Meeting the Challenges of Sustainable Finance

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Fellow - AI & Emerging Technologies

In response to the economic impacts of both Covid-19 and climate change, EU member states have launched ambitious future investment plans, committing to reduce their emissions by at least 55% by 2030. A 'greening' of investments and finance is thus an immediate priority in order to achieve these ambitions.

Institut Montaigne and the School of Management and Innovation at Sciences Po have organized a series of events on the future of investment in Europe to address these issues. This article follows the sixth of those events-a discussion about sustainable finance-with Gonzague de Blignières, co-founder of RAISE; Ambroise Fayolle, vice-president of the European Investment Bank; Fanny Picard, founder and CEO of Alter Equity; and Natacha Valla, economist and dean of the School of Management and Innovation at Sciences Po.

Europe as the leader in a fair and ambitious ecological transition

The climate crisis requires a radical acceleration in the greening of business practices and financing. To meet the goals proposed by the Paris climate agreement, greenhouse gas (GHG) emissions must be reduced by an estimated 5% per year, equivalent to the environmental impact of Covid-19 in 2020.

This challenge should be considered an opportunity for Europe, which has historically had higher environmental, social and governance (ESG) standards than the United States. The goal is to build on this already-established lead, as the environmental impact of projects and companies becomes an increasingly important factor for attracting talent. As well as their attractiveness on ESG criteria, environmentally resilient companies are also best placed to attract increasing levels of capital from investors wary of the financial risks posed by climate change.

Driven by this dynamic, major players in European finance are further orienting themselves towards the ecological transition. This includes not only investors and asset managers but also the European Central Bank (ECB), which has taken on a pioneering role among central banks in its monetary policy strategy, and the European Investment Bank (EIB). The EIB has promised a record €95 billion of financing during 2021 and aims to become the European Union's "climate bank" by setting ambitious targets, such as increasing its share of investments in green projects from 25% in 2020 to 50% in 2025.

Support for climate policies is not only needed on a national level-as the recent crises linked to rising fuel prices have shown-but on an international one as well.

Despite the energy and capital being deployed, the adequate rhythm for a successful transition remains a balancing act between rapidly addressing the climate crisis on the one hand, and ensuring that the transition is fair and carried equitably by all sectors of society on the other. Support for climate policies is not only needed on a national level-as the recent crises linked to rising fuel prices have shown-but on an international one as well. In particular, support will be required for certain Eastern European countries, as well as for many developing countries, in order to adapt their policies with these constraints in mind, and not solely focus on reducing GHG emissions.

Criteria is key

Responsible governance and concrete objectives are the cornerstones of sustainable finance. A prerequisite for concrete objectives is adopting a shared taxonomy that provides a standard definition of what it means to be ‘green.' Without a shared taxonomy, information asymmetry and the temptation for businesses to 'greenwash' may scare off investors at the precise moment when investment is most needed to finance the transition.

The European Union has therefore launched three pieces of legislation that deeply impact asset managers and investment funds.

The EU taxonomy for sustainable activities aims to classify economic activities that can be considered ‘green’ according to three cumulative criteria-contributing to at least one of the six environmental objectives proposed by the taxonomy, not causing significant harm to any of the five other objectives, and respecting minimum social safeguards.

The Sustainable Finance Disclosures Regulation (SFDR), which covers sustainability reporting within the financial services sector, helps investors make environmentally informed decisions by classifying funds into three distinct categories under Sections 6, 8 and 9 of the SFDR regulation, each with stringent and documented investment criteria. Section 9 investment strategies, for example, have a sustainable investment objective. This means they are considered to be proactive regarding ESG, whereas Section 8 strategies are seen to simply promote ESG.

The Corporate Sustainability Reporting Directive (CSRD), formerly known as the NFRD, imposes transparency obligations on large companies regarding their ESG practices.

With these three tools, the European Union now has considerable influence over the allocation of funds. However, the EU’s approach is not the only one. China is also developing its own system, whose interoperability with the European taxonomy is the subject of the Common Ground Taxonomy report produced by the International Platform on Sustainable Finances (IPSF).

Strict conditions are not limiting investment targets

The introduction of stringent criteria for selecting investments could have made it difficult for funds to identify suitable targets; however, this has not been the case. In addition to the many ESG-native startups and scaleups, many existing companies want to invest in becoming greener, and many green infrastructure projects-renewable energy, energy efficiency in buildings, etc.- also require significant investments. It is also important to note that returns from 'impact businesses' are now at high enough levels to meet the investment criteria of major private equity investors. Nevertheless, identifying targets for virtuous investment is made more difficult by limited access to companies' environmental impact data, as well as the time it takes for companies to implement a clear environmental roadmap.

The major remaining obstacles to green investment are related to financing innovation and long-term projects, on the one hand. Developing new, innovative technologies will be essential to achieving the environmental objectives for 2050, and this requires significant investments - the returns on which may well take longer than the norm. As well as requiring more patient investors, targeted public investments will also be necessary in order to attract private funds to key projects.

Developing new, innovative technologies will be essential to achieving the environmental objectives for 2050, and this requires significant investments.

On the other hand, the financing of projects that involve biodiversity protection, such as water management, continues to face particular difficulties. These projects usually involve smaller investments yet require a level of expertise that investors have struggled to develop.

Investors also have a role to play

Investors can also continue to work on aligning their own interests with sustainable investment strategies. These could include aligning compensation with environmental KPIs, forming a team dedicated to environmental reporting, and setting up internal carbon pricing (ICP). To calculate the internal profitability of infrastructure projects, the EIB for instance uses a carbon price that increases over time, rising from €80 in 2021 to €800 in 2050-a trajectory that aligns with the European objective of achieving carbon neutrality by 2050.

Incorporating carbon pricing into investment decisions is not simply a matter of goodwill. The environmental risk and increasing unattractiveness of ‘brown’ assets mean that these assets may quickly become either unprofitable or unsellable. Investors are rapidly becoming aware of this reality, and taking action as a result.

Copyright: JONATHAN NACKSTRAND / AFP