ESG, Insights/27 Apr 2022

Finance Plays a Key Role in the Fight Against Climate Change

Climate change is a hot topic in today’s world. All of us are trying to do our part in this hard battle to keep our planet still liveable for the future generations. Sustainable finance is one of the many tools that can be used in the fight against climate change, and it can be used in various different ways to steer global business and investments in a more sustainable direction.

The financial sector has significant power in funding and bringing awareness to issues relating to climate change and sustainability, which is recognised by the most recent treaty on climate change, also known as the Paris Agreement. One of the goals of this treaty is to make finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development. This means that the financial sector must be deeply involved in the fight against the climate change.

The development of sustainable finance instruments

In the beginning, sustainable finance mostly focused on sustainable investing by the way of negative exclusion where investors excluded unethical assets and sectors, such as tobacco, weapons and gambling, from their portfolios. In the last few years, however, financial institutions have improved their offering in the green and sustainable product categories, enabling investors to make direct investments that have a positive impact on the environment. These instruments have continued to gain popularity as investors are becoming increasingly concerned about their investments’ impact on the environment.

In addition to investors, companies that are seeking to raise funds have also become more attuned to their environmental impact. Therefore, nowadays a sustainability link is becoming more of a rule rather than an exception in the loan agreements of large corporations, and a growing number of companies are issuing green, social, and sustainability-linked bonds.

The graph presented below clearly shows that the sustainability-linked loan market underwent significant growth in 2021. We can expect this trend to continue this year as sustainability-linked loans already formed a large part of sustainable financial instruments at the beginning of 2022.

Legislation, frameworks and problem with greenwashing

Despite the rapid growth of the sustainable finance market, policymakers have not been as fast to act. This means that financial institutions, together with borrowers, have been obliged to act as forerunners that make innovations with respect to further developing sustainable financial instruments. There are still no regulations in place for green and sustainable finance, and these instruments are therefore not standardised, which can lead to problems with greenwashing.

For example, although companies set KPIs in their sustainability-linked loans, we cannot be certain if the company is actually setting competitive targets or targets that it would have achieved in any case. With regard to green bonds and green loans, questions remain as to which activities and projects can be classified as green and funded by such instruments and whether such funded assets actually have a positive impact on the environment and the climate.

While guidelines, such as the Green Bond Principles and the Sustainability Linked Loan Principles, act as a good baseline for these instruments, they are only recommendations and therefore not binding regulations. In addition, there are no exact definitions for different ESG-related criteria, which can vary to a great extent between the institutions in question.

The EU to the rescue

To address the lack of binding legislation, the EU has established an advisory body called the Platform on Sustainable Finance to tackle various sustainable finance-related problems and questions. Its main purpose is to develop the EU Taxonomy, which will help with the classification of sustainable activities.

The EU Taxonomy sets out six environmental goals:

  • climate change mitigation,
  • climate change adaptation,
  • sustainable use and the protection of water and marine resources,
  • transition to a circular economy,
  • pollution prevention, and
  • control and protection and restoration of biodiversity and ecosystems.

In order for an economic activity to qualify as a sustainable activity under the EU Taxonomy, it must substantially contribute to at least one of these objectives and do no significant harm to the others in addition to meeting minimum social safeguards.

Once the EU Taxonomy has been finalised, it can be assumed to provide companies, investors, and policymakers with appropriate definitions for sustainable activities. This, in turn, should help prevent greenwashing and direct investments towards more sustainable targets.

What comes next?

All in all, we can see that many things have been accomplished and many are currently in progress, but the sustainable finance market still remains unregulated and unstandardised. The EU Taxonomy is a huge step in the right direction, but some work still must be done in order to secure the financial resources required to be able to achieve the climate target of 2.0°C set out in the Paris Agreement. The European Commission has estimated that sustainable investments must undergo an annual increase of EUR 260 billion if we want to achieve the climate target by 2030. This estimate, however, is only one of many others that mostly range between EUR 175 billion and EUR 290 billion.

Both investors and financiers will need to review their portfolios and balance sheets and familiarise themselves with the EU Taxonomy and the related Sustainable Finance Disclosure Regulation. Accordingly, financial regulators and policymakers will need to step up and revise existing regulations and propose new regulations in addition to the EU Taxonomy to make sustainable finance easier to access and understand.

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