knowledge 11 February 2021 |

Embedding Sustainability

Introduction

The concept of ‘sustainable development’ has long been associated with the 1987 Brundtland Report which defined it as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs”.  However, for many years, there was no common understanding of what ‘sustainable development’ and the related term ‘sustainability’ meant in practice, and the level to which sustainability was truly integrated into public policy and business practices remained limited.

That has all changed now.  The signing of the Paris Agreement and the adoption of the UN’s Sustainable Development Goals in 2015 have laid the basis for a new sustainability agenda and served as catalysts for the rapid transformational change that is being demanded of societies and economies over the next few decades.

To drive standards and to avoid the greenwashing of the past, where companies publicly and superficially espoused sustainable credentials while carrying on harmful activities, the EU has taken a lead in developing mandatory standards for sustainability, particularly in the financial sector where private capital will underpin the costs involved in meeting the climate objectives agreed in the Paris Agreement as well as other environmental and social goals.

This short note looks at some of the changes taking place at EU level in relation to sustainability and the likely impacts of those changes over the next few years.

EU Developments

The EU Taxonomy Regulation¹ which came into force in 2020 seeks to do something fundamental by defining in objective terms what it means to carry on an ‘environmentally sustainable economic activity’.  To be classified as being an environmentally sustainable economic activity, that activity must contribute to at least one of six specified environmental objectives (such as climate change mitigation, climate change adaptation, and the protection and restoration of biodiversity and ecosystems), cause no significant harm to any of the other environmental objectives, meet minimum social safeguards (such as respecting international human rights), and meet detailed technical criteria being developed by the European Commission.  Those technical criteria will contain the substance of the parameters to be satisfied in order for an activity to qualify as ‘environmentally sustainable’.

The scope of the Taxonomy Regulation appears at first glance to be limited with its aim being to establish the degree to which an investment is environmentally sustainable.  In that context, it is expressed to apply only to financial market participants making available financial products (such as investment funds and pension funds), large undertakings required to publish non-financial statements under the Non-Financial Reporting Directive (“NRFD”), and measures adopted by Member States or the EU with respect to financial products or corporate bonds that are described as being environmentally sustainable.

Its impact, however, is likely to be much greater than that.  By setting minimum thresholds, it creates a common understanding about what activities can meaningfully be described as ‘green’.  When you consider that EU and Member State legislation and the EU budget is likely to align over time to that definition of ‘green’, then the impact of the Taxonomy Regulation could be described as transformative.

In addition, when taken together with the disclosure requirements imposed by the Sustainable Finance Disclosure Regulation² and the Low Carbon Benchmarks Regulation³ introduced in 2019, the huge appetite in the market for environmentally sustainable investments is likely over time to be channelled into those which are ‘Taxonomy-aligned’.

Furthermore, by requiring financial institutions and large companies to describe how and to what extent the relevant undertaking’s activities are associated with economic activities that qualify as environmentally sustainable, it will incentivise a greater allocation of capital to those activities.  Some banks are already taking steps to review their loan books to see what can be categorised as ‘environmentally sustainable’ and could in the future make changes to lending criteria and demand more information from customers before agreeing to lend, including for SME and retail loans, which would impact on the availability of finance.

This trend is likely to be reinforced by banking regulators and supervisors who will carry out stress tests and supervisory reviews taking into account sustainability risks to which the banks are subject.

As part of its development of a Renewed Sustainable Finance Strategy which is due to be published during the first quarter of 2021, the EU is also currently reviewing NRFD.  It is possible that environmental disclosures under NRFD will be aligned, at least to some extent, with the criteria set out in the Taxonomy Regulation.  Given that the scope of categories required to report under NRFD may be expanded, more companies could find themselves having to review their activities to explain how sustainability issues affect their business as well as how their business affects society and the environment (the so called double-materiality reporting requirement).  Those reports are likely to be the subject of audit with moves underway at European and international level to create a common reporting standard for those disclosures.

The EU is also currently carrying out a consultation on corporate governance to tackle what is perceived to be an outsized focus on short-term financial performance compared to long-term development and sustainability aspects.  For larger companies and institutions in particular, this could result in directors’ duties being clarified to take account of a broader group of stakeholders, director variable remuneration being linked to performance against sustainability targets, the introduction of a mandatory supply-side due diligence to ensure certain minimum environmental and social standards are satisfied, and the introduction of requirements with respect to the sustainability expertise of the board.

The initiatives described above are, of course, not the only actions being taken at EU or Member State level to combat the climate crisis and other environmental and social issues.  Sectoral legislation aimed at tackling harmful activities is also being prioritised with a view to meeting the EU’s obligations under the Paris Agreement as well as the increased ambitions embodied in its updated 2030 and 2050 targets.

However, the EU’s actions under the umbrella term of ‘Sustainable Finance’, are aimed at ensuring that, through the financial system, sustainability is embedded at all levels of economic activity, including by requiring financial institutions and other market participants to take account of sustainability risks and factors in carrying on their activities, and by requiring those entities as well as certain companies to disclose how environmentally sustainable their activities and investments are.

The new EU regulatory framework for sustainability is still taking shape and it is likely to be many years before it is finally settled.  New initiatives such as the development of a taxonomy for ‘brown’ or harmful activities, as well as social objectives, are likely to be developed in the coming years.  Capital requirements, which impact on the cost of lending for banks against certain activities, may be adjusted in the latter part of this decade to take account of the new sustainability paradigm.  Other future initiatives may include the introduction of further green and carbon taxes to properly impose the costs of pollution on those responsible. 

Given the scale of the challenges posed by tackling the climate crisis as well as other environmental and social issues, it is clear that we are at the beginning of a journey towards sustainability rather than near its end.  The key takeaway at this stage for all businesses, big and small, is to continue to embed sustainability in business practices, both in terms of risks and opportunities, to enable them to adapt to the seismic changes we are likely to see in the coming years.