Sustainable Finance: Overview, ESG & Regulation

Sustainable finance not only represents a new form of understanding and managing investments, but also reflects the commitment of institutions, companies and governments to a greener and more equitable future.

Europe, in particular, has taken the lead in establishing regulations and frameworks guiding this change towards a more sustainable economy.

In this article, we explore the essence of sustainable finance, its importance and the key regulations that are shaping its evolution.

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What is Sustainable Finance?

Sustainable finance is defined as the incorporation of ESG (environmental, social and governance) factors within investment and financial decisions with the objective of achieving long term returns and contributing to sustainable development.

This focus goes further than simply economic benefits, it looks to generate positive social and environmental impacts.

Whilst considering ESG factors, investors and financiers can identify opportunities and risks that aren’t always evident through traditional financial analysis.

Why is Sustainable Finance important?

Sustainable finance is essential because it recognises that financial decisions have wider impacts than economic returns. These decisions can influence social wellbeing, environmental health and the stability of the global economy.

Upon adopting a sustainable focus, financial institutions can play a crucial role in the promotion of equitable development and the fight against global challenges like climate change.

Furthermore, considering ESG factors can help investors to identify and mitigate risks that could negatively affect the long term performance of their investments.

What is transition finance?

Transition finance represents an essential factor within the field of sustainable finance.

While sustainable finance encompasses both finance that is already sustainable (green finance) alongside finance in the process of transition towards sustainable performance levels (transition finance).

Transition finance is specifically centred on private financial investments that look to reduce actual greenhouse gas emissions and other impacts. Its objective is to facilitate the transition towards a climate neutral and sustainable economy.

In other words, it’s for companies with different starting points that are looking to finance their path towards a sustainable future.

On the 13th of June 2023, The European Commission issued non-binding recommendations for how companies, both financial and non financial, can voluntarily use the sustainable finance tools of the EU to search for or provide transition financing.

The EU’s toolbox of sustainable finance endorses both companies with the highest sustainability recordings, alongside those with different start points that have clear sustainability objectives. Furthermore, it allows the smallest companies to obtain proportionally, finance for their transition.

The EU’s Financial Sustainability Framework

The European Union has been a pioneer in the promotion and regulation of sustainable finance, establishing a solid framework that looks to align financial activities with the sustainability and climate change objectives. Detailed below are some of the principal components of this framework.

EU Sustainable Finance Plan of Action

The EU’s Sustainable finance plan of action is an integral strategy that looks to reassign capital towards sustainable investments, manage the financial risks stemming from climate change and promote transparency in economic activities.

The main objective of this plan is to support the EU’s 2030 Agenda and the Paris Agreement objectives. Across diverse initiatives and regulations, the plan looks to guarantee that the European financial system contributes actively to the transition towards an economy with less carbon and climate resilience.

Sustainable Finance Disclosure Regulation (SFDR)

The SFDR establishes bases for uniform disclosure of information related to sustainability by entities within the financial sector.

Its objective is to provide investors with clarity to the impacts of their investments on the environment and society. Guaranteeing a transparent and cohesive disclosure, the regulation looks to avoid “greenwashing” and ensure that investors have the necessary information to make informed decisions.

Non Financial Information Directive (NFDR)

The NFRDs objective is to improve the transparency and comparability of non financial information established by large companies in the EU.

This directive establishes the framework for the disclosure of information surrounding the impact of business activities on the environment, society and workers. In doing so, it looks to establish, for investors, consumers and other interested parties, a clearer vision as to the position and performance of companies in terms of sustainability.

Corporate Sustainability Reporting Directive (CSRD)

CSRD heightens and re-enforces disclosure obligations established by the NFRD. Whilst the NFRD focuses on the disclosure of non-financial information, CSRD goes further, requiring companies to disclose detailed information regarding its alignment to the EU’s sustainability objectives.

This directive recognises that sustainability is essential for economic success in the long run and looks to guarantee that companies report transparently on their efforts and achievements in this sphere.

Sustainable Finance Taxonomy

The European commission’s sustainable finance Taxonomy is a classification system that defines what economic activities can be considered sustainable.

This tool is essential to guide investments towards activities coherent with the sustainability objectives of the EU.

By providing a clear and uniform definition as to what constitutes a sustainable activity, taxonomy looks to avoid “greenwashing” and guarantees that the investments actually contribute to the ecological transition.

Green Bonds

Green bonds are debt instruments issued for specific financial projects that have clear environmental benefits.

These bonds have gained popularity in recent years, mainly because they offer investors the opportunity of contributing directly to the funding of sustainable projects.

The EU has established a framework for Green Bonds, defining clear criteria that financial projects must comply with in order to guarantee their positive impact on the environment.

Sustainable Finance Standards & Frameworks

The regulatory framework surrounding sustainable finance has rapidly evolved, and with it, has emerged a series of standards and frameworks to guide companies on their path to sustainability.

These frameworks and standards vary in their focus and applicability, but all look to establish clarity and coherence in the disclosure and management of risks and opportunities related to ESG.

GRI (Global Reporting Initiative Standards): Currently, these standards are the most used and accepted for the presentation of sustainability reports. They’re divided into three segments: Universal, Sector and Topic, and they prioritise the participation of interested parties and the evaluation of materiality as an integral part of reporting criteria.

SASB (Sustainability Accounting Standards Board): SASB standards identify subassemblies of ESG information relevant for the creation of long term value. It develops specific themes and measurements for each of the 77 industries it covers.

SDGs (Sustainable Development Goals): 17 objectives introduced by ONU in 2015 covering the three pillars of ESG. They form part of the 2030 Agenda for Sustainable Development.

TCFD (Task Force for Climate-related Financial Disclosures): Created by the Financial Stability Board (FSB), TCFD looks to improve the quality of information disclosed to investors, loan offers and insurance brokers on risks related to the climate.

IFC (International Finance Corporations) Performance Standards: These standards develop an international reference point to identify and measure environmental and social risks within a company or their investment activity.

Every one of these standards and frameworks have their pros and cons, but all together they represent a collective force to align the financial world with global sustainability objectives.

Sustainable Finance Challenges

The financial world is experiencing a significant transition towards sustainability, with a particular focus on environmental, social and governance criteria.

However, this transition isn’t free of challenges:

Lack of consistent ESG data

The main challenge that the entire market faces is the lack of agreement on ESG data and the availability of these data points.

Unlike traditional financial information, a standard or framework for universal ESG information doesn’t exist. This generates difficulty when trying to analyse and compare the data between companies and nurture the market’s scepticism surrounding the ESG measures effectiveness.

To address this problem, the International Sustainability Standards Board (ISSB) is developing a “comprehensive global baseline”.

Mobilisation and Incentivisation of Private Companies

Another significant challenge is the mobilisation and incentivisation of private companies, especially small to medium enterprises, to share their ESG data.

These SMEs, that represent a large proportion of global companies, will be essential in the global transition towards a sustainable economy.

Company Challenges on an Individual Level

On an individual company level, there exists various key challenges:

Looking beyond the ESG tagline: Companies should identify and address specific problems within their organisation instead of simply adhering to general topics.
Integration of investment or credit decisions: Financial institutions should integrate an ESG strategy in their credit and investment decision processes.
ESG Expertise & Training: It’s vital to rely on ESG experts and training opportunities within the company to address sustainability related questions in an effective manner.
Communication of ESG agreements: Companies should communicate effectively how they have managed ESG risks and promoted sustainable practices.
Integration of ESG in Risk Management: Companies should integrate ESG considerations in their risk management to protect themselves against risks related to sustainability.

These challenges highlight the necessity of a holistic and well informed focus on sustainability within the financial sector.

Conclusion

Sustainable finance represents a crucial evolution in the financial world, aligning financial investments and decisions with environmental, social and governance objectives.

Financial companies and institutions advancing on this path, will face challenges with relation to standards, disclosure and adaptation to a regulatory framework alongside constant evolution.

However, these challenges also present opportunities to innovate, adapt and lead in a world which looks for sustainable and resilient solutions to climate change.

To effectively address these sustainable finance challenges, it’s essential to rely on adequate tools and solutions.

APLANET offers ESG technology for decision making processes, helping you to organise, measure, analyse and report your ESG data in a personalised, efficient and reliable fashion. If you want more information on how we can help you, contact us here.

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