Introduction and Context
Sustainability represents a significant challenge for political, regulatory, and supervisory authorities, as well as for financial system operators. In this context, financial system operators can play a pivotal role in facilitating the transition to a more sustainable economy through the efficient allocation of resources and the development of new products and services. In recent years, a vigorous debate has emerged at the international and European levels regarding the appropriate means of incorporating Environmental, Social, and Governance (ESG) criteria into the current prudential regulatory framework.
There is a growing consensus among international institutions that innovative digital applications in finance can support the decarbonisation and sustainable transition process. These applications are collectively known as Green FinTech (or Climate Fintech). Such applications encompass operational innovations, products and platforms.
Regulatory Developments and Frameworks
On an international level, the classification proposed in 2022 by the Green Digital Finance Alliance[1], which is compatible with internationally formulated FinTech taxonomies, is becoming the standard. Financial and non-financial companies of a greater size are already subject to more rigorous sustainability reporting requirements. These are designed to increase both the quantity and quality of information disclosed, in line with the demands of market participants. The enactment of the Corporate Sustainability Reporting Directive was preceded by the issuance of the Taxonomy Regulation, while the inaugural set of sustainability standards was published by EFRAG.
Nevertheless, despite the advancements that have been made, it is evident that the regulatory framework for sustainability reporting is not yet comprehensive. Further developments are required, particularly in regard to the European climate taxonomy, with the objective of encompassing all categories of economic activity and avoiding disincentives for investments in areas not yet covered.
In parallel with the increasing focus on the disclosure of ESG aspects, there is also a growing interest in the accounting implications of these issues. As of 1 January 2024, the International Financial Reporting Standards (IFRS) 1 and 2 came into force. These standards set out the basic requirements for sustainability-related financial reporting and require the disclosure of supplementary information regarding risk exposure and climate-specific opportunities.
In particular, IFRS S1 sets out the requirements for the disclosure of a company’s sustainability-related risks and opportunities. This entails the disclosure of information pertaining to:
- The governance processes, controls and procedures employed by the company to monitor, manage and supervise sustainability risks and opportunities;
- The company’s strategy for managing sustainability risks and opportunities;
- The processes utilised by the company to identify, assess, prioritise and monitor sustainability risks and opportunities;
- The company’s performance in relation to sustainability risks and opportunities, including progress made in achieving the targets set by the company or required by law or regulation.
Conversely, IFRS S2 is inextricably linked with IFRS S1 and delineates the stipulations governing the disclosure of information from the former standard to third parties.
Among the most notable initiatives at the European level is the European Commission’s proposal of the so-called Corporate Sustainability Due Diligence Directive (CSDD), which aims to introduce specific governance, sanctions and liability obligations for larger companies in order to protect human rights and the environment. The directive could have a significant impact on financial intermediaries, with new tasks and responsibilities for corporate bodies and new processes to identify and mitigate negative impacts on human rights and environmental protection.
Additionally, at the European level, the European Banking Authority (EBA) is spearheading a new phase of development. In the beginning of 2024, the EBA has initiated a consultation process regarding the new Guidelines on the Management of Environmental, Social and Governance Risks[2]. As is widely acknowledged, the guidelines stipulate the necessity for institutions to identify, quantify, oversee and assess ESG risks, including through the formulation of strategies to address the potential challenges posed by the transition to a climate-neutral economy within the EU. It is evident that from the perspective of the European banking regulator, climate change, environmental degradation, social issues and other environmental, social and governance factors present considerable challenges to the economy that have a significant impact on the financial sector.
In order to guarantee the stability and integrity of financial institutions in the short, medium, and long term, the guidelines delineate the requirements that institutions must adhere to when defining their internal processes and ESG risk management methods. In essence, the new guidelines (which were subject to a period of consultation until the end of April this year) have been developed on the basis of monitoring of credit institutions and the supervisory experience of the competent authorities. This has revealed that ESG risk management is still at an early stage of development and is an evolving field in the majority of European institutions.
The EBA has indicated that, despite the measures implemented in recent years, there are still significant deficiencies in the incorporation of ESG risks into corporate strategies and risk management frameworks[3]. This could potentially compromise the stability and resilience of financial institutions as the European Union transitions towards a more sustainability-focused economy and ESG risks become more tangible.
Challenges and Risks in ESG Integration
The evolution of the financial system towards greater sustainability is a complex process, characterised by significant challenges that require a joint commitment from all relevant actors. One of the most significant challenges is the lack of standardised data and metrics to assess the environmental and social impact of financial activities. The current state of affairs is such that the collection and reporting of ESG information is fragmented and uneven, which in turn hampers an accurate and comparable assessment of sustainable performance.
Furthermore, the proliferation of greenwashing, defined as the practice of portraying financial products as environmentally sustainable without genuine adherence to ESG principles, creates confusion among investors and erodes confidence in the market. It is therefore imperative that controls and sanctions be strengthened in order to counteract this phenomenon and ensure greater transparency and integrity in the financial sector.
In this regard, the recent so-called greenwashing directive (Directive EU 2024/825 of the European Parliament and of the Council) of 28 February 2024 is worthy of consideration. The directive was adopted with the specific objective of facilitating the proper functioning of the internal market, based on a high level of consumer and environmental protection, and making effective and efficient progress in the green transition. The directive identifies a crucial element in facilitating informed consumer purchasing decisions, thereby promoting sustainable consumption patterns. This implies that economic operators are to be held accountable for providing transparent, pertinent, and dependable information concerning the vast array of green issues.
The European Union’s objective in adopting this directive is to enhance consumer protection by establishing specific regulations to address unfair commercial practices that mislead consumers and impede their ability to make informed sustainable consumption choices. These practices include the premature obsolescence of goods, deceptive environmental claims (commonly referred to as “greenwashing”), misrepresentative information about the social characteristics of products (including financial products) and the businesses of economic operators, and opaque and unreliable sustainability labels. It is evident that the objective of this legislation is not merely to afford consumers enhanced protection; it will also have a significant impact on economic operators in general.
It is evident that guaranteeing the veracity, intelligibility and dependability of environmental claims will facilitate a level playing field for all market actors, thereby enabling consumers to select products that are genuinely more environmentally friendly than competing products. The result will be greater competition, which will in turn lead to the production of more environmentally friendly products, thereby reducing the negative impact on the environment.
The transition to a sustainable economy will necessitate significant investment, both public and private. Nevertheless, the conventional financial system may be insufficient to address these financial requirements independently. It is thus imperative to develop novel financial instruments and dedicated investment channels to effectively mobilise capital towards sustainable projects and initiatives.
In addition to the necessity of acquiring financial resources, financial institutions are confronted with the challenge of managing and mitigating climate and environmental risks. It is of the utmost importance to integrate the analysis of such risks into the decision-making and governance processes in order to guarantee the responsible and sustainable management of capital. Furthermore, the evolving regulatory framework on ESG represents an additional source of uncertainty for the financial sector. It is of the utmost importance that regulations are clear, consistent and harmonised internationally in order to provide stability and confidence to market participants.
A further significant challenge is that of financial inclusion. It is of the utmost importance to guarantee that the transition to a sustainable economy does not result in the exclusion of specific demographic groups, but rather facilitates access to sustainable financial products and services, particularly for the most vulnerable communities.
Ultimately, financial education is pivotal in fostering informed and responsible investment decisions. Therefore, it is vital to disseminate a financial culture that incorporates ESG principles to enhance awareness among investors and citizens about the significance of sustainability. It is imperative to emphasise the interconnection between sustainability and digitalisation, given that technological innovation can play a pivotal role in facilitating the transition to a more sustainable economy in the financial sector. The evolution of FinTech offers a number of avenues through which ESG objectives can be pursued:
- Firstly, the utilisation of big data and artificial intelligence can facilitate the identification and assessment of sustainable investment opportunities, in addition to enabling investors to monitor the environmental and social impact of their financial activities with greater accuracy and timeliness.
- Secondly, technology can facilitate the development of new sustainable financial products, including green bonds, social impact bonds and crowdfunding for environmentally sustainable projects. This offers innovative financial instruments to channel capital towards initiatives that promote sustainability.
In this context, the growing relevance of so-called carbon credit projects should not be overlooked. These are negotiable certificates, that is to say, securities equivalent to one tonne of CO2 not emitted or absorbed as a result of an environmental protection project. The objective of such projects is to reduce or reabsorb global emissions of CO2 and other greenhouse gases. It is in this regard that the recently introduced anti-greenwashing directive will be able to exert most of its influence.
In the event that claims based on offsetting greenhouse gas emissions are prohibited, it will be necessary to pay close attention to the advertising of companies’ investments in environmental initiatives, including carbon credit projects. These investments should only be permitted to the extent that they provide information in a non-deceptive manner and in accordance with the requirements of EU law.
FinTech Solutions and Future Directions
Moreover, ESG data analysis can assist financial institutions in identifying and managing climate and environmental risks, thereby enhancing their risk assessment and overall risk management capacity. It is possible to cite a number of concrete applications of FinTech that are already in place and which have the objective of promoting sustainability. These include crowdfunding platforms for green finance, which enable individuals and investors to finance environmentally sustainable projects, and sustainable savings management applications, which assist users to invest responsibly and in line with their values. Moreover, blockchain-based solutions can guarantee the traceability and provenance of products, thereby facilitating more conscious and transparent consumption patterns.
In conclusion, it is imperative that financial intermediaries invest in understanding the interactions between climate and environmental factors and traditional risks, recognising the importance of such an approach for the sustainability of their business model. Maximising the potential of the interconnection between ESG issues and digitalisation can facilitate the promotion of sustainability in the financial sector and contribute to the development of a more resilient and responsible economy.
References
- Green Digital Finance Alliance and Swiss Green Fintech Network, ‘Green Fintech Classification’, 2022, https://www.greendigitalfinancealliance.org/initiatives/green-fintech-classification. ↑
- European Banking Authority, ‘Draft Guidelines on the Management of ESG Risks’, Consultation Paper, 18 January 2024, https://www.eba.europa.eu/sites/default/files/2024-01/c94fd865-6990-4ba8-b74e-6d8ef73d8ea5/Consultation%20papaer%20on%20draft%20Guidelines%20on%20ESG%20risks%20management.pdf. ↑
- European Banking Authority, 33. ↑
