Sustainable finance
Sustainable finance is the set of practices, standards, norms, regulations and products that pursue financial returns alongside environmental and/or social objectives. It is sometimes used interchangeably with Environmental, Social & Governance investing. However, many distinguish between ESG integration for better risk-adjusted returns and a broader field of sustainable finance that also includes impact investing, social finance and ethical investing.
A key idea is that sustainable finance allows the financial system to connect with the economy and its populations by financing its agents in seeking a growth objective. The long-standing concept was promoted with the adoption of the Paris Climate Agreement, which stipulates that parties must make "finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development." In addition, sustainable finance has a key role to play in the European Green Deal and in other EU International agreements, and its popularity continues to grow in financial markets.
In 2015, the United Nations adopted the 2030 Agenda to steer the transition towards a sustainable and inclusive economy. This commitment involves 193 member states and comprises 17 goals and 169 targets. The SDGs aim to tackle current global challenges, including protecting the planet. Sustainable finance has become a key cornerstone for the achievement of these goals.
Various government programs and incentives support green and sustainable initiatives. For instance, the U.S. Environmental Protection Agency provides grants and low-interest loans through its Clean Water State Revolving Fund for projects that improve water quality or address water infrastructure needs. The Small Business Administration also offers loans and grants for green businesses. Research and utilize these programs to secure necessary financing.
Terminology
The terminology is essential to understand the different concepts around sustainable finance and the differences. The United Nations Environment Programme defines three concepts that are different but often used as synonyms, namely: climate, green and sustainable finance. First, climate finance is a subset of environmental finance, it mainly refers to funds which are addressing climate change adaptation and mitigation. Then, green finance has a broader scope because it also covers other environmental issues such as biodiversity protection. Lastly, sustainable finance includes Environmental, Social and Corporate Governance factors in its scope. Sustainable finance extends its domain to the three components of ESG; it is therefore the broadest term, covering all financing activities that contribute to sustainable development.Tools and standards
Green bonds
Green bonds are loans issued in the market by a public or private organization to finance environmentally friendly activities. Their issuance is growing steadily with an average growth of over 50% per year over the last five years. They reached $170 billion in 2018 and $523 billion in 2021.The aim of this type of bond is to encourage the financing of green projects by attracting investors and therefore reducing the cost of borrowing. According to empirical studies, the high demand for this type of bond provides it with a lower yield than its standard equivalent. Scientists recommend including this climate factor in the risk assessment of bonds. The aim is, on the one hand, to increase the borrowing cost of brown bonds which can fund carbon-intensive projects and de-incentivise their investment by increasing the weight of climate risk. On the other hand, the goal is to reduce the weight of risk of green bonds in order to stimulate investment and potentially encourage banks to reduce the interest rate of these bonds.
From a legal point of view, green bonds are not really different from traditional bonds. The promises made to investors are not always included in the contract, and not often in a binding way. Issuers of green bonds usually follow standards and principles set by private-led organisations such as the International Capital Market Association 's Green Bond Principles or the label of the Climate bond initiative. The Paris agreement on climate change highlighted a desire to standardize reporting practices related to green bonds, in order to avoid greenwashing. To date, there are no regulations requiring the borrower to specify its "green" intentions in writing, however, the EU is currently developing a green bond standard which will force issuers to fund activities aligned with the EU taxonomy for sustainable activities. This standard is expected to be a voluntary standard, operating alongside other voluntary standards, with academics and practitioners raising the policymakers' awareness to the dangers of imposing it as a mandatory standard.
The European Union has already created its own "Next Generation EU Green bonds framework" to use green bonds to raise part of the funds for the Next Generation EU project. This project promises an investment of 750 billion euros in grants and loans, by the European Commission, aiming to revive the post-covid-19 economy in the 27 EU member states. Up to 30% of the budget will be raised by issuing green bonds, which results in up to 250 million, and a total of 14.5 million had already been raised by January 2022. This will make the European Commission the largest issuer of green bonds. On 21 December 2024, the European Union Green Bonds Regulation comes into force, allowing the issue of "European Green Bond" by companies, regional or local authorities and EEA supra-nationals.
Empirical studies show that the risk of greenwashing is present and may wrongly induce investors to accept lower rates of return than for brown investments. The standardization of this taxonomy would reduce the criticism of greenwashing that can be attributed to this type of obligation and enhance clarity and transparency in their use. Rating agencies should focus more on this type of risk in order to identify and quantify it better.
Taxonomy of sustainable activities
Because energy transition is a broad concept and sustainability or green can apply to many projects, several taxonomies are being established to evaluate and certify "green" investments.In 2018, the European Commission created a working group of technical experts on sustainable finance to define a classification of economic activities, in order to have a robust methodology defining whether an activity or company is sustainable or not. The aim of the taxonomy is to prevent greenwashing and to help investors make greener choices. Investments are judged by six objectives: climate change mitigation, climate change adaptation, the circular economy, pollution, effect on water, and biodiversity.
The taxonomy came into force in July 2020. The taxonomy is seen as the most comprehensive and sophisticated initiative of its type; it may inspire other countries to develop their own taxonomies or may indeed become the world's 'gold standard. However, when the disclosure regime comes into effect in January 2022 there will still be huge gaps in data and it may be several years before it becomes effective.
The classifications of fossil gas and nuclear energy are controversial. The European Commission asked its Joint Research Centre to assess the environmental sustainability of nuclear. The results will be investigated for three months by two expert groups before the commission makes a decision on the classification. Natural gas is seen by some countries as the bridge between coal and renewable energy, and those countries argue for natural gas to be considered sustainable under a set of conditions. In response, various members of the expert group that advises the European Commission threatened to step down. They stated they see the inclusion of gas as a contradiction to climate science, as methane emissions from the natural gas form are a significant greenhouse gas.
The UK is working on its own separate taxonomy.
Green-supporting factor on capital requirements
To encourage banks to increase green lending, commercial banks have been proposing to introduce a "Green-supporting factor" on banks' capital requirements. This proposal is currently being considered by the European Commission and the European Banking Authority. However this approach is generally being opposed by central bankers and nonprofits organisations, which propose instead the adoption of higher capital requirements for assets linked with fossil fuels.Mandatory and voluntary disclosure
In addition, another tool and some standards lie in reporting and transparency. In 2015, the Financial Stability Board launched the Taskforce on Climate-related Financial Disclosures which is led by Michael Bloomberg. The TCFD's recommendations aim to encourage companies to better disclose the climate-related risks in their business, as well as their internal governance enabling the management of these risks. In the United Kingdom, the governor of the Bank of England, Mark Carney, has actively supported the TCFD's recommendations and has called on several occasions for the implementation of obligations for companies in the financial sector to be transparent and to take into account financial risks in their management, notably through climate stress tests.In France, the 2015 Energy Transition Law requires institutional investors to be transparent about their integration of Environmental, Social and Governance Criteria into their investment strategy.
Nevertheless, empirical research has shown the limited effect of disclosure policies if they remain voluntary.
In addition, in October 2022, the Corporate Sustainability Reporting Directive was adopted. This new reporting rule will apply to all large firms, whether listed on stock markets or not. Therefore, around 50,000 companies will be covered by new rules, compared to about 11,700 with the former set of rules. More precisely, the impact of an organization on the environment, human rights and social standards will be introduced in this CSRD. Indeed, this reporting directive asks for more detailed reporting requirements thanks to common criteria, in line with the EU’s climate goals. The commission will adopt the first set of standards by June 2023 after that, the aim of the commission is to enlarge more and more companies to this set of standards. Indeed, from 1 January 2026, the rules will apply to listed SMEs and other undertakings, with reports due in 2027. However, SMEs can opt out until 2028. Thanks to this new set of rules, the EU has become a front-runner in global sustainability reporting standards.