Luisa Nenci, CEO of SustainValues: A Capital Market Union or a Sustainable Financial Market?

In his political guidelines for the next European Commission, President Jean-Claude Juncker pushed for the establishment of a capital market union. Such a union should develop and integrate capital markets in order to cut the cost of raising capital. This is especially important for small and medium-sized businesses (SMEs). A capital market union should also reduce dependence on bank-sourced funding and increase the attractiveness to invest in the EU. Mr Juncker also suggested to reform the Economic and Monetary Union in an attempt to enhance the convergence of economic, fiscal and labour markets across the Eurozone which would help to preserve the stability of the euro as well. He supported the introduction of additional controls on banks with a single supervisor and resolution mechanisms.

To make integration and convergence feasible, a transformative roadmap should be formulated for every country: a new strategy for the post–2015 agenda. For the successful implementation of such an approach, the financial sector has an essential role to play, steering economic actors towards the adoption of more responsible investment solutions. The proposed strategy should furthermore include a set of legislative tools to facilitate the creation of a transformative framework for the financial sector.

“The new policy framework will give the financial sector, through political consensus, the possibility to enhance its role from intermediary to proactive.”

A number of steps have already been taken by the G20 and the European Union to strengthen financial regulation pertaining to capital and liquidity requirements, licensing, and supervision such as the Basel Capital Accords II and III, the core principles for effective banking supervision, etc. In particular, actions covering three basic fields of financial regulation, are ongoing for:

1. Prudential regulation – to ensure improved stability and solidity of financial institutions;
2. Conduct of business regulation – to introduce a fairer and more transparent business management practices; and,
3. Systemic regulation – to increase financial market stability and improve access to finance.

Further steps may be taken if it considered convenient to extend financial regulation to include the current sustainability initiatives and principles such as the Equator Principles, the UNEP Finance Initiative Partnership, the Principles for Responsible Investment, the Global Compact Principles, the IFC/EBRD Performance standards and exclusion lists, National Environmental Standards, Universal Declaration of Human Rights, WBCSD 2050 vision, UNFCCC Climate Finance Principles, and others.

The implementation of a sustainability rationale will lead to the building of an appropriate governance structure that facilitates financial institutions (FIs) attain improved transparency and management policies, in addition to better monitoring for green investments. Being market driven, FIs should be free to consider each financial instrument on its merit. FIs’ choices and market decisions regarding the strengths and weaknesses of any given instrument are to be based on market criteria. However, political institutions should develop policy objectives and formulate rules for the guidance, evaluation, and monitoring of the green investment without trespassing on the flexibility and autonomy of financial institutions.

The current, and highly complex, system of financial regulation was not designed to encourage innovative interventions and approaches to overcome risk barriers and market failures and/or imperfections. The new policy framework will give the financial sector, through political consensus, the possibility to enhance its role from intermediary to proactive. The selection and financing of companies that are not merely reacting to standards, but effectively pursue green market opportunities, allows FIs an opportunity to actively promote the allocation of financial resources to green and profitable business ventures.

The proposed framework may be created by applying the same methodology of the Basel Committee on Banking Supervision (2012). The assessment should moreover seek full compliance with the 29 Core Principles for Effective Banking Supervision published by the Bank for International Settlements. The implementation of sustainability principles will be graded by measuring the level of compliance to defined criteria. To customise the framework at the national level, these criteria could be weighted differently from country to country. At supranational level, adherence to the framework can then be evaluated by defining minimum and maximum levels of achievement on each of the criteria established.

The assessment process will consist of three main steps:

1. An assessment of the current financial core principles in order to evaluate their compliance with the identified sustainability and good governance principles to be included in the framework; establish the framework; identify the main and direct eco-systemic risks facing the financial system; monitor and analyse markets and other financial and economic factors that may lead to the indirect accumulation of eco-systemic risks; systematically proof and review the framework in order to achieve objectivity and comparability between countries.
2. Formulate appropriate policy objectives addressing future emerging risks, as well as opportunities for reform toward a green economy. Global environmental policy objectives and other long-term shared policy objectives at international level – such as the Kyoto Protocol, the Convention for Biodiversity, and others – should also be included in order to align the framework at European and international levels. The framework should also include mechanisms for effective cooperation and coordination amongst the relevant agencies at both national and international levels.
3. Run a sensitivity analysis on possible future stress-test scenarios to assess how such policies may affect the financial markets – money, capital, and bond markets, and banks and other financial institutions.

The following limitations should be analysed:

• Favouring green investments in financial market regulation could create new risks and/or a failure to adequately regulate the existing risks;
• The construction of a framework could lead to a build-up of dangerous trends, resulting in a compliant / non-compliant structure.

In fact, a transformative sustainability policy framework will cause remarkable changes in the environmental and social fields through harmonisation. It will not create a restrictive regulatory framework erected around pollution / emission punishment. The inclusion of sustainability criteria into policy interventions should transform the actual use of prudential regulation, ethical conduct, and the systemic control of the financial sector’s actors. Consequentially, the public and private trust will increase, thus facilitating the integration of different national and regional markets.

Moreover, the framework will identify innovative interventions and approaches for overcoming current national barriers to low-carbon and climate-resilient investments. Risks, costs, and liquidity gaps will be reduced because of improved financial stability – itself the result of better regulatory policies. Scaling up green investments will also have a transformational impact on both cost and performances. It is the goal of the shared policy objectives to mobilise as much green capital as possible. Therefore better performance may be achieved with the increased ability of rallying private capital to leverage and multiply public green investments.

About the Author

Luisa Nenci is CEO of SustainValues. She is an environmental economist and green finance strategist. Please visit www.sustainvalues.net for contact and additional information.