Australia’s sustainable finance agenda: Implications for corporate governance

What is sustainable finance?

Sustainable finance refers to any form of financial activity, including investment, insurance, banking, accounting, trading and financial advice, that integrates environmental, social and governance (ESG) considerations into financial decision-making. Once seen as a specialist investment strategy, the integration of ESG factors into investment decision-making is increasingly seen as essential for ensuring protection of value and reduction of risk over the long-term. ESG factors are no longer seen by the investment community as non-financial but as material to core business value.

As a policy, sustainable finance can be seen to have two aims: firstly to support a long-term transition to a low carbon, resource-efficient and socially inclusive economy; and secondly to improve the ability of existing financial systems to incorporate ESG factors. The Higher Level Expert Group (HLEG) in Europe explained that sustainable finance can be defined narrowly or broadly as depicted in Figure 1.²

Figure 1 HLEG definitions of sustainable finance

Regardless of definitional detail, momentum is certainly building in the banking, insurance and investment industries to meet the trillions of dollars of finance that is required to deliver on the United Nations Sustainable Development Goals (SDGs) and the Paris Agreement’s goal of limiting temperatures from rising two degrees above pre-industrial levels.

The challenge of improving financial sustainability

Modern financial systems are hugely complex: they are regulated by a swathe of different areas of law; they span jurisdictional borders and they deal with very fast-moving and innovative markets. This means that improving financial sustainability requires a co-ordinated, cross-industry, cross-country effort which is both complex and challenging. With foreign investors now owning approximately 45 per cent of Australian equities,³ international developments in this area will influence investment pathways just as much as national progress.

As the financial system becomes more focused on sustainability, the information requested by providers of both equity and debt finance will change and so will their investment strategies.

Sustainable finance and corporate governance

The way financial systems function has a significant impact on the way money flows and therefore on economic development. From a corporate governance perspective, financial systems determine the way shareholders behave and the information they expect from listed companies. As the financial system becomes more focused on sustainability, the information requested by providers of both equity and debt finance will change and so will their investment strategies. This presents both risks and opportunities for corporate Australia. Ultimately less money will flow towards unsustainable economic activities and more towards activities seen as environmentally and socially sustainable.

Already the effects of the international Taskforce on Climate-related Financial Disclosures (TCFD) are being felt by ASX-listed companies as investors call for increased disclosure on climate risks.⁴ Pressure on companies to provide this type of information is only likely to increase as institutional investors, in turn, face increased pressure to explain how they incorporate ESG factors into their decision-making. Throughout the investment chain, there will be a demand for ESG information such that it can flow from the company to asset managers, then to asset owners and on to the ultimate beneficiaries of investment funds. At each stage of the chain, more stringent legislative requirements around reporting will increase transparency and permit better informed decision-making. The European Union’s Sustainable Finance Action Plan (discussed in more detail below) is helpful in understanding the wide range of changes necessary to improve financial sustainability. This framework targets many actors in the financial system: creators of financial products, financial advisors, credit rating agencies, institutional investors, asset managers, prudential regulators and company directors.

International developments

The European Union (EU) has been at the forefront of international efforts to build a more sustainable financial system. In December 2019 the HLEG, comprising 20 senior experts from civil society, the finance sector and academia, was asked to provide advice to the Commission on how to steer the flow of finance towards sustainable investment and protect the stability of the financial system.

Based on the HLEG’s recommendations, on 8 March 2018 the European Commission issued a Communication (COM(2018)97) detailing its Action Plan on Financing Sustainable Growth.⁵ The plan comprised the following ten action points:

1. Establishing a classification system for sustainable economic activities
2. Creating standards and labels for green financial products
3. Fostering investment in sustainable projects
4. Incorporating sustainability when providing investment advice
5. Developing sustainability benchmarks
6. Better integrating sustainability in ratings and research
7. Clarifying the duties of institutional investors and asset managers
8. Incorporating sustainability in prudential requirements
9. Strengthening sustainability disclosure and accounting rule-making
10. Fostering sustainable corporate governance and attenuating short-termism in capital markets

Other financial centres across the world have started to establish Sustainable Finance Roadmaps that will provide guidance across the sector on how to systematically make the transition to a more resilient and sustainable economy. For example, the UK Green Finance Taskforce provided a final report to the UK Government on accelerating Green Finance in March 2018, Canada has established an Expert Panel on Sustainable Finance and China released guidelines on establishing a green finance system in late 2016⁶.

However, the EU plan is undoubtedly the most comprehensive and ambitious with a strict implementation timetable. Possibly the most interesting part of the plan is the development of a classification system or taxonomy of sustainable economic activities. The Action Plan recognises that in order for capital to flow to sustainable activities there has to be a shared understanding of what sustainable means. On 24 May 2018 the Commission issued a proposal for a regulation on the establishment of a framework to facilitate sustainable investment (COM(2018)0353). This draft legislation is currently passing through the EU law-making process meaning it is still subject to change. However, it establishes four criteria that must be satisfied if an economic activity is to be considered as environmentally sustainable. The activity must:

1. contribute substantially to one or more of the environmental objectives (see below)
2. not significantly harm any of the environmental objectives
3. be carried out in compliance with minimum social safeguards, particularly regarding labour and discrimination
4. comply with the technical screening criteria (developed by a group of technical experts who released their latest report in June 2019⁷)

The environmental objectives are listed as follows:

• Climate change mitigation — avoiding or reducing greenhouse gas emissions, for example, through improving energy efficiency or switching to renewable energy (Article 6)
• Climate change adaptation — reducing the negative effects of expected climate change, for example, by strengthening the ability of assets or activities to withstand physical risks (Article 7)
• Sustainable use and protection of water and marine resources, for example protecting the aquatic environment from wastewater or improving water efficiency (Article 8)
• Transition to a circular economy, waste prevention and recycling — for example, through reducing the use of primary raw materials or increasing re-use of materials (Article 9)
• Pollution prevention and control, for example, improving air, water or soil quality (Article 10)
• Protection of healthy ecosystems for example, nature conservation; sustainable land management and sustainable agriculture (Article 11)

The technical screening criteria developed to support the taxonomy are very detailed and industry-specific and set thresholds for determining whether an activity can be classified as ‘sustainable’. They list economic activities across industries such as agriculture, manufacturing, energy, waste, transportation, communication, construction and real estate. These economic activities range from those more obviously environment-related such as electricity production to those that are less obvious for example, data processing or water transport. They identify industries that could be harmful to the environment but also those with the potential to help mitigate and respond to climate change. In other words, they identify industries at risk as well as those with great opportunities.

The definitions in the taxonomy are central to the EU policy framework because they will flow into other areas of the EU action plan to provide a unified understanding of environmental sustainable investment. They will link to standards for green bonds, carbon benchmarks and metrics for disclosure of climate risks. Thus initial users of the taxonomy are envisaged to include financial market participants offering financial products labelled as environmentally sustainable investments. It is thought that once the environmental definitions are agreed upon, a similar process will be initiated for defining social sustainability.⁸ Creating the taxonomy is a huge task and once complete it is highly likely to form the backbone, not only of EU regulation but of regulation across the world.

In an unprecedented collaboration of leaders across banking, finance, peak bodies and academia, the Australian Sustainable Finance Initiative is currently preparing a Sustainable Finance Roadmap to be launched in 2020.

Australian developments

In Australia there is not yet a centralised government-led plan for sustainable finance but action is afoot. In an unprecedented collaboration of leaders across banking, finance, peak bodies and academia, the Australian Sustainable Finance Initiative (ASFI) is currently preparing a Sustainable Finance Roadmap to be launched in 2020.

The ASFI was born out of industry discussions which culminated in a conference in July 2018 where a group of Australian financial sector organisations, representing $10 trillion in assets across the banking, insurance and investment industries, signed a joint statement in support of sustainable finance.⁹

The ASFI was established to enable the financial services sector to contribute more systematically to the transition to a more resilient and sustainable economy, consistent with global goals such as the UN Sustainable Development Goals and the Paris Agreement on climate change. It brings together Australia’s major banks, superannuation funds, insurance companies, financial sector peak bodies and academia to set out a roadmap for realigning the finance sector to support greater social, environmental and economic outcomes for Australia. The roadmap will make recommendations to further four primary objectives:

• Mobilising capital to deliver both national and global sustainable development goals.
• Enhancing the resilience and stability of the financial system.
• Ensuring better informed financial decision-making through enhanced disclosures.
• Delivering a financial system that meets community and consumer expectations for sustainability.¹⁰

In addition, the Australian Prudential Regulation Authority (APRA) and the Australian Securities & Investments Commission (ASIC) have both signalled the importance of climate-related risks through public statements. ASIC, in its September 2018 report on climate risk disclosure by Australia’s listed companies, found that in most instances climate risk disclosures were far too general, and of limited use to investors.¹¹ ASIC has since incorporated requirements for climate disclosure in its regulatory guidance.¹² APRA published an Information paper entitled Climate change: Awareness to action in March 2019 and has clearly stated it will be increasing its scrutiny of how banks, insurers and superannuation trustees are managing climate risk. Both regulators acknowledge the risk that climate change poses to financial stability and the role of directors in mitigating such risk.

Research insights into the state of play in Australia

Our research had three primary tasks: (1) to explore what Australia could learn and adopt from the EU Action Plan; (2) to undertake a systems map of the different actors and groups in Australia relevant to sustainable finance; and (3) to interview key stakeholders from within the Australian finance sector to understand the barriers and potential facilitators for sustainable finance.

Our mapping of the Australian finance sector, together with interviews with 23 stakeholders, highlighted that the Australian financial sector is complex with many interdependent relationships between multiple actors. Notably, interviews with Australian expert stakeholders revealed an emerging global sustainable finance landscape, largely being driven in niches within the Australian context. In some industry segments, private organisations and associations are pioneering voluntary initiatives supported by aspirational leaders.

Stakeholders we interviewed were grouped across five categories: financial institutions; market infrastructure; external observers; peak bodies; and regulatory agencies. Across these broad categories, four emerging themes were identified as particularly salient for achieving sustainable finance in the Australian context: (1) achieving policy certainty; (2) improving corporate governance; (3) co-ordinating market mechanisms; and (4) building sustainability into culture and behaviour.

1. Achieving policy certainty

All stakeholder participants indicated that consistent policy signals were important. At times this was conflated with calls for a more consistent political agenda. Stakeholders highlighted the distortion created by a legacy of inconsistent climate and energy policies and an absence of a clear sustainability agenda from the Federal Government.

2. Improving corporate governance

All stakeholder groups identified corporate governance frameworks and processes as an important lever for enabling sustainable finance. However, opinions varied in terms of which mechanisms they thought would be most effective. Several suggested mandating consideration of sustainability factors within directors’ fiduciary duties and having more sustainability expertise on boards.

Financial institutions, market participants and observers all stated the importance of increasing the transparency of company reporting and some suggested integrated reporting as a means to ensure disclosure was connected to comparable financial metrics. Some thought asset managers and credit rating agencies should also be forced or encouraged to disclose information to industry participants.

3. Co-ordinating market mechanisms

Stakeholder participants highlighted how an increasing proportion of consumers were demanding sustainable assets. Several thought fund managers should be mandated to consult beneficiaries about the extent to which they wanted to include ESG factors into investment decision making and provide guidance on what that means. Others highlighted the key role that analysts and price signals play in driving demand as being more important than regulation. Additionally, several stakeholders highlighted the need for collaboration between research (especially science) and industry to identify opportunities and develop new financial tools.

4. Building sustainability into culture and behaviour

There was general recognition that the finance sector could learn from experienced professionals from Europe and other countries. Some advocated for mandatory training of asset managers, analysts, consultants and financial advisers, especially in relation to climate and systemic sustainability issues. Several stressed a need to incorporate sustainability into the higher education of finance professionals.

The benefits of sustainable finance

A sustainable financial system offers improved resilience and stability to manage short-term shocks and the long-term transition to a low carbon, resource-efficient and socially inclusive economy. It will provide improved financial decision-making through enhanced transparency, better risk management and improved governance processes that consider environmental and social factors in lending, insurance and investment decision-making. By clarifying investor duties and enhancing disclosure requirements, consumers will have access to improved information about their investments that better aligns with their expectations and provides increased confidence that their funds are being invested responsibly. With more emphasis on sustainable finance and improved financial infrastructure to support financial decision-making, there will be an increase in the awareness of and support for investment in sustainable projects and green financial products. A financial system that focuses on sustainable finance will ultimately enhance the long-term resilience and global competitiveness of the Australian economy.

Next steps for governance professionals

It will be important for governance professionals to ask the following questions:

• Does my company engage in economic activities covered by the EU taxonomy?
• Alternatively, do we rely heavily on, or invest in, economic activities covered by the taxonomy?
• If so, could this create future risks for our business?
• Are we collecting the information we need to fully understand our environmental impact and whether we meet any relevant thresholds?
• How can we communicate our risk awareness to interested stakeholders such as investors?

The taxonomy is currently still not final and is designed to be continually updated. Information on its progress and related documents, including a helpful guide on ‘Using the Taxonomy’, can be found here: https://ec.europa.eu/info/publications/sustainable-finance-teg-taxonomy_en.