Abstract
We identify as core issues of any sustainability-oriented financial regulation a lack of data on profitability of sustainable investments, a lack of broadly acknowledged theoretical insights (typically laid down in standard models) into the co-relation and causation of sustainability factors with financial data, and a lack of a consistent application of recently adopted rules and standards. The three factors together hinder as of now a rational, calculated approach to allocating funds with a view to sustainability which we usually associate with “finance”.
In order to avoid undesirable and unforeseeable effects of regulation, we argue against any regulation addressing capital requirements, mandating sustainability risk modelling or the inclusion of sustainability factors in investment or remuneration policies. Instead, regulators should focus on enhancing expertise on the side of intermediaries and supervisors alike. In particular, regulators shall introduce smart regulation tools, such as regulatory sandboxes, innovation hubs and waiver programmes benefiting early adopters of sustainable finance modelling/models, utilizing approaches developed in other fields of experimental financial regulation (in particular Fintech and RegTech).
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Notes
- 1.
See European Commission, The European Green Deal (11 December 2019), COM/2019/640 final, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=COM%3A2019%3A640%3AFIN.
- 2.
For a detailed discussion of the European Commission’s work programme announced per 21 April 2021 and 6 July 2021, see infra, at II.2.
- 3.
See European Commission, Action Plan: Financing Sustainable Growth (3 March 2018), COM/2018/097 final, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52018DC0097.
- 4.
See for a more extensive view Zetzsche & Anker-Sørensen, EBOR 2021, ___.
- 5.
See SFAP 2018, supra note 3, at 2.3.
- 6.
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, pp. 13–43.
- 7.
See Article 1(2) Taxonomy Regulation (EU) 2020/852.
- 8.
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, pp. 1–16.
- 9.
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, OJ L 317, 9.12.2019, pp. 17–27.
- 10.
See SFAP 2018, supra note 3, at 2.5. The SFAP 2018 resulted in two legislative proposals, yet the proposals have not been adopted by the old European Commission, leaving this work strand for the new European Commission appointed in late 2019.
- 11.
See SFAP 2018, supra note 3, at 4.1. A consultation preparing the revision was then performed under the new European Commission appointed in late 2019; See also proposed amendments to the NFRD: Proposal for a Directive of the European Parliament and of the Council amending Directive 2013/34/EU, Directive 2004/109/EC, Directive 2006/43/EC and Regulation (EU) No 537/2014, as regards corporate sustainability reporting, COM/2021/189 final.
- 12.
See SFAP 2018, supra note 3, at 3. The Juncker EU Commission collected feedback in consultations. The implementation was left to the new Commission. See, for instance, ESMA’s technical advice to the European Commission on integrating sustainability risks and factors in MiFID II, https://www.esma.europa.eu/sites/default/files/library/esma35-43-1737_final_report_on_integrating_sustainability_risks_and_factors_in_the_mifid_ii.pdf; ESMA’s technical advice to the European Commission on integrating sustainability risks and factors in the UCITS Directive and AIFMD, https://www.esma.europa.eu/sites/default/files/library/esma34-45-688_final_report_on_integrating_sustainability_risks_and_factors_in_the_ucits_directive_and_the_aifmd.pdf.
- 13.
See SFAP 2018, supra note 3, at 4.2.
- 14.
The EU Commission uses the term “mainstream investment”. For the term used in this paper, see BakerMcKenzie, Sustainable Finance: From Niche to New Normal, 2019.
- 15.
See European Commission, In-Depth Analysis in Support of The Commission Communication, COM (2018) 773, https://ec.europa.eu/clima/sites/clima/files/docs/pages/com_2018_733_analysis_in_support_en_0.pdf
- 16.
On the divergence of sustainability ratings, see, e.g., Doni & Johannsdottir 2019 at 440 (arguing on the differences in “scope, coverage and methodology” among different ESG rating providers); Berg et al. 2020 (on the importance of considering original or rewritten data of ESG rating providers: the same providers may change methodology over the years that can significantly change ESG firms ratings impacting empirical research and investment decisions); Dorfleitner et al. 2015, 465 (comparing three of the most used ESG rating approaches, the authors find a clear lack of convergence in ESG measurement); Berg et al. 2020 (comparing six of the most relevant ESG rating providers, the authors find evident divergences in “scope of categories, different measurement of categories, and different weights of categories”).
- 17.
Regarding divergent results of studies on profitability of sustainable investments (independent of the asset class), see, e.g., Cunha et al. (2019), 688–689 (the authors analyse “the performance of sustainable investments in developed and emerging stock markets from 2013 to 2018 “ by using “global, regional and country‐level sustainability indices as benchmarks” and comparing them with “respective market portfolios”, conclude that given the discordant results, conclusions cannot be drawn yet; however, there is increasing hope for investors to obtain higher risk-adjusted returns if engaging in sustainable investments in certain geographies); Friede et al. (arguing that 90% of the studies surveyed show a nonnegative correlation between ESG and corporate financial performance); but see also Fiskerstrand et al. 2019 (showing no significant relation between ESG and stock returns in the Norwegian stock market); on sustainable investing and higher financial returns, see, e.g., Filbeck et al. 2016 (analyzing socially responsible investing hedge funds compared to conventional hedge funds); on sustainable investing and lower financial performance in mutual funds, see, e.g., El Ghoul & Karoui 2017; Riedl & Smeets 2017.
- 18.
For details, see view Zetzsche & Anker-Sørensen, EBOR 2021, ___.
- 19.
See SFAP 2018, supra note 3, at 2.5.
- 20.
- 21.
See Thaler & Sunstein2008. See also Enriques & Gilotta2015 (discussing the function of market disclosure as a “soft-form substitute of more substantive regulations”, dubbed “stealth substantive regulation”). But see also Gentzoglanis2019 (arguing that firms preferring a non-regulated or less regulated state of operations will comply with a set of disclosure requirements in order to avoid “substantive” regulation.).
- 22.
See, e.g., Mancini 2020.
- 23.
See Zetzsche & Anker-Sørensen, EBOR 2021, ___.
- 24.
European Commission, Proposal for a Commission Delegated Directive amending (1) Directive 2010/43/EU as regards the sustainability risks and sustainability factors to be taken into account for Undertakings for Collective Investment in Transferable Securities (UCITS); (2) Delegated Regulation (EU) No 231/2013 as regards the sustainability risks and sustainability factors to be taken into account by Alternative Investment Fund Managers; (3) Delegated Regulations (EU) 2017/2358 and (EU) 2017/2359 as regards the integration of sustainability factors, risks and preferences 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; (4) Delegated Directive (EU) 2017/593 as regards the integration of sustainability factors into the product governance obligations; (5) Delegated Regulation (EU) 2015/35 as regards the integration of sustainability risks in the governance of insurance and reinsurance undertakings; (6) Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organizational requirements and operating conditions for investment firms (all proposals as of 21 April 2021).
- 25.
See Commission Delegated Regulation (EU) …/… supplementing Regulation (EU) 2020/852 of the European Parliament and of the Council by establishing the technical screening criteria for determining the conditions under which an economic activity qualifies as contributing substantially to climate change mitigation or climate change adaptation and for determining whether that economic activity causes no significant harm to any of the other environmental objectives, C/2021/2800 final.
- 26.
European Commission, EU Taxonomy, Corporate Sustainability Reporting, Sustainability Preferences and Fiduciary Duties: Directing finance towards the European Green Deal, COM/2021/188 final (21 April 2021), at 13.
- 27.
See view Zetzsche & Anker-Sørensen, EBOR 2021, ___.
- 28.
See, e.g., Friede (2020), 1276–1278 ; OECD2020; further, see supra note 17 on results of studies regarding sustainability and financial performance. Some of the more recent studies include Balachandran & Nguyen 2018 (suggesting a causal influence of carbon risk on firm dividend policy); Balvers et al. 2017; (stating that financial market information can provide an objective assessment of losses anticipated from temperature changes if the model considers temperature shocks as a systematic risk factor); Colacito et al. 2019 (finding that seasonal temperature rises have significant and systematic effects on the U.S. economy).
- 29.
Choi et al. 2020 (finding that stocks of carbon-intensive firms underperform firms with low carbon emissions in abnormally warm weather, since retail investors tend to sell that stock, indicating a premium for low-carbon firms in that environment) versus Addoum et al. 2020 (not finding evidence that temperature exposures significantly affect establishment-level sales or productivity, including among industries traditionally classified as “heat sensitive”).
- 30.
See, on the one hand, Larcker & Watts 2020 (finding that in real market settings investors appear entirely unwilling to forgo wealth to invest in environmentally sustainable projects. When risk and payoffs are held constant and are known to investors ex-ante, investors view green and non-green securities by the same issuer as almost exact substitutes. Thus, the greenium is essentially zero); Murfin Spiegel 2020 (finding limited price effects to rising sea levels); Baldauf et al. 2020 (stating that house prices reflect heterogeneity in beliefs about long-run climate change risks rather than the severity of the risk itself).
against Eichholtz et al. 2019; (arguing in favour of a premium for corporate environmental (ESG) performance based on commercial real estate investments); Krueger et al. 2020; (arguing that institutional investors believe climate risks have financial implications for their portfolio firms); Alok et al. 2020 (finding that managers within a major disaster region underweight disaster zone stocks to a much greater degree than distant managers, indicating a bias); Painter 2020 (finding that counties more likely to be affected by climate change pay more in underwriting fees and initial yields to issue long-term municipal bonds compared to counties unlikely to be affected by climate change); Bernstein et al. 2019 (finding that homes exposed to sea level rise (SLR) sell for approximately 7% less than observably equivalent unexposed properties equidistant from the beach); Huynh & Xia, Climate Change News Risk and Corporate Bond Returns, J. Fin. Quant. (September 2020, in press), https://doi.org/10.1017/S0022109020000757 (finding that investors are willing to pay a premium for better environmental performance); Hartzmark & Sussman 2019; (presenting “causal evidence” from fund inflows that investors market wide value sustainability).
- 31.
Riedl Smeets 2017 (finding that investors are willing to forgo financial performance in order to invest in accordance with their social preferences); Joliet & Titova 2018 (arguing that SRI funds add some SRI factors to make investment decisions, and thus more than financial fundamentals matter); Rossi et al. 2019; (analysing retail demand for socially responsible products and finding that social investors are willing to pay a price to be socially responsible while individuals who consider themselves financially literate are less interested in SR products than others); Gutsche & Ziegler 2019 (arguing that a left-/green political orientation correlates with the willingness to pay for certified sustainable investments).
- 32.
See, e.g., Busch et al. (2016), 311 (arguing that the long-term impact of investment strategies may depend on multiple factors and that the consequences of the ESG integration strategies are still uncertain on several aspects) against Pedersen et al. 2020 (seeking to model the impact of ESG preferences, trying to define the “ESG-efficient frontier” and showing the costs and benefits of responsible investing.); Bender et al. 2019 (analysing metrics for capturing climate-related investment considerations).
- 33.
See the references supra note 16.
- 34.
See, e.g., Jebe 2019, 685 (arguing on the necessity of merging and harmonizing ESG and financial information disclosure).
- 35.
See ESAs, Letter to the European Commission, Public consultation on a Renewed Sustainable Finance Strategy (15 July 2020), https://www.esma.europa.eu/sites/default/files/library/2020_07_15_esas_letter_to_evp_dombrovskis_re_sustainable_finance_consultation.pdf.
- 36.
The Global Financial Crisis of 2007–2009 was evidence of the large impact of unwanted effects stemming from rules relating to interest rates, mortgage credit criteria, derivatives, securitization techniques and accounting rules on society. Compared to the SFAP and Sustainable Finance Strategy 2021, the rules that may have collectively contributed to the Global Financial Crisis were relatively minor in scope. By that comparison, if the Sustainable Finance Strategy 2021 gets it wrong, we would expect value destruction of an enormous size.
- 37.
See, e.g., Bender et al. 2019, 191–213 (reviewing data characteristics for metrics such as carbon intensity, green revenue, and fossil fuel reserves, highlighting their coverage and distributional characteristics; even though the data can illuminate risk factors to include in a corporate or investment strategy, we lack a financial adaptation strategy building on such data).
- 38.
ESAs, July letter, supra note 35.
- 39.
See Malte Hessenius et al., European Commission. Testing Draft EU Ecolabel Criteria on UCITS equity funds (June 2020), Climate Company and Frankfurt School of Finance & Management, https://op.europa.eu/en/publication-detail/-/publication/91cc2c0b-ba78-11ea-811c-01aa75ed71a1/language-en/format-PDF/source-137198287.
- 40.
See ESAs, July letter, supra note 35.
- 41.
This basic insight is supported by research on corporate carbon disclosures. See, for instance Liesen et al. 2017 (arguing that financial markets were inefficient in pricing publicly available information on carbon disclosure and performance; mandatory and standardized information on carbon performance would consequently not only increase market efficiency but result in better allocation of capital within the real economy).
- 42.
Article 9 and 10 SFDR do not limit “sustainable” investments and products to products in line with the sustainability definition of the Taxonomy Regulation. While Article 25 of the Taxonomy Regulation inserts some references to the Taxonomy Regulation (in particular, the DNSH principle), financial market participants can still include another explanation on how the sustainability objective is to be attained by other means, as long as this information is accurate, fair, clear, not misleading, simple and concise.
- 43.
See references supra n 16 and 34.
- 44.
Chowdhry et al. 2018; (studying joint financing between profit-motivated and socially motivated investors); Barber et al. 2021; (finding that losses due to social commitments vary with investor types, with investors subject to legal restrictions (e.g., Employee Retirement Income Security Act) exhibiting lower losses than publicly and NGO-sponsored vehicles).
- 45.
See Zetzsche & Anker-Sørensen, EBOR 2021, ___.
- 46.
See on governance of metrics Chiu 2021 (this volume).
- 47.
Ibid.
- 48.
Ibid.
- 49.
See Romano, 1, 28.
- 50.
See Title IV of the Joint ESMA and EBA Guidelines on the assessment of the suitability of members of the management body and key function holders under Directive 2013/36/EU and Directive 2014/65/EU (CRD IV and MiFID II), at 41 (“Institutions need to provide sufficient resources for induction and training of members of the management body. Receiving induction should make new members familiar with the specificities of the institution’s structure, how the institution is embedded in its group structure (where relevant), and business and risk strategy. Ongoing training should aim to improve and keep up to date the qualifications of members of the management body so that at all times the management body collectively meets or exceeds the level that is expected. Ongoing training is a necessity to ensure sufficient knowledge of changes in the relevant legal and regulatory requirements, markets and products, and the institution’s structure, business model and risk profile”.). Similar provisions requiring induction and training of the governing body can be found in all EU regulations, see for instance Article 21 (d) AIFMD Implementing Regulation (L2),
- 51.
See Buckley, Arner, Zetzsche et al. 2020.
- 52.
See Enriques & Zetzsche 2014.
- 53.
Note that the Wirecard scandal is not evidence to the contrary. Wirecard, under German law, was not regulated at the top level. Further, many important subsidiaries were not regulated. See Langenbucher et al., What are the wider supervisory implications of the Wirecard case? (2020), Study requested by the ECON Committee.
- 54.
Of course, one could think to rewrite the limited liability rule, a basic principle of company law (or adopt similar radical proposals). Cf. on limited liability in the context of environmental laws Akey & Appel 2020. But the argument against quack legislation aired herein is all the truer for tampering with basic governance features.
- 55.
See CRD IV, arts. 92–96.
- 56.
See Engle et al. 2020 (researching a model to hedge climate risk, and discussing multiple directions for future research on financial approaches to managing climate risk); Fernando et al. 2017 (distinguishing between environmental risk and “greening” a firm, and arguing that institutional investors shun stocks with high environmental risk exposure, which we show have lower valuations, as predicted by risk management theory. These findings suggest that corporate environmental policies that mitigate environmental risk exposure create shareholder value, while “greening” as such does not).
- 57.
See ESAs, July letter, supra note 35.
- 58.
See the discussion in Alexander & Fisher 2019, 15–20 (arguing that sustainability risks, collectively, are of systemic dimensions); see also Alexander 2014, 16–17.
- 59.
See Alexander & Fisher (2019), 7–34 (arguing that sustainability risks, collectively, are of systemic dimensions).
- 60.
- 61.
Cf. Zetzsche et al. 2017 (coining the term “Smart Regulation”).
- 62.
Cf. Zetzsche et al. 2017 (coining the term “Smart Regulation”); Buckley, Arner, Veidt et al. 2020; Zetzsche et al. 2020; Brummer & Yadav (2019), 248–249 (arguing that innovation poses a challenge for regulators since regulators are expected to warrant financial innovation, simple rules and market integrity at the same time, with limited resources). But see Omarova, JFR 2020 ___ (criticizing a smart regulation approach).
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Zetzsche, D.A., Anker-Sørensen, L. (2022). Towards a Smart Regulation of Sustainable Finance. In: Câmara, P., Morais, F. (eds) The Palgrave Handbook of ESG and Corporate Governance. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-99468-6_4
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DOI: https://doi.org/10.1007/978-3-030-99468-6_4
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