Investment funds and the financing of a sustainable economy: a regulatory perspective - Gerry Cross, Director of Financial Regulation - Policy and Risk

Introduction

Good afternoon. It is a pleasure to be here this afternoon to participate in this session on Sustainability and the Funds Industry - the Challenge and Opportunity Ahead, part of Climate Finance Week.

The interplay of financial regulation, the financing of a sustainable economy (or “sustainable finance”), and climate risk is an important topic. It is a topic that is high on the agenda of the Central Bank of Ireland. And one where the funds and asset management sector is to the fore as the agenda moves rapidly forward.

I want to use the opportunity of these short remarks to take stock of the developments that are rapidly underway in this area. I also want to stand back a little from some of the many details and to ask how we should interpret these developments. For all of us – whether we are market participants, financial regulators, or users of financial services - it is important to understand as well as we can the significant changes that are taking place in how the funds sector is being required to contribute to the achievement of a sustainable economy. This is particularly important for us here in Ireland which is home to such a material section of the European and global funds industry.

Let me mention that my colleague Vas Madouros, who is the Director responsible for financial stability at the Central Bank, is also speaking on this broad topic today as part of Climate Finance Week. His remarks will be of interest to those of you wishing to gain further insight into the Central Bank’s approach to this topic. Many of you will also have read, and if not I recommend it to you, the economic letter published by former Governor Philip Lane in February this year.

Reading the changes

A good deal of new legislation on the issue of financial regulation, sustainability, and climate risk has been making its way through the European legislative process over the very recent period. In order to properly give effect to this legislation, either as supervisors or practitioners, it is important that we understand well its underpinning principles, its key objectives, and its critical moving parts. Let me explain how these might be best understood from a financial regulatory perspective.

Firstly, of course there are the risks to the ongoing soundness and stability of financial firms arising from either direct climate risks – physical risks: for example flooding, storm events, etc; or from transition risks: changes in legislation or popular sentiment giving rise to “stranded assets” or a sudden decline in the outlook for a given technology or activity to which financial firms are significantly financially exposed. Depending upon the type of event and underlying correlations, such developments could give rise to either individual firm vulnerabilities or to a wider financial stability event.

Secondly, there is the conduct perspective. That is the financial regulatory concern to ensure that financial markets function transparently and well, with investors and consumers being fairly treated. One important aspect here is to ensure that where investments or financial products are described as green or sustainable, this is based on reliable parameters that are consistently applied both within jurisdictions and across Europe. Without this, not only are investors liable to not be getting what they reasonably believe they are getting, but beyond this, confidence in the implementation of the sustainability agenda runs a significant risk of being undermined.

This brings me to the third way in which financial regulation is evolving to take account of climate change and sustainability factors. Put shortly, financial regulation is evolving, and central banks and regulators need to adapt to these changes. In the Strategic Plan of the Central Bank of Ireland we make clear that the objective of financial regulation includes “ensuring that the financial system operates in the best interests of consumers and the wider economy“. This recognises the contributive or derivative nature of financial regulation. It makes clear that financial regulation is not an end in itself but is there in service of wider goals. And these goals are ultimately matters for democratic determination, for decision at the political level. What is clear from developments of the recent period is that the legislative authorities are increasingly and strongly determining that one of the important objectives to be achieved is a sustainable economy. The focus of economic policy is increasingly focused on producing not just an effective economy but a sustainable and effective economy. That represents a far reaching development both for financial regulators and for participants in financial markets and services.

And this leads to the fourth aspect that I would like to bring out. This is that we are in a dynamic phase where the goals of legislators can be interpreted as being not just to introduce changes that will ensure that financial services contribute more to the achievement of a sustainable economy but also to introduce changes that will in themselves give rise to further changes creating even more momentum towards this goal. I think that this is an important aspect in the understanding of what is sought to be achieved. For it answers some of the questions as to why financial firms are required to do things which go beyond what their clients and investors currently are demanding. It is because legislators consider that once provided with this information and disclosure, investors will increasingly demand better performance of firms in this regard. In this way legislators are asking financial regulators and financial firms to create the conditions for an ever deeper achievement of economic sustainability.

From our point of view at the Central Bank of Ireland, we approach these developments in the light of our statutory mandates of safeguarding monetary and financial stability, securing the proper and effective regulation of financial service providers and markets, and ensuring that the best interests of consumers of financial services are protected. It is important to note that we approach climate risk and sustainable finance in a manner that is consistent with this mandate and not in any way that would go against it.

Let me turn to now to some of the specifics of the developing sustainable finance regulatory landscape. The EU sustainable finance action plan was published in March 2018 and the four most urgent actions were taken forward as legislative proposal and amendments to existing financial regulation.

Taxonomy for sustainable activities

Firstly there is the proposal to create an EU taxonomy, or classification system, in relation to what can be considered an environmentally sustainable economic activity for investment purposes. The taxonomy will identify economic activities that substantially contribute to one or more environmental objectives. This will include activities that have a positive impact on the environment (such as renewable energy production). And it will include economic activities that may continue to have a negative impact on the environment, but where these economic activities have substantially reduced that negative impact. This will enable polluting sectors to move onto greener pathways. Final negotiations between the European Parliament and the Council (so called “Trilogues”) on this proposal started on 23 October. Agreement is expected before the end of the year.

The rationale behind the taxonomy is clear, a standardised and trusted taxonomy will benefit both the industry and investors. Firms presently identify sustainable economic activities and sustainable investable assets in-house and on a voluntary basis. This is time consuming and costly, and the result is that different financial institutions use different taxonomies. Consequently, investors often find it too burdensome to check and compare different information for different financial products. This creates uncertainty and discouragement for investors and hampers the transition towards a sustainable economy. It also gives raise to the potential for issues like ‘green washing’. This type of practice goes against the interest of users of financial services, undermines the reputation of genuine sustainable investment products and slows down the progress towards sustainable finance goals. This is a key source of concern from an investor protection standpoint. Investors must receive accurate information in order to make informed choices and this has always been a key mission for the Central Bank. As a result, we support measures that will enhance certainty and increase investor confidence in the financial system.

An initiative that will further assist in this work and one which is linked to the taxonomy is the expansion of the Ecolabel concept to financial products. Already we have EU Ecolabels on many household goods, which identify the energy efficiency performance of the product. It is proposed that with an effective taxonomy in place, Ecolabels could be assigned to determine the greenness of financial products. The Technical Report of the European Commission regarding the EU Ecolabel criteria has found that investment funds are particularly suited to this type of assessment. In order to create awareness, increase investment, and enhance investor trust, the EU Ecolabel logo would be clearly identifiable on any prospectus or promotional material. Work is continuing on this.

Low carbon benchmarks

EU legislators have recently agreed the creation of two new categories of voluntary benchmark designed to help orient the choice of investors who wish to adopt a climate-positive investment strategy. The climate-transition benchmark will offer a low-carbon alternative to the commonly used benchmarks. And, a “Paris-aligned” benchmark will only comprise companies that can demonstrate that they are aligned with a 1.5˚ Paris target. Benchmark administrators – those responsible for publishing and maintaining reference benchmarks – will be required to comply with the rules governing these benchmarks if they want to label the benchmarks they issue as sustainable. Administrators of significant benchmarks – those benchmarks that are above certain thresholds in terms of usage – will be required to disclose the degree of “Paris alignment” of those benchmarks. They are also required to “endeavour” to provide at least one EU Climate Transition benchmark by 2022. These amendments to the Benchmarks Regulation will provide strong support to investors wishing to invest in companies on the basis of sustainability. They will also assist industry in creating new investment products, determining asset allocation strategies and measuring performance.

Disclosure (and behavioural) requirements

The last part of the Action plan is the Sustainability Disclosure Regulation. In many ways, this is where the rubber will hit the road for both industry and regulators. The requirements are far reaching.

The Regulation introduces significant obligations on what financial market participants (FMPs) must disclose about how they integrate ESG factors in their activities so that investors who use the services of those firms are well informed of the environmental and social impact of their decisions. And of course, the line between disclosing something and the need to do or not do something is not always a sharp one.

Which firms are included?

But firstly it is important to understand who the regulation will apply to. Effectively it will apply to financial firms whose role in the market includes making investment decisions on behalf of others. And this of course is precisely what the funds industry does, which puts it squarely at the centre of these new requirements. “Financial market participant” is defined as including UCITS management companies, and alternative investment fund managers (AIFMs), as well as others such as insurance companies that provide investment products; firms that provide portfolio management; and pension product manufacturers / providers amongst others. The regulation also imposes important requirements on financial advisors.

Adverse impacts on sustainability

Financial market participants will be required to disclose on their website their policies with respect to the due diligence to be carried out in relation to the principal adverse impacts of investment decisions on sustainability factors. If they do not consider adverse effects of investment decisions on sustainability they will be requid to publish clear reasons why they do not do so. For firms or groups with more than 500 employees, these will be required to publish such policies without the possibility to explain why they do not.

Financial advisers will be required to disclose whether they consider sustainability factor impact in relation to the products they advise on, and if not why not.

These requirements are subject to the rider that due account should be taken of the size, nature and scale of the activity and the type of produce made available / advised on by the FMP or financial adviser. So there is an important proportionality component.

Sustainability risks

Firms will be required to disclose in precontractual documents how sustainability risks are integrated into their investment decisions and the impact of those risks on the returns of the financial product in question. Where sustainability risks are considered not relevant, this must be clearly and concisely explained. Firms remuneration policies must include information as to how they are consistent with integration of sustainability risks. And those policies must also be published on their website.

Sustainability products

Where a product is sold as promoting environmental or social characteristics the firm will be required to disclose information as to how those characteristics are met and how any benchmark referenced is consistent with those characteristics.

While it is not yet fully clear what the final text of the Taxonomy Regulation will be, it seems clear that firms which offer a fund targeting sustainability objectives will be required to disclose using the Taxonomy what these objectives are and the methodologies used to assess, measure and monitor progress against these objectives, as well as an assessment of the overall sustainability-related impact of the financial product.

For this to work data about company or issuer performance against the Taxonomy activity criteria would be required. In this context, the necessary data might include:

• Revenue breakdown by Taxonomy-eligible activities, or expenditure allocation to each Taxonomy-eligible activity.
• Performance against the technical screening criteria, or environmental management data where this is an acceptable proxy for compliance with the technical screening criteria.
• Management data on social issues such as Labour rights policies, management systems, audits, reporting.

In an ideal world this data would be easily available but this is not yet the case. At present, less than 20% of companies devote attention to the standards on climate reporting developed by the Taskforce on Climate-related Financial disclosure, the TCFD, that was set up by the Financial Stability Board. So in an effort to improve corporate disclosure the European Commission has issued non-binding guidelines under the Non Financial Reporting Directive, these guidelines target an estimated 6,000 large listed companies with a view to enhancing their delivery of high quality climate-related reporting.

UCITS and AIFMD proposals

In response to a request from the Commission, ESMA has recently produced advice to integrate sustainability risks within UCITS and AIFMD funds regulatory frameworks. The advice recommended a high-level principles-based approach, requiring fund management companies to take into account and integrate sustainability risks when complying with their existing organisational requirements and resource and staff function management. Both UCITS management companies and AIFMs will have to take into account sustainability risks and, where applicable, the principal adverse impact of investment decisions on sustainability factors, when carrying out their due diligence requirements. They would be required to develop engagement strategies for the exercise of voting rights and reducing principal adverse impact of investee companies on sustainability factors. These suggested amendments to the UCITS and AIFMD frameworks are currently under consideration by the European Commission.

Conclusion

As I said at the start of my comments, this is an area of financial regulation that is developing rapidly. It is important for all of us - regulators and financial market participants - to be well sighted on the changes. Not only on the relevant details - though these are of course very important - but also on the underlying direction of travel. What we are seeing is a material evolution in financial regulation. One which is consistent with a change in how a well functioning economy is perceived and understood, with environmental sustainability one of its determining features. In applying the new regulatory requirements deriving from this it will be important that we understand not just the technical requirements but the underpinning objectives and spirit.

Thank you for your attention.

My thanks to Philip Brennan, James O'Sullivan and Johanna Zelenak.