Will European regulations enable a genuine transition to a sustainable economy? (Study)

Abstract

• Contemporary economic models have enabled significant development in industrialized countries but now pose certain problems in terms of the environment and the autonomy of countries in the Eurozone.
• Regulators are increasingly interested in environmental and climate issues; and three regulatory texts are now relatively complete in this area: the Sustainable Finance Disclosure Regulation (SFDR), the Regulation on the Taxonomy of Environmentally Sustainable Economic Activities (accompanied by its delegated acts), and the draft Pillar III ESG (environmental, social, governance) technical implementation standards.
• Although these texts cover all ESG issues, they focus particularly on climate change. However, other environmental risks also deserve special attention, notably the erosion of ecosystems and biodiversity.
• In order to limit environmental impact and better achieve climate change mitigation objectives, regulations should also encourage greater restraint. In particular, they should discourage the production or import of a number of goods and services whose existence does not provide any real gain in well-being, while their environmental impact is significant.
• Finally, given the climate and environmental emergency, it would be reasonable to opt for a resilient and sustainable economy, even if this could lead to lower financial returns and economic growth in the short and medium term.

The market economy and free trade of the last five decades have enabled significant economic development in industrialized countries. The principle of economies of scale, which consists of minimizing unit costs by increasing production quantities, has been at the heart of contemporary economic models. This principle has also led to economic globalization and deregulation of the banking and financial system since the 1970s.

However, these economic models now pose a number of problems in terms of the environment and the autonomy of the countries in the Eurozone. These models rely heavily on the use of natural resources, including fossil fuels, the intensive processing of these resources (a process that emits greenhouse gases and often pollutes water and soil), and, in many cases, relocation of production to produce more at lower cost, thereby generating long-distance transport (which emits high levels of greenhouse gases) and a lack of autonomy in the production of certain essential products.

In addition, continued growth in consumption has led to the intensive exploitation of natural resources, calling into question the sustainability of our economic model and the living conditions of human populations and other living species.

Finally, the massive use of fossil fuels to power industry and maintain production has created a strong dependence on these energies, which today makes the transition to carbon-free energies complex.

Since 2020, environmental and climate criteria have begun to be integrated by European regulatory and supervisory authorities with the main objectives of prudent management of ESG risks, alignment with the objectives of the Paris Agreement, and greater transparency on climate risks and impacts. For the time being, three regulatory texts can be considered relatively complete in this area: the Sustainable Finance Disclosure Regulation (SFDR), the Regulation on the Taxonomy of Environmentally Sustainable Economic Activities (accompanied by its delegated acts), and the draft Pillar III ESG technical implementation standards. These three texts also respond to growing demand from investors and savers to invest in environmentally sustainable projects or financial products.

The purpose of this note is to analyze these regulatory texts, in particular whether or not they enable real and profound changes in climate and environmental matters. It also aims to offer some food for thought, highlighting the principle of sobriety. These ideas promote the resilience and sustainability of an economy, although they could lead to lower financial returns and economic growth in the short and medium term.

1. An overview of the main financial regulations relating to climate and the environment

The most advanced regulatory texts in terms of taking climate and environmental criteria into account are the Sustainable Finance Disclosure Regulation (SFDR), the Regulation on the Taxonomy of Environmentally Sustainable Economic Activities (accompanied by its delegated acts) and the draft Pillar III ESG technical implementation standards [3].

The SFDR applies to financial market participants (portfolio management companies, investment funds, insurance companies, etc.), the Regulation on the Taxonomy of Environmentally Sustainable Economic Activities applies to all companies (financial and non-financial) with more than 500 employees, and Pillar III ESG applies to all credit institutions issuing securities listed on a regulated market in the EU.

The SFDR aims to increase transparency regarding the sustainability of investments. In order to reduce the information asymmetry between investors and financial market participants or financial advisers, this regulation requires the latter to publish information (pre-contractual and during the life of a contract) on the integration of sustainability risks, as well as on the consideration of the negative effects of these risks and the environmental and social characteristics of investments. This regulation responds to growing demand from investors to invest in sustainable and environmentally friendly financial assets. As a result, investors, who are increasingly sensitive to sustainability issues, can more easily distinguish between so-called « sustainable » investments and make investment choices that minimize their environmental impact.

The Sustainable Economic Activities Taxonomy Regulation amends and supplements the SFDR, in particular by making it possible to identify the environmental sustainability of an economic activity. This identification therefore makes it possible to determine the degree of environmental sustainability of an investment. An activity is considered sustainable within the meaning of the Taxonomy Regulation if it contributes substantially to one or more environmental objectives[4], does not significantly harm other environmental objectives (to which it does not contribute), is carried out in accordance with internationally established human and labor rights, and complies with the technical screening criteria established by the European Commission (by means of delegated acts). This regulation also requires the publication of financial ratios demonstrating the alignment of the activities of financial and non-financial companies with the Taxonomy. For example, non-financial companies are required to publish the share of their turnover, investment and operating expenses that meet the criteria set out in the Taxonomy[5], while credit institutions must, among other things, publish the « green  » (GAR), i.e., the ratio of their balance sheet corresponding to the objectives of the Taxonomy.

Finally, the ESG Pillar III « regulation » consists of introducing information on ESG risks into institutions’ Pillar III disclosures. It complements the Taxonomy regulation in terms of the transparency of credit institutions. It provides investors and savers with an overview of the environmental and climate risks to which a credit institution is exposed, as well as the measures taken by the latter to mitigate these risks. Investors and customers of a bank would thus be able to know whether the bank finances high-emission activities and, if so, the share of financing for these activities in its portfolio, through two ratios: the « green » asset ratio (see above) and the « green » asset ratio of the banking portfolio (BTAR).

2. Some elements of critical analysis of the texts

SFDR

The transparency required by the SFDR regulation with regard to the sustainability of investments and financial products encourages investment firms to increasingly take ESG criteria into account, thereby making it possible to direct investments towards more sustainable projects. This also sends a positive signal to the market, particularly the existence of investments that are not solely aimed at maximizing profitability, but also at investing responsibly. Several funds already offer « ESG, » « climate, » « circular economy, » « carbon neutrality 2050, » and other products. However, this transparency is based on ESG labels or « scores » that have only recently begun to develop. The methods currently available for classifying an asset as a « green asset » or « ESG asset » remain limited and insufficiently developed, particularly in terms of the criteria taken into account: they are often restricted to just a few criteria. We can assume that the SFDR regulation will have a greater impact on the « greening » of finance and investments once these methods have been further developed.

Taxonomy

The regulation on the taxonomy of environmentally sustainable economic activities is a major innovation in that, from now on, financial variables that take environmental sustainability (and particularly the impact on climate change) into account are being introduced and made available to regulators, investors, and civil society. This makes it possible to identify in sufficient detail how the activities of an eligible company contribute to climate change mitigation and adaptation. Companies will then tend to reduce activities that emit high levels of greenhouse gases and favor the development of those that are aligned with the Taxonomy[7].

However, the system is not yet complete from an environmental perspective, as only the sustainability criteria relating to climate change mitigation and adaptation have been developed (by means of delegated acts). However, other environmental objectives—detailed in Articles 12 to 15 of the regulation—must be subject to specific assessment criteria for all economic activities. For example, anthropogenic pollution and the significant reduction of ecosystems (particularly through deforestation) exert considerable pressure on the environment (i.e., significant decline in wildlife populations and^sixth mass extinction). Therefore, the Taxonomy should be expanded without delay to include these environmental objectives, as provided for in the Regulation.

This regulation should also introduce the concept of well-being gains from an economic activity. Certain activities encourage greater consumption without any real improvement in well-being, accompanied by harmful effects on the environment and even on human health: they should be subject to divestment or even higher taxation. This would promote so-called « essential » activities and those that can be considered useful to society. This would be consistent with the concept of sobriety—one of the most effective ways to combat climate change and environmental risks.

Pillar III ESG

In addition to the various ESG disclosures that it requires credit institutions to publish,the ITS[8]Pillar III ESG published by the EBA[9] introduces a new ratio to complement the GAR ratio: the BTAR ratio (i.e., the ratio of « green » assets in the banking portfolio). This ratio addresses the « disadvantages » of the GAR ratio (defined by the Taxonomy), which excludes certain types of assets from the numerator, while including them in the denominator. These include exposures to companies that are not covered by the NFRD[10] (fewer than 500 employees), as well as exposures in thetrading book, which skews the GAR ratio downwards for institutions with such exposures. The BTAR ratio thus provides a more accurate green asset ratio because it considers the same types of assets in both the numerator and denominator. However, it is limited to the scope of the banking book.

The ITS Pillar III ESG is a major innovation in banks’ disclosures and would make their loan portfolios « greener. » However, the quantitative information to be disclosed is currently focused solely on climate risks. In addition, in the final version of the ITS, two important elements have been changed from the consultation version.

• The first concerns the initial proposal for exposures to each of the companies on the list of the 20 largest emitters globally, in Europe, or per EU member state. This has been replaced by the requirement to publish the aggregate exposure to the 20 largest emitters globally only. Thus, using the argument of banking secrecy, banks seem to have convinced the regulator that their particularly carbon-intensive clients should not be mentioned in Pillar III publications. However, without this type of publication, counterparties have less direct incentive to transform their business model , as their names will not be publicly displayed in the list of the most polluting companies.
• The second concerns the initial proposal to publish the average probability of default for sectors to which banks are exposed and which are identified as particularly high greenhouse gas emitters. This was removed from the final version of the ITS, meaning that investors and depositors are unable to ascertain how ESG risks are taken into account in banks’ internal rating models, thereby reducing the scope of the comprehensive overview of the credit risk of institutions’ loan portfolios.

3. Proposing some new avenues for a more sustainable and eco-responsible economy

In 2009, researchers at the Stockholm Resilience Centre stated that anthropogenic pressures had reached such a scale that a sudden change in the global environment could no longer be ruled out (see Rockström et al., 2009). They defined nine planetary boundaries, the exceeding of one or more of which would be deleterious or even catastrophic, as it could cause sudden and non-linear environmental changes within continental and planetary scale systems. According to the Stockholm Resilience Centre, six of these nine planetary boundaries have already been exceeded: land use change, biodiversityintegrity, phosphorus andnitrogen cycles, climate change, chemical pollution (particularly plastics), and the freshwater cycle[11].

The work of the Stockholm Resilience Center on planetary boundary crossing confirms in a way the conclusions of the study by Meadows et al. (1972) that there is a possibility of economic collapse in the current century if we continue with a « business-as-usual » scenario[12]. In the ACPR and ECB climate stress tests[13], the « business-as-usual » scenario corresponds to the NGFS « warmer world » scenario[14], which translates into a significant physical risk in the medium and long term, including an increase in the frequency and severity of extreme weather events.

The^second part of the IPCC’s^sixth report[15] draws attention to the fact that if global warming exceeds +1.5°C compared to pre-industrial levels, there would be a high, even very high, risk of human heat stress with increased mortality and morbidity, disruption of marine and terrestrial ecosystems, loss of agricultural production, shortages in southern and central Europe, river and rain flooding, coastal flooding, and risks to infrastructure.

Based on these various findings, determining specific assessment criteria for climate change mitigation and adaptation objectives may not be sufficient to ensure the sustainability of ecosystems and the safe functioning of humanity. First, all human activity has an impact on the environment. An activity that mitigates climate change, for example, rarely has no impact on climate change and ecosystems (particularly natural areas and biodiversity). Second, while technologies can reduce greenhouse gas emissions when used equally or increasingly, this is not necessarily the case. Thirdly, although the use of « clean » energies reduces greenhouse gas emissions, the production, transport, and use of materials requires carbon-based energies, which, as we know, contribute to climate change. In addition, the limited capacity to produce these energies (given current global production and consumption levels) and to recycle materials should also be taken into account.

As detailed in Chapter 5 of Part III of the IPCC’s^Sixth Assessment Report, published in April 2022, actions to mitigate climate change and environmental degradation should also focus on making our economies more energy-efficient. Solutions involving a reduction in demand and therefore consumption should be considered and supported by legislators. In the same vein, legislators should take a closer look at the link between consumption and human well-being and consider the fact that an increase in consumption, and therefore economic growth, does not automatically translate into an increase in well-being (see Nordhaus and Tobin (1973), Jackson (2010), Lachaize and Morel (2013), Creutzing et al. (2022)).

European legislators should therefore not only favor consumption and production patterns that are less energy-intensive or based on « clean » energy and technological solutions, but also « discourage » the production or import of certain non-essential goods and services whose existence does not lead to a significant increase in well-being, while their environmental impact is significant. This « discouragement » could be achieved by requiring each type of activity to be assessed and published in terms of its impact on well-being (or collective utility), in addition to its environmental impact. This would encourage disinvestment when the environmental impact of an activity is high in relation to the well-being it provides, and a decline in demand (through pricing) when such an activity is also subject to higher taxation.

This type of demand-side solution obviously requires a certain amount of multidisciplinary work and research to identify the types of activities, goods, or services that bring about a real gain in well-being for the population and those that have no real beneficial effect, or even have a negative effect on consumers (particularly on their physical and mental health). However, it opens up new perspectives, particularly towards sobriety, by prioritizing the objectives of well-being and sustainability. Thus, even if certain activities were to decline or even disappear in the long term, sobriety should be considered beneficial overall, as it is one of the only means of achieving a sustainable economic system and decent living conditions in the long term.

Finally, given the climate emergency and the significant environmental degradation observed over the last five decades, as well as the decline in natural resources and the increased difficulty in sourcing raw materials, it would be very reasonable to prioritize sustainability over short- and medium-term profitability and economic growth in order to avoid major physical shocks in the years to come that could severely disrupt living conditions on Earth. In this same context, and based on the work of Meadows (1972), Nordhaus and Tobin (1973), Jackson (2010), Lachaize and Morel (2013), Creutzing et al. (2022), rather than continuing to consider gross domestic product (GDP) growth as the key macroeconomic variable, it would be reasonable to focus on the share of this growth that is necessary to achieve a high level of well-being and a sustainable economic system while minimizing climate and environmental impact.

Conclusion

The productivist economic models of the last five decades, consisting of lower unit costs and increased production, have brought a certain degree of prosperity to developed countries but now pose a number of environmental problems. Indeed, growing consumption and production are putting considerable pressure on the climate and the environment. This is why, in addition to measures targeting supply-side technologies, regulations should also include measures targeting demand, particularly those that promote moderation without reducing the population’s level of well-being. This requires multidisciplinary studies to assess the impact of each activity, good, or service on collective well-being or utility. Thus, any activity or production of goods or services that has a high environmental impact but is assessed as providing low or even negative well-being in the long term should be specifically publicized to encourage divestment or even higher taxation by the authorities. This reflection also requires a revision of traditional economic thinking that emphasizes increased production and economic growth. Indeed, given the climate emergency and the significant environmental degradation observed (six of the nine planetary boundaries have been crossed), priority should be given to the part of economic growth that brings real gains in well-being with the least environmental impact, in order to achieve a resilient and sustainable economy and decent living conditions for all human populations and other living species.

References

ACPR, (2020), Scenarios and main assumptions of the climate pilot exercise;

ALLEMAND N., (2021). « Climate: is the ECB really stressed? (Note), BSI Economics;

DHIMA J., (2021). « Banking regulation in the age of environmental risk » (Note),BSI Economics

CREUTZIG F. et al. (2016). « Beyond Technology: Demand-Side Solutions for Climate Change Mitigation, » Annual Reviews of Environment and Resources, Vol. 41:173-198

CREUTZIG F. et al. (2022). « Demand-side solutions to climate change mitigation consistent with high levels of well-being, » Nature Climate Change, 12, 36-46 (2022) https://doi.org/10.1038/s41558-021-01219-y

NFRD Directive (Directive 2014/95/EU of the European Parliament and of the Council of October 22, 2014);

EBA Consultation paper on draft ITS on Pillar 3 disclosures on ESG risks (EBA/CP/2021/06);

EBA Final Draft implementing technical standards on prudential disclosures on ESG risks in accordance with Article 449a CRR (EBA/ITS/2022/01);

EBA Guidelines on loan origination and monitoring (EBA/GL/2020/06);

EBA Guidelines on institutions’ stress testing (EBA/GL/2018/04);

EBA (2020), Mapping climate risk: Main findings from the EU-wide pilot exercise;

EBA Report on management and supervision of ESG risks for credit institutions and investment firms (EBA/REP/2021/18);

ECB Guide on climate-related and environmental risks, Supervisory expectations relating to risk management and disclosure;

ECB Climate risk stress test, SSM stress test 2022, October 2021;

GARDES C. (2021), « Taxonomy: the cornerstone of decarbonization financing? (Opinion piece), » Forbes Magazine

IPCC, 2022: Climate Change 2022: Impacts, Adaptation, and Vulnerability. Contribution of Working Group II to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [H.-O. Pörtner, D.C. Roberts, M. Tignor, E.S. Poloczanska, K. Mintenbeck, A. Alegría, M. Craig, S. Langsdorf, S. Löschke, V. Möller, A. Okem, B. Rama (eds.)]. Cambridge University Press. In Press.

IPCC, 2022: Climate Change 2022: Mitigation of Climate Change. Contribution of Working Group III to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [P.R. Shukla, J. Skea, R. Slade, A. Al Khourdajie, R. van Diemen, D. McCollum, M. Pathak, S. Some, P. Vyas, R. Fradera, M. Belkacemi, A. Hasija, G. Lisboa, S. Luz, J. Malley, (eds.)]. Cambridge University Press, Cambridge, UK and New York, NY, USA. doi: 10.1017/9781009157926

JANCOVICI J.-M., (2017). « 100% renewable for no more money, easy peasy? » https://jancovici.com/transition-energetique/renouvelables/100-renouvelable-pour-pas-plus-cher-fastoche/

LACHAIZE P., MOREL J., (2013). « The uses of GDP, » Volume 1, The Shift Project

Proposals from the Citizens’ Climate Convention, January 2021;

MEADOWS D. H. et al., (1972). The limits to growth, Universe Books

NORDHAUS W. D. and TOBIN J., (1973). « Is Growth obsolete? », National Bureau of Economic Research

EBA Opinion on disclosure requirements in relation to environmentally sustainable activities under Article 8 of the Taxonomy Regulation;

European Taxonomy Regulation (Regulation (EU) 2020/852 of June 18, 2020 on promoting sustainable investments and amending Regulation (EU) 2019/2088);

SFDR Regulation (Regulation (EU) 2019/2088);

Rioust de Largentaye, A. (2013). Tim Jackson. « Prosperity without growth. » Afrique contemporaine, 245, 152-154. https://doi.org/10.3917/afco.245.0152

ROCKSTRÖM J. et al., (2009). « Planetary Boundaries: Exploring the Safe Operating Space for Humanity, » Ecology and Society, Vol. 14, No. 2, Art. 32

SCHWARTZ B. (2004). “The paradox of Choice – Why more is Less”, Harper Perennial

Taxonomy Regulation Delegated Act (COMMISSION DELEGATED REGULATION (EU) …/… of 6.7.2021 supplementing Regulation (EU) 2020/852 of the European Parliament and of the Council by specifying the content and presentation of information to be disclosed by undertakings subject to Articles 19a or 29a of Directive 2013/34/EU concerning environmentally sustainable economic activities, and specifying the methodology to comply with that disclosure obligation);

Taxonomy Climate Delegated Act (COMMISSION DELEGATED REGULATION (EU) …/… of June 4, 2021 supplementing Regulation (EU) 2020/852 of the European Parliament and of the Council by establishing the technical screening criteria for determining the conditions under which an economic activity qualifies as contributing substantially to climate change mitigation or climate change adaptation and for determining whether that economic activity causes no significant harm to any of the other environmental objectives).

Websites:

https://www.stockholmresilience.org/research/planetary-boundaries.html

https://www.stockholmresilience.org/research/research-news/2022-01-18-safe-planetary-boundary-for-pollutants-including-plastics-exceeded-say-researchers.html

https://www.stockholmresilience.org/research/research-news/2022-04-26-freshwater-boundary-exceeds-safe-limits.html