Environmental, Social and Governance (ESG) investing sits at the intersection of an extraordinary convergence of public policy initiatives and private capital flows. While ESG investing has been a key theme in private markets for some time, capital flows to these assets classes are accelerating as they are facilitated by emerging European and domestic policy. Conventional thinking was that ESG investing could be attributed to three main drivers:
However, ESG investments are increasingly delivering superior returns and the accelerating flows to ESG investments can no longer be attributed to purely altruistic motives. This is set to continue with economic growth at a European and Irish level being linked to achieving carbon neutrality by 2050, facilitated by a range of policy and regulatory instruments that seek to drive private sector capital flows to sustainable investments through a combination of binding targets and regulatory facilitation.
Drivers Of Change
In 2019, the EU implemented a series of measures in the Clean Energy Package that targeted a 40 per cent reduction in greenhouse gas (GHG) emissions by 2030. However, before the end of the same year the European Commission published its European Green Deal Communication[i], which included a substantially more ambitious target of a 50 per cent reduction in GHGs by 2030, with a view to moving to 55 per cent reduction. In 2020, this 55 per cent reduction target by 2030 was adopted in the Communication on Stepping up 2030 Europe’s Climate Ambition (the Climate Target Plan) in September 2020, with carbon neutrality at an EU level targeted by 2050[ii].
These developments are notable not merely for their extraordinary ambition or even the pace at which the ambition levels are increasing. They are also notable for the fact that these measures are not just focused on the energy sector but rather on the entire economy. The European Green Deal is different to all previous energy packages in that it is a growth strategy grounded in an all-sector approach to reducing emissions and decoupling growth from resource use. Decarbonisation across all sectors is required, as is integration of digital technology and linkage between systems and sectors.
In addition to significant review of law and policy impacting energy, transport, buildings and construction, agriculture, and industry and manufacturing, the EU is developing a Regulation establishing the framework for achieving climate neutrality to serve as an overarching climate law to bind the EU institutions and Member States to take necessary actions to achieve carbon neutrality by 2050[iii].
Energy And Climate Policy In Ireland
Climate neutrality is also enshrined in Irish government policy. The 2019 Climate Action Plan[iv] (currently being updated); the Programme for Government[v]; and the Climate Action and Low Carbon Development (Amendment) Bill 2021[vi] are establishing a policy and legislative framework for Ireland to achieve an average 7 per cent annual reduction in emissions over 2021-2030 (which equates to a reduction of 51 per cent over the decade); meeting 70 per cent of electricity demand by renewable sources by 2030; and ensuring all cars and vans in 2030 are electric vehicles (EVs).
In addition to political commitment to climate action, Ireland has the advantage of plentiful renewable resources, particularly offshore wind. Moreover, there is an increased appetite on the part of private capital to progress infrastructure development projects. As is the case in many jurisdictions, stakeholders are keen to see work progress on the enabling framework required for infrastructure project planning, funding and delivery (particularly as regards energy market regulation, the streamlining and resourcing of consenting and planning processes; timely grid connection; and optimal frameworks for routes to market).
The Funding Challenge
Meeting these 2030 and 2050 climate targets will require one of the greatest mobilisations of capital and investments in infrastructural and behavioural change ever seen. The European Commission estimates that, in addition to the investment in the previous decade, an additional €350 billion of investment will be necessary each year to meet the target of reducing GHG emissions by 55 per cent in 2030. The Commission considers that the long-term economic disruptions and adverse social consequences resulting from failing to make these investments would far outweigh these costs. The European Central Bank, the European Investment Bank and many central banks have made similar statements.
Public money is not enough to drive the change; private capital must play a significant role in achieving overall global success. A number of things must work together to mobilise this private capital. Global and domestic initiatives include standardised taxonomies and metrics, renewed tax policies, and establishing task forces to advance technological and engineering solutions. Almost all of these initiatives involve significant resources.
The investment pillar of the European Green Deal, the EGD Investment Plan[vii], aims to mobilise at least €1trillion. Other cornerstone EU policies – the Sustainable Finance Package[viii] and the Capital Markets Union[ix] – are developing frameworks to facilitate the re-direction of private investment towards sustainable and decarbonised materials, processes, products, services, and infrastructure, and to facilitate the use of market-based financing, securitisation, and other funding alternatives to meet the financing requirements of those working to implement the European Green Deal goals.
Progress towards directing private capital flows towards sustainable investments has been slow. In a recent survey commissioned by Standard Chartered,[x] many business leaders noted that funding was a major obstacle to meeting their emissions targets with significant investment needed to make the transition to net zero carbon emissions. The survey revealed that 85 per cent of companies surveyed require medium or high levels of investment to transition (91 per cent of carbon-intensive companies) and respondents noted difficulties in finding the money they need to go green.
The first measure in the EU Sustainable Finance Package to be implemented was the EU Sustainable Finance Disclosure Regulation (SFDR), which applied (in part) from 10 March 2021. SFDR approaches ESG issues in the investment cycle from two angles: (i) sustainability risks as ESG events or conditions that could cause a material impact on the value of an investment; and (ii) investment decisions themselves may have adverse impacts on ESG issues that financial services and product providers should take into account as responsible businesses.
SFDR applies to “financial market participants” and “financial advisers” including Alternative Investment Fund Managers (AIFMs) and Undertakings for the Collective Investment in Transferable Securities (UCITS) managers, investment firms that provide portfolio management, and investment firms that provide investment advice. SFDR requires disclosures to be made on websites, in periodic reporting, and in pre-contractual documentation.
The disclosures focus on how financial market participants incorporate sustainability into investment decision-making. While framed as a “disclosure” regulation, in practice SFDR has prompted a lot of work on firms’ policies and procedures. Preparing the disclosures requires a review of ESG policies and the gathering of granular detail on a wide range of “principal adverse impacts” on sustainability factors. A lot of this data is not currently collected or recorded in the manner envisaged by the rules (if it is collated at all). This means that as well as having a direct impact on “financial market participants” and “financial advisers”, the SFDR is likely to have a ripple effect across the market for firms’ subsidiaries and counterparties as well as for corporates. Companies will receive more ESG information requests from asset managers, funds, data analytics providers and ratings agencies and increased scrutiny of ESG performance will impact how they attract investment and access finance.
While not directly applying to the funds themselves, funds are indirectly impacted as each fund manager is required to comply with SFDR, even managers not promoting ESG funds. Pre-contractual documents for funds were required to be amended and further amendments will be required when the level II requirements are implemented. Funds needed to be classified in accordance with their sustainability approach: dark green, light green or non-ESG. The classification process drove, and will further drive, the considerations around the positioning of products in the sustainability spectrum and is evidence of the pivot of managers to ESG and the success of redirecting capital flows into sustainable products.
Generally speaking, securitisations themselves are out of scope of SFDR but we have seen some managers responding to the SFDR by including updated versions of their standard sustainability risks disclosure in offer documents.
The EU Securitisation Regulation already sets out due diligence and disclosure standards for securitisations. In relation to ESG, the recitals of the Regulation note that where data on the environmental impact of assets underlying securitisations are available, the originator and sponsor of such securitisations should publish that data. In addition, for “STS” labelled securitisations, the disclosure of available information related to environmental performance of “residential loans or auto loans or leases” is required.
The EU Securitisation Regulation is expected to be reviewed by 1 January 2022 and this review is likely to introduce further ESG related disclosures into the framework. The EU Capital Markets Recovery Package (CMRP) introduced a mandate for the European Banking Authority to publish a report by 1 November 2021 on developing a specific sustainable securitisation framework “for the purpose of integrating sustainability-related transparency requirements” into the EU Securitisation Regulation. There is a strong likelihood that any changes will draw heavily on SFDR.
Irish credit institutions are subject to increasing supervisory expectations on the management of climate change risk and to increasing disclosure requirements as a result of recent changes to the EU Capital Requirements Regulation (CRR).
The European Central Bank, as regulator of larger banks in the Eurozone, set out its expectations on consideration of climate-related and environmental risks in banks’ business strategy, governance, and risk management frameworks in recent supervisory guidance and the Central Bank of Ireland has similarly declared that it will be become increasingly active and intrusive in its approach to the supervision of climate change risks.
Recent amendments to the CRR are intended to embed ESG disclosures in EU banks’ reporting requirements under Pillar 3 of the Basel Framework. The exact scope of banks’ Pillar 3 ESG disclosures under CRR is subject to finalisation but it is expected that mandatory disclosure on topics including climate change risks, mitigating actions, and banks’ green asset ratios will apply from June 2022. A decision on whether to apply a dedicated prudential treatment for ESG assets under CRR is not due to be made before 2025 at the earliest.
In addition, to the extent that EU credit institutions provide portfolio management services, they will be subject to SFDR as “financial market participants”.
The transition from carbon intensive investments to a carbon neutral economy gives rise to significant challenges and requirements for investment. This was recognised in the process to develop the EU Taxonomy Regulation which included the concept of a “transitional activity”. A transitional activity is one for which there is no technologically and economically feasible low-carbon alternative; that has substantially lower greenhouse gas emissions than the sector or industry average; does not hamper the development and deployment of low-carbon alternatives; and does not lead to a lock-in of assets incompatible with the objective of climate neutrality considering the economic lifetime of those assets. This addition to the taxonomy was controversial, reflecting the obstacles and challenges in balancing net zero goals with current technological and economic realities.
While Europe’s 2030 and 2050 climate ambitions represent significant challenges, they also represent extraordinary opportunities. Significantly, these targets represent opportunities that the market is embracing as private capital inflows to ESG investments accelerate. As regulatory frameworks to facilitate this investment continue to be developed, we can expect this trend to continue and accelerate as new assets classes and new financial instruments emerge.
Ireland’s natural renewable resources and policy leadership in the climate sphere put it in a powerful position to play a leadership role in the energy transition. Ireland’s response to this challenge is a “moon shot” ambition of its own, to significantly accelerate technological and engineering progress. With the issue of its new climate law, Ireland is on the starting block of the race of a lifetime.
Tara is a Partner and Co-Head of Arthur Cox’s Asset Management and Investment Funds Group. Tara has extensive experience in advising leading asset managers and fund promoters. Tara represents clients both globally and domestically in the structuring, establishment, management and sale of a wide variety of investment funds in the UCITS and alternative space. Tara advises those funds, their management companies, servicing operations and directors of their regulation, compliance and corporate governance requirements. Tara has also advised on a number of large asset management group and platform amalgamations. Tara has a particular expertise in ETFs and is a leadership member of the Irish chapter of Women in ETFs. Tara is a regular contributor to international journals and publications.
Sarah Thompson is a financial services regulatory partner in the Arthur Cox Belfast Office in Northern Ireland. Sarah has experience in advising a broad range of clients on financial regulation matters. Prior to joining Arthur Cox, Sarah worked in London as part of the Financial Regulation Group of Linklaters LLP and the Financial Services Regulatory team of Kirkland & Ellis International LLP.
Brendan is a partner in the Finance Department and is part of the firm’s Financial Regulatory and Capital Markets Groups. Brendan advises a range of Irish and international clients on financial markets infrastructure, regulatory capital, trustee and agency law, securities regulation and debt capital markets matters. Brendan also regularly advises corporate and institutional clients on netting, collateral and hedging issues and capital management structures.
Katrina is a Professional Support Lawyer in the Arthur Cox Infrastructure, Construction & Utilities Group. Katrina is responsible for know-how, training and development in the areas of energy sector regulation, construction law, and public procurement law. Katrina has advised on infrastructure development projects and regulation across several sectors including energy, education and waste management.
Alex is Head of the Energy, Renewables & Natural Resources Group and a member of the Arthur Cox Sustainable Business Committee, with particular responsibility for the firm’s Pro Bono practice. Alex has a broad based infrastructure and utilities practice, with particular expertise in renewables, energy and natural resources law. Alex has almost twenty five years energy regulatory, transactional and major projects experience in Ireland and Australia and has been centrally involved in the liberalisation of the energy markets in both jurisdictions. He has extensive experience acting for government, regulators, financiers, market participants and customers, both on the island of Ireland and internationally, and combines broad industry expertise with a strong background in energy regulation and reform.