Can sustainable finance save our planet?
"The era of global warming has ended; the era of global boiling has arrived" – these are the words of UN Secretary-General António Guterres, announcing that July 2023 will likely be the warmest month on record.
If the thought of global boiling does not alarm you, what about the impacts of climate change reported over the past few months alone:
- The destruction of 9.4 million hectares of Canada's wild forests due to uncontrollable wildfires;
- The accelerated bleaching of coral reefs and other critical ecosystems;
- The permanent thawing of the Earth's cryosphere (consisting of all the frozen components of the Earth's system).
- The loss of arable land and declining food production;
- Environmental risks and extreme weather events cause millions of deaths per year, posing significant risks to human health and significantly reducing labour
All of this bears witness to the fact that climate change has the potential to decimate not only the environment but economies and communities as well.
What makes climate change more alarming is its multiplying and destabilising effect on existing social, economic and governance issues. Something which we in Africa can ill afford.
Never has the need for all stakeholders to collaborate been so patently urgent, but collaboration continues to be hindered by geopolitical forces, powerful lobbies, the poly-crises distracting leadership, low economic growth, and a lack of regulatory and policy convergence.
On the last point, at least, some important indicators give reason for hope.
Convergence: Information available to market participants is improving thanks to the work undertaken by the Task Force on Climate-related Financial Disclosure ("TCFD") and the Taskforce on Nature-related Financial Disclosures("TNFD"). Improved disclosure of climate-related and nature-related risks and opportunities also ensures that corporates adopting the recommendations are better able to understand the risks to their businesses. The TFND is poised to present its framework in September 2023.
Improvement in consistency of disclosure and reporting sets the scene for regulators to better manage systemic risk posed by climate change and biodiversity loss and to guard against associated market conduct risk. The UK government recently announced plans to develop its own IFRS-based sustainability reporting standard, importantly indicating that this will form the basis of future reporting legislation and regulation. The Johannesburg Stock Exchange ("JSE") has issued sustainability and climate disclosure guidance in South Africa, drawing from the various international standards available. This guidance is voluntary but provides an indication of the direction of travel for future regulation in South
ESG metrics integration
Financial institutions play a critical role in ensuring that the correct projects are funded and appropriate risk-mitigation measures are implemented to buffer economies from the worst effects of climate change. Shareholder demand, together with a realisation of the materiality of these non-financial risks, has led to increased scrutiny of ESG metrics by investment teams. The measuring of ESG metrics by funders and investors, as well as potential future legislative amendments requiring reporting and disclosure, will further drive the integration of these considerations into the strategy and policies of businesses, requiring a change to business as usual. As a result of voluntary adoption in the financial sector and the convergence of a common standard, as discussed above, regulators are increasingly turning toward policy and legislative interventions. The Financial Sector Conduct Authority ("FSCA") recently, in its Statement on Sustainable Finance, set out its programme of work to develop a regulatory framework addressing the emerging conduct risks associated with sustainable finance, including:
- Lack of standardised terminology.
- Inaccurate or misleading information.
- Inconsistent or unreliable reporting; and
- Disclosure of the key risks that it will be seeking to address.
These developments in South Africa are in line with the updated technical paper "Financing a Sustainable Economy" (the "Technical Paper") published by the National Treasury in 2021. The Technical Paper recommends that measures be introduced in the context of South Africa's finance sector, with specific reference to the risks and opportunities posed by environmental and social factors. The Technical Paper makes recommendations "to establish minimum practice and standards with regard to climate change and emerging environmental and social risks," which will likely be implemented by way of, amongst other things, regulatory obligations imposed on banks, insurers, pension funds, collective investment schemes, private equity funds and capital markets participants. While some may argue that progress is too slow, all indicators point toward regulators gearing up to implement the recommendations of the Technical Paper.
The race for sustainable finance
"Sustainable finance" is an overarching concept, capturing the role that the financial sector should play in addressing ESG challenges. It requires financial institutions to integrate ESG factors into investment decision-making and real-world borrowers and investees to monitor, disclose and report with respect to these factors.
Broadly speaking, according to the Technical Paper, sustainable finance seeks to achieve two goals:
"The first is to improve the contribution of finance to sustainable and inclusive growth, in particular funding society's long-term needs for innovation and infrastructure and accelerating the shift to a low-carbon and resource-efficient economy.
The second is to strengthen financial stability and asset pricing, notably by improving the assessment and management of long-term material risks and intangible drivers of value creation – including those related to ESG factors."
The goal in South Africa is to ensure that financial institutions do the following:
- contribute to the realisation of the Sustainable Development Goals ("SDGs").
- promote the just transition to a low-carbon and climate-resilient economy; and
- assist with financial stability in circumstances where, for example, the financial consequences of preparing for climate risks and addressing extreme weather events place enormous pressure on our economy.
The Technical Paper identifies, among other things, the need for a taxonomy for green, social, and sustainable finance initiatives. National Treasury has proposed the Green Finance Taxonomy, based on the EU taxonomy, which sets out a South African-specific classification system, allowing corporates and financial institutions to test their activities against an agreed benchmark. While not yet expanded sufficiently to provide a complete system, assessment of a project or activity against the taxonomy, where possible, gives credibility and can assist the financial sector in determining eligibility for sustainable finance, ensuring that capital is actually allocated to projects able to make an impact, meeting SDG goals.
The consequences for financial institutions
The implementation of the envisioned sustainable finance regime, with increased reporting and disclosure requirements, will come at a significant cost to financial institutions. The Technical Paper indicates that financial institutions will need to adapt their strategies, methodologies, and modelling to incorporate uniform metrics and address new regulatory requirements introduced under the umbrella of "sustainable finance." As can be noted from the Financial Sector Conduct Authority's Sustainable Finance Statement, regulators will exercise stricter oversight and require more transparency in respect of the investments made by financial institutions and the financial products which they offer consumers. Regulators will require disclosure as to how investments contribute to sustainability (including, for example, carbon emission reporting) and how financial institutions measure and manage their ESG risks. Indeed, the FSCA's Statement on Sustainable Finance indicates that the regulator is currently considering whether the Green Finance Taxonomy should be mandatory and is actively encouraging supervised entities to consider adoption.
Financial institutions will need to build capacity and prioritise continuous professional development to understand and meet the new requirements. Additional monitoring and reporting requirements are likely to require a technology solution or will be labour-intensive, given that these requirements will need to be implemented both internally (for example, by way of increased oversight and reporting of the activities of the board) and externally in relation to each investment (per portfolio and transaction). Some financial institutions are already ahead of the curve having subscribed to various voluntary initiatives requiring similar data acquisition and monitoring processes, but for most it will require re-direction.
Implementing a sustainable finance regime globally will also require companies and institutions to bear the full cost of their enterprise rather than externalising some of these costs. In addition, the goal of enabling a just transition away from a high-carbon, resource-intensive economy towards sustainable energy production and resource use requires financial institutions to pay closer attention to the ESG components of their investment decisions. For example, financial institutions will be required to consider whether particular investments benefit local communities or workers. This may make the investment itself costlier and will certainly require closer monitoring by the financial institution to meet its reporting requirements to the relevant regulator.
However, there remains the potential for huge financial rewards. There is a growing body of research demonstrating increased long-term financial performance of investments when ESG is implemented. The increase in climate-friendly technologies, as well as increased investor demand for ESG investments, also present enormous investment opportunities. In this regard, the Business Commission on Sustainable Development estimates that there are more than USD 12 trillion in market opportunities to address the SDGs. A PwC report predicts that up to 21.5% of assets under management (representing approximately US$33.9 trillion) will be held in ESG-focused investments by 2026. It is also likely that tax incentives may be introduced to promote a reduction in carbon output.
The work to be undertaken by the FSCA and the Prudential Authority in collaboration with other South African regulators will promote certainty and level the playing field between financial institutions. As sustainable finance evolves and becomes embedded within the regulatory sphere, financial institutions will need to have the capacity to adapt quickly to meet these requirements. Some of this work is already underway by those financial institutions that have adopted voluntary ESG initiatives. As UN Secretary-General António Guterres has cautioned, to turn the tide on the worst of climate change, "We must turn a year of burning heat into a year of burning ambition".
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