Renewed EU Sustainable Finance Strategy – A Moody’s Report
Renewed EU Sustainable Finance Strategy: building on progress, supporting the transition and setting global ambition By Rahul Ghosh, Jimmy Greer
MOODY’S ESG SOLUTIONS
Why a Renewed Strategy?
On 6 July 2021, the European Commission unveiled the Renewed EU Sustainable Finance Strategy. The ‘Strategy for Financing the Transition to a Sustainable Economy’, sets out its approach to addressing ongoing and emerging challenges that will support the EU Green Deal and an inclusive and sustainable recovery from the COVID-19 pandemic.
In this post, Moody’s ESG Solutions provides initial observations on the strategy’s key objectives and challenges it faces in delivery. We also provide our perspectives on how ESG data and analytics can help market practitioners support its vision.
The Commission also put forward a proposal for a European Green Bond Standard (EU GBS). The standard aims to become the “gold standard” for green bonds. In its proposal it sets out four areas of requirements: EU Taxonomy alignment, transparency of use-of-proceeds, external review and supervision.
The transition towards the EU’s sustainability goals requires unprecedented efforts to mitigate and adapt to climate change, rebuild natural capital and strengthen resilience and wider social capital, all as part of a sustainable recovery from the COVID-19 crisis.’ – European Commission
The Strategy sets out how it will support the EU Green Deal and Europe’s transition to becoming a carbon neutral continent by 2050 through:
Financing the transition to sustainability and expanding coverage of the EU taxonomy.
Building in inclusiveness with greater support for SMEs and individuals to access sustainable finance and participate in building a sustainable economy.
Tackling the financial sector’s resilience to sustainability risks and supporting its contribution.
Playing a more active role in global institutional infrastructure of sustainable finance.
As it notes, much has changed since 2018, when the first iteration of the Action Plan on Sustainable Finance was launched. New policy frontiers have emerged requiring further support – from the need to better finance the transition activities aligned with a more sustainable future, to the growing urgency to improve action on issues such as biodiversity and to meet the unprecedented socio-economic recovery challenges brought on by the pandemic.
Beyond climate, expanding science-based approaches and better means to support the transition for a future is more nature-based, resilient and social
Supported by the work of the EU Platform on Sustainable Finance, the Commission will look to develop how the current EU Taxonomy supports intermediate transition steps and will examine ways to extend the taxonomy to recognize activities with an intermediate level of environmental performance. It will also set out taxonomy criteria for water, circular economy, pollution prevention and biodiversity for adoption in the first half of 2022. And by the end of 2021 it will also set out the provisions required for a social taxonomy.
The renewed strategy also acknowledges the systemic role of resilient financial institutions that must be mobilized to support the transition. In this regard, it aims to improve science based-target setting, disclosure and monitoring of the sector’s commitments, and will require financial institutions to set out their own sustainability transition and decarbonization plans.
ESG data and content providers can help market practitioners identify the extent to which companies, or portfolios, are closely aligned with emerging regulations, both in the near and longer-term as new topic areas are covered. For example, Moody’s ESG Solutions recently launched a dataset to help companies respond to the EU’s Sustainable Finance Disclosure Regulation (SFDR) requirements, covering 2,500 entities and 11 mandatory indicators. Our coverage will expand to all 18 mandatory indicators later this year – ahead of SFDR reporting requirements coming into effect from 2022. We have built a comprehensive framework to assess the extent to which companies globally align to the EU Taxonomy.
Inclusiveness: provide individuals and SMEs with greater access to sustainable finance
The strategy notes the critical role of small- and medium-sized enterprises (SMEs) in supporting the transition. The 23 million SMEs across Europe are the backbone of the economy, and their activities at a local level, and as part of supply chains, have strong potential to support EU Green Deal objectives.
At present, there are few routes for individuals and SMEs to access sustainable finance. SMEs also lack resources to complete sustainability reporting requirements to the same extent as large companies. Low levels of SME reporting can create challenges for investors and large companies when making investment and supplier decisions. Better disclosure would also allow banks to ramp up lending to SMEs that demonstrate robust ESG credentials.
The strategy proposes that the Capital Markets Union and the sustainable finance framework together will aim to provide SMEs with more financing opportunities. For example, green loans to support energy performance improvements or zero emission vehicle switching. On reporting, the European Financial Reporting Advisory Group is set to prepare a simplified voluntary sustainability reporting standard for SMEs aligned to the Corporate Sustainability Reporting Directive. The Commission will also explore how technology and data can be deployed to support SMEs to achieve sustainable outcomes and participate in related digital opportunities.
The application of technology into new risk measurement techniques will be critical to gain a better understanding of ESG exposures across SMEs of varying size, location and industry. We have developed predictive ESG scores using model-driven, machine learning algorithms leveraging SMEs’ size, location and industry characteristics. Predicted metrics allow us to compare companies across industrial sector, any market cap size segment, and location, and identify where potential risks may lie for greater due diligence and engagement.
Double materiality reinforced at the heart of the strategy
Better management of ESG considerations that both carry financial risks and have an impact on stakeholders and the environment is an essential foundation to the pathway out of the pandemic for Europe and the global economy.
The strategy further embeds the intertwined and equally important elements of business risk and sustainability impact – double materiality or dual materiality – at its core, setting out the intention for the concept to be integrated into the work of public authorities across the EU financial system by 2022. Alongside this, it explicitly sets out the need for the financial sector to integrate double materiality.
International cooperation to further deepen understanding and adoption of double materiality principles will be a critical but challenging endeavor. Reflecting the position of its stakeholders Moody’s ESG Solutions believes that the resilience and long-term value creation proposition afforded by a double materiality approach will be key.
We believe that firms should disclose not only how sustainability issues may affect enterprise value, financial returns and cost of capital, but also how they affect broader society and the environment. Underpinned by adherence to normative principles and guidelines from organizations such as the ILO, OECD and the UN, our ESG assessments are aligned with the double materiality perspective. Business risks and stakeholder and environmental impact are captured in equal measure through our ESG materiality assessment to generate industry-specific outcomes (see Figure 1).
Figure 1: ESG Materiality assessment – weighting criteria
Source: Adapted from ESG Assessment Methodology Executive Summary, V.E, a part of Moody’s ESG Solutions
* As set out in international reference texts and societal expectations.
** Stakeholder risks if companies do not manage their responsibilities.
*** Company risks that relates to reputation, human capital, operational efficiency or legal risk.
Global coordination: balancing ambition with consensus
As one of the 22 specific actions set out in the renewed plan, the Commission will seek to “promote ambitious cooperation” to develop international sustainable finance initiatives and standards. This will include encouraging global standard-setters, notably the IFRS Foundation, in pursuit of ambitious baseline disclosure standards and common taxonomy objectives and criteria.
Since the launch of the EU’s action plan in 2018, sustainable finance initiatives have proliferated across the globe. Countries spanning Bangladesh, Canada, Mongolia, Singapore, South Africa and the UK, to name a few, are developing sustainable taxonomies – each designed to cater for the local context. Disclosure standards and policies are also evolving, particularly with respect to climate risks.
In terms of practical compliance, multiple region- or country-specific taxonomies and standards would potentially mean commoditizing the debate as to what constitutes “green” or “sustainable” activities. This could in turn lead to a complex web of localized definitions, criteria and thresholds. Localized initiatives also reflect the significant differentiation in economic composition, regulatory requirements, and corporate performance across jurisdictions – a point acknowledged within the Commission proposals.
Finding common ground will likely require balancing ambition with consensus and compromise. Co-led by the EU and China, the work of the International Platform on Sustainable Finance in developing a “common ground taxonomy” will be important, particularly with respect to whether the double materiality approach championed by the EU is recognized across the platform’s 17 members.
Global harmonization will require a collective effort from all market players, and providers of ESG data and assessments can make an important contribution to this debate. Through market engagements such as our membership of the Future of Sustainable Data Alliance Council, or our active participation in working groups supporting the creation of an EU sustainability reporting standard, we are collaborating to work through market problems and develop data that can enable us to meet our global sustainability goals.
European green bond standard will reinforce best practice, but usability of taxonomy will influence pace of adoption
Alongside the strategy, the Commission has also put forward a legislative proposal to create a European green bond standard (EU GBS) with the objective of creating a “gold standard” for green bond issuance. The standard will be voluntary in nature and open to all issuers, including those located outside the EU. Key requirements under the proposal span the full alignment of bond proceeds with the EU Taxonomy, transparency on proceeds allocation and mandatory compliance reviews carried out by a registered external reviewer.
The EU GBS will serve to reinforce industry best practices, particularly when it comes to proceeds transparency and the quality and verification of green bond reporting. At present, the level of detail provided on use of proceeds within green bond frameworks can vary considerably. By mapping eligible projects to the detailed criteria and thresholds enshrined within the EU Taxonomy, the standard will help build investor trust around financial products marketed as green. Meanwhile, requirements for mandatory annual reporting on proceeds allocation, environmental impact reporting and pre- and post-issuance reviews are all positive for market transparency.
That said, the practical usability of the Taxonomy remains a key consideration that will ultimately influence the pace and extent to which the EU GBS is adopted. It remains to be seen how stringently eligibility metrics and stipulations –including compliance with “do not significant harm” and minimum social safeguards criteria – will be adhered to or whether there will be room for interpretation for more complex projects (for example, green securitization backed by large pools of smaller projects with limited granular information). We note that the draft regulation already contains provisions to exempt sovereign issuers from demonstrating project-specific alignment with the taxonomy for activities relating to tax expenditures and subsidies. In addition, other environmental activities financed by green bonds – including those related to circular economy or biodiversity – are likely to be out of scope for some time.
Figure 2: Sustainable debt issuance in Europe by type, % share
Sources: Moody’s ESG Solutions and Environmental Finance Bond Database
Note: Percentage distribution based on overall value of issuance.
One potential risk when it comes to standards is that the green bond market splits into the less prescriptive but widely-used Green Bond Principles and the EU GBS, or even that issuers elect to finance environmental activities via other labels, such as sustainability “use of proceeds” bonds or sustainability-linked bonds, which do not fall under the scope of the regulation. On the latter, the Commission will also work on establishing standards for additional labels, including transition and sustainability-linked bonds next year. The challenge of multiple labels in part reflects the fast-evolving landscape of Europe’s sustainable debt markets. As Figure 2 shows, social, sustainability and sustainability-linked bonds have accounted for more than 40% of labelled issuance volumes (by value) in 2021 to date.
Moody’s ESG Solutions provides insights and analyses on ESG themes and multi-stakeholder performance, climate-related risks and opportunities and global sustainable finance trends.
For more information, visit esg.moodys.io/insights-analysis