Green finance is a common language

 Jean-Baptiste Vaujour is a Professor of Practice at emlyon business school where he teaches about consulting and green finance. He is an energy economist and a registered expert at the EU Commission and for the World Energy Council. He has recently published a book on the decarbonisation of the economy.

 

In this article, we explore the stakes around the emergence of a common language when stakeholders discuss green finance.  Based in economic theory, this requirement has been a constant request from market participants and a major regulatory achievement for the European Commission. Unfortunately, it is also only a prerequisite to actual environmental impact and even so, it already faces challenges and strong headwinds.

Economic theory requires transparent information for efficient decisions

Most of economic theory rests on the idea that market channel information to stakeholders in a transparent, immediate and free way. Investors can then decide on an efficient allocation of capital based on rational expectations. In real life, this process is achieved through the iterative price discovery that results from millions of transactions in liquid markets. The deeper and the more liquid the market, the closer it will be to the theoretical ideal. Foreign exchange markets or the yogurt market are close to this situation.

The trouble with the environmental crisis is that information about it is scarce, uncertain and expensive to obtain and process (i.e. an investment fund would need to hire climate scientists and economists to build a very imperfect view of the potential consequences on a specific market at a given time horizon). Stakeholders collectively know that there is an issue but cannot price it and therefore cannot make informed decisions (discussion here).

What is “green”?

Taking one step further, the issue becomes even more dire when investors have to make decisions about green activities. In order for a transaction to occur, both parties have to agree on the properties of the underlying asset. However, there is no clear-cut definition of what a green asset is. Should it focus on the environment? Can other ESG dimensions be addressed? Is it enough to commit to reduce the environmental footprint or should fixed targets be enforced? Should the environmental impact be the primary determinant of decision-making or should it be one amongst others?

Going into the details of a company’s environmental policy or through the clauses of the documentation of a green bond reveals the boundless imagination of actors and it becomes difficult to assess one commitment against the other. Which is greener? Is there greenwashing involved? Can nuclear energy be considered green? Should a renewable power plant owned by an oil major be discarded?

Investment analysts are faced with a quagmire of names and definitions and either have to dedicate significant time and money to assess the different value proposals using proprietary analysis grids or they just have to rely on the good faith of the counterparty. Either way is suboptimal according to economic theory and leads to decisions that are inconsistent with the environmental crisis.

Inventing a new language

Based on this diagnostic, market participants have created industry-based standards to organise a convergence around common definitions. This lead to the creation of labels such as the Nordic Swan Ecolabel and the SRI label in France. These labels provide a methodology and specific criteria that have to be respected in order to be able to claim the alignment with the label. These initiatives, while laudable and methodologically sound, remained market initiatives and were therefore non-compulsory.

The emergence of a consistent framework

This is where regulators stepped in. The need was identified, market participants need to coordinate the way they speak about environmental action. In order to achieve this, three pillars needed to be addressed.

The first pillar is to have a common way to measure and report the environmental impact. The IFRS created the International Sustainability Standards Boards (ISSB) in order to address the question and to propose common environmental reporting standards in the same way it created and maintains traditional accounting rules. In parallel to this, the European Commission developed its own sets of rules through the CSRD (in close collaboration with the IFRS and capitalising on pre-existing market initiatives). Both sets of rules have strong convergences but they diverge on a central concept, double materiality. Double materiality means a company has to report an environmental impact if it is material, in the same way it has to report a change in business. The question is then to know what environmental materiality means. The ISSB is of the opinion that materiality should be limited to potentially significant consequences on the reporting entity, while the EU has adopted a broader definition in which materiality encompasses potentially significant consequences to the environment. The second approach is much more ambitious in terms of environmental protection but raises questions about the feasibility (and cost) of the measures and reporting. The discussion is ongoing between both entities to smooth out differences that may seem technical but are grounded in divergent political appreciations.

The second pillar builds on the first one. Once a common reporting framework is set in place, it becomes possible to define what a “Green” activity is. This is the objective of the European Green Taxonomy, to provide all market participants with a common guide to assess whether an investment can or cannot be labelled as green. The definition rests on three pillars:

1.      Do no significant harm – this is assessed along multiple environmental dimensions

2.      Have a positive impact on at least one environmental dimension

3.      Comply with international social and environmental norms

Should a company respect all three criteria, then it can claim to be compliant with the taxonomy.

The third pillar is to adopt technical regulations for the sectors that need additional specifications. The Sustainable Finance Disclosure Regulation provides specific requirements for labelling funds as green (article 6, 8 and 9), the Green Bonds standard covers debt markets, etc.

What can we make of this?

The past 10 years have been dedicated to negotiating and defining this complex regulatory framework whose sole purpose is to create ex nihilo a new common language. In this sense, it is a considerable regulatory achievement and, despite all its flaws, a success. Market participants now have common tools and references to address situations and, using them, should come to the same conclusions. However, the actual implementation of these tools is proving to be quite difficult, especially for SMEs. This is at the heart of the recent Draghi report: if large companies have the resources and the sophistication to address these new requirements, the financial and human resources required to comply are often out of reach for smaller companies.

This leads to broader considerations. If it is indeed indispensable to have a common language, should we not have a more pragmatic approach and provide incentives to smaller actors to focus on actual impact instead of the reporting obligations while pushing bigger ones to do both at the same time?