Europe needs investments to finance the transition to an environmentally sustainable economic path of growth decoupled from the use of resources. This is not only sensible environmental policy but shrewd economic policy; short-term costs of adopting decarbonizing and resource-efficient solutions are outweighed by long-term benefits to healthier air, improved ecosystem services, industrial efficiency and jobs.
The problem is threefold:
- Incentives are distorted- The value of ecosystem services is not reflected in the prices of goods, this leads to failures in financial risk analysis. As such, financial risk analysis does not do a sufficient job in preventing environmental harm.
- The regulation of financial markets does not allay short-termism- Short-term thinking is promoted through short-term performance indicators in financial decision-making.
- Regulatory uncertainty- Without clear signals from policy-makers private investments to decarbonization will be insufficient.
The costs of this transition cannot be fully covered by public finances; for example public infrastructure investments have been falling since the 1970s from 5 % to 2.5 % of the European GDP. Following the financial crisis, public budgets for investing on low-carbon, resource efficient assets will likely remain constrained. This means that to close the financing gaps member state governments and the European Union need to influence the direction of private investments through smart regulation, i.e. a mix of hard and soft law. Simplified this political process should follow a two-fold path, first introducing harmonized and mandatory ways for measuring and disclosing the environmental footprints of investment portfolios and second incentivizing shifts to low-carbon resource-efficient technologies, assets and companies. During the next parliamentary term, the work of the EU and the member states should concentrate on two aspects:
- As a part of the creation of a European Capital Markets Union, there should be an effort to reorient capital markets towards a long-term perspective. A failure to create incentives for capital markets to adopt longer-term perspectives, where environmental risk factors will materialize, would lead to a failure to mobilize sufficient finances for an environmentally sustainable economic transition.
- As a part of the Long-Term investments communication and related policy proposals, the Commission should introduce and develop specific asset classes and projects green infrastructure or renewable energy. Policy-makers will also need to ensure that investors can have access to attractive investment vehicles supporting the above mentioned policy goals such as risk-sharing instruments.
Roadmap and policy recommendations
1. EU has to create indicators for measuring ecosystem services in a harmonized manner.
2. These indicators have to be integrated in to the reporting of both companies and public institutions (e.g in the case of the European Semester)
3. Environmentally harmful subsidies have to be phased out.
4. Clear political signals in the field of environmental and climate policy have to provide a stable regulatory framework
5. As the improvement of the long-term investment climate of Europe was set as one of the main priorities to guide the work of Commissioner Hill, GLOBE EU sees that this reform process should include the clarification on improving the financing opportunities for low-carbon, resource-efficient investments in the Member States and the EU level guided by the creation of a cross-sectorial, inter-DG Sustainable Financing working group in the Commission.
Better accountability of the systemic risks of inaction posed by the current short-term centered market trajectories should be made public and be integrated as a part of future financial regulation in Europe and capital markets should be reoriented towards the long-term through the integration of environmental, social and governance (ESG) measures. ESG-performance metrics exist, but the financial industry needs to be encouraged to mainstream such practices. The EU needs to ensure that a set of core and sectorial Key Performance Indicators (KPIs) are defined in a unified, consistent and comparable manner. This should be done first at a company level (CSR) and then reflected in the ESG impacts of investors and investment products. The European Commission should ensure that such objectives are reached through consultations with stakeholders and a smart mix of binding and non-binding guidance. The financial sector should have the possibility to be involved in designing positive regulation and incentives in the area, to reward instead of punish commitments to environmental sustainability.
Exploring ESG possibilities in upcoming European financial regulation:
- Mandating all financial products (e.g. all UCITS funds) to measure and disclose their environmental and social footprints in investors’ portfolios in a harmonized and comparable manner;
- Mandating all institutional investors (in particular pension funds and insurers with liabilities extending out decades) to disclose on a comply-or-explain basis, to what extent, if at all, they take into account environmental and social considerations when making investment decisions and, if they do, explaining which processes they have deployed to do so. This could be done via a “Statement of Investment Principles” with a dedicated section on ESG and subject to public scrutiny. The IORP Directive should emphasize in that respect much more the importance of managing non-financial factors and risks and measuring their impacts. By the same token, the current revision of the Shareholder Rights Directive could provide space for such disclosure. The shareholder such as any other property holder should have the fundamental right to exercise property rights, which have been made unreasonably complicated by the intermediaries existing between investors and companies. Investors should have the knowledge of environmental impacts of their investments; this could open discussions on the long-term sustainability and resilience of the business models facing the transition to decoupled growth patterns. Institutional investors especially, have interests in owning assets which can preserve their wealth in the long-term as liabilities often fall decades from the initial investment choices.
- All intermediaries (in particular stock brokers, custodians, banks, proxy advisors and investment consultants) in the investment and financial chain should be also incentivized or mandated to take into account ESG factors and their impacts. European Codes of Conduct could be developed and supplemented by hard regulation where appropriate.
- In its work on the international arena of capital market regulation, the Commision should investigate the impact of future regulatory choices in the IMF and the Financial Stability Board, such as solvency rules should be studied. We should recognize the importance of macro-economic without discouraging long-term investments by capital markets. The EU should work towards a Basel 4 deal which would include strengthening capital requirements to capture all quantifiable risks for institutional investors should pass through environmental risk assessments and harmonized ESG-data and integrated reporting,
- Credit-rating agencies should mainstream environmental risks, as already done by industry front-runners such as Standard & Poors.
Improving financing for green infrastructure projects
European investment funds hold assets of approximately 8 trillion, the Commission estimates that infrastructure investment needs financing in the range of € 1.5-2tn until 2020, if done efficiently it is estimated that the additional infrastructure investment in energy efficiency and low-carbon technologies for power generation needed globally for a low-carbon transition until 2030 would be 3.2 trillion euros.
Policy has to provide predictability to reduce risk for long-term investment in resource efficient, low-carbon assets. The scale and speed of the required transition requires the participation of parliaments and civil society, to nudge the European Commission, finance ministries and private-sector actors to increase their effort to bring about a financial system which can provide the required funds. At the moment the market for ESG-investments is skewed towards European institutional investors (94 % of assets), increasing its attractiveness in the retail market has to be supported, so that asset managers would be more open to see the potential of these investment strategies.
Work done by US financial institutions on normalizing loan documents and harmonizing underwriting rules for commercial and residential markets and informing both regulators and banks on potential new asset classes for green financing. Cambridge University business platform Banking Environment Initiative regrouping banks and researchers indicated that “traditional investment valuation methodologies like Discounted Cash Flow (DCF) analysis are static tools that work best when future market conditions are relatively certain.” At the moment however quantification problems caused by policy uncertainties created by hesitant action by governments leads to capital moving away from investments that could have provided growth and resilience on the long-term. Traditional investment valuation techniques undervalue the positive impacts and the potential value of low-carbon resource-efficient investment. This forces banks to incorporate more complicated options approaches to investment-valuation for investment decisions in the field of green finance in order to mitigate policy and market uncertainties for their investments.
The European economy’s reliance on bank-loans, its weak aggregate demand and a lack of investor confidence means that in business-as-usual scenarios private finance would not be able to bridge the gaps. The de-risking trend for investors such as banks, insurers and pension funds has meant a shift to liquid assets leading to reduced infrastructure investment that could finance green projects. As it stands, the European financial regulation is inconsistent with Europe’s climate and environmental goals. In a situation of competition for capital in the global level, actors in the financial sector are not sufficiently incentivized to make long-term investment in their portfolio management decisions and are biased towards short-termism.
Long-term investments in infrastructure projects have traditionally been a part of the government’s purview the governmental frameworks for PPP’s should be well thought-out, transparent, cost-effective. Corporate finance has been seen as the most important tool in bridging the European green infrastructure financing gap, as bank lending and institutional investors are de-risking and the capital markets are still small players in the sector. Continued public investment is needed in order to guarantee and incentivize private funding in projects with positive externalities for the economy as a whole. The implementation of the new public procurement regulation should be followed, as this could improve financial planning for green projects, Investors are having difficulties in finding green projects which can generate expected returns to investment.
European insurers have seen to show increased interest in financing infrastructure. Environmentally responsible investment suits pension funds well as their long-term liabilities make them patient investors. In many MS’s legislation dictates that their funds are to be channeled productively and prudently taking ESG factors into account. The OECD has developed high-level principles for institutional investors when engaging in long-term green financing , with a chapter especially concentrating on the barriers to green investing, the recommendations of this policy paper should be taken into account in any further action taken on the basis of the long-term financing communication.
The biggest problem is perceived to be the fundamental lack of policies to address market failures in a consistent and clear fashion and the lack of suitable infrastructure investment opportunities which can deliver risk-adjusted returns: “Pension funds need a clearer understanding of government’s infrastructure plans beyond the political cycle. A long-term plan for infrastructure (over 10-20 years) that sets out firm government commitments in the sector is essential to provide greater transparency and increased certainty for the private sector. If political support is undefined and procurement policy lacks clarity then investors will not establish a presence in the market.“ Clearer political signals supportive of green growth by the EU in its infrastructure projects is key. This can be achieved through long-term public guarantees and credit enhancement tools.
Sharing best practices in the field should be improved at the European level, so that ESG-factors would become a major theme in investment choices and ownership strategies. The fourth largest pension fund in Sweden AP4: “has already started taking action using a dynamic investment strategy to decarbonize its US equities and emerging markets portfolios in a way that lowers carbon intensity by 50% to 80% without sacrificing financial returns. Based on this promising experience, AP4 is now committing to decarbonize its entire equities portfolio (USD 20 billion) as soon as possible.”
Asset-backed securitisation provides a route for mainstream capital markets to invest in long-term assets. In the US these business models have been successful (SolarCity), providing lower costs of capital and improving the competitiveness of solar power contracts to installations compared with traditional utility bills, credit rating agency Standard & Poor’s rated the project BBB+ meaning that both pension funds and other institutional investors could buy in. The EU should help securities market to develop by providing predictable policy on the standardized terms for securities in the European level and designing indicators that take into account the quality of the assets financed and the credit risk assessments of the securitized financial instruments.
 Climate Policy Initiative analysis for the New Climate Economy project, based on data from:
International Energy Agency (IEA), 2012. Energy Technology Perspectives: How to Secure a Clean Energy Future. Paris.
Organisation for Economic Co-operation and Development (OECD), 2012. Strategic Transport Infrastructure Needs to 2030. Paris.
Organisation for Economic Co-operation and Development (OECD), 2006. Infrastructure to 2030. Paris.