect. 12.4.3.3(i). 105 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 106 ‘Environmentally sustainable economic activities’ as defined in Art. 3 Taxonomy

regulation, on which see Sect. 12.2.8.3. 107 Art. 7 Taxonomy Regulation. In practice, several questions have arisen with regard to the application of Art. 9 SFDR. (i) Must a product to which Article 9(1), (2) or (3) SFDR applies only invest in sustainable investments as defined in Article 2(17) SFDR? If not, is a minimum share of sustainable investments required (or would there be a maximum limit to the share of “other” investments)? (ii) Where an EU Climate Transition Benchmark (EU CTB) or EU Paris-aligned Benchmark (EU PAB) exists, is it necessary for a product to track an EU PAB or an EU CTB on a passive basis for Article 9(3) SFDR to apply to it? (iii) If the questions above are answered in the affirmative and if the

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(ii) Reduction of Carbon Emissions Where a financial product has a reduction in carbon emissions as its objective (i.e. one of the ‘sustainable investment’108 objectives), financial market participants must include in the pre-contractual disclosures set out in Sect. 12.4.2 above the objective of low carbon emission exposure in view of achieving the long-term global warming objectives of the Paris Agreement.109 However, where no EU Climate Transition Benchmark110 or EU Paris-aligned Benchmark111 in accordance with Regulation (EU) 2016/1011112 is available, financial market participants must include in the pre-contractual disclosures set out in Sect. 12.4.2 above a detailed explanation of how the continued effort of attaining the objective of reducing carbon emissions is ensured in view of achieving the long-term global warming objectives of the Paris Agreement.113 (iii) Methodology Used for the Relevant Indices and Benchmarks Financial market participants must include in the pre-contractual disclosures set out in Sect. 12.4.1 above an indication of where the methodology used for the calculation of the relevant indices and the benchmarks can be found.114

minimum standards of an EU PAB or an EU CTB do not require the index components to be sustainable investments, can the product fall within the scope of Article 9(3) SFDR? See the letter dated 7 January 2021 from the joint ESAs to the European Commission (JC 2021 02). 108 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 109 Art. 9(3), first paragraph, SFDR. 110 See Art. 3(1)(23a) Regulation (EU) 2016/1011. 111 See Art. 3(1)(23b) Regulation (EU) 2016/1011. 112 Regulation (EU) 2016/1011 of the European Parliament and of the Council

of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014 (OJ L 171, 29.6.2016, p. 1). 113 Art. 9(3), second paragraph, SFDR. 114 Art. 9(4) SFDR.

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(iv) ‘Level 2’ Regulation The disclosure rules set out above will be fleshed out in greater detail in RTSs to be adopted by the Commission and drawn up jointly by the ESAs. More precisely, the ESAs must jointly develop draft RTSs to specify the details of the (a) content and (b) presentation of the above information to be disclosed (by 30 December 2020, 1 June 2021 or 1 June 2022, as applicable115 ). When developing the draft RTSs, they must take into account (i) various types of financial products, their ‘sustainable investment’116 objectives and the differences between them, as well as (ii) the objective that disclosures must be accurate, fair, clear, not misleading, simple and concise.117

12.5 Sustainability Disclosures at Product Level on Websites 12.5.1

General

The third type of sustainability disclosure set out in the Sustainable Finance Disclosure Regulation is explored in this Sect. 12.5 and concerns sustainability disclosures at product level on websites.

115 But see Sect. 12.9.6. 116 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 117 Art. 9(5) and (6) SFDR. Power is delegated to the Commission to supplement the

Sustainable Finance Disclosure Regulation by adopting the relevant RTSs in accordance with Articles 10 to 14 of Regulations (EU) No 1093/2010, (EU) No 1094/2010 and (EU) No 1095/2010. On 23 April 2020, the ESAs published a consultation paper setting out the RTSs they propose in this regard: Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). Market parties could respond until 1 September 2020. The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03). See also: ESAs Survey on templates for Environmental and/or Social financial products under SFDR (https://ec.europa.eu/eusurvey/runner/ ESGtemplatesSFDR).

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12.5.2

Content

For each financial product with an environmental, social or ‘sustainable investment’118 objective, financial market participants must publish and maintain on their websites: 1. a description of the environmental or social characteristics or the ‘sustainable investment’119 objective; 2. information on (i) the methodologies used to assess, measure and monitor the environmental or social characteristics or (ii) the impact of the ‘sustainable investments’120 selected for the financial product, including (a) its data sources (b) screening criteria for the underlying assets and (c) the relevant sustainability indicators used to measure the environmental or social characteristics or the overall sustainable impact of the financial product; 3. the pre-contractual information on whether a financial product promotes environmental and/or social characteristics (see Sect. 12.4.3.3 above) and/or has ‘sustainable investment’121 as its objective (see Sect. 12.4.3.4 above); 4. the sustainability information set out in periodic reports.122 Financial market participants must ensure that the information set out above is kept up to date. Where a financial market participant amends such information, a clear explanation of such amendment must be published on the same website.123

118 ‘Sustainable investment’ is defined in Art. 2(17) 119 ‘Sustainable investment’ is defined in Art. 2(17) 120 ‘Sustainable investment’ is defined in Art. 2(17) 121 ‘Sustainable investment’ is defined in Art. 2(17)

SFDR, see Sect. 12.2.7. SFDR, see Sect. 12.2.7. SFDR, see Sect. 12.2.7. SFDR, see Sect. 12.2.7.

122 Art. 10(1), first paragraph, SFDR. Financial market participants that qualify as

IORPs must publish and maintain the information referred to in Art. 10(1), first subparagraph, SFDR in accordance with point (f) of Article 36(2) of Directive (EU) 2016/2341 (IORP Directive), see Art. 15(1) SFDR. According to Art. 15(2) SFDR, even though insurance intermediaries do not qualify as financial market participants (but as financial advisers), they must communicate the information referred to in Art. 10(1), first subparagraph, SFDR in accordance with Art. 23 of Directive (EU) 2016/97 (IDD). 123 Art. 12(1) SFDR.

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427

Presentation Requirements

The information set out in Sect. 12.5.2 above must be clear, succinct and understandable to investors. It must be published in a way that is accurate, fair, clear, not misleading, simple and concise and in a prominent easily accessible area of the website.124 12.5.4

‘Level 2’ Regulation

The disclosure rules set out above will be fleshed out in greater detail in RTSs to be adopted by the Commission and drawn up jointly by the ESAs. More precisely, the ESAs must jointly develop draft RTSs to specify (a) the details of the content of the information set out in Sect. 12.5.2 above and (b) the presentation requirements set out in Sect. 12.5.3 above (by 30 December 2020125 ). When developing the draft RTSs, they must take into account various types of financial products, their characteristics and objectives and the differences between them.126

12.6 Sustainability Disclosures at Product Level in Periodic Reports 12.6.1

General

The fourth and final types of sustainability disclosure set out in the Sustainable Finance Disclosure Regulation are explored in this Sect. 12.6 and concern sustainability disclosures at product level in periodic reports

124 Art. 10(1), second paragraph, SFDR. 125 But see Sect. 12.9.6. 126 Art. 10(2) SFDR. Power is delegated to the Commission to supplement the Sustainable Finance Disclosure Regulation by adopting the relevant RTSs in accordance with Articles 10 to 14 of Regulations (EU) No 1093/2010, (EU) No 1094/2010 and (EU) No 1095/2010. On 23 April 2020, the ESAs published a consultation paper setting out the RTSs they propose in this regard: Joint Consultation paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). Market parties could respond until 1 September 2020. The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03).

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(i.e. annual reports, PEPP Benefit Statements and other types of periodic reports127 ). 12.6.2

Content

Where financial market participants make available a financial product with an environmental, social or ‘sustainable investment’128 objective, they must include a description of the following in periodic reports: 1. for a financial product with an environmental or social objective, the extent to which environmental or social characteristics are met; 2. for a financial product with a ‘sustainable investment’129 objective (i) the overall sustainability-related impact of the financial product by means of relevant sustainability indicators; or (ii) where an index has been designated as a reference benchmark, a comparison between the overall sustainability-related impact of the financial product with the impacts of the designated index and of a broad market index through sustainability indicators; 3. where a financial product (i) promotes environmental characteristics130 or (ii) has ‘sustainable investment’131 as its objective; a. the information on the ‘environmental objective’ or ‘environmental objectives’132 to which the investment underlying the financial product contributes; and b. a description of how and to what extent the investments underlying the financial product are in economic activities that qualify as ‘environmentally sustainable’133 ; this description must 127 See Art. 11(2) SFDR. 128 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 129 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 130 See Art. 8(1) SFDR, discussed in Sect. 12.4.2.3(i). 131 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 132 The following objectives are designated as ‘environmental objectives’: (a) climate

change mitigation; (b) climate change adaptation; (c) the sustainable use and protection of water and marine resources; (d) the transition to a circular economy; (e) pollution prevention and control; (f) the protection and restoration of biodiversity and ecosystems (Art. 9 Taxonomy Regulation), see Sect. 12.2.7. 133 See on this term Art. 3 Taxonomy Regulation, on which see Sect. 12.2.8.3.

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specify the proportion of investments in ‘environmentally sustainable economic activities’134 selected for the financial product, including details on the proportions of enabling and transitional activities, as a percentage of all investments selected for the financial product; 4. where a financial product promotes environmental characteristics, financial market participants must include the following statement: ‘The “do no significant harm” principle135 applies only to those investments underlying the financial product that take into account the EU criteria for environmentally sustainable economic activities. The investments underlying the remaining portion of this financial product do not take into account the EU criteria for environmentally sustainable economic activities’.136‚137

In addition, pursuant to the Taxonomy Regulation, where a financial product is not subject to pre-contractual transparency on whether a financial product (i) promotes environmental characteristics138 or (ii) has ‘sustainable investment’139 as its objective,140 the following statement must be included in the period reports: ‘The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities’.141‚142 134 As defined in Art. 3 Taxonomy Regulation, on which see Sect. 12.2.8.3. 135 The ‘do no significant harm’ principle is an element in the definition of ‘sustainable

investment’ set out in Art. 1(17) SFDR and to be fleshed out in relevant RTSs. See Sects. 12.2.7.1 and 12.2.7.2. 136 As defined in Art. 3 Taxonomy Regulation, on which see Sect. 12.2.8.3. 137 Art. 11(1), first paragraph, SFDR, read in conjunction with Art. 5 and 6 Taxonomy

Regulation. Financial market participants may use the information in management reports in accordance with Article 19 of Directive 2013/34/EU or the information in nonfinancial statements in accordance with Article 19a of that Directive where appropriate (Art. 11(1), second paragraph, SFDR). 138 See Art. 8(1) SFDR, discussed in Sect. 12.4.2.3(i). 139 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 140 See Art. 9(1), (2) and (3) SFDR, discussed in Sects. 12.4.3.4(i) and (ii) above. 141 As defined in Art. 3 Taxonomy Regulation, on which see Sect. 12.2.8.3. 142 Art. 7 Taxonomy Regulation.

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12.6.3

‘Level 2’ Regulation

The disclosure rules set out above will be fleshed out in greater detail in RTSs to be adopted by the Commission and drawn up jointly by the ESAs. More precisely, the ESAs must jointly develop draft RTSs to specify the details of the content and presentation of the information set out in Sect. 12.6.2 above (by 30 December 2020, 1 June 2021 and 1 June 2022, as applicable143 ). When developing the draft RTSs they must take into account the various types of financial products, their characteristics and objectives and the differences between them. The ESAs must update the RTSs in the light of regulatory and technological developments.144 12.6.4

Disclosure in Accordance with Applicable Sectoral Legislation

The information set out in Sect. 12.6.2 above must be disclosed in accordance with the applicable sectoral legislation, i.e. through annual reports, PEPP Benefit Statements and other types of periodic reports.145

143 But see Sect. 12.9.6. 144 Art. 11(4) and (5) SFDR. Power is delegated to the Commission to supplement the

Sustainable Finance Disclosure Regulation by adopting the relevant RTSs in accordance with Articles 10 to 14 of Regulations (EU) No 1093/2010, (EU) No 1094/2010 and (EU) No 1095/2010. On 23 April 2020, the ESAs published a consultation paper setting out the RTSs they propose in this regard: Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16). Market parties could respond until 1 September 2020. The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03). See also: ESAs Survey on templates for Environmental and/or Social financial products under SFDR (https://ec.europa.eu/eusurvey/runner/ ESGtemplatesSFDR). 145 See Art. 11(2) SFDR: (a) for AIFMs, in the annual report referred to in Article 22 of Directive 2011/61/EU; (b) for insurance undertakings, annually in writing in accordance with Article 185(6) of Directive 2009/138/EC; (c) for IORPs, in the annual report referred to in Article 29 of Directive (EU) 2016/2341; (d) for managers of qualifying venture capital funds, in the annual report referred to in Article 12 of Regulation (EU) No 345/2013; (e) for managers of qualifying social entrepreneurship funds, in the annual report referred to in Article 13 of Regulation (EU) No 346/2013; (f) for manufacturers of pension products, in writing in the annual report or in a report in accordance with national law; (g) for UCITS management companies, in the annual report referred to in Article 69 of Directive 2009/65/EC; (h) for investment firms which provide portfolio management, in a periodic report as referred to in Article 25(6) of Directive 2014/65/EU; (i) for credit institutions which provide portfolio management, in a periodic report as referred to in

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12.7 Sustainability Disclosures and Marketing Communications Without prejudice to stricter sectoral legislation (in particular the UCITS, MiFID II, IDD and PRIIPs legislation146 ), both financial market participants and financial advisers must ensure that their marketing communications do not contradict the information disclosed pursuant to the Sustainable Finance Disclosure Regulation.147 The ESAs may jointly develop, through the Joint Committee, draft implementing technical standards (ITSs) to determine the standard presentation of information on the promotion of environmental or social characteristics and ‘sustainable investments’.148‚149

12.8

National Competent Supervisors

Member States must ensure that the national competent supervisors designated in accordance with sectoral legislation monitor the compliance of financial market participants and financial advisers with the requirements of the Sustainable Finance Disclosure Regulation. They must have all the supervisory and investigatory powers that are necessary for the exercise of their functions under the Sustainable Finance Disclosure Regulation.150 For the purposes of the Sustainable Finance Disclosure Regulation, the national competent supervisors must cooperate with each other and must

Article 25(6) of Directive 2014/65/EU; and (j) for PEPP providers, in the PEPP Benefit Statement referred to in Article 36 of Regulation (EU) 2019/1238. 146 Directive 2009/65/EC (UCITS Directive); Directive 2014/65/EU (MiFID II Directive); Directive (EU) 2016/97 (IDD Directive); Regulation (EU) No 1286/2014 (PRIIPs Regulation). 147 Art. 13(1) SFDR. 148 ‘Sustainable investment’ is defined in Art. 2(17) SFDR, see Sect. 12.2.7. 149 Art. 13(2), first paragraph, SFDR. Power is delegated to the Commission to adopt

the implementing technical standards referred to in the first subparagraph in accordance with Article 15 of Regulations (EU) No 1093/2010, (EU) No 1094/2010 and (EU) No 1095/2010, see Art. 13(2), second paragraph, SFDR. 150 Art. 14(1) SFDR.

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provide each other, without undue delay, with such information as is relevant for the purposes of carrying out their duties under the Sustainable Finance Disclosure Regulation.151

12.9

The Harmonising Effect of the Sustainable Finance Disclosure Regulation 12.9.1

General

In the previous sections, we explored the main features of the Sustainable Finance Disclosure Regulation. In this Sect. 12.9, an attempt is made to assess whether the Sustainable Finance Disclosure Regulation is likely to succeed in harmonising sustainability-related (i) disclosure rules and (ii) fiduciary duties, not only across Member States, but also across financial products and distribution channels. 12.9.2

Uniform Rules in a Regulation

First of all, the fact that the Sustainable Finance Disclosure Regulation offers uniform rules included in a regulation rather than in a directive is clearly a positive feature from the viewpoint of harmonisation. After all, the rules contained in a regulation have direct effect, whereas the rules in a directive would have to be transposed into national law to take effect within the national legal order of a Member State with all the risks of implementation differences between the Member States that this entails. The following features of the Sustainable Finance Disclosure Regulation are less positive from the perspective of harmonisation. 12.9.3

Member State Options and Exemptions

The Sustainable Finance Disclosure Regulation contains three Member State options152 and two exemptions.153 Both features at least potentially negatively impact on the degree of harmonisation of sustainability-related

151 Art. 14(2) SFDR. 152 See Art. 16(1) (on which see footnote 12 above) and 17(2) (on which see footnotes

13 and 14 above) SFDR. 153 See Art. 17(1) SFDR (on which see footnotes 13 and 14).

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disclosure rules and fiduciary duties across Member States, financial products and distribution channels. 12.9.4

Comply or Explain

Financial market participants and financial advisers may sometimes choose not to comply with certain sustainability disclosures at entity and product level, as long as they explain why they do not do so.154 This feature also at least potentially negatively impacts on the degree of harmonisation of sustainability-related disclosure rules and fiduciary duties across financial products and distribution channels. 12.9.5

Drafting Harmonised Rules at Level 2 and 3 is a Challenging Exercise

The key terms and definitions used in the Sustainable Finance Disclosure Regulation and the substantive rules themselves show a high degree of abstraction and will need to be fleshed out in greater detail at level 2 and 3.155 The Sustainable Finance Disclosure Regulation’s degree of harmonisation will crucially depend on crystal-clear clarifications and elaborations of the rules at level 2 and 3 that are workable in practice. This is no easy task. An example: on 23 April 2020, the ESAs published their Joint Consultation Paper on ESG Disclosures containing, among others, the draft RTSs specifying the details of the (a) content and (b) presentation of the pre-contractual sustainability disclosures at product level. The following paragraph in the Joint Consultation Paper shows that drafting these RTSs turned out to be a challenging exercise for the ESAs: The scope of the SFDR is extremely broad, covering a very wide range of financial products and financial market participants. The SFDR is in essence trying to harmonise ESG disclosure standards for disclosures of different types of information complexity, granularity and consumer-friendliness,

154 See Sects. 12.3.3.1, 12.3.2 and 12.4.3.2. 155 With ‘level 3’, I mean to refer to the ESAs powers to (i) develop formally non-

binding ‘soft law’ instruments such as recommendations and guidelines and (ii) conduct peer reviews comparing regulatory practices to ensure consistent application of the rules adopted at levels 1 and 2.

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ranging from detailed fund prospectuses to the concise “key information documents” for pan-European pension products (PEPPs). On the one hand, a more maximalist approach to disclosures aims at providing detailed information, and on the other, a more minimalistic approach to consumers aims to avoid information overload and ensure that the information is read and can be understood by consumers. This leads to sustainability-related information requirements designed for pre-contractual disclosures in longer documents needing to be reconciled with the need to ensure information is produced at a comprehensible level for consumers consuming shorter documents.156

12.9.6

The Level 2 Rules Have Been Delayed Due to COVID-19

As set out in the previous paragraph, the Sustainable Finance Disclosure Regulation’s degree of harmonisation crucially depends on crystal-clear clarifications and elaborations of the rules at level 2 and 3 that are workable in practice. However, due to ‘the unprecedented economic and market stress caused by the COVID-19 crisis’ the Commission decided to extend the deadline for the public consultation on the draft RTSs. At the same time, the Commission decided that the application date of the Sustainable Finance Disclosure Regulation itself remained unchanged and that it continued to apply from 10 March 2021. According to the Commission this was justified since ‘in terms of substance the application of the SFDR is not conditional on the formal adoption and entry into force or application of the [RTSs] as it lays down at Level 1 general principles of sustainability-related disclosures (…)’.157 The joint ESAs published their final drafts of the level 2 rules on 4 February 2021.158 The Commission did not manage to adopt these rules before the SFDR became applicable on 10 March 2021. As an emergency measure, the joint ESAs therefore suggested to the national supervisors to encourage

156 Joint Consultation Paper, ESG Disclosures, Draft regulatory technical standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (JC 2020 16), on p. 6. The final report of the joint ESAs was published on 2 February 2021 (JC 2021 03). 157 See the Commission’s letter to the ESAs dated 20 October 2020 (Ref. Ares(2020)5678036) (available at https://www.esma.europa.eu/sites/default/files/lib rary/eba_bs_2020_633_letter_to_the_esas_on_sfdr.pdf), at p. 2. 158 JC 2021 03.

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financial market participants and financial advisers to comply with the level 2 rules anyway.159 To add to the confusion, the joint ESAs published a consultation document on 15 March 2021, which provided for a change to the ‘final’ drafts of the level 2 rules published on 4 February 2021.160 All in all, financial market participants and financial advisers hardly had time to prepare themselves.161 12.9.7

Certain Entities and Products Will Be Out of Scope—Both Now and in the Future

The key terms ‘financial market participant’, ‘financial adviser’ and ‘financial product’ are defined in a closed-ended manner. As soon as a financial entity does not qualify as a ‘financial market participant’ or as a ‘financial adviser’, and/or does not render services or perform activities with regard to a ‘financial product’, that entity or product will fall outside the regulatory perimeter of the Sustainable Finance Disclosure Regulation. This legislative approach runs a real risk of leading to insufficient harmonisation and an uneven playing field with regard to sustainabilityrelated (i) disclosure rules and (ii) fiduciary duties between, on the one hand, financial entities and products that fall within the scope of the Sustainable Finance Disclosure Regulation, and, on the other hand, financial entities and products that fall outside its scope, such as FinTech entities providing services with regard to crypto-assets—both now and in the future. This risk could perhaps be ‘neutralised’ by amending the Sustainable Finance Disclosure Regulation to the effect that it will delegate power to the Commission to adopt RTSs (drawn up jointly by the ESAs), designating that certain additional types of financial entities/products will also qualify as ‘financial market participant’/‘financial adviser’/‘financial product’, to the extent that this is necessary from the viewpoint of

159 JC 2021 06. 160 JC 2021 22. See p. 57 et seq. a consolidated version of the level 2 rules. 161 That there are many questions among financial market participants and financial

advisers about the proper meaning of all kinds of concepts used in the SFDR is evident from the letter dated 7 January 2021 from the joint ESAs to the European Commission (JC 2021 02).

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harmonisation and creating (or preserving) a level playing field. ‘Perhaps’, because any empowerment under Art. 290, TFEU162 must be limited to non-essential elements. For that reason, the legislators have always refrained from granting delegated powers to the Commission which would change the scope of a regulation where this would imply a policy change or choice. Should this solution for that very reason not be legally viable, it might also be an option to define the key terms ‘financial market participant’, ‘financial adviser’ and ‘financial product’ in a more open-ended manner to make the Sustainable Finance Disclosure Regulation future-proof. 12.9.8

The Relationship with the Taxonomy Regulation is not Always Clear

As previously noted, the exact link between the concept of ‘do not significantly harm’ under the Sustainable Finance Disclosure Regulation163 and the concept of ‘significant harm to environmental objectives’ under the Taxonomy Regulation164 is unfortunately not entirely clear and should be clarified by the Commission.165 This lack of clarity is likely to create confusion and may therefore negatively impact on the degree of harmonisation of sustainability-related disclosure rules and fiduciary duties across Member States, financial products and distribution channels. 12.9.9

Limited Availability of Raw Harmonised ESG Data

As previously noted, at this early stage, the data required to calculate adverse impacts according to the relevant indicators will often not be readily available or attainable directly from investee companies, which means that the entities subject to the Sustainable Finance Disclosure Regulation will often be dependent on third-party data providers claiming to have access to the required information.166 So, as it currently stands,

162 ‘TFEU’ stands for ‘Treaty on the Functioning of the European Union’. 163 See Art. 2(1)(17) SFDR, on which see Sect. 12.2.7.2. 164 See Art.17 Taxonomy regulation. 165 See Sect. 12.2.8.2. 166 In a similar vein: Securities and Markets Stakeholder Group, SMSG advice to the ESA’s Joint Consultation Paper on ESG Disclosures (draft regulatory technical standards

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there is limited availability of raw harmonised ESG data. This will very likely have a negative impact on the degree of harmonisation of sustainability-related disclosure rules and fiduciary duties across Member States, financial products and distribution channels. Against this backdrop, the European Association of Co-operative Banks (EACB), the European Banking Federation (EBF), the European Fund and Asset Management Association (EFAMA), the European Savings and Reyail Banking Group (ESBG), Insurance Europe and Pensions Europe have recently called ‘(…) the EU to build and / or support, based on existing solutions, a centralised electronic European ESG data register. We understand that a common European Green Deal dataspace to support green deal priorities is already envisaged in the EU data strategy. We encourage the European Commission to investigate how our proposal can fit in this context. (…) The availability of raw harmonized ESG data would allow for better comparability, increase transparency, lower barriers and costs, generate efficiency, reduce complexity and attract new players. The data register would provide a very valuable source of information to markets and policy makers alike. Such database should also help data preparers by eliminating current multiple different requests’.167

In line with this, the Commission has announced that it will propose to set up an EU-wide platform (European single access point) that provides investors with ‘seamless access’ to financial and sustainability related company information.168 In this context, it is also notable that the French Autorité des Marchés Financiers (AMF) and the Dutch Autoriteit Financiële Markten (AFM) have issued a position paper, proposing a European regulatory framework for sustainability-related service providers (SSPs) aimed at preventing

with regard to the content, methodologies and presentation pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation EU 2019/2088 (14 September 2020) (ESMA22-106-2858), pp. 3–4. See also Sect. 12.3.3.1 (v). 167 See their letter to DG FISMA dated 9 June 2020 (ref: HG/EB/20-024), at p. 2 (downloadable at https://www.efama.org). 168 See the most recent version of the CMU Action Plan: COM(2020) 590 final (24 September 2020), Action 1.

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misallocation of investments, greenwashing and ensuring investor protection. The AMF and the AFM advocate: (i) an ad hoc European mandatory regulatory framework for SSPs; (ii) a framework requiring establishment of SSPs in the EU and their supervision by ESMA; (iii) a regulatory focus on transparency about methodologies, potential conflicts of interest, and governance and internal control requirements; (iv) allowing for proportionality and continued market innovation; (v) a step-by-step approach: a set of core requirements for SSPs that serves as a starting point, to be reviewed periodically taking into account market developments and, where appropriate, complemented by additional measures.169 ESMA has proposed a European legal framework for ESG ratings and assessments along the same lines as AMF and AFM. To a large degree, these proposals have been inspired by the requirements of the CRA Regulation, as there are clear parallels between the processes of ESG and CRA rating providers and the objectives pursued by that regulation.170 12.9.10

A Central Supervisor is Lacking

Having a harmonised set of rules is a necessary precondition for achieving harmonisation but is not sufficient in itself. To achieve actual harmonisation, supervisory convergence or even centralisation of supervision is essential. As it currently stands, supervision and enforcement of the Sustainable Finance Disclosure Regulation is a matter for the national competent supervisors.171 Supervisors in some Member States may be more lenient than supervisors in other Member States. Of course, the national supervisors have a duty to collaborate with each other, and jointly with the ESAs, they can work on common best practices.172 But this will probably be insufficient to bring about true harmonisation. Designating ESMA as the sole supervisor and enforcer of the Sustainable Finance Disclosure Regulation would be something to consider. 169 See Position Paper: Call for a European Regulation for the provision of ESG data, ratings, and related services (https://www.afm.nl/en/nieuws/2020/december/reguleeraanbieders-duurzaamheidsdata). See Daniel Cash, ‘Calls for ESG Rating Agency Regulation Grows Louder in Europe, But Could It Actually Save the Industry?’ (https://financ ialregulationmatters.blogspot.com/2020/12/calls-for-esg-rating-agency-regulation.html). 170 See ESMA’s letter to DG FISMA dated 28 January 2021 (ESMA30-379-423). 171 See Sect. 12.8. 172 Art. 14(2) SFDR, on which see Sect. 12.8.

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In the context of the plans for a further integration of the European capital markets (the Capital Markets Union (CMU) Action Plan), convergence and centralisation of supervision are quite high on the agenda of the European Commission, but progress is slow on this file.173 In 2017 and 2018, the Commission already made an attempt to designate ESMA as the direct supervisor of certain types of collective investment schemes and of crowdfunding service providers and wanted to give ESMA the power to approve certain prospectuses.174 It also wanted to place providers of PEPPs under the direct supervision of EIOPA.175 Those plans have all failed. Why? More supervisory powers for ESMA (or for the other ESAs) is at the expense of the influence of the national supervisors and therefore of the Member States. France and, for example, the Netherlands were in favour of more supervisory centralisation, but Germany was not. In view of the above, from a practical point of view, a proposal to designate ESMA as the sole supervisor and enforcer of the Sustainable Finance Disclosure Regulation is unlikely to reach the finish line, especially in the current political climate (less instead of more Europe). At the same time, perhaps the recent Wirecard scandal will serve as a game changer. After all, in future talks on centralisation of supervision in Europe, it will be more difficult for Germany to claim that their supervision is always of a high quality, since the German financial markets supervisor BaFin and also the German Financial Enforcement Panel (FREP) had to face a very critical report from ESMA regarding its supervision of Wirecard AG.176

173 See the most recent version of the CMU Action Plan: COM(2020) 590 final (24 September 2020) at Action 16: ‘The Commission will (…) consider proposing measures for stronger supervisory coordination or direct supervision by the European Supervisory Authorities’. 174 See COM(2017) 536 final (20 September 2017) (certain collective investment schemes and certain prospectuses); COM(2018) 113 final (8 March 2018) (crowdfunding service providers). 175 See COM(2017) 343 final (29 June 2017). 176 See ESMA, Fast track peer review report on the application of the guidelines on

the enforcement of financial information (ESMA/2014/1293) by BaFin and FREP in the context of Wirecard (3 November 2020) (ESMA42-111-5349). ‘BaFin’ stands for ‘Bundesanstalt für Finanzdienstleistungaufsicht’.

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12.9.11

No Harmonisation of Liability Law

The Sustainable Finance Disclosure Regulation remains silent on the civil liability of financial market participants and financial advisers for a breach of the sustainability-related disclosure rules and fiduciary duties it features. This is apparently left to the national systems of private law in the Member States. The general EU principle of effectiveness (also known as effet utile) may have a harmonising effect on how national civil courts should assess damages claims for a breach of the sustainability-related disclosure rules and fiduciary duties set out in the Sustainable Finance Disclosure Regulation, but even if that is the case, there is still room for national, and therefore potentially divergent, approaches.177 In addition, it cannot be excluded that some national civil courts will take the liberty of accepting sustainability-related disclosure rules and fiduciary duties that go beyond those included in the Sustainable Finance Disclosure Regulation, based on national prospectus liability rules, private law fiduciary duties, private law duties of care and broad private law concepts such as good faith/reasonableness and fairness. This constitutes a real risk, especially since it can be expected that the regulatory sustainability-related disclosure rules and fiduciary duties will become stricter in the years to come (through amendments of the Sustainable Finance Disclosure Regulation itself and/or amendments at level 2 and/or 3). It is not at all unusual that it takes ten years before a civil case reaches the competent national supreme court, and this will be no different for damages claims for breaches of sustainability-related disclosure rules and fiduciary duties. It will no doubt be tempting for some national supreme courts to give retroactive effect to the regulatory sustainability-related disclosure rules and fiduciary duties in force at some point in time through the backdoor of broad private law concepts.178 177 See: D. Busch, The private law effect of MiFID: Genil and Beyond, European Review of Contract Law 2017/1, pp. 70–93; D. Busch, The private law effect of the EU market abuse regulation, Capital Markets Law Journal 2019/3, pp. 296–319; D. Busch, The influence of the EU prospectus rules on private law, Capital Markets Law Journal 2020/4 (all with further references, also to the relevant decisions from the Court of Justice of the European Union). 178 See B. Bierens, Hoofdstuk 6: De bancaire zorgplicht, klimaatverandering en het Europese ‘Actieplan: duurzame groei financieren’, in: D. Busch et al. (eds), Zorgplicht in de financiële sector, Kluwer, Deventer 2020, § 2.4. See more generally on the phenomenon of supreme courts giving retroactive effect to regulatory law through the backdoor of broad private law concepts: D. Busch, ‘The Future of the Special Duty of Care in the

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Supplementing the Sustainable Finance Disclosure Regulation with truly European liability rules for a breach of the sustainability-related disclosure rules and fiduciary duties, it features would beyond any doubt be preferable from the viewpoint of harmonisation. However, as previously mentioned, in the current political climate (less rather than more Europe), that is likely to be a non-starter for the time being. Should the European Commission nevertheless wish to consider the introduction of truly European liability rules for a breach of the sustainability-related disclosure rules and fiduciary duties included in the Sustainable Finance Disclosure Regulation, it is submitted that it should bear in mind that the traditional private law consequences for a breach of a rule or duty may not be entirely adequate in the current context. Suppose that it is clear that a financial adviser rendered an investor the wrong advice in the sense that it advised financial products that are not sustainable, whereas the financial adviser advised him or her that they were, and also suppose that the adviser should have known or even knew that the financial products were not sustainable. Sustainability and return on investment are not necessarily correlated. It is therefore conceivable that the investor did not suffer any damages due to the inadequate advice. A traditional tort claim for damages or damages for breach of contract may therefore not always work in this context. If it was clear to the financial adviser that a certain degree of sustainability was crucial to the investor, the latter should perhaps have the power to annul the contract, triggering restitutionary claims in both directions, but that may not necessarily have the desired effect either. After all, what the investor wants is to be put in a position that his or her investments are as sustainable as he or she expected them to be based on the financial adviser’s advice. A damages claim in natura may therefore perhaps be an option to actually put him or her in that position, at least in certain cases. In a more radical approach, the notion of ‘damage’ could be redefined as including damage to the environment, etc., and not necessarily to the investor’s patrimony, in which case harmonised EU law could perhaps oblige the relevant financial adviser to pay damages to a sustainability fund, either at EU level or at Member State level. Drafting harmonised EU liability rules in this context will in any event require some serious out-of-the-box thinking.

Dutch Financial Sector’ (EBI WP No. 63) (https://papers.ssrn.com/sol3/papers.cfm?abs tract_id=3586931), Sect. 12.5.4 (iii).

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12.9.12

No Harmonisation of the Administrative Sanctioning Regime

Finally, the Sustainable Finance Disclosure Regulation does not offer a harmonised administrative sanctioning regime for a breach of the sustainability-related disclosure rules and fiduciary duties it features. In fact, it does little more than reiterating the general EU principle of effectiveness (effet utile): Member States shall ensure that the competent authorities (…) monitor the compliance of financial market participants and financial advisers with the requirements of [the Sustainable Finance Disclosure Regulation]. The competent authorities shall have all the supervisory and investigatory powers that are necessary for the exercise of their functions under [the Sustainable Finance Disclosure Regulation].179

The introduction of a truly European administrative sanctioning regime for a breach of the sustainability-related disclosure rules and fiduciary duties would of course be preferable from the viewpoint of harmonisation. However, as previously mentioned, in the current political climate (less rather than more Europe), that is likely to be a non-starter for the time being.

12.10

Outlook

Is the Sustainable Finance Disclosure Regulation an exercise in vain? Not quite, one would hope, but before we reach a sufficient degree of harmonisation of sustainability-related disclosure rules and fiduciary duties there is still a long way to go. And even if we reach the required degree of harmonisation in the EU, will this lead to a more sustainable world? As may be gleaned from the European Green Deal and the Sustainable Finance Action Plan, the European Union is certainly aiming high when it comes to sustainability.180 But the EU is not an island. There 179 Art. 14(1) SFDR. 180 See the Green Deal presented by the Commission on 10 December 2019 (COM

(2019) 640 final) and the proposal dated 4 March 2020 for a ‘European Climate Law’ (COM (2020)80 final). See for the Sustainable Finance Action Plan: European Commission, Action Plan: Financing Sustainable Growth, COM(2018) 97 final (8 March

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are roughly two opposite scenarios. In a pessimistic scenario, the more lenient or even non-existent sustainability agenda of other geopolitical powers gives them a competitive edge that is detrimental to the EU. In a positive scenario, the EU becomes a global standard-setter in the area of sustainability. Large global institutional investors such as Blackrock and State Street in any event say they are strong supporters of the sustainability agenda.181 Also, the re-entry of the United States of America in the Paris Climate Agreement under the Biden Administration may give us some hope.182

2018); for the present position, see https://ec.europa.eu/info/business-economy-euro/ banking-and-finance/sustainable-finance_nl. Cf. V.P.G. de Serière, Idealism or realistic approaches? Regulatory possibilities to require financial institutions to more substantially contribute to achieving climate goals? An overview, Journal of International Banking Law and Regulation 2020/3, pp. 94–106. 181 See https://www.blackrock.com/corporate/literature/publication/blk-sustainab ility-mission-statement-web.pdf and https://www.statestreet.com/values.html. 182 See

https://www.whitehouse.gov/briefing-room/statements-releases/2021/01/ 20/paris-climate-agreement/. Cf. also the Public Statement of John Coates (acting director division of corporation finance, U.S. Securities and Exchange Commission, SEC) dated 11 March 2021 ‘ESG disclosure – keeping pace with developments affecting investors, public companies and the capital markets’ (https://www.sec.gov/news/publicstatement/coates-esg-disclosure-keeping-pace-031121).

CHAPTER 13

Integrating Sustainable Finance into the MiFID II and IDD Investor Protection Frameworks Veerle Colaert

13.1

Introduction

Sustainable Finance as a new EU priority. Even though the sustainable finance idea dates back from at least 1992,1 it only gained momentum in the EU after the United Nations adopted the Sustainable Development Goals (SDG) in 2015 and the EU signed the United Nations’ Paris 1 In the context of the 1992 Rio Earth Summit (https://www.un.org/en/conferences/ environment/rio1992, retrieved on November 17, 2020) the “United Nations Environment Programme” set up a cooperation with the banking sector, resulting in the “UNEP Statement by Banks on the Environment and Sustainable Development”, later extended to become the “UNEP Statement of Commitment by Financial Institutions on Sustainable Development”. See for a brief historic overview: https://www.unepfi.org/about/unep-fistatement/history-of-the-statement/ (retrieved on November 17, 2020).

V. Colaert (B) Chair of the Securities and Markets Stakehoder Group advising ESMA, KU Leuven University, Leuven, Belgium e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_13

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Climate Agreement in the same year.2 In 2017, the European Commission appointed a High-Level Expert Group (HLEG) to prepare a comprehensive blueprint for reforms. The group defined sustainable finance on the basis of two imperatives: (i) to improve the contribution of finance to sustainable and inclusive growth and the mitigation of climate change and (ii) to strengthen financial stability by incorporating environmental, social and governance (ESG) factors into investment decision-making.3 It concluded that there was no single lever to achieve these ambitions, but that a comprehensive review was needed.4 Shortly after, on 8 March 2018, the European Commission adopted its eighth Climate Action Plan, entirely dedicated to sustainable finance and heavily reliant on the recommendations of the HLEG (‘Sustainable Finance Action Plan’).5 It defined the following three main objectives of sustainable finance: (i) reorienting capital flows towards sustainable investment in order to achieve sustainable and inclusive growth, (ii) managing financial risks stemming from climate change, resource depletion, environmental degradation and social issues and (iii) fostering transparency and long-termism in financial and economic activity.6 On 8 April 2020, the European Commission launched a consultation to inform its Renewed Sustainable Finance Strategy, to be published in 2021.7 Scope and goal of this contribution. A substantial number of measures proposed in the Sustainable Finance Action Plan intervene in the relationship between investment product distributors and investors. 2 United Nations, ‘Paris Agreement’ (2015) https://unfccc.int/files/essential_backgr ound/convention/application/pdf/english_paris_agreement.pdf (retrieved on November 17, 2020). See especially art. 2 (1) (c) stating that the Agreement aims to strengthen the global response to the threat of climate change, … including by … making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development. 3 High-Level Expert Group on Sustainable Finance, ‘Final Report’ (2018) https:// ec.europa.eu/info/sites/info/files/180131-sustainable-finance-final-report_en.pdf, 6 (retrieved on November 17, 2020). 4 Ibid., 5. 5 European Commission, ‘Communication - Action Plan: Financing Sustainable Growth’

(COM(2018)97 final, 8 March 2018). 6 Ibid., 2. 7 European Commission, ‘Consultation Document - Consultation on the Renewed

Sustainable Finance Strategy’ (8 April 2020), https://ec.europa.eu/info/consultations/ finance-2020-sustainable-finance-strategy_en (retrieved on November 17, 2020).

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This is not surprising. Multiple studies have shown a gap between investors’ intentions and preferences on the one hand, and their actual behaviour on the other hand (see section 13.2). Given the important part which financial services providers play in retail investors’ access to sustainable investments, regulatory intervention in the relationship between the investment product distributor and the investor can be part of the answer. In this contribution, we will critically assess the changes to the MiFID II and IDD investor protection frameworks. In a first section, we will sketch the behavioural problems explaining why retail investors not always act upon their investment preferences and the role of the investment product distributor in this respect. Against this background, a second section will offer a critical overview of the most important changes to the MiFID II and IDD investor protection frameworks. A final section concludes.

13.2

Role of the Investment Product Distributor

Gap between investors’ intentions and behaviour. As mentioned in the introduction, multiple studies have shown a gap between investors’ intentions and preferences on the one hand and their actual behaviour on the other hand. Retail investors indeed often do not align their investments with their personal values.8 This gap has been attributed to a perception of high volatility and less profitability in ESG investments, combined with a lack of notoriety and availability of ESG products.9 Regulatory options. The new disclosure obligations on sustainability, introduced by the Disclosure Regulation,10 are an important part of the regulatory response to this problem. Disclosure, however, may not suffice to reorient retail investor capital towards sustainable investment. Even when investors are well-informed and convinced of the benefits of ESG products, this is not always reflected in their actual investment behaviour, 8 Paetzold, F., & Busch, T. (2014). “Unleashing the Powerful Few: Sustainable Investing Behaviour of Wealthy Private Investors”. Organization & Environment (347), 348; Pilaj, H. (2017). “The Choice Architecture of Sustainable and Responsible Investment: Nudging Investors Toward Ethical Decision-Making”. Journal of Business Ethics (743), 743. 9 Paetzold and Busch (n 8) 348 and 349; Pilaj (n8) 743; EUROSIF, ‘European SRI study 2018’, www.eurosif.org/wp-content/uploads/2018/11/European-SRI-2018-Study. pdf, 76 (retrieved on November 17, 2020). 10 Disclosure Regulation (EU) 2019/2088. See the contribution of D. Busch in this book.

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because of the complexity of investment decisions, limited attention at the moment of choice and procrastination.11 Investment product distributors can play an important role in bridging the gap between the values of investors and their actual investment choices. They can raise knowledge and awareness of sustainable products at the very moment investors need to make a choice, thus helping to counter problems of bounded rationality, and, more in particular, the limited attention problem which has been defined as one of the main causes of the gap.12 They can do so by including a substantial number of ESG products in their product range and providing information, but also by including ESG factors in the definition of the target market of their products and by asking their clients about their ESG preferences before giving advice or investing on their behalf.13 The Sustainable Finance Action Plan explicitly recognised the important role of investment product distributors in this regard, noting that “(b)y providing advice, investment firms and insurance distributors can play a central role in reorienting the financial system towards sustainability”.14 In April 2020, the European Commission launched a Consultation to inform its Renewed Sustainable Finance Strategy, to be published in 2021. The 3rd and 50th questions of this consultation are particularly revealing on further potential measures to increase retail investments in sustainable investment products: “Question 3: When looking for investment opportunities, would you like to be systematically offered sustainable investment products as a default option by your financial adviser, provided the product suits your other needs?” and “Question 50: Do you think that retail investors should be systematically offered sustainable investment products as one of the default options, when the provider has them available, at a comparable cost and if those products meet the suitability test?”.15 The Commission did not yet publish a summary of results at the time of finalising this contribution. 11 Pilai (n 8) at 745 and 748. 12 Pilai (n 8) at 750. Pilaj makes the interesting comparison with a hypothetical super-

market, where fair-trade products are kept in storage, available only on explicit request, and where most consumers do not make use of an explicit shopping list. Even consumers with a preference for fair-trade will in such circumstances often end up with other products. 13 Pilai (n 8) at 749–750; EUROSIF (n 9) at 76; Sustainable Finance Action Plan (n 6) at 6–7. 14 Sustainable Finance Action Plan (n 6) at 6. 15 European Commission, ‘Consultation’ (8 April 2020) (n 8) at 8 and 21.

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The EU investor protection framework. The second version of the Markets in Financial Instruments Directive or MiFID II16 determines the greater part of the legal framework governing the relationship between investment product distributors and their clients. However, MiFID II only covers investment services relating to the financial instruments listed in its annex,17 while other services and investment products are regulated in other directives and regulations. The Insurance Distribution Directive or IDD18 introduced a “MiFID-like” regime for “insurance-based investment products”; the PEPP Regulation19 regulates pan-European pension products; and the Crowdfunding Regulation20 deals with loans, transferable securities and ‘admitted instruments for crowdfunding purposes’21 offered via crowdfunding platforms.22 And yet only the MiFID II and IDD Frameworks have been amended in view of the Sustainable Finance Action Plan. The PEPP Regulation has only been adopted in 2019, when the Commission had already issued its proposals for MiFID and IDD amendments in view of sustainable finance,23 and the Crowdfunding

16 Directive 2014/65/EU on Markets in Financial Instruments and amending Directive 2002/92/EC and Directive 2011/61/EU, OJ L 173, 12 June 2014. 17 Annex I.A lists the investment services; Annex I.C lists the MiFID financial instruments. 18 Directive 2016/97/EU of 20 January 2016 on insurance distribution (recast), OJ L 19, 2 February 2016. 19 Regulation (EU) 2019/1238 of the European Parliament and of the Council of 20 June 2019 on a Pan-European Personal Pension Product (PEPP), OJ L 198, 25 June 2019. 20 Regulation (EU) 2020/1503 of the European Parliament and of the Council of 7 October 2020 on European crowdfunding service providers for business, and amending Regulation (EU) 2017/1129 and Directive (EU) 2019/1937, OJ L 347, 20 October 2020. 21 Defined in art. 2 (1) (n) of the Crowdfunding Regulation as shares of a private limited liability company that are not subject to restrictions that would effectively prevent them from being transferred, including restrictions to the way in which those shares are offered or advertised to the public. 22 See for a cross-sectoral comparison of the assist-your-customer-regimes applicable to those products: D. Busch, V. Colaert and G. Helleringer, “An ‘Assist-Your-Customer Obligation’ for the Financial Sector?” in V. Colaert and D. Busch, European Financial Regulation – Levelling the cross-sectoral playing field (Bloomsbury Hart, 2019) 343–376. 23 The PEPP Regulation refers to MiFID II and IDD, respectively, for the conduct of business rules applicable to MiFID and IDD distributors of PEPPs (art. 23 (1) (a) and (b) of the PEPP Regulation), but all other distributors advising on PEPPs must comply

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Regulation has only been adopted in 2020, after the sustainable finance amendments to the MiFID and IDD Frameworks were already in a final stage. Nevertheless, the PEPP Regulation only mentions sustainable finance in a recital,24 while the Crowdfunding Regulation only requires the Commission to present a report to the European Parliament and the Council, before 10 November 2023, among other things on the possibility of introducing specific measures to promote sustainable and innovative crowdfunding projects.25

13.3

Main Changes to the MiFID and IDD Frameworks

Legislative process leading to amended MiFID II and IDD Frameworks. In 2018, the European Commission launched two Draft Commission Delegated Regulations on the integration of sustainability risks and factors into the MiFID II and IDD Frameworks26 , amending MiFID

with the specific suitability rules included in the PEPP Regulation itself (art. 23 (1) (c) and art. 34 (4) PEPP Regulation). 24 Recital 8, which only deals with the creation of a personal pension product which will have a long-term retirement nature and will take into account environmental, social and governance (ESG) factors a referred to in the United Nations-supported Principles for Responsible Investment. 25 Art. 42 (2) (s) Crowdfunding Regulation. 26 More precisely in (i) MiFID II Commission Delegated Regulation (EU) 2017/565

of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards Organisational Requirements and Operating Conditions for Investment Firms and Defined Terms for the Purposes of that Directive, OJ L 87, 31 March 2017; (ii) IDD Commission Delegated Regulation (EU) 2017/2358 of 21 September 2017 supplementing Directive (EU) 2016/97 of the European Parliament and of the Council with regard to Product Oversight and Governance Requirements for Insurance Undertakings and Insurance Distributors, OJ L 341, 20 December 2017; and (iii) IDD Commission Delegated Regulation (EU) 2017/2359 of 21 September 2017 supplementing Directive (EU) 2016/97 of the European Parliament and of the Council with regard to Information Requirements and Conduct of Business Rules applicable to the Distribution of Insurance-based Investment Products, OJ L 341, 20 December 2017.

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Delegated Regulation (EU) 2017/565 and IDD Delegated Regulation (EU) 2017/2359, respectively.27 After consultations28 and a technical advice by ESMA29 and EIOPA,30 the original Commission draft proposals have been fine-tuned and additional draft proposals were issued, to amend MiFID Delegated Directive 2017/593/EU and IDD Delegated Regulation (EU) 2017/2358.31 These draft proposals are due to be adopted in 2021. In the explanatory memoranda, the Commission states that by explicitly including sustainability preferences in to the MiFID and IDD Frameworks, the legislator wishes to reinforce the new sustainable finance regulations—Disclosure Regulation EU n° 2019/2088, Climate Transition Benchmark Regulation EU n° 2019/2089 and Taxonomy Regulation EU n° 2020/852—and to integrate sustainability considerations into the investment, advisory and disclosure processes in a consistent manner

27 Draft Commission Delegated Regulation amending Regulation (EU) 2017/565 (Ref. Ares(2018)2681500, 24 May 2018); Draft Commission Delegated Regulation amending Delegated Regulation (EU) 2017/2359 (Ref. Ares(2018)2681527, 24 May 2018). 28 ESMA, ‘Consultation Paper: On Integrating Sustainability Risks and Factors in MiFID II’ (ESMA35-43-1210, 19 December 2018); EIOPA, ‘Consultation Paper on Technical Advice on the Integration of Sustainability Risks and Factors in the Delegated Acts under Solvency II and IDD’ (EIOPA-BOS-18/483, 26 November 2018). EIOPA also did an on-line survey between 17 September and 3 October 2018 seeking stakeholders’ views and current approaches regarding the consideration of sustainability factors. 29 ESMA, ‘Technical advice to the European Commission on Integrating Sustainability Risks and Factors in MiFID II’ (ESMA35-43-1737, 30 April 2019). 30 EIOPA, ‘Technical Advice on the Integration of Sustainability Risks and Factors in the Delegated Acts under Solvency II and IDD’ (EIOPA-BoS-19/172, 30 April 2019). 31 Commission Delegated Regulation (EU) …/… of XXX amending Delegated Regulation (EU) 2017/565 as regards the Integration of Sustainability Factors, Risks and Preferences into certain Organisational Requirements and Operating Conditions for Investment Firms (Ref. Ares(2020)2955205, 8 June 2020); Commission Delegated Directive (EU) …/… of XXXX amending Delegated Directive (EU) 2017/593 as regards the integration of sustainability factors and preferences into the product governance obligations (Ares(2020)2955234, 8 June 2020); Commission Delegated Regulation (EU) …/… of XXX amending Delegated Regulation (EU) 2017/2358 and Delegated Regulation (EU) 2017/2359 as regards the Integration of Sustainability Risks into the Product Oversight and Governance Requirements for Insurance Undertakings and Insurance Distributors and into the rules on Conduct of Business and Investment Advice for Insurance-based Investment Products (Ref. Ares(2020)2955230, 8 June 2020).

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across sectors.32 In this contribution, we will, among other things, evaluate to what extent such a consistent cross-sectoral integration has indeed been achieved. In the rest of this section, we will discuss the main changes which the proposed regulations and proposed directive will bring to the EU investor protection framework.33 We will discuss (i) the new sustainability-related definitions; (ii) the amended suitability assessment process;34 (iii) the amended product governance process; and (iv) the amended conflicts of interests procedure. 13.3.1

Definitions

Both the amended MiFID and IDD delegated acts35 introduce a number of new sustainable finance-related definitions, which are linked to definitions of the Disclosure Regulation.

32 Explanatory Memorandum to the Commission Delegated Regulation amending MiFID II Delegated Regulation (EU) 2017/565 (Ref. Ares(2020)2955205, 8 June 2020) at 2; Explanatory Memorandum to the Draft Commission Delegated Directive amending MiFID Delegated Directive (EU) 2017/593 (Ares(2020)2955234, 8 June 2020) at 2; and Explanatory Memorandum to the Commission Delegated Regulation amending IDD Delegated Regulations (EU) 2017/2358 and (EU) 2017/2359 (Ref. Ares(2020)2955230, 8 June 2020) at 2. 33 We will not go into the changes to the governance requirements and the risk

management process, since those only indirectly aim at investor protection. 34 Recital 3–5 of Commission Delegated Regulation amending MiFID II Delegated Regulation (EU) 2017/565 (Ref. Ares(2020)2955205, 8 June 2020). 35 New art. 2 (7)–(9) MiFID Delegated Regulation (EU) 2017/565; new art. 1 (5)– (6) MiFID Delegated Directive (EU) 2017/593; and new art. 2 (4)–(6) IDD Delegated Regulation (EU) 2017/2359.

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Sustainability preferences.36 Sustainability preferences are “a client’s or potential client’s choice as to whether either of the following financial instruments should be integrated into his or her investment strategy”: a. A financial instrument that has as its objective sustainable investments,37 i.e. an investment in an economic activity that contributes to an environmental objective38 or in an economic activity that contributes to a social objective,39 provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance. b. A financial instrument that promotes, among others, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices40 and that either (i) pursues, among others, sustainable investments,41 or (ii) as of 30 December 2022, considers principal adverse impacts on sustainability factors.42

36 The definitions in the MiFID and IDD Delegated Regulations are the same, except for the use of “financial instrument” in the MiFID Delegated Regulation, while the IDD Delegated Regulation uses the term “financial product”. As such it is a pity that no uniform language is used on this matter, especially since the MiFID level 1 directive 2014/65/EU, also uses the term “investment product”, which includes structured deposits next to financial instruments, while the IDD-framework uses the term “insurancebased investment product ”. Both the MiFID and IDD Delegated Regulations could therefore have used the term “investment product”, which would also be consistent with the PRIIPs Regulation’s use of the term “packaged retail and insurance-based investment products ”. 37 As defined in art. 2 (17) of Disclosure Regulation (EU) 2019/2088. 38 This is measured, for example, by key resource efficiency indicators on the use of

energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy. 39 In particular, an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities. 40 See art. 8 Disclosure Regulation (EU) 2019/2088. 41 As defined in art. 2 (17) of Disclosure Regulation (EU) 2019/2088. 42 As referred to in art. 7 (1) (a) of Disclosure Regulation (EU) 2019/2088, which

provides that the disclosures which financial market participants should make in regard

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The difference between (a) financial products that pursue sustainable investment objectives and (b) financial products that promote environmental or social characteristics is to be understood as follows. Financial products that pursue sustainable investment objectives guarantee the attainment of a certain level of sustainability, whereas financial products that promote environmental or social characteristics do not necessarily achieve that.43 Sustainability factors mean “environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters”.44 Sustainability risk means “an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment”.45 13.3.2

Suitability Assessment

The suitability test. When providing portfolio management, investment advice or insurance advice, investment firms and insurance intermediaries have to assess whether their investment services, financial instruments or insurance-based investment products are “suitable” for a particular client. For that purpose, they have to obtain information regarding the client’s knowledge and experience, financial situation and investment objectives.46 Integrating sustainability in the suitability test. In their report, the High-Level Expert Group recommended to “require investment advisors to ask about, and then respond to, retail investors’ preferences about the

of such products, should include a clear and reasoned explanation of whether, and, if so, how a financial product considers principal adverse impacts on sustainability factors. 43 Recital 6 of Commission Delegated Regulation amending MiFID II Delegated Regulation (EU) 2017/565 (Ref. Ares(2020)2955205, 8 June 2020) and recital 6 of Commission Delegated Regulation amending IDD Delegated Regulations (EU) 2017/2358 and (EU) 2017/2359 (Ref. Ares(2020)2955230, 8 June 2020). 44 Reference is made to art. 2 (24) of Disclosure Regulation (EU) 2019/2088. 45 Reference is made to art. 2 (22) of Disclosure Regulation (EU) 2019/2088. 46 Art. 25 §2 MiFID II in conjunction with art. 54 MiFID Delegated Regulation

2017/565; art. 30 §1 IDD in conjunction with art. 9 IDD Delegated Regulation 2017/2359.

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sustainable impact of their investments as a routine component of financial advice”.47 In March 2018, the Commission held a consultation on the integration of ESG considerations in the suitability assessment. The consultation showed that information regarding the investment objectives of the client generally still related to financial objectives, while nonfinancial objectives of the client, such as sustainability preferences, were usually not addressed. Only a minority of the clients proactively raised such preferences themselves.48 The Commission concluded that investment firms and insurance intermediaries consistently did not give appropriate consideration to sustainability factors in the suitability process. Nonetheless, respondents also indicated that the overall interest of their clients for sustainable products was growing, as was evident from the increase in information requests linked to ESG issues. In response to the question what regulatory action should be taken in this respect, respondents were split among the options of not integrating sustainability in the suitability test, using non-binding guidance or clearly requiring it in legislation.49 The Commission, however, decided “to amend the MiFID II and IDD delegated acts in Q2 2018 to ensure that sustainability preferences are taken into account in the suitability assessment ”.50 In May 2018, ESMA already updated its Guidelines on the MiFID II suitability assessment and provided that: “it would be a good practice for firms to consider non-financial elements when gathering information on the client’s investment objectives, and […] collect information on the client’s

47 High-Level Expert Group on Sustainable Finance (n 4) at 28. 48 Explanatory Memorandum to the Commission Delegated Regulation amending

MiFID II Delegated Regulation (EU) 2017/565 (Ref. Ares(2020)2955205, 8 June 2020) at 1; Explanatory Memorandum to the Commission Delegated Regulation amending IDD Delegated Regulations (EU) 2017/2358 and (EU) 2017/2359 (Ref. Ares(2020)2955230, 8 June 2020) at 1–2. 49 European Commission, ‘Impact Assessment accompanying the Proposal for a Regulation of the European Parliament and of the Council on the establishment of a framework to facilitate sustainable investment; Proposal for a Regulation of the European Parliament and of the Council on disclosures relating to sustainable investments and sustainability risks and amending Directive (EU) 2016/2341; and Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) 2016/1011 on low carbon benchmarks and positive carbon impact benchmarks’ (SWD(218) 264 final, 24 May 2018) at 129. 50 Sustainable Finance Action Plan (n 6) at 7.

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preferences on environmental, social and governance factors ”.51 Both the Delegated MiFID II and IDD Regulations have recently been amended in order to explicitly transpose such good practice into binding legal provisions. Main changes. First, the relevant provisions now explicitly require that when investment firms, insurance intermediaries or insurance undertakings obtain information on the investment objectives of their clients, this should include information on any sustainability preferences of their clients.52 Second, investment firms should have adequate policies and procedures to ensure that they understand the nature, features (including costs) and risks of the investment services and financial instruments selected for their clients, which should from now on also include any sustainability factors.53 The amended IDD Framework lacks a similar provision. However, it seems logic that even without an explicit provision, also insurance intermediaries and insurance firms should have in place similar suitability policies and procedures and that sustainability factors should from now on be part of them. Finally, also, the requirement to provide retail clients with a suitability report has been amended to ensure that the outline of the advice and the explanation of how the recommendation is suitable for the retail client, not only covers how the recommendation meets the client’s investment objectives, knowledge and experience, his or her attitude to risk and capacity to sustain losses, but also how it meets the client’s sustainability preferences.54 It should be noted that the wording of the IDD Delegated

51 ESMA, ‘Final Report: Guidelines on certain aspects of the MiFID II suitability requirements’ (ESMA35-43-869, 28 May 2018) at 38, para 28. In the IDD-framework, EIOPA never issued any suitability guidelines. 52 Art. 1 (6) (a) of June 2020) amending lation 2017/565/EU; Ares(2020)2955230, 8 (EU) 2017/2359.

Commission Delegated Regulation (Ref. Ares(2020)2955205, 8 articles 54 §2 (a) and art. 54 (5) of MiFID Delegated Reguart. 2 (3) (a) of Draft Commission Delegated Regulation (Ref. June 2020) amending art. 9 (2) (a) of IDD Delegated Regulation

53 See Art. 1 (6) (c) of Commission Delegated Regulation (Ref. Ares(2020)2955205, 8 June 2020) amending art. 54 (9) MiFID Delegated Regulation 2017/565/EU. 54 See Art. 1 (6) (c) of Commission Delegated Regulation (Ref. Ares(2020)2955205, 8 June 2020) amending art. 54 (12) MiFID Delegated Regulation 2017/565/EU; art. 1, §3 Commission Delegated Regulation (Ref. Ares(2020)2955230, 8 June 2020) amending art. 14 §1 IDD Delegated Regulation 2017/2359.

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Regulation already differed substantially from the corresponding provision of the MiFID II Delegated Regulation before the amendments, using the term ‘suitability statement’ instead of ‘suitability report’; ‘customer’ instead of ‘retail client’, ‘his financial situation’ instead of ‘his capacity to sustain losses’, etc. It is not surprising then that the addition of “sustainability preferences” to the list of elements to give feedback on to clients has also been framed differently in the MiFID Delegated Regulation and the IDD Delegated Regulation. In the first, it is put as a separate point on which the firm needs to report; in the latter, it is inserted as part of the statement on how the recommendation meets the customer’s investment objectives and whether the customer’s investment objectives are achieved by taking into account any of his or her sustainability preferences. It is difficult to assess whether this new difference in wording also means that a different emphasis should be given to sustainability preferences in the MiFID suitability report and the IDD suitability statement. This legal insecurity is in any event regrettable, since this question could have been easily avoided by using the same wording in both regulatory frameworks. Avoiding mis-selling. The Commission decided to introduce the definition of “sustainability preferences” to “allow for the necessary differentiation between investment objectives on the one hand and sustainability preferences on the other” and to “avoid mis-selling, which may happen should a sustainability factor take precedence over a client’s personal investment objective”.55 In its consultation, ESMA had already pointed out that the introduction of ESG elements into the suitability assessment should—obviously— never be against the interests of the client. ESMA therefore concluded that a client’s ESG objectives are of secondary importance and are only to be considered after a first product selection has taken place on the basis of the traditional suitability test: an assessment of the client’s knowledge and experience, financial situation and other objectives.56

55 Explanatory Memorandum to Commission Delegated Regulation amending MiFID II Delegated Regulation (EU) 2017/565 (Ref. Ares(2020)2955205, 8 June 2020) at 3; Explanatory Memorandum to the Draft Commission Delegated Regulation amending IDD Delegated Regulations (EU) 2017/2358 and (EU) 2017/2359 (Ref. Ares(2020)2955230, 8 June 2020) at 3. 56 ESMA, ‘Consultation Paper’ (ESMA35-43-1210, 19 December 2018) (n 28) at 23, para. 11.

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In respect of the MiFID framework, the Commission decided to clarify this in a recital 5 of the amending Regulation, while the IDD amending Regulation does not feature a similar recital. The MiFID recital states that “investment firms should have in place appropriate arrangements to ensure that the inclusion of sustainability factors in the advisory process and portfolio management does not lead to mis-selling practices or to the misrepresentation of instruments or strategies as fulfilling sustainability preferences where they do not. In order to avoid such practices or mispresentations, investment firms should first assess the investor’s investment objectives, time horizon and individual circumstances, before asking their clients for their potential sustainability preferences ”. The recital raises a number of problems. First, the wording of the recital is strange, since the amended articles 54 (2) (a) and 54 (5) of the MiFID II Delegated Regulation explicitly consider sustainability preferences as part of the assessment of the client’s investment objectives (“investment objectives, including sustainability preferences”). The amendments being made to the Level 2 Regulation, this is indeed the only approach compliant with the Level 1 text. In our view, the inclusion of sustainability preferences into the “investment objectives” test means that a transaction can only be considered suitable for a client, if it complies both with the financial and sustainability preferences. The result of the suitability test should not differ on the basis of what assessment comes first. Second, the last sentence of the recital, which concludes that the sustainability test should come chronologically after the “ordinary” suitability test, reduces the much broader scope of the rest of the recital, suggesting that “such [mis-selling] practices and misrepresentations” can be avoided by respecting the above-mentioned chronology. However, the legislative history of this recital shows that the reach of the recital is much wider and stems from the conflicts of interests considerations. In its consultation, ESMA indeed gave a number of examples of mis-selling practices which might occur as a result of conflicts of interests in the field of investment advice or portfolio management, such as the use of ESG considerations to sell own products or more costly ones or to generate churning of clients’ portfolios.57 Even though the Securities and Markets Stakeholder Group (SMSG) advised to include those examples in the 57 ESMA, ‘Consultation Paper’ (ESMA35-43-1210, 19 December 2018) (n 28) at 10, para 13.

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recital,58 and ESMA followed this advice in the final version of its technical advice to the Commission,59 the examples have not made it to the final version of the recital. This is regrettable, since these examples clearly show that more is needed to avoid mis-selling than respecting a certain chronology during the suitability process, while the current wording of the recital could lead to a more restrictive reading. ESMA Guidelines. As mentioned above, ESMA held a consultation preceding its technical advice to the Commission on the integration of sustainability risks and factors into the MiFID framework. In this consultation, ESMA took the opportunity to also consult on a number of proposed changes to its Guidelines on the Suitability assessment.60 In general, ESMA has indicated that it wants to keep amendments to the Guidelines on the Suitability assessment high level in order to leave sufficient flexibility for investment firms and allow supervisory authorities to develop a supervisory practice.61 One of the most contentious issues in regard of the practical implementation of the amended suitability test is how investment firms should assess whether a product is sustainable. This is a first important item which ESMA proposed to address in its Suitability Guidelines. ESMA consulted more in particular on the idea that the information about clients’ ESG preferences gathered by investment firms should be sufficiently granular to allow the investment firm to assess the suitability of the investment and must also be consistent with the EU classification system (taxonomy) for ESG investments. Until a unified EU classification has entered into force, however, investment firms should clearly specify what they consider to be ESG preferences and considerations, while taking into account current market practices.62

58 SMSG, ‘Advice to ESMA - ESMA Consultation Papers on Integrating Sustainability Risks and Factors in MIFID, the UCITS Directive and AIFMD’ (ESMA22-106-1683, 6 March 2019) at 9, para 7. 59 ESMA, ‘Technical Advice’ (ESMA35-43-1737, 30 April 2019) (n 29) at 14, para 26 and at 16. 60 ESMA, ‘Suitability Guidelines’ (ESMA35-43-869, 28 May 2018) (n 51). 61 ESMA, ‘Consultation Paper’ (ESMA35-43-1210, 19 December 2018) (n 28) at 22,

para. 6. 62 Ibid., with a proposal to amend para 28 ESMA Guidelines Suitability assessment (see footnote 93). Because political agreement on the Disclosure Regulation was only reached after the ESMA consultation, it could not be taken into account in the advice. For that

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Second, ESMA intends to clarify in its Suitability Guidelines the relationship between the suitability test and the product governance regime in respect of sustainable finance. In the context of firms’ obligation to have in place adequate policies and procedures to ensure that they understand the nature, features, including costs, risks of investment services and financial instruments selected for their clients, including any sustainability factors, ESMA suggests that the firms’ analysis conducted for the purposes of product governance obligations (see infra) should also be taken into consideration.63 Third, ESMA offered a number of very interesting insights regarding guidelines which it wants to leave unchanged (at least for now). First, ESMA requires that investment firms, when collecting information about investors’ ESG preferences, take into account any reasons why investors could fail to answer questions correctly. Firms should aim to prevent perceptive or cognitive distortions from impairing the validity and reliability of answers provided by investors (for example, by asking investors to self-assess their ESG preferences).64 Secondly, the willingness of a client to invest in ESG products should—obviously—not be used against the interests of that client.65 This means according to ESMA that a client’s ESG objectives are of secondary importance and are only to be considered after a first product selection has taken place on the basis of the client’s knowledge and experience, financial situation and investment objectives66 —a consideration that has been explicitly included in the recitals of the delegated directive (as discussed above). Thirdly, ESMA acknowledges that, as is the case for the assessment of other criteria relevant for the suitability assessment, firms can develop different methodological approaches to achieve compliance with the amended rules. In a simplified approach the client would, for instance, be asked which percentage of his or her portfolio he or she wishes to invest in environmentally sustainable, social and/or good governance investments, while in a more advanced portfolio approach, the investment firm would be able to determine the ‘ESG

reason, ESMA indicates that other amendments to the Delegated Regulation may be proposed in the future (see at 4 para 4). 63 Ibid. at 25, with a proposal to amend para 70 of the Guidelines. 64 Ibid. at 22, para. 10. 65 Ibid. 66 Ibid. at 23, para. 11.

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profile’ of the client’s portfolio on the basis of the client’s preferences for E, S and/or G investments and assess it against the client’s ESG preferences.67 Fourthly, ESMA explicitly confirms that the assessment of the client’s ESG preferences should not be linked to the size of his or her portfolio; the assessment of the ESG objectives should therefore not be limited to wealthier clients.68 Finally, ESMA confirms, probably unnecessarily, that ESG products can also be suitable for clients without ESG preferences, but that non-ESG products are never suitable for clients with ESG preferences.69 Finally, in regard of timing, ESMA will only implement the proposed amendments to the Guidelines after the amendments to Delegated Regulation (EU) 2017/565 will have been adopted by the European Commission.70 These amended guidelines will then only apply after the entry into application of the amended Regulation, which is scheduled 18 months after its entry into force.71 The amended Guidelines will then immediately become applicable to existing clients. This does not mean, however, that all client profiles will have to be updated by day one. Firms will, however, have to take the amended Guidelines into account when reviewing existing profiles.72 Outlook. The above changes will definitely raise awareness of investors on the existence of sustainable investment products and present sustainable products as an actual investment option. However, much stronger measures are feasible, such as presenting sustainable investment products as the default option when such products also suit the other needs and objectives of the client. This is indeed a policy option on which the European Commission has recently been consulting.73 It remains to be seen, however, whether such a measure will indeed be implemented. While it would certainly boost sustainable finance among retail investors, it would also give a paternalistic edge to the suitability assessment and may even lead to “stranded assets”. 67 Ibid. at 23, para. 12. 68 Ibid. at 23, para. 13. 69 Ibid. at 23–24, para. 14. 70 Ibid. at 24, para 16. 71 Ibid. 72 Ibid. at 24, para 17. 73 European Commission, ‘Consultation’ (8 April 2020) (n 8) at 8.

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13.3.3

Product Governance

Product governance. MiFID II and IDD have introduced a new “product governance” regime on top of the suitability and appropriateness requirements, in order to further reduce the risk of mis-selling.74 Product governance rules require that MiFID and IDD product manufacturers (i) design products in such a manner that they meet the needs of an identified target market of end clients, (ii) tailor their distribution strategy to this target market and (iii) take reasonable steps to ensure that the products are distributed to this target market. MiFID Product distributors in turn need to also identify a target market for the products they distribute, either because the product manufacturer was not subject to MiFID II or to refine the target market in function of their knowledge of their client base,75 while no similar obligation exists for insurance distributors, who can rely on the target market defined by the product manufacturer. MiFID and IDD product distributors are in principle not allowed to sell to clients outside the target market76 and must provide the product manufacturer with feedback.77 Integration of sustainability into the product governance framework. As part of the Commission’s ambition to reorient capital flows towards sustainable investment, the EU regulators have also integrated sustainability factors and preferences into the product governance requirements.78 In its 2018 guidelines on product governance, ESMA already provided that firms should specify which investment objectives and client needs a product had been designed to meet. Objectives and needs

74 See for a more elaborate overview of the MiFID product governance regime: Veerle Colaert, ‘Product governance: Paternalism Outsourced to Financial Institutions?’ 2020 6 EBLR 977-1000; Danny Busch, ‘Product governance and Product Intervention under MiFID II / MiFIR’ in Danny Busch and Guido Ferrarini, Regulation of the EU Financial Markets. MiFID II and MiFIR (Oxford: OUP, 2017) 123–137. 75 If the MiFID product manufacturer is the same institution as the product distributor, only one target market needs to be defined (see last section of art. 10 (2) MiFID Delegated Directive (EU) 2017/593). 76 Subject to a number of exceptions. See Colaert, ‘Product governance’ (n 73) at 983. 77 Art. 16 (3) and 24 (2) MiFID II and Art. 9–10 MiFID Delegated Regulation

2017/593/EU; Art. 25 IDD and art. 4–11 IDD Delegated Regulation 2017/2358/EU. 78 Recital 4 of Commission Delegated Directive amending MiFID Delegated Directive (EU) 2017/593 (Ref. Ares(2020)2955234, 8 June 2020).

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could be fine-tuned by specifying the particular aspects of the investment and the expectations of targeted clients. By way of example, ESMA provided that “a product may be designed to meet the needs of a specific age demographic, to achieve tax efficiency […], or be designed with special product features to achieve specific investment objectives such as “currency protection”, “green investment”, “ethical investment”, etc., as relevant.”79 EIOPA did not publish any guidelines on product governance. In January/February 2018, the Commission engaged in targeted interviews on ESG integration and taxonomy with 23 medium-sized to large asset managers and institutional investors (insurance companies and pension funds) that had already integrated ESG factors in their investment decision process and/or have SRI products. Respondents considered ESG factors in their product selection, but with different periodicity (i.e. always or only when the product was specifically dedicated to ESG strategies).80 Recent amendments to the MiFID and IDD Frameworks created binding provisions in this respect. Limitation. The amended legal framework has, however, an important limitation: sustainability factors should only be considered in the product approval process and in the other product governance and oversight arrangements for financial instruments “that are intended to be distributed to clients seeking financial instruments with a sustainabilityrelated profile”.81 The Commission indeed explicitly confirmed that the possibility to identify a target market for clients without sustainability

79 ESMA, ‘Guidelines on MiFID II product governance requirements’ (ESMA35-43620, 5 February 2018) at 7, para 18. In the draft guidelines, the “clients’ needs” were even a category, separate from “clients’ objectives”. “Objectives” then referred to the investment objectives of target clients, i.e. the wider financial goals or overall strategy, such as “liquidity supply”, “retirement provision”, or the expected investment horizon. Those objectives could then be “fine-tuned” by specific clients’ needs that would narrow or broaden the scope of the objectives, and could vary from specific to more generic such as: age, country of tax residence, special product features” like “currency protection”, “green investment”, “ethical investment”, etc. See ESMA, ‘Consultation Paper – Draft guidelines on MiFID II product governance requirements’ (ESMA/2016/1436, 5 October 2016) at 23–24. The final Product governance Guidelines, however, just used one general category “objectives and needs”. 80 European Commission, ‘Impact Assessment’ (SWD(218)264final, 24 May 2018) (n 49) 129. 81 Recital 5 of the Commission Delegated Directive amending MiFID Delegated Directive (EU) 2017/593 (Ref. Ares(2020)2955234, 8 June 2020).

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preferences should be maintained.82 In such case, no information about the sustainability of the product needs to be included in the target market description, except that it is targeted to investors without sustainability preferences. If, on the other hand, financial instruments are intended to be distributed to clients with a sustainability-related profile, the target market should then be defined at a sufficiently granular level: it should specify to which group of clients with specific sustainability preferences the financial instrument is supposed to be distributed.83 EIOPA clarified in its technical advice to the Commission that a general statement that an insurance product has an ESG profile would not be sufficient.84 This seems to mean that the target market description should specify whether and to what extent each of the E, S and G factors are accomplished by the product. In our opinion, the limited scope of the product governance amendments is regrettable. It would have been preferable if, similarly to the risk profile of a product, the ESG profile of each product needed to be defined with a high granularity. This would avoid that product manufacturers and / or distributors who do not want to do the effort to define the ESG profile of a product, would just classify it as “targeted to clients without sustainability preferences”. Moreover, in order to allow an easy match between product governance and suitability, the sustainability profile of each product should be defined in a sufficiently granular way. As discussed above, ESMA intends to amend its Suitability Guidelines to clarify that investment firms can either develop a simplified approach to ESG suitability, for instance, be asked which percentage of his or her portfolio he or she wishes to invest in ESG investments, or a more advanced portfolio approach, determining the ‘ESG profile’ of the client’s portfolio on the basis of the client’s preferences for E, S and/or G investments, and assess it against the client’s ESG preferences. The latter approach would 82 Explanatory Memorandum to the Draft Commission Delegated Directive amending MiFID Delegated Directive 2017/593/EU (Ref. Ares(2020)2955234, 8 June 2020) at 2. 83 Recital 5 of the Commission Delegated Directive amending MiFID Delegated Directive 2017/593/EU (Ref. Ares(2020)2955234, 8 June 2020). EIOPA wanted to explicitly include this in a new recital 5bis of the IDD Delegated Regulation (EU) No 2017/2358 (see EIOPA, ‘Technical Advice’ (EIOPA-BoS-19/172, 30 April 2019) (n 30) at 37). In the end, however, it became just a recital of the amending regulation (recital 4 of Commission Delegated Regulation (Ref. Ares(2020)2955230, 8 June 2020). 84 EIOPA, ‘Technical Advice’ (EIOPA-BoS-19/172, 30 April 2019) (n 30) at 37.

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only work if the target market of a product would allow equally refined knowledge of the investment products. Main changes. Art. 9 (9) of the MiFID Delegated Directive provides that MiFID product manufacturers have to identify at a sufficiently granular level the potential target market for each financial instrument and specify the type(s) of clients with whom the needs, characteristics and objectives of the financial instrument are compatible. This provision has been amended by explicitly adding that the needs, characteristics and objectives of clients include “any sustainability preferences”.85 Similarly, art. 5 (1) of the IDD Delegated Regulation now provides that the target market should be determined at a sufficiently granular level, taking into account, the characteristics, risk profile, complexity and nature of the insurance product, “as well as its sustainability factors”.86 It is quite remarkable that the MiFID target market is defined in terms of the target client and his or her sustainability preferences, whereas the IDD target market is defined in terms of the insurance product and its sustainability factors. It is not clear whether this difference in approach will in practice lead to a different target market definition between MiFID financial instruments on the one hand and IDD insurance products on the other hand. Those differences, which do not seem substantiated by the differences between those products, are in any event regrettable because of the legal uncertainty they create and the potential unlevel playing field between very similar products. In order to determine whether a product meets these characteristics, investment firms were already required to assess whether the risk/reward profile of the product is compatible with the target market, as well as whether the design of the product is driven by characteristics that benefit the client and not by a business model that relies on poor client outcomes to be profitable. This provision has been complemented with a requirement to check whether the financial instrument’s sustainability factors are

85 Art. 1 (2) (a) of Commission Delegated Directive (Ref. Ares(2020)2955234, 8 June 2020) amending art. 9 (9) MiFID Delegated Directive 2017/593/EU. 86 Art. 1 (2) of Commission Delegated Regulation (Ref. Ares(2020)2955230, 8 June 2020) amending art. 5(1) IDD Delegated Regulation (EU) No 2017/2358.

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consistent with the target market.87 In the same vein, also the IDD Delegated Regulation has been changed. It already provided that the product approval process should ensure that the design of insurance products meets, among other things, the objectives, interests and characteristics of customers. It is now clarified that this should include their sustainability preferences.88 As regards the obligations for distributors, the MiFID Delegated Directive provides that the products and services they wish to offer or recommend should be consistent with the needs, characteristics and objectives, including any sustainability preferences, of an identified target market.89 Similarly, product distribution arrangements under IDD should ensure that the objectives, interests and characteristics of customers are duly taken into account. In this provision as well, it has been clarified that this includes any sustainability preferences.90 When reviewing products, both MiFID product manufacturers and distributors and IDD product manufacturers should consider whether the product remains consistent with the needs, characteristics and objectives, including any sustainability preferences, of the identified target market.91 Both MiFID and insurance distributors are furthermore subject to information obligations to the product manufacturer. Whereas, this obligation is formulated in a general manner in the MiFID Delegated

87 Art. 1 (2) (b) of Commission Delegated Directive (Ref. Ares(2020)2955234, 8 June 2020) amending art. 9 (11) Delegated Regulation 2017/593/EU; Art. 1(2) of Commission Delegated Regulation (Ref. Ares(2020)2955230, 8 June 2020) amending art. 5–6 IDD Delegated Regulation (EU) No 2017/2358. 88 Art. 1 (1) of Commission Delegated Regulation (Ref. Ares(2020)2955230, 8 June 2020) amending art. 4 (1) (i) IDD Delegated Regulation (EU) No 2017/2358. 89 Art. 1 (3) (a) of Commission Delegated Directive (Ref. Ares(2020)2955234, 8 June 2020) amending art. 10 (2) MiFID Delegated Directive 2017/593/EU. 90 Art. 1 (5) of Commission Delegated Regulation (Ref. Ares(2020)2955230, 8 June 2020) amending art. 10 (2) (c) of IDD Delegated Regulation (EU) No 2017/2358. 91 Art. 1 (2) (c) and 1 (3) (b) of Commission Delegated Directive (Ref. Ares(2020)2955234, 8 June 2020) amending art. 9 (14) and art. 10 (5) MiFID Delegated Directive 2017/593/EU; art. 1 (3) of Commission Delegated Regulation (Ref. Ares(2020)2955230, 8 June 2020) amending art. 7 (1) IDD Delegated Regulation (EU) No 2017/2358. Since there are no obligations to define a target market for insurance distributors, there are no product review obligations for distributors either. Art. 10 (6) IDD Delegated Regulation (EU) No 2017/2358 does provide for a requirement for insurance distributors to regularly review their product distribution arrangements.

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Directive,92 the IDD Delegated Regulation specifically refers to the situation where the insurance distributor “becomes aware that an insurance product is not in line with the interests, objectives and characteristics of the customer belonging to the target market ”. The latter obligation has thus been amended to explicitly include “sustainability preferences” in the provision.93 Differences between MiFID and IDD Frameworks. Even though the MiFID and IDD product governance rules introduce substantially the same regime, the specific provisions implementing the regime were already quite different and much less aligned than the respective suitability frameworks. The IDD Delegated Regulation contained a number of rules with no direct MiFID equivalent, for instance, on product testing, distribution channels and product distribution arrangements. In general, in all those provisions, all references to the “objectives” of the customers belonging to the target market have been amended to clarify that these include “any sustainability preferences”.94 Also, the wording used in equivalent provisions was already very different. We have argued before that especially for IBIPs, it does not make sense to apply a regime different from the MiFID framework.95 The current need to adapt both regimes in accordance with the sustainable finance action plan again underlines the inefficiency of maintaining two separate regimes which aim at the same objective, for economically very similar products. EMSA Guidelines. In the consultation preceding its technical advice to the Commission, ESMA announced that it would also amend its product governance Guidelines in accordance with the above changes to the MiFID Delegated Directive. Also, in respect of the changes to the product governance Guidelines, ESMA announced that it intended to

92 See art. 10 (9) MiFID Delegated Directive 2017/593/EU. 93 Art. 1 (6) of Commission Delegated Regulation (Ref. Ares(2020)2955230, 8 June

2020) amending art. 11 of IDD Delegated Regulation (EU) No 2017/2358. 94 Art. 1 (2)–(6) of Commission Delegated Regulation (Ref. Ares(2020)2955230, 8 June 2020) amending art. 5 (2), (3), (4), 6 (1) and (2), 8 (3), and 10 (2) of IDD Delegated Regulation (EU) No 2017/2358. 95 Veerle Colaert, ‘European Banking, Securities and Insurance Law: Cutting through Sectoral Lines?’ (2015) 52 CMLRev, 579–1616, at 1605; in respect of the know-yourcustomer requirements, see also: Busch, Colaert and Helleringer (n 22) at 363.

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take a high-level approach.96 ESMA intends to explicitly mention ESG preferences as part of the “client’s objectives and needs”,97 and to add a new case study about an Impact Investment Fund.98 ESMA also intends to emphasise again that it is not necessary to identify a negative target market for ESG products, as ESG products can obviously also be sold to investors who did not express specific ESG preferences.99 Even though ESMA has not explicitly specified a timeline of when it would implement those changes and when they would enter into force. It seems reasonable to expect ESMA to take the same approach as in respect of the Suitability Guidelines (see above). No complete taxonomy. As with the suitability test, also for the product governance, the question of how to assess the sustainability of a product for purposes of the product governance rules is dependent on a well-developed taxonomy of environmental, social and governance standards. However, the Taxonomy Regulation is at present insufficiently developed to create sufficient guidance on E, S and G. As with the suitability test, it will be up to investment firms to specify what they consider to be ESG preferences and considerations, while taking into account current market practices. We can only hope, that, as for the other target market factors, financial market participants will join forces and come up with an updated “European MiFID Template”,100 including a welldeveloped ESG scale to identify the ESG profile of a product in a very granular level, and allowing to distinguish between the sustainability of the product in terms of environment, social matters and governance.

96 ESMA, ‘Consultation Paper’ (ESMA35-43-1210, 19 December 2018) (n 28) at 15, para 12. 97 Ibid. at 18. 98 Ibid. at 18–19. 99 Ibid. at 15, para 13. 100 FinDaTex (Financial Data Exchange Templates) is a joint structure established by

representatives of the European financial services sector with the view to coordinate, organise and carry out standardisation work to facilitate the exchange of data between stakeholders in application of European financial markets legislation, such as MiFID II, PRIIPs and Solvency 2. One of its major achievements was the creation of a “European MiFID Template” for the definition of the target market under MiFID II. The third, improved version of this template, should be used as of 10 December 2020. FinDaTex has already announced on 24 June 2020 that a review of its EMT template for the integration of ESG target market criteria has been initiated. See https://findatex.eu/ news/40/findatex-launches-work-on-esg-target-market (retrieved on 17 November 2020).

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Conflicts of Interests

Conflicts of interests Regime. Conflicts of interests are one of the most prominent problems leading to mis-selling and investor detriment. The MiFID and IDD regime to contain conflicts of interests is based on organisational requirements in three steps: (i) identification of potential sources of conflicts of interests, (ii) management of conflicts of interests on the basis of a conflicts of interest policy and (iii) disclosure of conflicts of interests if the investment firm or insurance intermediary cannot ensure that a conflict of interests will not damage the interests of clients.101 ESG considerations may give a new pretext to engage in mis-selling practices. It is therefore not surprising that the EU legislator has sought to refine the MiFID and IDD rules on conflicts of interest in the face of sustainable finance. Even if the legislative changes to both the MiFID and the IDD regime are rather limited, they have been complemented with two interesting recitals. Amendments. In the MiFID framework, the sustainability amendments to the conflicts of interests regime focus on the first step, “identification”. Article 33 of the MiFID Delegated Regulation lists 5 minimum criteria to be taken into account when identifying conflicts of interests which may damage the interests of a client. This article has been amended to clarify that the interests of the client include his or her sustainability preferences. Those changes are hardly shocking. One could even argue that they merely make explicit what diligent investment firms should already be doing. This is underscored by the recitals of the amending regulation. Recital 4 indicates that when identifying the types of conflicts of interest which may damage the interests of the client, investment firms should include those types of conflicts of interest which stem from the distribution of sustainable investments, or from investments that promote environmental or social characteristics.102 As discussed above, also recital 5, which currently mainly deals with the suitability test in regard of investment advice and portfolio management, originally had a much clearer conflicts of interests focus. In the consultation preceding its technical advice to the Commission, ESMA clarified that firms needed to have in place appropriate arrangements to ensure that the inclusion 101 See art. 16 (3) and 23 of MiFID II and art. 27 and 28 IDD. 102 Recital 4 of Commission Delegated Regulation (Ref. Ares(2020)2955205, 8 June

2020) amending MiFID Delegated Regulation 2017/565/EU.

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of ESG considerations in the advisory process and portfolio management would not lead to mis-selling practices or misrepresentation and does not damage the interests of the clients. ESMA also gave a number of interesting examples of how ESG considerations could be used to damage the interests of the clients: selling own-products or more costly products, recommending unnecessary transactions to or carrying them out for clients (“churning”), or misrepresenting products or strategies as fulfilling ESG preferences when they do not.103 The SMSG had advised to include those examples in the recital, and ESMA confirmed in its final advice to the Commission that this would indeed be useful. Nevertheless, those examples have not been included in the final text of the Regulation, and the current recital 5 now seems to mainly deal with the inclusion of sustainability factors in the suitability test (see above).104 The examples given in the ESMA consultation, however, are still helpful to get a clearer picture of how the inclusion of ESG considerations can lead to damages to clients’ interests, and to help investment firms in creating conflicts of interests procedures which duly take those potential conflicts into account. For insurance distribution activities related to insurance-based investment products, the conflicts of interests regime has also been amended, albeit not in the first step, “identification”, but in the second step of the regime, “management”. Conflicts of interest policies of insurance intermediaries and undertakings should explicitly deal with sustainability preferences: when assessing the damage to the interest of the customer as a consequence of a conflict of interests, insurance intermediaries and undertakings should explicitly take into account damages to the customer’s sustainability preferences.105 In respect of the first step, “identification”, the amending Regulation does clarify in its recital 5, that insurance intermediaries and insurance undertakings should identify any conflict of interest that may arise in relation to sustainability factors and in the course of any distribution activities related to insurance-based investment products, not only in cases where customers have informed them about their

103 ESMA, ‘Technical Advice’ (ESMA35-43-1737, 30 April 2019) (n 29) at 16, with a proposal to introduce a new recital 59bis. 104 See also footnotes 57 and 58. 105 Art. 3 (1) of IDD Delegated Regulation (EU) 2017/2359, as amended by

Commission Delegated Regulation (Ref. Ares(2020)2955230, 8 June 2020).

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sustainability preferences.106 In its technical advice, EIOPA had suggested to include in the recital a number of non-exhaustive examples of ESG considerations when identifying conflicts of interests, including remuneration and incentive structures for external asset managers and proxy advisors as well as remuneration and incentives schemes to promote the distribution of ESG products or to achieve specific sustainability targets of the insurance undertaking and which are different from the ESG preferences of the target market.107 The final recital, however, does not mention those examples. The amendments to the similar MiFID and IDD conflicts of regimes show again a striking difference in approach. Even though the end result may not be very different, it is, again, regrettable that the legal regimes applicable to investment products which are highly similar from an economic perspective, show differences which cannot be explained on the basis of differences between those products. Again, this creates unnecessary differences in legal processes to implement the rules, as well as uncertainty.

13.4

Conclusion

Sustainable finance is clearly one of the topics which will dominate financial regulation in the following years. In the Sustainable Finance Action Plan, the European Commission has opted for a review of the entire legislative framework with a view to mobilising the financial sector in the transition to a more sustainable economy. In this contribution, we have focused on the amendments to the EU investor protection framework. 13.4.1

No Cross-Sectoral Playing Field

Investment products beyond MiFID and IDD products. In the explanatory memoranda of the amending regulations and directive, the

106 Recital 5 of Commission Delegated Regulation amending IDD Delegated Regulation (EU) 2017/2358 and IDD Delegated Regulation (EU) 2017/2359(Ref. Ares(2020)2955230, 8 June 2020). 107 EIOPA, ‘Technical Advice’ (EIOPA-BoS-19/172, 30 April 2019) (n 30) at 33, with a proposal to introduce a new recital 3 (bis) in IDD Delegated Regulation (EU) 2017/2359.

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Commission mentioned that it intended to integrate sustainability considerations into the investment, advisory and disclosure processes in a consistent manner across sectors. Despite these good intentions, reality proves very different. The notion “investment products” is very broad, including, inter alia, not only financial instruments, but also insurancebased investment products, pension products and crowdfunding products. However, only the MiFID and IDD Frameworks have been amended to integrate sustainable finance into the EU investor protection regimes. The recently adopted PEPP and Crowdfunding Regulations do not integrate sustainable finance in their investor protection regimes yet. The delay in integrating sustainable finance into those regulations, compared to the measures already taken in MiFID and the IDD, makes the unlevel playing field which already existed between products, depending on their distribution channel, even worse.108 Unjustified differences between MiFID and IDD Frameworks. But even within the amended MiFID and IDD Frameworks, sustainability considerations have not been integrated in a consistent manner across sectors. On the contrary, sustainable finance amendments have created new differences between both regulatory frameworks, which the Commission does not justify, and are in our opinion not justified on the basis of differences between insurance-based investment products on the one hand and other investment products on the other. This contribution has provided a number of striking examples. In the MiFID suitability ‘report’, for instance, “sustainability preferences” is a separate point on which investment firms have to report, whereas in the IDD suitability ‘statement’, it is inserted as part of the information how the recommendation meets the customer’s investment objectives. In respect of product governance, the MiFID target market should be defined in terms of the

108 It has been argued before that retail investors—the Crowdfunding Regulation calls them “non-sophisticated” investors—should be protected in the same way irrespective of the distribution channel (see for instance Busch, Colaert and Helleringer (n 22) at 363 and 373–374. The Crowdfunding Regulation clearly does not follow that idea, creating an unlevel playing field in respect of rules governing the distribution of investment products, depending on the distribution channel. The Commission has justified this different approach on the basis of the consideration that the costs and therefore the compliance burden in respect of crowdfunding should not be too high. However, if one agrees that crowdfunding is, in the end, just another distribution channel through which investors get access to investment products, this is not a convincing argument (see Busch, Colaert and Helleringer (n 22) at 363).

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target client and his or her sustainability preferences, whereas the IDD target market is defined in terms of the insurance product and its sustainability factors. And in respect of conflicts of interests, the amendments to the MiFID framework have focused on the first step of the conflicts of interest regime, “identification”, whereas the amendments to the IDD Framework have focused on the second step, “management”. For most of those changes, the legal effect of both frameworks will probably be more or less the same—even though further research on the implementation in practice of both regimes should confirm this. However, the differences in wording create legal uncertainty and make the practical implementation process of both regimes different, which is inefficient. It stresses the fact that creating a level playing field between economically very similar products in separate legal frameworks is not efficient. We argued before that even if one succeeds in creating a relatively level playing field at level 1 of the Lamfalussy procedure, it is almost undoable to keep this up at levels 2 and 3, and in subsequent changes to levels 1, 2 or 3 at a later stage.109 The sustainability amendments discussed in this contribution provide further proof of this statement. 13.4.2

Evaluation of Revised Investor Protection Rules

Apart from the above criticism, the implementation of the Commission’s sustainable finance agenda in the MiFID and IDD investor protection frameworks is, in general, quite straightforward. Suitability test. The new obligatory questions about ESG preferences in the suitability assessment will undoubtedly contribute to making clients more conscious of the possibilities they have to bring about a more sustainable world through their investments. It may moreover help in solving the problem that investors do not opt for ESG products because of limited attention for this segment in their decision-making process. The changes to the suitability test are therefore important to close the valueaction gap between investors’ intentions and their behaviour. We doubt, however, whether the emphasis on a suitability test in two phases—with a first selection of products on the basis of knowledge and experience, financial objectives and financial situation, followed by a second selection in function of sustainability preferences—is legally sound, or even

109 Colaert (2015) 52 CMLR Rev (n 94) at 1603–1605.

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needed in order to avoid mis-selling. It is regrettable in this respect that the recital which introduces this idea did not retain a wider variety of examples of mis-selling which could occur on account of sustainability considerations. More importantly, however, much stronger measures are feasible, such as presenting sustainable investment products as the default option, provided that the product also suits the other needs and objectives of the client.110 Such a measure would boost sustainable finance among retail investors. It would, however, also give a paternalistic edge to the suitability assessment, and may lead to “stranded assets”. Product governance. In order to avoid mis-selling and to allow for an efficient application of the suitability test, ESG preferences have also been integrated in the product governance regime. Apart from the above-mentioned unjustified differences between the MiFID and IDD Frameworks, we have criticised the fact that only in respect of products with a “sustainability-related profile” sustainability information with sufficient granularity should be included in the target market of that product. For other products, it would be sufficient to mention that they are targeted to investors without sustainability preferences. In our opinion, this is a missed opportunity. It would have been preferable if, just as with regard to the risk profile of a product, the regulator would require that the ESG profile of each and every product should be defined with a high degree of granularity. Conflicts of interest. As mentioned above, there is a striking lack of coherence between the MiFID and IDD approaches to integrating sustainable finance in the conflicts of interests regimes. Moreover, we have expressed regret that the examples mentioned in the ESMA consultation did not make it to the recitals of the amending regulations. 13.4.3

Lack of Complete Taxonomy

The amended MiFID and IDD obligations are shaped by systematic references to ESG-risks and -factors. A key question which remains unsolved, however, is how these three elements (E, S and G) are to be understood. As yet, the Taxonomy Regulation only determines when an investment can be considered as environmentally sustainable. In order to meet the revised MiFID and IDD investor protection frameworks, financial service

110 European Commission, ‘Consultation’ (8 April 2020) (n 8) at 8.

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providers will also need to determine when an investment complies with social and governance factors. For now, financial service providers have to develop their own policy in this regard, which they can do, for instance, on the basis of national labels. However, these labels differ in content and quality. That situation is far from ideal111 : it heightens the cost of compliance, causes uncertainty, and leads to different implementations by different financial institutions. And for investors, it undermines comparability and transparency of products and services—two explicit objectives of the EU’s sustainable finance policy. Acknowledgements The author would like to thank Drs Arnaud Van Caenegem for many fruitful discussions on this theme, and especially for bringing to her attention the interesting behavioural finance literature on the gap between investors’ intentions and behaviour.

111 ESMA, ‘Technical Advice’ (ESMA35-43-1737, 30 April 2019) (n 29) at 17; See e.g. DUTCH BANKING ASSOCIATION, ‘NVB response to Commission proposals on financing sustainable growth - MiFID II suitability requirements’ (21 June 2018) https://ec.europa.eu/info/law/better-regulation/initiatives/ares-2017-5524115/ feedback/F12273_en?p_id=237222 (retrieved on November 17, 2020).

CHAPTER 14

Emission Allowances as Financial Instruments Filippo Annunziata

14.1

Introduction

The scope of these notes is, first of all, to provide an overview of the recent developments that have gradually seen the inclusion, in the scope of MiFID and of the Market Abuse Regulation, of emission allowances. This will be done in an attempt to understand whether this evolution may support the development of more efficient and robust emission allowances trading schemes and, ultimately, the reduction of CO2 emissions in the Planet. The key question, that still needs to be answered, is whether subjecting emission allowances to the core provisions of EU capital 1 There is considerable literature on the EU emissions trading scheme that considers

both economic and regulatory issues. For a focus on the latter see, also for further references, J. Van Zeben, The Allocation of Regulatory Competence in the EU Emissions Trading Scheme, Cambridge University Press, 2014; J.B. Skjaerseth and J. Wettestad, EU Emissions Trading: Initiation, Decision-Making and Implementation, Ashgate, 2008; J. Wettestad and T. Jevnaker, Rescuing EU Emissions Trading: The Climate Policy Flaghsip, Palgrave Macmillan, 2016.

F. Annunziata (B) Università Luigi Bocconi, Milan, Italy e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3_14

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markets legislation may effectively prove to be useful for the development of a Green Economy and for the protection of the environment. Emission allowances trading schemes are far from being a novelty. Back in 2003, a European system for trading carbon emissions was set up, within the broader framework of the Kyoto Protocol and of the international agreements for the reduction of CO2 emissions.1 At the time, during the negotiations of the Kyoto Protocol, the EU Commission endorsed the position that Emissions Trading Schemes (ETS)—together with the other tools introduced by the Protocol itself—would provide a strong contribution to the global reduction of CO2 emission.2 The advantages were made clear both for the industry and for institutions. For the first, emissions trading would offer interesting incentives towards the reduction of emissions: trading emission allowances provides the industry with exchangeable assets, a solution that looked preferable to others that might be envisaged in order to reduce emissions—such as taxation—in terms of flexibility and final results. For institutions and governments, emissions trading should also be considered as an effective and flexible tool for environmental policies. In the European Union, Directive 2003/87/EU of 13 October 13 introduced a harmonised and centralised regime for emissions trading, that has been, since its inception, in continuous operation, albeit the first 15 years proved to be, at times, troublesome. Several factors, including the financial crisis of 2008, raised unpredicted challenges to the scheme that was then refreshed in 2013. The EU ETS system has been actually operational since 2005, providing a structured and standardised system of electronic registers, that allows for the transfer, the safekeeping and the writing-off of rights on emission allowances in Europe. In the infancy of the EU ETS, each Member State had its own register, but, starting from 2012, national registers were substituted by the EU one. In the literature, several reasons are generally set out in order to support the assumption that emission allowances trading schemes produce

2 In September 2004 the European Commission—being called upon by the European Council to prepare a cost/benefit analysis on emissions reduction strategies, including midand longer-range targets—launched a consultation to gather ideas and research results from stakeholders on a global climate change regime for the future. Consequently, a conference was held on 22 November and the comments and information included into the Commission’s report for the Council, i.e. the Communication “Winning the Battle Against Global Climate Change”, adopted on 9 February 2005.

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positive externalities.3 First of all, ETS seem to contribute to the definition of a clearer, and more predictable overtime, price on carbon.4 The costs generated by CO2 emissions and their negative impacts (public health, weather conditions, extinction of parts of the animal or vegetable world, etc.) are made more transparent and are more easily incorporated into the price of goods and services. Further benefits seem to come from the combination of ETS and cap limits on emissions: with a steadily declining cap on emissions, an ETS delivers a predictable path for their reductions, setting a long-term goal for businesses and investments. For this purpose, as of 2010, a declining cap to the quantity of emission allowances was set out (until 2020 and beyond), so as to enable market participants to promptly adjust their investment decisions and environmental policy.5 Flexibility is another advantage of ETS: systems may be designed according to different rules that fit multiple environments and economic profiles. ETS might even provide additional sources of revenues for governments, when combined, for example, with a system of auction of permits. Different ETS can also be linked one to the other, so as to increase the size of the market, thus making it sturdier and more efficient.6 3 T.H. Tietenberg, Emissions Trading. Principles and Practices. Resources for the future, 2nd ed., Washington, DC, 2006. 4 For climate policy purists, “putting a price on carbon” represents the most economically efficient means to reduce emissions, at the lowest cost. In a cap-and-trade scheme, industries buy and sell allowances to emit greenhouse gases, within a cap that shrinks over time. Also, according to the European Commission, trading brings flexibility that ensures emissions are cut where it costs least to do so. A robust carbon price also promotes investments in clean, low-carbon technologies. For further information on the progress of the concrete impacts of the ETS, please see the Report from the Commission to the European Parliament and the Council - Report on the functioning of the European carbon market (COM/2019/557 final/2), available at the following link: https://eurlex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52019DC0557R(01). 5 Actually, in 2015, the European Commission unveiled its proposal to revise the EU Emissions Trading System (ETS), to take effect from 2021. This would speed up the pace of emission reductions and help the EU meet its pledge to cut greenhouse gas emissions by at least 40% by 2030. In particular, in July 2015, the European Commission published its proposed revision to the EU Emissions Trading System (ETS), outlining the steps needed to cut greenhouse gas (GHG) emissions from 2021 in order to achieve the EU climate change commitments for 2030. 6 The number of emissions trading systems around the world is increasing, also through bilateral and multilateral relationships and agreements. First of all, in addition to the EU Emissions Trading System (EU ETS), national or sub-national systems are already

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14.2 Emission Allowances Within the Scope of Capital Markets and Financial Legislation While the structure and the mechanisms that underpin the functioning of the EU ETS system are, by now, well known, and there is considerable literature on the topic, discussions on the protection of the environment and the development of secondary markets for emission allowances have stimulated a process of gradual inclusion of CO2 allowances in the perimeter of financial markets regulation. This process developed alongside two different directions: the first saw the progressive inclusion, within the legislation on auctions and exchange of emission allowances, of rules clearly based and modelled upon capital markets and financial legislation. The second direction—that ultimately somehow prevailed over the first— shows the direct inclusion of emission allowances within the scope of capital markets legislation, especially MiFID and MAR. 14.2.1

Emission Allowances in MiFID I

Having a look at the first trend, the EU ETS—notwithstanding its potential benefits—soon provoked the undesirable manifestation of speculations and abusive conducts, stimulated by its somewhat fluid regulatory framework as well as by the absence of an effective repressive apparatus. Art. 12, paragraph 1-bis of the EU ETS Directive—as amended by the 2009 Directive7 —empowered the Commission with the task to “examine whether the market for emissions allowances is sufficiently protected from insider dealing or market manipulation” and, if appropriate, “bring forward proposals to ensure such protection”.

operating or under development in Canada, China, Japan, New Zealand, South Korea, Switzerland and the United States. The European Commission is also a founding member of the International Carbon Action Partnership (ICAP), which brings together countries and regions with mandatory cap-and-trade systems. The Commission finally supports the development of domestic carbon markets through the Partnership for Market Readiness (PMR): a platform for the exchange of experience on carbon market instruments, where it assists some 17 countries in preparing and implementing their internal policies. 7 Reference is made to Directive 2009/29/EC amending Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance trading scheme of the Community.

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In its subsequent Communication to the Parliament and the Council,8 the Commission noted that “although the European carbon market has grown significantly both in size and sophistication during its first six years of operation, it remains a relatively young market. It is therefore important to ensure that such market can continue to expand and safely be relied upon to give an undistorted carbon price signal. It follows that the market needs to have an appropriate market oversight framework. Such framework needs to secure fair and efficient trading conditions for all market participants through transparency requirements as well as by preventing and sanctioning market misconduct, in particular insider dealing and market manipulation”9 . Actually, shortly before the above-mentioned Communication, the Commission had already issued measures aimed at preventing market abuse in the auction market, setting them out in Regulation n. 1031 of 12 November 2010 (so-called Auction Regulation). In particular, in a regulatory framework based on the definition of financial instrument given by MiFID I—which did not contemplate emission allowances except when they represented the underlying of derivative contracts—the Auction Regulation actually extended the rules and safeguards established by the Market Abuse Directive of 2003 to ETS, regardless of the qualification of emission allowances as financial instruments. To this end, a first regulatory microcosm on market abuse was provided for within that same Auction Regulation, actually mirroring

8 Reference is made to COM (2010) 796 final, named “Towards an enhanced market oversight framework for the EU ETS”, issued in Brussels on 21 December 2010, p. 2. 9 The European Commission detected that, during 2009 and 2010, three incidents occurred in the European carbon market which illustrated the wider range of risks that needed to be dealt with. Although these incidents did not constitute market abuse in the sense of the Market Abuse Directive, they did give rise to calls for stricter regulation of the European carbon market, i.e.: (i) cases of value-added tax (VAT) fraud were detected in the carbon market in 2009–2010. While presenting a serious problem, this type of fraud is not specific to the carbon market and has in the past occurred on other markets as well. The Commission worked closely with Member States to fight this issue, and a new Directive on the application of the VAT reverse charge mechanism for emissions trading was adopted on 16 March 2010; (ii) so-called phishing attacks from fraudsters trying to get unauthorised access to accounts of market participants are also not specific to the carbon market, but nevertheless prompted the Commission to take rapid actions in cooperation with Member States; (iii) the resale in the European carbon market by a Member State of CERs that had already been used for EU ETS compliance. This was an incident specific to the carbon market.

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the Market Abuse Directive (“MAD”), including its definitions, the identification of prohibited conducts, supervisory powers and sanctions. Those rules also replicated the controversial definition of inside information, as well as the basic division between insider trading and market manipulation, provided for by the MAD.10 The provisions against market abuse contained in the Auction Regulation ultimately captured: (i) the spot markets of emission allowances; (ii) the auction markets of emission allowances; (iii) more generally, emission allowances and activities and services on emission allowances not included in the scope of MiFID I (Directive 2004/39/EU—see below). Looking at the second trend—i.e. the direct inclusion of emission allowances in the scope of MiFID and Market Abuse Legislation—a first, significant step in this direction was taken in 2004, i.e. six years before the Auction Regulation, in the context by MiFID I. Building extensively upon the definition of commodity derivatives originally introduced by the Investment Services Directive of 1993, MiFID I enlarged and amplified the catalogue of derivatives that would be considered as falling into its scope. The catalogue included then derivatives on emission allowances. This “mifidization” of emission allowances occurred as a consequence of two converging approaches: firstly, the re-definition, by MiFID I, of the contours of commodity derivatives to be considered of a substantially “financial” nature; secondly, the—in some way astonishingly wide—new category of “exotic” derivatives included in MiFID I (in particular, those included in point C(10) of Annex I). The enlargement of the scope of the Directive, and consequently of the regulation of investment services and activities, made by MiFID I, was not, however, an easy exercise, and this because of the need to negotiate an acceptable equilibrium between the over-expanding approach of the new definition of commodity and exotic derivatives, on the one side, and the needs of producers and traders of raw materials and commodities (especially, energy and gas), on the other side. Such balance was achieved by keeping some of the main lines of 10 The Auction Regulation provided for a definition of insider dealing and market manipulation. According to its art. 3, par. 28, “insider dealing” is “the use of inside information as prohibited pursuant to Articles 2, 3 and 4 of Directive 2003/6/EC in relation to a financial instrument within the meaning of Article 1(3) of Directive 2003/6/EC referred to in Article 9 of that Directive unless otherwise stated in this Regulation”, thereby referring to MAD conducts. According to art. 3, par. 30 of the Auction regulation, also “market manipulation” was defined in a similar way, by referring to Article 1(2) of Directive 2003/6/EC.

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business of commodity producers and traders away from the grip of financial markets regulations. MiFID I, in fact, introduced a number of quite complicated exemptions for commodity derivatives trading by firms not operating otherwise in the financial sector, setting a standard that underpins several of the exemption rules that are still to be found in MiFID II. Apart from the exemptions regime, in MiFID I, ultimately, emissions trading would be considered as financial instruments when employed as underlying of derivatives of a financial nature. In principle, in MiFID I, a derivative on emission allowances would therefore be treated no differently than any other derivative on commodities or other underlying “assets”. The well-known issues concerning the exact perimeter, and the precise line of division, between financial and commodity derivatives (the latter to be considered of a commercial nature, thereby falling outside the scope of MiFID), would also apply to derivatives on emissions trading, similarly to other commodity derivatives. Ultimately, therefore, the room that MiFID I left to the provisions of the Auction Regulation was quite significant: one might rightly say that, until MiFID II, the lead in terms of addressing markets’ efficiency and preventing market abuse in relation to emission allowances was effectively left to the Auction Regulation, and to its provisions, modelled on those of the Market Abuse Directive of 2003. Most of the transactions on emission allowances would, in fact, have ultimately fallen outside the scope of MiFID I: to put it bluntly, in order to argue for emission allowances to fall in the scope of MiFID I, one would have to consider (at least): (i) whether the instrument was effectively a commodity or exotic derivative of a “financial” nature, according to the complex approach of MiFID; (ii) whether the transaction(s) on that instrument were effectively to be considered as a provision of one or more investment services; (iii) whether a case for exemption under MiFID I would be applicable to the transaction (including, for instance, when transactions were not carried out “professionally” and “towards the public”); (iv) whether any further, specific exemption set out in MiFID I—particularly in relation to commodity derivatives—was applicable to the specific case or situation.

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14.2.2

Emission Allowances in MiFID II

The landscape set by MiFID I was, indeed, just a first step towards the inclusion of emissions trading into the scope of financial markets legislation. The second step has ultimately been taken by MiFID II, as the latter directly classifies rights on emission allowances falling in the EU ETS, as financial instruments. With a simple addition to the list of financial instruments, attached to the Directive under Annex I, emission allowances per se have therefore become financial instruments (see n. 12 of the list of financial instruments—Annex I, Section C). The approach that considers emission allowances as relevant for MiFID purpose—if they are employed as the underlying asset of a derivative that presents the indexes required for a derivative to be considered of a financial nature—basically remains unchanged in MiFID II vis-à-vis its predecessor MiFID I.11 However, emission allowances, falling into the scope of the EU 2003 Directive, are now treated as financial instruments, even in relation to spot transactions. In the context of MiFID II, “thin air” (or, rather, rights on “thin air”) is, therefore, not too different from securities, shares, bonds, money market instruments, albeit any man of common reason would probably have some difficulties in grasping such a similarity. This “all-inclusive” approach follows that majority opinion whereby the applicability of the investment services regulation to emission allowances is eligible for increasing transparency and efficiency of the market, improving its liquidity, as well as contributing to the reduction of transaction costs. However, one cannot overlook that the abovementioned solution could potentially place an excessive burden upon negotiations and, consequently, curtail market development.

11 On these topics cfr. Sciarrone Alibrandi, A. Grossule, E., Commodity Derivatives, in D. Busch, G. Ferrarini (eds.), Regulation of the EU Financial Markets. MiFI II and MiFIR, OUP, 2017, Chapter 16, pp. 439 ff. Some preliminary remarks, before MiFID II came into force, can also be found in f. F. Annunziata, “Strumenti derivati, disciplina del mercato dei capitali ed economia reale: una frontiera mobile. Riflessioni a margine del progetto di revisione della MiFID”, in I contratti “derivati”: dall’accordo alla lite, U. Morera and R. Bencini (eds.), Bologna, Il Mulino, 2013, 13 ff.

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14.3 Emission Allowances as Financial Instruments The reasons that led to the qualification of emission allowances as financial instruments in MiFID II are a consequence of the evolution of secondary markets for emission allowances over the last few years. The growing amount of transactions and the need to preserve and ensure the transparency and integrity of secondary markets convinced the Commission to include emission allowances in the scope of MiFID II and, therefore, into the scope of Market Abuse Directive (now, Market Abuse Regulation). The previous approach—a blurred mixture of the Auction Regulation and MiFID I—was not sufficient anymore. As the Commission observed in its FAQ of 2014: “Trading in allowance derivatives already falls under the scope of MiFID and Market Abuse Directive. By now bringing emission allowances under the same framework, the regulation on emission allowances trading (EUA), the spot market will be aligned with what is applicable to the EUA derivative markets. Together, MiFID and the rules on market abuse provide a comprehensive framework for trading in financial instruments and the integrity of the market. The extension to EUAs will introduce greater security for traders of EUAs but without interfering with the purpose of the market, which remains emissions reduction”. One may wonder whether—in the Commission’s words—reference to market abuse would be merely a consequence of the expected inclusion of emission allowances in the scope of MiFID II or whether it was, in fact, the driving force behind the new approach. We believe that the right way to look at this is, in first instance, to turn the two factors the other way around: because of the need to prevent manipulative practices on the markets of emission allowances, they would effectively need to be fully covered by MiFID II. This is, naturally, because rules against market abuse apply to financial instruments as defined by MiFID II, and thus, two masters (like Arlequin in Carlo Goldoni’s seminal comedy of 1746) are served at once and at the same time. It should be underlined that treating emission allowances as financial instruments also implies that the trading platforms on which the allowances are exchanged via spot transactions become subject to the comprehensive MiFID II provisions on trading

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venues.12 The new MiFID II approach therefore has far-reaching consequences, as it impacts not only trading activities and other investment services, but also trading venues and the structure of secondary markets for emission allowances, subjecting also the latter to the typical forms of supervision and control that one finds in the area of EU capital markets legislation. On the basis of the above, it is therefore not surprising to read, in the recitals of MiFID II, clear references to the typical issues of transparency and markets efficiency that are also the inspiring forces of EU market abuse legislation: “A range of fraudulent practices have occurred in spot secondary markets in emission allowances (EUA) which could undermine trust in the emissions trading scheme, set up by Directive 2003/87/EC of the European Parliament and of the Council, and measures are being taken to strengthen the system of EUA registries and conditions for opening an account to trade EUAs. In order to reinforce the integrity and safeguard the efficient functioning of those markets, including comprehensive supervision of trading activity, it is appropriate to complement measures taken under Directive 2003/87/EC by bringing emission allowances fully into the scope of this Directive and of Regulation (EU) No 600/2014 of the European Parliament and of the Council, by classifying them as “financial instruments”.” (MiFID II, recital 11).

14.4

Emission Allowances Under Mar Regulation

The trend towards the inclusion of emission allowances into the scope of EU capital markets legislation was also accelerated by Regulation (UE) n. 596 of 16 April 2014 (so-called MAR Regulation), which replaced the previous Market Abuse Directive. Recital 37 of MAR—after having recalled the previous existence of a specific market abuse regime exclusively dedicated to the auctions of emission allowances—clarifies that

12 Currently, there are three platforms in place: the European common auction platform

(EU T-CAP) related to all the Member States; the German auction platform (EEX DE) and the English platform (ICE UK) where Germany and the United Kingdom place their emission allowances. Under the Auction Regulation, the placement of emission allowances on the platform takes place trough standardised electronic contracts, such as two-days spot contracts and five-days future contracts.

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“as a consequence of the classification of emission allowances as financial instruments, this regulation should constitute a single rule book of market abuse measures applicable to the entirety of the primary and secondary markets in emission allowances”. It follows that the MAR legal framework “should also apply to behaviours or transactions, including bids, to the auctioning on an auction platform authorised as a regulated market of emission allowances or other auctioned products based thereon, including when auctioned products are not financial instruments, pursuant to Auction Regulation”. As a consequence, thereof, the concerns of a regulatory vacuum that induced the European Commission to insert provisions against market abuse within the Auction Regulation were no longer justified, as emission allowances were entirely brought into the warm embrace of EU Capital markets legislation. Considering MAR, there are basically two aspects that make the position of emission allowances peculiar in the context of the regulation. The first is due to the fact that emission allowances are also regulated in other areas of EU legislation, that ultimately also touch upon issues of transparency, market information and efficiency. As already discussed, specific rules aimed at preventing abuses in the emission allowances markets had already been introduced before MAR, in emission allowances EU legislation (in particular, the Auction Regulation). The entry into force of MiFID II and MAR produced, as a consequence, the repeal of those specific provisions, but emission allowances do remain subject to their own sectorial rules that need to be somewhat coordinated with MAR. This is something quite peculiar to emission allowances, as other financial instruments included in MiFID II or MAR do not enjoy the same approach. The second aspect is that MAR must take into account that inside information, for emission allowances, is basically information that refers to contracts, trades and positions on the market, quite differently from what happens in relation to inside information for corporate issuers. Emission allowances are therefore treated in a peculiar way when considering issues such as the disclosure of inside information, or even information-based market manipulation: the perspective that MAR takes towards emission allowances is that, in this context, one may indeed lack a traditional “issuer of a financial instrument”, as the source of inside information. Having a look, instead, at transaction-based market manipulation, the approach

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taken towards emission allowances is closer to that taken in relation to any other financial instrument that fall within the scope of MAR. Concerning the first element (i.e. the interrelationship between MAR and other sectoral legislation), there are several examples to be found in the text of the regulation. One of the most interesting ones is the “reasonable investor test”. According to recital (14), the “reasonable investor test” should, in general, take into account the ex ante available set of information, and its “anticipated impact”, to be considered in light “of the totality of the related issuer’s activity, the reliability of the source of information and any other market variables likely to affect the financial instruments, the related spot commodity contracts, or the auctioned products based on the emission allowances in the given circumstances”. For emission allowances the test necessarily must be carried out also in the light of “any other market variables”, including—as recital (14) sets out—“auctioned products based on emission allowances”. In a similar way, for emission allowances, the “precise” nature of inside information needs to be assessed looking at its “potential effect on the prices of the financial instruments, the related spot commodity contracts, or the auctioned products based on the emission allowances” (MAR, recital 18). In addition, “for derivatives which are wholesale energy products, information required to be disclosed in accordance with Regulation (EU) No 1227/2011 of the European Parliament and of the Council should, in particular, be considered as inside information” (MAR, recital 18).13 It is interesting to note that, both in recitals (14) and (18), reference is made to “auction products based on the emission allowances”: this sets up a connection between the regulation of the auction markets for emission allowances and that of secondary markets for their exchange. A similar “bridge” is also set out by recital (26)14 , with an approach that derives from the one originally taken in the (now repealed) provision of 13 Consistently with MAR, art. 2 of REMIT Regulation - Regulation (EU) No 1227/2011 establishes that “inside information” means information of a precise nature which has not been made public, which relates, directly or indirectly, to one or more wholesale energy products and which, if it were made public, would be likely to significantly affect the prices of those wholesale energy products. 14 MAR, recital (26): “Use of inside information can consist of the acquisition or disposal of a financial instrument, or an auctioned product based on emission allowances, of the cancellation or amendment of an order, or the attempt to acquire or dispose of a financial instrument or to cancel or amend an order, by a person who knows, or ought to have known, that the information constitutes inside information. In this respect, the

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the Auctions Regulation. This is equally a consequence of the re-shaping of market abuse provisions for emission allowances, from the previous to the current regime. Recital (21) of MAR also sets out a specific, and quite elaborate, background for certain exemptions applicable to emission allowances, all of which are basically justified on the basis of the existence of Sectoral legislation.15 According to Art. 6, par. 3, in fact: “This Regulation does not apply to the activity of a Member State, the Commission or any other officially designated body, or of any person acting on their behalf, which concerns emission allowances and which is undertaken in pursuit of the Union’s climate policy in accordance with Directive 2003/87/EC”. Clearly, there is therefore a dual regulatory approach for emission allowances: on the one side, sectoral legislation, on the other, the standard, general market abuse regime, applicable to all financial instruments. competent authorities should consider what a normal and reasonable person knows or should have known in the circumstances”. 15 MAR, recital (21) “Pursuant to Directive 2003/87/EC of the European Parliament and of the Council, the Commission, Member States and other officially designated bodies are, inter alia, responsible for the technical issuance of emission allowances, their free allocation to eligible industry sectors and new entrants and more generally the development and implementation of the Union’s climate policy framework which underpins the supply of emission allowances to compliance buyers of the Union’s emissions trading scheme (EU ETS). In the exercise of those duties, those public bodies can, inter alia, have access to price-sensitive, non-public information and, pursuant to Directive 2003/87/EC, may need to perform certain market operations in relation to emission allowances. As a consequence of the classification of emission allowances as financial instruments as part of the review of Directive 2004/39/EC of the European Parliament and of the Council, those instruments will also fall within the scope of this Regulation. In order to preserve the ability of the Commission, Member States and other officially designated bodies to develop and implement the Union’s climate policy, the activities of those public bodies, insofar as they are undertaken in the public interest and explicitly in pursuit of that policy and concerning emission allowances, should be exempt from the application of this Regulation. Such exemption should not have a negative impact on overall market transparency, as those public bodies have statutory obligations to operate in a way that ensures orderly, fair and non-discriminatory disclosure of, and access to, any new decisions, developments and data that have a price-sensitive nature. Furthermore, safeguards of fair and non-discriminatory disclosure of specific price-sensitive information held by public authorities exist under Directive 2003/87/EC and the implementing measures adopted pursuant thereto. At the same time, the exemption for public bodies acting in pursuit of the Union’s climate policy should not extend to cases in which those public bodies engage in conduct or in transactions which are not in the pursuit of the Union’s climate policy or when persons working for those bodies engage in conduct or in transactions on their own account”.

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However, considering the interplay between the two, after MAR, it is the latter that ultimately prevails, as clarified by recital (37)16 and by Art. 2, par. 1, according to which: “This Regulation also applies to behaviour or transactions, including bids, relating to the auctioning on an auction platform authorised as a regulated market of emission allowances or other auctioned products based thereon, including when auctioned products are not financial instruments, pursuant to Regulation (EU) No 1031/2010. Without prejudice to any specific provisions referring to bids submitted in the context of an auction, any requirements and prohibitions in this Regulation referring to orders to trade shall apply to such bids”. In this respect, emission allowances are truly unique in the context of MAR, as this is a topic where Regulation 516/2014 actually “spills over” and directly regulates matters originally addressed by sectoral legislation. Naturally, this also has significant consequences in terms of enforcement, sanctions and related provisions. The second peculiar dimension of emission allowances under MAR is the fact that the key notion of “inside information” for these products is much more linked to trades and position. Rules on disclosure and treatment of inside information are therefore addressed to market participants: as already set out by recital (51) “the requirement to disclose inside information needs to be addressed to the participants in the emission allowance market”. The duty to disclose inside information, therefore, is not addressed to (as is typical for MAR) the “issuer of a financial instrument”, but to market participants. The notion of “market participant” is not left to its potentially ambiguity, but is clearly defined by art 3 n. (20): “‘emission allowance market participant’ means any person who enters into transactions, including the placing of orders to trade, in emission allowances, auctioned products

16 MAR, recital (37) “Regulation (EU) No 1031/2010 provides for two parallel market abuse regimes applicable to the auctions of emission allowances. However, as a consequence of the classification of emission allowances as financial instruments, this Regulation should constitute a single rule book of market abuse measures applicable to the entirety of the primary and secondary markets in emission allowances. This Regulation should also apply to behaviour or transactions, including bids, relating to the auctioning on an auction platform authorised as a regulated market of emission allowances or other auctioned products based thereon, including when auctioned products are not financial instruments, pursuant to Regulation (EU) No 1031/2010”.

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based thereon, or derivatives thereof and who does not benefit from an exemption pursuant to the second subparagraph of Article 17(2)”.17 The need to carve out emission allowances from the general approach of MAR in relation to inside information is clearly visible through the specific definition of “inside information” provided by art. 7, wherein emission allowances benefit from a specific definition, where no reference to an “issuer” is made: “(c) in relation to emission allowances or auctioned products based thereon, information of a precise nature, which has not been made public, relating, directly or indirectly, to one or more such instruments, and which, if it were made public, would be likely to have a significant effect on the prices of such instruments or on the prices of related derivative financial instruments”.18

14.5 Inside Information Concerning Emission Allowances As with any other inside information, price sensitivity is naturally a prerequisite for emission allowances as well, that needs to be assessed on the basis of the potential impact a certain activity might have on market prices. Once again, emission allowances receive a particular treatment in MAR, as there are certain, clear thresholds that are identified in order to distinguish between price-sensitive and non-price-sensitive information. In this respect, recital (51) clarifies that “In order to avoid exposing the market to reporting that is not useful and to maintain cost- efficiency of the measure foreseen, it appears necessary to limit the regulatory impact of that requirement to only those EU ETS operators which, by virtue of their size and activity, can reasonably be expected to be able to have a significant effect on the price of emission allowances, of 17 Art. 8, par. 4 consequently establishes that “This Article applies to any person who possesses inside information as a result of: (a) being a member of the administrative, management or supervisory bodies of the issuer or emission allowance market participant […]”. 18 As a practical demonstration of the well-established attention to MAR precautions in relation to inside information, it is worth referring to the structure of the main allowances trading platforms, where regulatory reporting services are often provided with reference to MiFID II/MiFIR, REMIT Transaction Reporting, EMIR Trade Reporting and, above all, inside information reporting. See, for instance, the section “Regulatory Reporting Services” of the German auction platform (EEX DE) website, available at the following link: https://www.eex.com/en/markets/reporting-of-inside-information.

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auctioned products based thereon, or of derivative financial instruments relating thereto and for bidding in the auctions pursuant to Regulation (EU) No 1031/2010”.19 Setting the threshold of materiality for emission allowances is a specific exercise that has no equivalent for other financial instruments falling within the scope of MAR. This peculiarity is, on the one side, the consequence of the lack of an “issuer” and, on the other side, the interrelationship with other sectoral legislation. According to recital 52: “Where emission allowance market participants already comply with equivalent inside information disclosure requirements, notably pursuant to Regulation (EU) No 1227/2011, the obligation to disclose inside information concerning emission allowances should not lead to the duplication of mandatory disclosures with substantially the same content. In the case of participants in the emission allowance market with aggregate emissions or rated thermal input at or below the threshold set, since the information about their physical operations is deemed to be non-material for the purposes of disclosure, it should also be deemed not to have a significant effect on the price of emission allowances, of auctioned products based thereon, or of the derivative financial instruments relating thereto. Such participants in the emission allowance market should nevertheless be covered by the prohibition of insider dealing in relation to any other information they have access to, and which is inside information”. All of the above is clearly reflected in the disclosure regime applicable to market participants of emission allowances. According to art. 17: “An emission allowance market participant shall publicly, effectively and in a timely manner disclose inside information concerning emission allowances which it holds in respect of its business, including aviation activities as specified in Annex I to Directive 2003/87/EC or installations within the meaning of Article 3(e) of that Directive which the participant concerned, or its parent undertaking or related undertaking, owns or controls or for the operational matters of which the participant, or its parent undertaking or related undertaking, is responsible, in whole or in part. With regard to installations, such disclosure shall include information relevant to the capacity and utilisation of installations, including planned or unplanned unavailability of such installations. The first subparagraph shall 19 It is, again, noteworthy that this passage “links” the primary auction market, to secondary markets, by setting out that price sensitivity needs to be assessed on both sides: again, an approach that is peculiar to that of emission allowances.

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not apply to a participant in the emission allowance market where the installations or aviation activities that it owns, controls or is responsible for, in the preceding year have had emissions not exceeding a minimum threshold of carbon dioxide equivalent and, where they carry out combustion activities, have had a rated thermal input not exceeding a minimum threshold”. Also, Paragraphs 1 to 5 of Article 17 apply to: a. emission allowance market participants in relation to inside information concerning emission allowances that arises in relation to the physical operations of that emission allowance market participant; b. any auction platform, auctioneer and auction monitor in relation to auctions of emission allowances or other auctioned products based thereon that are held pursuant to Regulation (EU) No 1031/2010. Useful hints in order to identify what effectively amounts to inside information for emissions allowances, particularly for the purpose of the disclosure regime under MAR, were provided, amongst EU Supervisors, by BaFin in Germany. In its comprehensive guide on Inside information (published on line), BaFin clarified that: “On the one hand, this may concern measures or events that impact the direct operation of an installation or the aviation activities of an emission allowance market participant. These include, for example, (unscheduled) downtime, the partial shutdown or final closure of installations, investment decisions relating to the construction of new installations, changes in the energy efficiency of large installations, for example due to a decision to modernise them to ensure the more efficient use of energy or a switch to a different fuel in an installation. It should be noted in this context that the events referred to above usually only constitute inside information if the event in question, taken in isolation, is also significant in terms of its potential to have a significant effect on prices. Examples of potential information relating to aviation activities that is subject to a notification obligation includes (partial) fleet downtime (route, aircraft), an increase in the fleet (route, aircraft) or a switch to different aircraft (e.g. new models that emit substantially less CO2 ). On the other hand, external factors such as fundamental decisions

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by the regulatory authorities, e.g. with regard to the general admissibility of fuels used, the free allocation quota or other structural reforms affecting the European emissions trading scheme (EU-ETS) may constitute inside information. An example might be the following: Trader A at a company learns that the free allocation quota for emission allowances will be cut. A knows that this has not been made public and understands that it will result in rising demand and hence also higher prices for emission allowances. A can leverage his insider knowledge to make a profit by buying emission allowances before the planned cut and selling them again at a later date once the information has been made public”. The same Guide clarifies that “The insertion in the first sentence of the first subparagraph of Article 17(2) clarifies that participants are only required to disclose inside information if they operate installations or aviation activities. Under certain circumstances, however, these may also include (legally independent) trading units if they belong to a company with activities within the meaning of the Emissions Trading Directive 2003/87/EC10 establishing a scheme for greenhouse gas emission allowance trading”. On the contrary: “Other market participants such as credit institutions or brokers are not subject to the requirements of Article 17(2) of the MAR”. As expected, differences between the regime applicable to emission allowances and other financial instruments tend to slim down when one considers the rules on market manipulation set down in MAR, especially transaction-based manipulation, or even the prohibitions against insider insider. In this respect, in fact, emission allowances turn back to being (mostly) financial instruments like all other, save for the fact that—in coherence with the approach taken by MAR, and as a consequence of the repeal of the corresponding provisions of the Auctions Regulation—market manipulation prohibitions apply to emission allowances and also to auctioned products based on the allowances. Art. 12 of MAR is therefore structured in such a way as to parify emission allowances to other categories of financial instruments falling in the scope of the Regulation, save for the expansion of its provisions to the auction markets for emission allowances, which are not necessarily trading venues, regulated under MiFID. Similar remarks apply to the indicators of manipulative behaviour set out in Annex I of the Regulation.

14

14.6

EMISSION ALLOWANCES AS FINANCIAL INSTRUMENTS

495

Emission Allowances in Remit Regulation

Due to the interplay between capital markets legislation, and sectorial EU legislation on emission allowances, similar concerns as those expressed in the context of MAR are to be found in the REMIT Regulation (Regulation n. 1227/2011 of October 25, 2011 on wholesale energy market integrity and transparency). There is clearly a link between wholesale markets on energy products and the MiFID-MAR regime, since abusive conducts on the first may impact on the secondary market of emission allowances. While recital 14 of REMIT provides examples of manipulative practices that are quite close to the ones that are captured by MAR, according to recital 13 of MAR: “Manipulation on wholesale energy markets involves actions undertaken by persons that artificially cause prices to be at a level not justified by market forces of supply and demand, including actual availability of production, storage or transportation capacity, and demand. Forms of market manipulation include placing and withdrawal of false orders; spreading of false or misleading information or rumours through the media, including the internet, or by any other means; deliberately providing false information to undertakings which provide price assessments or market reports with the effect of misleading market participants acting on the basis of those price assessments or market reports; and deliberately making it appear that the availability of electricity generation capacity or natural gas availability, or the availability of transmission capacity is other than the capacity which is actually technically available where such information affects or is likely to affect the price of wholesale energy products. Manipulation and its effects may occur across borders, between electricity and gas markets and across financial and commodity markets, including the emission allowances markets”. The REMIT Regulation, albeit not directly applicable to emissions trading, is clearly inspired, on this point, by principles similar to those that one finds in the typical field of securities markets regulation. As a matter of fact, contracts for emission allowances (as well as green certificates) are not wholesale energy products as they do not fulfil the requirements set out in Article 2(4) of REMIT.20 However, these contracts can have a significant price effect on wholesale energy markets. According to Article 10 20 According to such article, “wholesale energy products” includes the following contracts and derivatives, irrespective of where and how they are traded: (a) contracts

496

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of REMIT, therefore, emission allowances or derivatives relating to emission allowances—collected by trade repositories or competent authorities overseeing trading in emission allowances or derivatives thereof—must be provided to the Agency for the Cooperation of Energy Regulators (ACER) together with access to records of transactions in such allowances and derivatives. There are ultimately several interconnections between MAR and REMIT that were already developed in ESMA’s Discussion Paper on MiFID II/MiFIR of 22 May 2014 (ESMA/2014/548). In particular: i. MAR predominantly applies to financial instruments; however, it also expressly extends the scope of market manipulation and insider trading prohibitions to spot commodity contracts where any transaction or order in them or any behaviour in relation to them is likely to have an effect on the price or value of a financial instrument. ii. Market manipulation and insider trading prohibitions set out in MAR do not apply to “wholesale energy products” as defined in Article 2(4) of REMIT. REMIT, in its turn, establishes a framework applicable to wholesale energy products encompassing spot and derivative contracts in electricity and gas. Therefore, while the REMIT obligation to publish inside information applies to both spot and derivative contracts in electricity and gas, the prohibitions of insider trading and market manipulation do not apply to financial instruments where MAR prevails, and financial regulators are the competent authorities. In short, the interplay between REMIT and MAR-MiFID can be summarised by stating that wholesale energy products are exempted from the scope of MAR, except for the prohibitions of market manipulation and insider trading in electricity and gas derivatives where REMIT for the supply of electricity or natural gas where delivery is in the Union; (b) derivatives relating to electricity or natural gas produced, traded or delivered in the Union; (c) contracts relating to the transportation of electricity or natural gas in the Union; (d) derivatives relating to the transportation of electricity or natural gas in the Union. Contracts for the supply and distribution of electricity or natural gas for the use of final customers are not wholesale energy products. However, contracts for the supply and distribution of electricity or natural gas to final customers with a consumption capacity greater than the threshold set out in the second paragraph of point (5) shall be treated as wholesale energy products.

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declares MAR as applicable. It must be said, however, that the boundaries between these two areas of EU legislation are quite complex.

14.7 Exemptions Applicable to Emission Allowances Trading The choices made in the context of MiFID II in relation to the treatment of emission allowances naturally pose a tremendous issue of balancing the approach between financial markets legislation and control/regulation over the industrial sector. Ultimately, financial law is not intended to regulate industry directly. The consequences arising from MiFID II are therefore assisted by a number of exceptions. Looking at derivatives in emission allowances, MiFID II maintains an approach similar to MiFID I, by exempting from its provisions trading in derivatives that is closely linked to the main line of a (broadly speaking) non-financial business, and is not provided in the context of the carrying on of other investment services: these are, also, exceptions that would apply to any kind of commodities derivatives, regardless of their underlying, and that are not specific to emissions trading. Tailor-made exemptions, instead, do apply to emissions trading. The first is provided for by art. 1, par. 1, lett e) of MiFID II, and affects the trading of emission allowances that: (i) falls in the scope of the reporting requirements set out by the EU ETS Directive; and (ii) is carried out by dealing on own account, without providing services to clients: an activity, therefore, that is not directed, nor addressed to the market, but that exhausts its effects in the “internal” sphere of the relevant entity. It should be noted, however, that this exemption does not apply when algos or HFT techniques are employed. The second relevant case is the so-called ancillary exemption. According to art. 2, par. 1, lett. j) of MiFID II, the Directive shall not apply to “persons: (i) dealing on own account, including market makers, in commodity derivatives or emission allowances or derivatives thereof, excluding persons who deal on own account when executing client orders; or (ii) providing investment services, other than dealing on own account, in commodity derivatives or emission allowances or derivatives thereof to the customers or suppliers of their main business. However, the exemptions apply “provided that:—for each of those cases individually and on an aggregate basis this is an ancillary activity to their

498

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main business, when considered on a group basis, and that main business is not the provision of investment services within the meaning of this Directive or banking activities under Directive 2013/36/EU, or acting as a market-maker in relation to commodity derivatives;—those persons do not apply a high-frequency algorithmic trading technique; and—those persons notify annually the relevant competent authority that they make use of this exemption and upon request report to the competent authority the basis on which they consider that their activity under points (i) and (ii) is ancillary to their main business”. The ancillary exemption requires that an undertaking remains below the thresholds of two tests in order to be exempted from the scope of MiFID II. Under the first test (market share test), the quota threshold is set at 20%, which means that an entity is below the threshold if its speculative trading activity is less than 20% of the EU’s overall carbon market activity. Hedging transactions are not taken into account for this test when calculating a company’s speculative trading activity. The second test (core business test) measures a firm’s speculative trades on commodity derivatives as a percentage of its total trades in these commodities.21 The attempt to balance MiFID II’s far-reaching approach is also considered in the form of providing to Member States the possibility to adopt optional, additional exemptions. Under art. 3, par. 1 “Member

21 It has to be noted that the previous MiFID I regime included in the so-called ancillary exceptions also investment firms dealing on own account in derivatives. Art. 2, par. 1, of MiFID I, in particular, established that: “This Directive shall not apply to: […] (i) persons dealing on own account in financial instruments, or providing investment services in commodity derivatives or derivative contracts included in Annex I, Section C 10 to the clients of their main business, provided this is an ancillary activity to their main business, when considered on a group basis, and that main business is not the provision of investment services within the meaning of this Directive or banking services under Directive 2000/12/EC; […] (k) persons whose main business consists of dealing on own account in commodities and/or commodity derivatives. This exception shall not apply where the persons that deal on own account in commodities and/or commodity derivatives are part of a group the main business of which is the provision of other investment services within the meaning of this Directive or banking services under Directive 2000/12/EC; (l) firms which provide investment services and/or perform investment activities consisting exclusively in dealing on own account on markets in financial futures or options or other derivatives and on cash markets for the sole purpose of hedging positions on derivatives markets or which deal for the accounts of other members of those markets or make prices for them and which are guaranteed by clearing members of the same markets, where responsibility for ensuring the performance of contracts entered into by such firms is assumed by clearing members of the same markets”.

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States may choose not to apply this Directive to any persons for which they are the home Member State, provided that the activities of those persons are authorised and regulated at national level and those persons: provide investment services exclusively in emission allowances and/or derivatives thereof for the sole purpose of hedging the commercial risks of their clients, where those clients are exclusively operators as defined in point (f) of Article 3 of Directive 2003/87/EC, and provided that those clients jointly hold 100% of the capital or voting rights of those persons, exercise joint control and are exempt under point (j) of Article 2(1) of this Directive if they carry out those investment services themselves”. When trading emission allowances falls within the scope of MiFID II, the main consequences are those that typically derive from the application of investment services and activities regulations. The relevant entity would need to be licensed by a Competent Authority within the Union; fit and proper requirements apply to the management body and qualifying shareholders; prudential rules stemming from CRD IV would apply (and, among the latter, the quite sensitive topic of rules on remuneration). In most cases, this would result in a major industry player setting up an investment firm within the perimeter of its group. If MiFID II is applicable, the only other option available is that trading on emission allowances is carried out through a third-party bank or investment firm. In both cases, costs associated with trading in emission allowances are due to increase, either because these costs would directly be applicable to the regulated/supervised entity, or because services provided by third-party licensed firms would need to be remunerated.

14.8

Conclusions

The consequences arising from the approach taken by MiFID II could be far-reaching, notwithstanding the fact that only time will tell how significant they will be. A first, preliminary and probably obvious remark is self-explanatory: trading in emission allowances now becomes an activity basically regulated by capital markets legislation, unless it falls into one of the various exceptions. This is not the first time, and it will not be the last, that new businesses, activities or services are included in that perimeter, even though the case of emission allowances seems to be, in many ways, a striking example of how far the perimeter may stretch. The approach taken in MiFID II, however, is clearly designed in such a way as to

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provide more transparency and efficiency to secondary markets on emission allowances; however, there is no reference, in the context of MIFID II, as to the impact that this may ultimately have on the protection of the environment and on the ultimate goal of the entire system of emissions trading legislation, i.e. reducing the overall amount of CO2 emissions. The approach taken in the context of MiFID II and MAR is, so-to-say, entirely within the perimeter of capital markets regulations. We believe, however, that the issue should be raised. Transaction costs in emission allowances trading are definitely increasing as a consequence of MiFID II, and it is unclear how these will be offset by the positive impacts of the new rules not simply within the scope of capital markets, but more widely on the environment. In the context of CO2 emissions, capital markets legislation should not be considered as pursuing autonomous objectives: it should instead facilitate the ultimate goal of reducing emissions and improve the quality of the environment. Sturdy statistical and analytical data will be needed in order to provide, in the next years, further clarification on this issue. Considering the difficulties that are usually encountered when measuring the concrete impact of emission allowances trading systems, it is likely that these data will not be available, and conclusive for a long period of time. It will also not be easy to separate the effect of MiFID II from the more general measurements and evidences. There are, however, some pinpoints that can be set out and that should be considered. Looking at the positive effects that, on environmental protection, may derive from the inclusion of emission allowances in the scope of capital markets legislation, these are basically linked to the fact that—as a consequence of the approach stemming from MiFID I—secondary markets should effectively become more transparent, efficient and secure. The increased transparency and efficiency of the market should lead more investors to consider emission allowances as a potential target for their asset allocation, thus increasing the depth of the market, and the significance of the prices of CO2 allowances. Institutional investors—such as investment funds, pension funds, insurance undertakings—would also be in a position to consider emission allowances as suitable asset classes for their portfolio. The market for emission allowances will look more like a typical financial market, where different trading strategies would apply. This phenomenon will also be linked to the development of ESG engagement policies that professional investors have to comply with as a consequence of the new regime introduced, in the Union, by the Second

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Shareholders’ rights directive. As the protection of the environment is one of the topics that is typically considered in the context of the engagement policies of institutional investors, there is a clear link between the two sides of the matter. Enforcing ESG policies will now be a matter of Law and not simply of self-regulation: in this way, capital markets and financial regulation might effectively provide a contribution to the protection of the environment. The reduced risk of market abuse practices in secondary markets for emission allowances should also increase transparency, and the efficiency of the price-discovery mechanism for emission allowances and relative derivatives. Since, as anticipated, all these are benefits that are also generally associated with traditional emissions trading programme, if MiFID II reaches its objectives it should reverberate positively on the reduction of CO2 emissions, at least in the Union. Setting lower emissions caps overtime might become easier for legislators as the relative targets would be more easily attainable thanks to the increased efficiency of secondary market and trading activities on allowances. Even the most recent EU legislation is insisting on transparency in order to strengthen the transition to a low-CO2 , more sustainable, resource-efficient and circular economy. For instance, Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019, sets out rules on sustainability-related disclosures in the financial services sector (the “SFRD Regulation”). More precisely, the subject matter of such measure, as stated in its art. 1, is to “lay down harmonised rules for financial market participants and financial advisers on transparency with regard to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability-related information with respect of financial products”. The assumption of the regulation lies in the fact that, even if several current EU measures share the common objective of facilitating the uptake and pursuit of the activities of financial markets’ operators— and this by ensuring a more uniform protection of investors22 —the

22 Reference should be made to Directives 2009/65/EC (4), 2009/138/EC (5), 2011/61/EU (6), 2013/36/EU (7), 2014/65/EU (8), (EU) 2016/97 (9), (EU) 2016/2341 (10) of the European Parliament and of the Council, and Regulations (EU) No 345/2013 (11), (EU) No 346/2013 (12), (EU) 2015/760 (13) and (EU) 2019/1238 (14) of the European Parliament and of the Council.

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disclosure obligations “are insufficiently developed because such disclosures are not yet subject to harmonised requirements23 ”. Thus, the Regulation sets up a full disclosure mechanism imposing: transparency requirements for financial market participants, who are required to publish information on their websites on sustainability risk policies (see Art. 3); handling of adverse effects on sustainability at the level of the financial entity or financial product (see Art. 4 and 7 respectively); remuneration policies in relation to the integration of sustainability risks (Art. 5). The Regulation, therefore, ultimately uplifts the objectives of reducing CO2 emissions as a qualifying feature of financial products. To encourage the financial system to participate in the transition to climate neutrality in 2050, the European Regulation (EU) 2020/852, known as the “Taxonomy Regulation”, establishes a common classification for all Member States, in order to help investors identify environmentally sustainable economic activities, to promote cross-border investments and prevent market fragmentation. The Taxonomy Regulation, which will apply from 1 January 2022 in several phases, aims to protect the market against the risks of greenwashing by prohibiting the marketing of falsely ecological financial products. Against this comprehensive background, there are, however, some potential drawbacks to be considered. Trading professionally in emission allowances becomes more expensive after MiFID II, and transaction costs might impact negatively on the liquidity of the market. The application of CRD IV (now, CRD V) prudential requirements might also require the absorption of important level of capitals that would be distracted from direct investments in the industry: the effect that this might have on the system is, at the moment, totally unclear. The landscape introduced by MiFID II is also quite complex: there are at least two, if not three different sets of comprehensive legislation that may potentially be relevant for trading emission allowances, either on the spot, or on the derivatives market: the “old” EU ETS; MiFID II-MAR; more tangentially, REMIT. Opting in and out of each of these systems, through a complicated system of exemptions and exclusions, does not benefit the overall coherence of the regulatory approach. As always, when rules are too complicated, there is a risk of negative externalities, and of reducing the positive outcomes that might be expected from legislation. Keeping

23 See recital (5) of the Regulation 2019/2088.

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an eye to proportionality and to striking a proper balance between finance and industry may, ultimately, prove useful, as long as regulation remains flexible and clear enough.

Index

A AIFMD, 41, 49 Artificial Intelligence (AI), 62, 67, 70–72, 79 Assets Under Management (AUM), 163, 166 Audit function, 316 Autorité des Marchés Financiers (AMF), 437 Autoriteit Financiële Markten (AFM), 437

B Bank for International Settlement (BIS), 231, 303 Basel Committee on Banking Supervision (BCBS), 302 Basel framework for prudential supervision, 310 Basel III, 283 Benchmarks, 424 Better Regulation Agenda, 384

Big data, 62, 67, 71, 72, 81 Biodiversity, 362, 369, 370, 376 Blockchain sphere, 63 Blockchain technology, 62 Brown penalizing factor (BPF), 239 Business conduct, 115, 148, 150 Business Roundtable declaration, 64

C Capital Asset Pricing Model (CAPM), 262 Capital markets, 5, 8, 16 Capital Markets Union (CMU), 14, 352, 353, 390 Capital Requirement Directive (CRD), 16, 45, 46, 242, 243, 296, 305, 310, 325 Capital Requirement Regulation (CRR), 44, 46, 240, 241, 243, 305, 322, 394, 395 Capital requirements, 239, 244, 288, 289, 324

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 D. Busch et al. (eds.), Sustainable Finance in Europe, EBI Studies in Banking and Capital Markets Law, https://doi.org/10.1007/978-3-030-71834-3

505

506

INDEX

Carbon emissions, 424 Circular economy, 361, 367, 370, 376 Climate benchmarks, 330, 344–346 Climate change, 5, 12, 227–232, 234, 235, 243, 247, 250–252, 255, 256 Climate-related Financial Risks (CRFR), 228 Collective Commitment to Climate Action (CCAA), 25 Commission’s Action Plan, 28, 57 Compensation and sustainability, 198, 215 Comply or explain, 410, 414, 416, 418, 433 Comply-or-explain basis, 11, 169 Conflicts of interests, 452, 458, 469–471, 473, 474 Core Principles for Effective Banking Supervision, 304 Corona Recovery Fund, 6, 7 Corporate governance, 4, 8, 10–12, 21, 22, 56–58, 61, 86, 87, 89, 91, 95, 98, 100, 102, 110, 113, 114, 119, 122–124, 134, 137, 139, 143, 144, 146–149, 152, 155–160, 162, 164–170, 172–174, 337, 338, 350 Corporate Governance Action Plan, 180, 181 Corporate governance codes, 11, 12, 177–179, 188–191, 202, 207, 210, 211, 213–216, 218, 219, 221–223 Corporate philanthropy, 156–158 Corporate purpose, 10, 11, 85–89, 91–94, 96, 100, 106–114, 116–118, 120–125, 133, 134, 137–139, 142, 144–146, 148, 149

Corporate Social Responsibility (CSR), 10, 67, 87, 89, 90, 96–98, 107, 112, 141, 155, 190, 191, 202, 204, 205, 214, 218, 223 Corptech, 62 Cost-benefit analysis, 298 Cost-cutting, 63 Countercyclical capital buffers (CCyB), 243 COVID-19, 4, 5, 61, 434 CRA Regulation, 438 Credit rating agencies, 39, 40, 58, 283 Cross-sectional dimension, 237, 245, 249 Cross-sectoral playing field, 471 Crowdfunding platforms, 63, 72 Crypto-economy, 61, 62 Crypto-revolution, 63 CSR committee, 190, 198, 213, 214 CSR principles, 201, 223 D Delegated philanthropy, 156, 159, 160, 164 Digital finance, 61–64, 66–71, 73, 74, 76, 77, 79–81 Digital tokens, 67 Disclosure, 8, 14, 15, 21, 23, 26, 32, 33, 38, 40, 42, 46, 52, 54, 55, 57, 58, 286, 290, 292, 293, 311, 321–323 Disclosure rules, 398–400, 411, 415, 421, 425, 427, 430, 432, 433, 435–437, 440–442 Doing well by doing good, 156, 164 E Economic value, 87, 102, 104, 105, 132, 139 Ecosystems, 362, 369, 370

INDEX

Emission allowances, 16, 17, 477–497, 499–502 Employees, 178, 185, 189, 191, 200, 203–207, 209–213, 220, 223 Enlightened shareholder value (ESV), 10, 88, 102, 106, 114, 115, 119, 120, 125, 127, 128, 134–137, 139, 140, 149, 150 Environmental and social responsibility, 177, 189 Environmentally sustainable practices, 63 Environmental-related risks, 276 Environmental responsibility, 217 Environmental Risk Assessments (ERA), 291 Environmental sustainability, 62, 66, 67, 69, 73, 76, 78–81 Epistemic Aspects, 290 ESG, 9, 13, 14, 65, 67, 70, 78, 79 ESG data, 437 ESG goals, 162, 165, 170 ESG issues, 58 ESG market infrastructure, 336 ESG ratings, 438 ESG risks, 45, 46 Ethics, 196, 197, 202, 213, 218–221, 223 EU Action Plan for Financing Sustainable Growth, 294 EU climate benchmarks, 184 EU Disclosure Regulation, 171 EU Emissions Trading System, 16 EU Paris-aligned Benchmarks, 14 EU programme for Support to mitigate Unemployment Risks in an Emergency, 5 European Fund for Strategic Investments (EFSI), 34 European Green Deal, 19–21, 54, 57, 64, 65, 178, 181, 183, 437, 442

507

European Green Deal Investment Plan (EGDIP), 35 European Pillar of Social Rights, 371, 388 European single access point, 437 European System of Central Banks (ESCB), 306 EU’s High-Level Expert Group on Sustainable Finance, 239 EU Sustainable Development Strategy, 178, 181 EU taxonomy, 29, 44, 45, 58, 184, 294, 312 EU taxonomy of sustainable activities, 8 Exposure at default (EAD), 318 Exposure method, 295

F Financial Centres for Sustainability (FC4S), 68 Financial Inclusion Global Initiative, 69 Financial instability, 261, 262, 274 Financial regulation, 57 Financial risks, 228, 229, 232 Financial stability, 12, 13, 231, 232, 234, 235, 246, 251, 256, 260, 261, 263, 264, 266, 269–274 Fintech, 62, 63, 69–71, 75, 77, 78, 80

G G20, 68, 71, 74 Gender diversity, 190, 191, 198, 212, 222 Global Innovative Retail Payments Program, 69 Green Bond Principles (GBP), 332, 334

508

INDEX

Green bonds, 330, 331, 333, 334, 339, 344 Green finance, 61, 65, 68, 69, 71 Green financial products, 8 Greenhouse Gases (GHGs), 155, 279 Green macroprudential policy, 12 Green supporting factor (GSF), 239, 288, 289 Green swan, 231, 236 Greenwashing, 330

International Finance Corporation’s (IFC), 69 International Financial Reporting Standard (IFRS), 8, 27, 52, 54, 55, 58, 293 Investment product distributor, 447–449 Investment Services Directive, 482 Investor protection rules, 473 IORP II, 41

H High-Level Expert Group (HLEG), 185 High-level Expert Group on Sustainable Finance, 266, 268 Human rights and social matters, 183

K Key performance indicators (KPIs), 313

I IDD Framework, 449–451, 456, 463, 467, 472–474 ILAAP, 311, 318 Incentives of institutional investors, 160, 162, 174 Inside information, 482, 487, 488, 490–493, 496 Institutional investors, 152, 153, 159–166, 168–174 Insurance Distribution Directive (IDD), 9, 15, 36, 37, 41, 49, 58, 447, 449, 451, 452, 455–458, 462, 465–467, 469, 471–474 Intergovernmental Panel on Climate Change (IPCC), 279 Internal Capital Adequacy Assessment Process (ICAAP), 284, 311, 318, 321, 324 International Capital Markets Association (ICMA), 332–334, 350

L ‘Level 2’ regulation, 404, 411, 415, 421, 425, 427, 430 Liability law, 440 Liability risks, 261 Liquidity Coverage Ratio (LCR), 243 Liquidity requirements, 238, 243 Long-term development, 177 Long-term horizon, 301 Long-term investment horizon, 65 Long-term sustainable approach, 178 Long-term value, 90, 91, 103, 110, 123, 135, 139, 141, 150 Loss given default (LGD), 295, 318 Low Carbon Benchmarks Regulation, 352, 390 Low-carbon economy, 12, 228, 229, 245, 246, 256, 257, 262, 274, 301 Luxembourg Green Exchange, 6

M Macroprudential policy, 228, 232, 234–238, 245, 248–250, 255, 256

INDEX

Mandate of prudential supervisors, 299, 308, 325 Market Abuse Regulation (MAR), 16 Marketing communications, 400, 431 Market manipulation, 480–482, 487, 494–496 Markets in Financial Instruments Directive (MiFID), 449–452, 457–459, 462, 463, 465–469, 471–474 MiFID I, 480–485, 497, 500 MiFID II, 9, 15–17, 36, 37, 41, 49, 50, 58, 447, 449, 450, 455–458, 462, 483–487, 496–502 Minimum safeguards, 371, 385, 407, 408

509

N Net Stable Funding Ratio (NSFR), 243 Network for Greening the Financial System (NGFS), 246, 309 Next Generation EU Plan, 6 Non-financial disclosure, 182, 183, 190, 196, 197, 202, 209 Non-Financial Disclosure Directive, 8, 58 Non-financial reporting, 340 Non-Financial Reporting Directive (NFRD), 182–184, 217, 219, 266, 267, 359, 383, 391 Non-financial statements, 183

P Packaged Retail Investment and Insurance Products (PRIIPs), 31, 32 Paris Agreement, 12, 178, 181, 184 Paris Climate Agreement, 228, 238, 443 Peer-to-peer lending, 63, 67 Periodic reports, 400, 418, 426–428, 430 Perspective of shareholders, 152 Physical risks, 229, 230, 243, 261 Pofit maximisation, 10 Pollution prevention and control, 361, 368, 370, 376 Portfolio alignment, 294, 295, 312 Precautionary action approach, 249 Pre-contractual sustainability disclosures, 416, 433 Probability of default (PD), 295, 318 Product governance, 452, 460, 462–464, 467, 468, 472, 474 Profit maximization, 86, 113, 116 Prosocial shareholders, 155 Pro-stakeholders actions, 11 Prudential framework, 13, 278, 284, 285, 289 Prudential supervision, 276–278, 283, 287, 306, 325 Prudential supervisors, 13 Public incentives, 57 Pursuit of profit, 86, 108, 120, 122, 128, 138, 141, 144, 145

O OECD Code, 179, 190, 198, 199, 201, 206, 207, 209, 210, 212, 213, 215, 217, 219, 220, 222, 223 OECD Guidelines for Multinational Enterprises, 388

R Regulation on wholesale Energy Market Integrity and Transparency (REMIT), 17 Regulatory approach, 489, 502 Regulatory framework, 62, 69, 80

510

INDEX

Regulatory framework for prudential supervision, 305 Regulatory technology (Regtech), 71 Review clause, 388, 392 Revised Shareholder Right Directive, 169 Risk appetite frameworks (RAFs), 314 Risk framework method, 295 Risk management, 284, 299, 310, 311, 316, 317, 320, 324 S Scarcity of data, 290 Second EU Capital Requirement Regulation, 270 Sectoral legislation, 488–490, 492 Sectoral leverage ratio (SLR), 239, 244 Self-regulatory tools, 177 Shareholder primacy, 87, 108, 115, 117–119, 125, 143 Shareholder Rights Directive, 11 Short-term bias, 300 Short-term financial performance, 177 Single Supervisory Mechanism (SSM), 305 Six environmental objectives, 360 Social and green funding, 5 Social Bond Principles (SBP), 332, 334 Social responsibility, 214 Social value, 10, 11, 86, 87, 96, 102, 107, 108, 120, 127–129, 134, 138, 139, 142, 149 Soft law, 176, 177, 180, 187 Solvency II, 37, 41, 44, 49, 50 SRD II, 169, 170 Stakeholder capitalism, 89, 142 Stakeholderism, 64, 134–136 Stakeholders, 178, 185–187, 189, 191, 195, 196, 198–210, 214, 217, 218, 221–223

Standardization, 52, 57 Suitability assessment, 452, 454, 455, 457, 459–461, 473, 474 Supervisory review and evaluation process (SREP), 310, 311, 323, 324 Sustainability benchmarks, 8, 21, 37, 58 Sustainability Bond Guidelines (SBG), 332, 334 Sustainability considerations, 178 Sustainability disclosure, 399, 400, 408, 416, 425, 427, 431, 433 Sustainability-linked, 335 Sustainability-linked Bond Principles (SLBP), 333, 334 Sustainability-linked loans, 13 Sustainability-related service providers (SSPs), 437, 438 Sustainability reporting, 217–219, 223 Sustainability strategies, 58 Sustainable corporate governance, 152, 153, 155, 158, 160, 162, 164, 165, 169, 173, 174, 177, 181, 186–188, 224 Sustainable Development Goals (SDGs), 20, 24, 65, 356, 357, 445 Sustainable digital finance, 9, 10 Sustainable Digital Finance Alliance, 66 Sustainable economy, 61, 65 Sustainable finance, 4, 10–15, 152, 153, 155, 160, 169, 173, 174, 329, 330, 332, 333, 336, 337, 349, 350 Sustainable finance action plan, 3, 8, 13–15, 23, 442 Sustainable Finance Disclosure Regulation (SFDR), 13, 15, 29, 32, 41, 330, 337, 342, 343, 352, 357, 369, 371, 374, 378–382,

INDEX

387, 388, 390–392, 398–400, 405, 406, 408, 413, 416, 417, 425, 427, 431–436, 438–442 Sustainable infrastructure, 33–35, 57 Systemically relevant financial institutions (SIFIs), 245 Systemic risk, 4, 12, 232, 234–238, 241, 245, 248, 249 T Task Force on Climate-Related Disclosures, 26 Task Force on Climate-related Financial Disclosures (TFCD), 262, 292, 321 Task Force on Digital Financing, 65 Taxonomy, 451, 459, 463, 468, 474 Taxonomy Regulation (TR), 13, 14, 28, 29, 169, 171–173, 330, 341, 352, 390, 405–408, 423, 429, 436 Technical screening criteria (TSC), 363, 372, 391

511

Technological ecosystem, 66, 67 Transition risks, 229, 230, 241, 243, 261, 264, 270 Treaty on the Functioning of the European Union (TFEU), 297, 306, 307

U UCITS, 31, 41, 49 UK Corporate Governance Code, 179, 198 UN 2030 Agenda, 12, 20, 178, 228 United Nations Environment Programme (UNEP), 67 UN Task Force on Digital Financing, 66, 73

W World Bank, 68 World Bank Blockchain Lab, 68