A sustainable capital markets union manifesto

A Sustainable Capital Markets Union Manifesto Five priority areas and 23 policy recommendations to ensure that the Capital Markets Union Initiative delivers sustainable, long-term growth that serves the real economy and current and future generations of EU citizens.

The Commission’s new work program rightly reflects the sense of urgency around the economic and social imperative to restore growth in Europe. Capital Markets are a key enabler to achieve this objective, and Eurosif, the leading non-for-profit pan-European sustainable and responsible investment (SRI) membership organization and think tank, applauds the Capital Markets Union (CMU) initiative.

We believe that the two key conditions for the CMU to achieve its objectives are:  

To contribute to reducing the cost of capital for European companies, including SMEs. To build an investment environment conducive to greater long-term capital allocation for productive purposes, in particular – but not only – via public markets.

As part of this agenda, Eurosif strongly believes in a 6th key policy principle for the Capital Markets Union, in addition to the 5 already put forward by the Green Paper launching the consultation, namely on promoting long-term oriented investment practices, aligned with sustainable growth and economic development objectives . Here is why in brief: 

A growing, but still small, proportion of investors realizes that current business models, and more generally economic activity assuming unlimited natural resources, are not sustainable, creating systemic risk1. The Bank of England itself recently warned that global warming could have “significant effects” on markets and financial bodies2, and the G20 has recently asked the Financial Stability Board to look at the fall-out faced by the global financial sector, with the growing realization that climate rules will become much stricter3. Ensuring that these challenges are addressed will contribute to fostering greater investor confidence and participation, as well as avoiding potential future major financial crises.

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See for instance UNEP-fi, Lenses & Clocks, 2012.

See Bank of England, One Research Agenda Discussion Paper, 2015.

3 http://www.telegraph.co.uk/finance/economics/11563768/G20-to-probe-carbon-bubble-risk-to-global-financialsystem.html 2

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Companies with superior environmental, social and corporate governance performance tend to have a lower cost of capital, both in equity and debt terms 4 . Several studies also show that better sustainability policies lead to better credit ratings.

Superior sustainability quality is valued by the stock market (and therefore investors): more sustainable firms generally outperform less sustainable firms5. Sound corporate governance plays a key role in that result.

A Capital Markets Union incorporating sustainability (Environmental, Social and Governance) elements will contribute to curb excessive short-termism of capital markets, which was one of the factors that led to the recent global financial crisis, and is likely to foster resilience of the financial system.

More generally, Eurosif, believes that Europe’s growth and job creation agenda cannot be decoupled from the broader sustainability agenda. They are two sides of the same coin.

Policy initiatives seeking to “unlock investment in EU companies and infrastructure” and “improve the allocation of risk and capital” must, therefore, be aligned with the Europe 2020 Strategy objectives for smart, sustainable and inclusive growth, as well as other EU social, climate and energy objectives. Growth has to be compatible with today’s environmental and social challenges facing Europe.

As noted in the Green Paper accompanying the public consultation on building a Capital Markets Union, €8.4 trillion are held in stock market capitalization, and €12 trillion by pension funds and the insurance sector, so there are massive sums that can be better mobilized to support sustainable growth. As part of this 6th key principle to be added to the Capital Markets Union, Eurosif makes 23 specific policy recommendations clustered around 5 high-level policy themes.

The 5 high-level policy themes are: 1. Incorporate a strong and comprehensive corporate disclosure policy package.

2. Ensure that environmental, social and governance considerations are incorporated into investment practices.

3. Align incentives to reward corporate and investor stewardship practices reinforcing long-term value creation.

4. Promote a sound corporate governance framework via active and long-term oriented shareownership.

5. Scale-up long-term sustainable growth by leveraging financial innovation.

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See for instance meta-studies drawing upon leading academic work, such as Clark, Gordon L. and Feiner, Andreas and Viehs, Michael, From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance, 2015; Deutsche Bank Climate Change Advisors, Sustainable Investing: Establishing Long-term Value and Performance, 2012.

5 Ibid.

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I. Incorporate a strong and comprehensive corporate disclosure policy package

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Environmental, social and governance (ESG) factors can be material to financial performance . Corporate information disclosure around ESG factors can help investors more accurately price companies, and support those companies investing in long-term sustainability oriented projects. 93% of European investors agree 7 that more needs to be done in this respect , while investment approaches incorporating elements of corporate sustainability reporting have grown faster than the overall EU asset management market in 20118 2013 .The Non-Financial and Diversity Disclosure Directive marks an important first step that needs to be complemented by a comprehensive disclosure regime, to better meet investors’ expectations and improve the allocation of capital. This would create a virtuous circle, thus boosting Europe’s competitiveness.

1. Ensure the success of Directive 2014/95/EU by (a) ensuring consistent implementation at Member State level, and (b) by providing practical “Level 2” measures and guidance to companies to help them prepare relevant reporting, including guidance on Key Performance Indicators (KPIs). One of the key investor expectations with regards to nonfinancial reporting is the disclosure of material KPIs that enable peer comparison. Ideally, Eurosif would like to see a minimum number of general KPIs for all economic sectors, and a series of KPIs that would need to be sector-specific. A number of existing initiatives have produced interesting results in terms of KPIs, that can be used for such guidance (such as the European Federation of Financial Analysts Societies - EFFAS, or the Delphi project. In particular, EFFAS developed sector-specific KPIs for 114 subsectors, as well as a methodology for defining industry-specific KPIs that any third party can use).

2. Continue to progress legislation that ensures that corporate non-financial information is comparable, timely (i.e. simultaneous to financial disclosure), and mandating a short set of Key Performance Indicators, both sectorial and general, as these conditions are not fully met by the adopted text.

3. Mandate relevant corporate climate information disclosure: there is increasing evidence that climate change risks 9

constitute a significant portfolio risk for investors . A growing number of investors are taking steps to integrate climate 10 risk into their investment strategy, for example by tracking carbon exposure . Despite progress, corporate reporting 11 of GHG emissions covers less than 50% of mainstream investment indices . In addition, GHG emissions disclosure only 12 provides one part of the carbon risk equation and is not sufficient for investors . Companies also need to provide 13 investors with a forward-looking assessment of carbon risk and how it could impact their assets and cash-flows . Data allowing a comparison of company performance under various climate scenarios would be also useful.

4. Support the wider adoption of <Integrated Reporting>, as a way to promote long-term oriented corporate thinking, and provide relevant and forward-looking corporate information to investors.

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See Clark, Gordon L. and Feiner, Andreas and Viehs, Michael, From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance, 2015; Deutsche Bank Climate Change Advisors, Sustainable Investing: Establishing Long-term Value and Performance, 2012; Eurosif, Shareholder Stewardship: European ESG Engagement Practices (2013).

7 Eurosif & The Association of Chartered Certified Accountants, What do investors expect from non-financial reporting?, July 2013.

8 Eurosif, European Sustainable and Responsible Investment Study (2014).

9 Mercer, Climate Change Scenarios: Implications for Strategic Asset Allocation, 2011.

10 Montreal Carbon Pledge, 2014; Global Investors Coalition on Climate Change, Global Investor Statement, 2014.

11 See 2degrees Investing Initiative, From financed emissions to long-term investing metrics, 2013.

12 UNEP-fi, Portfolio Carbon: measuring, disclosing and managing the carbon intensity of investments, 2013.

13 2degrees Investing Initiative, Ibidem.

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II. Ensure that environmental, social and governance considerations are incorporated into investment practices

As ESG factors can affect the long-term performance of companies and have a material impact on stock 14 value and investment portfolio performance , they are relevant to most asset classes, from listed equities to private equity, from fixed income to real estate. Sustainable and Responsible Investment (SRI) is an investment approach recognizing the materiality of these factors and the fact that about 84% of the value of 15 a company today lies in its intangible assets . SRI approaches are long-term oriented and connected to the real economy. As such, policy-makers should strive to build a policy framework conducive to SRI practices.

When doing so, instruments and investment vehicles that can support SRI approaches should not be confused with SRI approaches themselves. For instance, Green Bonds are investment vehicles appealing to 16 SRI investors (60-80% of the demand), as well as mainstream investors .

1. Introduce detailed transparency on SRI policies of institutional investors, via a mandatory Statement of Investment Principles (“SIP”), in which institutional investors would state, on a comply-or-explain basis, the extent to which (if at all) non-financial, long-term and stewardship considerations are taken into account in the selection, retention and realization of investments, and explain how they implement such SRI policies. This could be done by amending the IORP or Shareholder Rights Directive.

2. Clarify the ambiguity around the notion of fiduciary duty, too often understood as “maximizing (short-term) financial return”, by emphasizing that ESG concerns are compatible, as they may impact long-term profitability, and consider a Recommendation or a Communication on this subject.

3. Be more explicit and specific in the IORP II (Pension) Directive proposal about the importance of taking into account non-financial (ESG) risks.

4. Ensure that key advisors in the investment chain also disclose how sustainability has been taken into consideration in their recommendations. For instance, investment consultants, who are gateways to significant amounts of institutional money, should be encouraged to develop a Code of Conduct for their industry, requiring them to incorporate ESG issues into their analysis and recommendations. Many consultants still do not raise stewardship 17 issues with their clients . Brokers, proxy advisors and credit rating agencies should also be encouraged to incorporate these considerations in their work.

5. Promote sustainable and responsible investment by public institutional investors (to start with the European Commission and Parliament Pension Funds), through initiatives similar to the Green Procurement one.

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See for instance two recent and meta-studies drawing upon leading academic work, such as Clark, Gordon L. and Feiner, Andreas and Viehs, Michael, From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance, 2015; Deutsche Bank Climate Change Advisors, Sustainable Investing: Establishing Long-term Value and Performance, 2012.

15 Ocean Tomo, 2015 Annual Study of Intangible Asset Market Value.

16 Eurosif, European Sustainable and Responsible Investment Study (2014).

17 NAPF, Engagement Survey 2014, November.

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III. Align incentives to reward corporate and investor stewardship practices reinforcing long-term value creation

Focusing on incentives is critical, as the current capital markets incentive system is primarily focused on (short-term) financial value. Re-aligning incentives (and rewards) with sustainable value creation, both on the investors’ and companies’ sides, will drive a new set of behaviors, aligned with the long-term and sustainable growth and jobs ambition of the CMU initiative. Eurosif has detailed its position on corporate governance in 18 financial institutions and remuneration policies in a dedicated policy paper , and has also prepared an 19 expert report on ESG engagement and shareholder stewardship practices .

1. Remuneration strategies of corporate Boards and senior management, including those of financial institutions, should include ESG-performance related criteria. Companies should disclose the extent to which ESG targets are incorporated, or explain the lack of ESG targets integrated in remuneration strategies. This would help companies’ long-term thinking and reward long-term productive and sustainable investments.

2. Encourage fee and incentive structures that better align interests of portfolio management staff of mutual and pension funds with those of their clients or beneficiaries. A significant portion of their remuneration, at least of their variable one, should reflect the sustainable value received by the fund from their services.

3. Publish a Recommendation supporting that all corporate governance and investor stewardship codes, be they national or pan-European, must incorporate considerations about ESG on a comply-or-explain basis. ESG considerations should span across all corporate governance mechanisms, including audit, remuneration, and risk management.

4. Expand the concept of stewardship codes to other players of the investment chain, beyond investors themselves, in particular to investment consultants. The UK Stewardship Code, introduced in 2010, has been a significant driver of change, as about 80% of UK pension fund’s RFP’s to asset managers now mention stewardship activities according to 20 NAPF 2014 Engagement Survey.

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Eurosif, Response to the European Commission's Green Paper on Corporate Governance in Financial Institutions and Remuneration Policies, September 2010.

19 Eurosif, Shareholder Stewardship: European ESG Engagement Practices, 2013.

20 NAPF, Ibidem.

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IV. Promote a sound corporate governance framework via active and long-term oriented share-ownership

Responsible and long-term oriented corporate governance is a critical component of a successful Capital Markets Union, as it helps boost confidence on capital markets, and reflects on the entire company, while ensuring successful, long-term growth. There is consensus that governance is material to the financial 21 performance of a company . Paradoxically, while investors increasingly look at this as part of their evaluation and due diligence processes, few of them actively make use of their ownership rights. Yet, 22 responsible shareholder engagement can lead to success stories .

1. Progress an ambitious revision of the Shareholder Rights Directive23, building a robust framework for the exercise of shareholder rights, while increasing transparency and accountability.

2. Make securities lending a more transparent practice24, and investigate ways in which lenders might be able to retain their voting rights. While contributing significantly to the market efficiency, stock lending practices can introduce a “stewardship” bias: currently, lenders are forced to choose between their loan fees and fiduciary duties to vote their shares. Lending also adds complexities that may lead to an investor being prevented to exercise his/her shareholder rights at the general meeting, because the custodian may not be able to relocate its client’s shares.

3. Address operational barriers to EU cross-border voting, including the absence of common frameworks for voting practices, or lack of application of existing rules in some instances (e.g. blocking of shares). Issuers and investors have over the past few years lost control of the custody chain, and it is not rare that institutional investors do not know if their votes have been casted or not, a basic right. The revision of the Shareholder Rights Directive will not address these operational aspects per se, some of them being already raised in the 2001 Giovannini report, in a Eurosif, ABI 25 and Eumedion letter to the Commission in 2010 , and in Eurosif’s position on the revision of the Shareholder Rights 26 Directive in 2014 .

4. Ensure that all Member States have a stewardship code promoting responsible share-ownership (long-term oriented engagement and voting with investors); these stewardship codes could be modelled according to guidance drafted by the European Commission.

5. As part of investment management contracts, asset managers should offer active share ownership measures and advice options for asset owners.

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See for instance the enhanced meta-study by Clark, Gordon L. and Feiner, Andreas and Viehs, Michael, From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance, 2015; Deutsche Bank Climate Change Advisors, Sustainable Investing: Establishing Long-term Value and Performance, 2012 22 As shown in Eurosif, Shareholder Stewardship: European ESG Engagement Practices (2013).

23 Eurosif, Position on the Proposal for a Shareholder Directive COM(2014) 2013, 2014.

24 International Corporate Governance Network (ICGN), Securities Lending Code of Best Practice, July 2007.

25 Eurosif, ABI and Eumedion letter to Commissioner Barnier, DG MARKT, August 2010.

26 Eurosif, Position on the Proposal for a Shareholder Directive COM(2014) 2013, 2014.

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V. Scale-up long-term sustainable growth by leveraging financial innovation

A degree of latent institutional investor demand for investments into long-term productive assets exists, as such investments have the potential to meet some of their needs (long duration liability-matching, inflation hedging, de-correlation from traditional asset classes). Yet, it is sometimes challenging for certain investors to implement these investments, as they may lack capacity and expertise or when underlying projects are too small. A number of policy initiatives can be taken to scale up these investments.

1. Make environmental and social screening a standard feature of long-term oriented investment vehicles and financial instruments aligned with the CMU objective. Such screening should be an eligibility requirement for underlying assets in ELTIFs, EuVCA and (by definition) EUsEFs, as well a big infrastructure investments. It should also constitute a key eligibility criterion for credit enhancement and risk-sharing mechanisms, for an intervention by the European Investment Bank, etc. This will help mitigate reputational and financial risks that may materialize over the long-term, and, therefore, improve the risk-return profile of these investments, while meeting growing investors’ 27 concerns about environmental and social considerations . It will also ensure optimal asset allocation, aligned with the EU’s overarching environmental and social objectives in the Europe 2020 Strategy, and would support further growth of the sustainable and responsible investment market, which, in turn, should foster the growth of green and social bonds, for instance.

2. Build a larger green bond market, by focusing on markets standards and growing demand. This would allow a broader pool of investors to engage in the market and attract more assets. For this to happen, a number of specific policy measures can be promoted: i. Develop market standards. So far, green bonds are “self-labelled” in the absence of a market standard. Some new initiatives (Green Bond Principles, Climate Bond Standard) are likely to evolve this, and need to be supported by regulators; ii. Encourage green bond issuance by cities, development banks and other public agencies iii. Boost demand via mandates of public funds and central banks; iv. Boost demand by growing the Sustainable and Responsible Investment market, as most buyers of green bonds today are SRI investors; v. Use market development through aggregating, securitization and covered bonds, improving the risk return profile via guarantees and credit enhancements.

3. Revitalise securitization in a sustainable way. Eurosif understands the motivation to revive securitization to provide alternative funding options to companies, including SMEs, and acknowledges that such techniques offer several benefits. However, we also recognize that securitization can have unintended consequences such as systemic risk, as evidenced in the backdrop of the Global Financial Crisis. Further, investors have lost confidence in these products: rebuilding trust will be a key success factor to attract capital in securitized products. We would therefore expect that any attempt to revitalise securitization should be subject to a set of key principles, such as: i. Simplicity: a ban on highly complex, synthetic products, and products based on low-quality, underlying collateral should be enforced; ii. Standardisation: securitization markets are not uniform across Europe. The heterogeneity of documentation and practices can dissuade investors. Policy-makers should foster the standardization of European securitisation markets and practices. iii. Transparency: policy-makers should enforce a comprehensive disclosure and transparency regime on all securitized products. Credit rating agencies should also be transparent on how they rate these products.

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As shown in Eurosif, European Sustainable and Responsible Investment Study (2014)

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iv. Aligned incentives: policy-makers should also make sure that incentives in the system are aligned with policy goals. The recent financial crisis evidenced some misalignments of incentives in the system, from loan originators, securitization intermediaries, credit rating agencies (CRAs), to investors.

That said, securitization can be a very useful way, for instance, to attract investments into climate-friendly smaller scale assets, such as renewable and energy efficiency assets. Eurosif therefore supports the idea of “green 28 securitization” launched by the Financing the Future Consortium .

4. Consider tax incentives and disincentives. Eurosif recommends incorporating tax incentives into ELTIFs, EuSEFs and EVCAs, as well as in the context of the foreseen large infrastructure projects, provided that they meet certain conditions, such as environmental and social screening. This could be a relatively easy way to boost demand, and the Commission could encourage Member States in this direction. The other fiscal dimension is to ensure that investors into ELTIFs are not subject to the Financial Transactions Tax, should this tax be implemented in 2016.

5. Launch a high-level forum on “Capital Stewardship” to progress financial innovation that serves infrastructure and th

other long-term investments. This could take the form of a 6 EU-led European Innovation Partnership. An EIPCS would enable to break silos and leverage different pools of expertise, to investigate new ways of putting capital markets at work for (sustainable) growth. It would gather a High Level Group composed of key European Commissioners, Ministers of Finance, financial institutions, institutional investors, public banks, cities and other stakeholders. It would seek to promote or develop innovative financial instruments, to help investors and financiers scale up investment flows addressing specific environmental or societal issues – eg. green bonds, public private partnerships, etc.

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Financing the Future Consortium, Shifting Private Finance towards Climate-Friendly Investments, 2015.

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“Unless countries move to greener growth paths - characterised by economic growth and human development that better conserves natural resources - continuing environmental degradation will lead to significant negative impacts on human well-being. […]

These impacts will put economic growth and development at risk, with a disproportionately high share of the burden falling on the poor in many parts of the world.”

- OECD, World Bank & United Nations Incorporating Green Growth and Sustainable Development policies into structural development agenda, Prepared for G20 Summit, Los Cabos, June 2012

“Environment is not just a matter for environmental ministers and policies. Growing numbers of financial regulators and central bankers are responding to the simple facts that the working of the financial system has environmental impacts, and that the state of the natural environment impacts the health and—ultimately—the stability of the financial system.

A healthy financial system is a keystone of an inclusive and sustainable global economy.

Such a system must nurture and invest in the key drivers of its economy, which crucially include a supportive natural environment.“ -Achim Steiner, UN Under-Secretary-General and Executive Director of the United Nations Environment Programme (UNEP), G20 Australia Summit, Brisbane, 11 November 2014

“The Capital Markets Union is one example of how the financial sector can act as part of the economic mainstream; supporting companies and encouraging growth. Financial services must be the oil in the economic machine. […] So that perhaps, generations from now, people here in Rome and across Europe will look back and think: after some difficult times, they refocused on the priorities, they made the right policy choices to restore economic growth and jobs; they got it right.”

-Lord Hill, European Commissioner, DG FISMA Speech “Building to last: boosting long-term investment in Europe” Rome, 12 December 2014

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About Eurosif

Eurosif is the leading pan-European sustainable and responsible investment (SRI) membership organisation whose mission is to promote sustainability through European financial markets. Eurosif works as a partnership of Europe-based national Sustainable Investment Forums (SIFs) with the direct support of over 65 Member Affiliate organisations drawn from the sustainable investment industry value chain. These Member Affiliates include institutional investors, asset managers, financial services, index providers and ESG research and analysis firms totalling over €1 trillion assets. Eurosif’s indirect European network spans across over 500 Europebased organisations. Eurosif is also a founding member of the Global Sustainable Investment Alliance, the alliance of the largest SIFs around the world. The main activities of Eurosif are public policy, research and creating platforms for nurturing sustainable investing best practices. www.eurosif.org Eurosif’s EU Transparency registration number with the European Commission is 70659452143-78. *Note that Eurosif views may not represent the views of all its members and affiliates.

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