When the International Monetary Fund (IMF) meeting is held remotely this year, there is no doubt that Covid-19 will be at the top of the agenda. Following the economic shock generated by the pandemic, the world is facing its deepest ever recession. This will require financing to keep businesses afloat and fund the global economic recovery.
However, to ensure global markets remain resilient in the future, the economic recovery must be environmentally, socially and also financially sustainable. The EU has set a target to become climate-neutral by 2050. To achieve this and drive sustainability on a global scale, it is even more important to accelerate the low-carbon transition and embed environmental, social and governance (ESG) standards across all industries.
No individual sector can be the sole driver of the change, and sustainability policy needs to be pushed in political synchrony across both the financial and the real economy. Economic sectors and markets are interconnected and, while the financial sector will drive forward the funding of Europe’s ambitious transition, it also has the challenge of supporting industries that are still in their sustainability infancy. Europe’s ESG goals cannot be achieved through ambition alone. It is going to require a cohesive approach that incentivises organisations to take greater risk to make Europe’s sustainable economy a reality.
Striking the right balance
One of the challenges of the sustainable transition is ensuring that the ambitious sustainability targets are within the capacity of the real economy. This is vital in evaluating whether an organisation is capable of radically changing its operations in the short term and can determine the best approach to incorporating ESG as part of its core business model. While some organisations might have already taken great strides to become more sustainable, others might still be in a period of transition. Penalising investment into sectors that are in the process of change would be inappropriate as it might deprive them of the capital they need to complete this process and thus undermine the ultimate end goal. For organisations that can prove they are trying to become more sustainable, a realistic and just approach is necessary to accompany them in this critical transformation.
To overcome the challenge of accelerating the transition across different industries, establishing clear and measurable targets in Europe’s sustainable transition roadmap will be key. While the Paris Agreement presents a clear end-goal for major EU industries, the roadmap to reaching this is less well-defined. Different industries will experience different challenges and therefore warrant different targets. Including steps and milestones for each industry will help create practical strategies, giving clear signals if and when certain economic activities need to be phased out to meet the objectives of the European Green Deal. This will give industries clear short-term and long-term objectives to be measured against, and ensure no sector is left out of the transition.
Funding the transition
To help industries reduce barriers when accessing finance through sustainable investment, co-operation between public and private sectors is going to be key. Particularly in the post-Covid-19 environment, where capital markets alone might not be able to supply all the necessary capital to support organisations’ sustainability journeys – establishing incentive and risk-sharing mechanisms through a partnership of public and private sectors will be required.
This will prove important in the support of early-stage research and innovation projects, as well as projects that are in the process of scaling up. Support could come in the form of public programmes and financial instruments that streamline application processes and thus lower barriers to private investment into projects. Equally, support could also come in the form of grants, debt or equity, including structured finance, that are tailored to the different stages of a project’s development. Any grants should include incentives where additional funding will be provided as organisations hit their sustainability targets.
Moreover, equity financing could be provided through a dedicated EU Green Deal Fund that is contributed to by the EU, national and regional capital, while also allowing private investors to participate. Crucially, no single sector or type of financing should be seen as the sole catalyst for the sustainability transition. If governments want to foster innovation to aid the transition, the same innovation will need to be shown on their side to maximise the funding to support sustainable projects.
Working from the same sheet
To accelerate Europe’s low-carbon transition and prevent misleading claims on the environmental nature of investment products (‘greenwashing’), there is a need to better identify sustainable investment opportunities and evaluate the embedded risk. In recent years, there has been a rapid growth in financial products linked to sustainability; yet their full uptake and mainstreaming requires a breadth of corporate ESG data that is not currently available. This information is needed to establish how ESG considerations affect risk and return of investment and lending activities.
So far, a big challenge has been the proliferation of unstandardised approaches on reporting, collecting and analysing ESG data. This makes it difficult for investors and lenders to compare and evaluate an issuer’s or a borrower’s ESG profile. Moreover, the lack of harmonisation in sustainability reporting frameworks and ESG rating methodologies dramatically increases the cost for firms, both corporates and investors, that operate across borders and have to engage with multiple reporting standards and ESG rating methods. This has resulted in ESG data being largely incomplete and insufficient to encourage widespread ESG investment.
Making ESG reporting standards mandatory as the first step, rather than voluntary, would go a long way to alleviating these challenges by helping promote the availability of useful information for decisions. In addition to making reporting approaches more standardised, it is also necessary to establish an accessible global reporting framework (or a few key frameworks) that all organisations and jurisdictions can work with.
The overall EU framework for sustainable finance is complex, and could benefit from simplification to encourage wider adoption and international uptake. For example, significant expertise is required to analyse and understand the technical criteria of the EU taxonomy for sustainable activities, particularly when it needs to be supplied under tight deadlines. Considering that the current sustainable finance landscape is not static, with organisations also needing to navigate new rules, the challenge is only going to become greater. A reduction in the complexity around the new requirements and terminology used would help industries better understand their obligations, adjust their corporate strategies and act on plans towards the sustainable transition.
The role of technology
A key to overcoming these challenges could lie in embracing new technologies. Technology such as artificial intelligence and machine learning present additional avenues for gathering ESG information, such as geospatial data, as well as the capacity to process information faster. For example, this could include the scanning of online news articles, identifying information that might affect ESG scoring. Moreover, the implementation of digital data sharing spaces, where organisations can share their information, would allow different industries to learn from one another and better enable firms to assess their ESG risks and impacts, and meet their sustainability objectives. From a product standpoint, digital tools, such as distributed ledger technology, could present more opportunities to co-financing local sustainability projects. This could be applied to green bonds that would open up ESG investment to new markets, allowing more citizens and firms to participate in the sustainable transition.
However, to ensure that the financial sector can harness new technologies, it is important that future regulation is technology-neutral and innovation-friendly. A cross-sectoral approach to ESG data sharing should be embraced and supported. Currently, digital tools and platforms operate mainly at a domestic level. There is a need to remove any potential barriers against using these digital platforms and tools across borders. Doing so would further encourage their use. This should not only be facilitated on a European level, but also globally. Climate change and other ESG challenges are global in nature and require harmonised global action.
Translating ambition into action
As the world gathers for its first remote IMF meeting, while the focus will be on establishing the pathway for the global economic recovery, it should also be viewed as an opportunity for advancing the sustainability agenda. Covid-19, despite having created global challenges on an economic and social level, also holds the impetus to accelerate the sustainable transition.
As jurisdictions rebuild, never has the importance of human wellbeing inherent in ESG principles been more relevant. Investment in products with ESG focus has been growing and there is no lack of ambition in building more sustainable economies. The objective now is to translate this ambition into a harmonised roadmap that all industries can understand and work towards. Ambition alone is not enough to achieve the goals to combat climate change and support societies. Barriers need to be broken down, not only across borders and sectors, but also in politics. Sustainability is a not separate agenda; it must permeate all our policy-making.
This article was first published in The Banker: 5/10/2020