The Changing Nature of Financial Regulation. Sustainable Finance As a New Policy Objective
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Until recently, no legal scholar researching financial regulation would have disputed that the main objectives of financial regulation are ensuring stability, market integrity and consumer protection, in addition to more general objectives of economic policy such as promoting efficiency, competition, innovation, and ultimately economic growth. They would typically agree that, in case of a conflict between those objectives, the stability-objective should, in principle, prevail.
Since the European Commission’s Sustainable Finance Action Plan of March 2018, however, sustainable finance has dominated the EU legislator’s agenda on financial regulation. To implement the Action Plan, a myriad of new regulations and amendments to existing regulatory frameworks have seen the light of day. The pace and amplitude of these regulatory changes, weaving sustainable finance into each and every facet of the EU financial rulebook, beg the question whether sustainable finance is changing the very nature of financial regulation.
In a recent paper, we have examined this question by assessing (i) whether sustainable finance should be considered as an autonomous objective of financial regulation, and (ii) how this new objective should stand in relation to the traditional objectives of financial regulation. We consider an objective as “autonomous” if without it, certain rules of financial regulation cannot be explained. If it is not indispensable to explain why certain rules have been put in place, it would merely be a supporting objective, which may help in refining and giving shape to measures addressing other, autonomous objectives.
1. Sustainable finance is no autonomous objective of financial regulation (yet)
In order to answer the first research question, we have first analysed whether the sustainable finance objective has been formulated as supporting (one or more of) the traditional objectives of financial regulation or as an autonomous objective. The Sustainable Finance Action Plan in fact clusters three sub-objectives under the sustainable finance objective: (i) reorienting capital flows towards sustainable investments; (ii) managing financial risks stemming from environmental and social factors; and (iii) fostering transparency and long-termism in financial and economic activities. On the basis of their wording, we have found that only the first sub-objective could potentially be considered an autonomous objective of financial regulation. The other sub-objectives are formulated as auxiliary to the first sub-objective or to traditional objectives of financial regulation: stability, market integrity and consumer protection.
We have then examined whether the concrete measures that have been adopted to implement the Sustainable Finance Action Plan so far, confirm that (the first sub-objective of) sustainable finance is an autonomous objective of financial regulation. These measures in essence (i) define sustainability terminology, which is essential, but in itself inadequate to further the sustainable finance objective; (ii) increase transparency, which reduces information asymmetry and thereby advances market integrity and investor protection; (iii) refine existing measures of investor and shareholder protection; and (iv) refine existing stability measures. Even though these new and amended measures invariably deal with ESG-factors, -preferences and -risks, they can, in our opinion, all be perfectly explained on the basis of traditional objectives of financial regulation.
Indirectly, those measures may also spur the reorientation of capital flows towards sustainable projects. The requirements for financial institutions to include ESG-risks into their risk assessment practices, for instance, enhance their stability, but may also incentivize companies to improve their ESG profile in order to enjoy lower financing costs. Another example are ESG transparency requirements. They may help investors to more easily find sustainable investment products that match their preferences—a typical investor protection objective—but may, as a result, also reorient capital flows towards sustainable investments. Moreover, ESG transparency requirements may incentivize companies to develop more sustainable business strategies in order to benefit from a market sentiment favouring sustainability. Those sustainable finance effects, however, depend on effective measures to prevent greenwashing and on ample prevalence of sustainability preferences among investors. If investors are not interested in sustainable investments, increased ESG transparency will not affect capital flows, nor trigger companies to develop a sustainable long-term strategy.
While those measures may have positive effects on the realisation of the sustainable finance objective, they can be fully explained without reference to sustainable finance. The sustainable finance objective can therefore not be qualified as an autonomous objective.
And yet, sustainable finance does have the potential to become an autonomous objective of financial regulation in the future. Our research has shown that the European legislator is exploring measures that would distinctly go beyond the traditional objectives of financial regulation. One idea is to require financial market participants to always offer retail investors sustainable products by default. Another idea is to apply a “brown penalty” or “green supporting factor” to banks’ capital requirements, depending on how much they invest in unsustainable or sustainable investments. Such measures would serve no other objective than reorienting capital flows to sustainable investments and could not be explained without referring to the sustainable finance objective.
These ideas have not yet been implemented in regulation, and it is uncertain whether they ever will be. If they would, sustainable finance would turn into an autonomous objective of financial regulation: such measures would advance sustainable finance, while being neutral or even detrimental to the traditional policy objectives of financial regulation.
2. Relation between sustainable finance and traditional policy objectives
This brings us to the second question, ie how regulators should prioritize the objectives of financial regulation in case they conflict. Even though each situation needs to be assessed in the light of the concrete circumstances, we have established a number of guiding principles. The first two serve as general principles in case of conflicting policy objectives of financial regulation; the third is specific to the sustainable finance objective.
First, in case of a possible conflict between objectives, a hard choice is often not required. A cost-benefit analysis may help in designing balanced measures.
Second, in case of a conflict between the traditional objectives of financial regulation, the stability of the financial system should prevail. Economically, the amounts at stake in regard of macro-stability significantly outweigh potential liabilities in regard of the other traditional policy objectives. Legally, macro-stability is the ultimate public interest objective.
Third, the sustainable finance objective should give way to the traditional objectives of financial regulation in case of a conflict. This may seem counter-intuitive, since sustainable finance is a tool in the service of a sustainable economy and a sustainable future for our planet, which should arguably be given the highest priority. However, sustainable finance measures are just one tool in the legislator’s toolbox to achieve this ultimate goal. Measures in other policy domains, such as tax law, environmental law, product regulation, and labour law, may have an equal or even higher impact in this respect. The same is not true for the traditional objectives of financial regulation. Stability, market integrity and consumer protection are to be fostered first and foremost with financial regulation. As a consequence, even if one considers achieving a sustainable economy to be of the highest urgency, this does not necessarily mean that sustainable finance should be given precedence at the expense of other objectives in case of a conflict. Stability, market integrity and a high level of consumer protection are in themselves, moreover, also fundamental to sustainable development. Therefore, sustainable finance measures that would undermine stability, market integrity or consumer protection, should be discarded and replaced with alternative tools to further a sustainable economy, such as tax incentives, environmental law or labour law.
Whether consciously or not, in pursuing sustainable finance, European policymakers have so far indeed not undermined the traditional policy objectives of financial regulation. On the contrary, as argued above, they have mainly attempted to indirectly further the sustainable finance objective via improvements in investor protection, market integrity and stability.
In our contribution, we have argued that more far-reaching measures are still conceivable that would autonomously further sustainable finance while being neutral to the traditional objectives of financial regulation, such as offering retail investors sustainable products by default. If the market for certified sustainable investment products is insufficiently large and diversified, however, such measures could fuel incentives for greenwashing or the formation of an artificial sustainable asset bubble. When considering to implement sustainable finance measures that go beyond refining investor protection, market integrity and stability, policymakers should, therefore, carefully assess any potential perverse effects on these traditional objectives of financial regulation.
3. The changing nature of financial regulation
On the basis of our research on the relation between sustainable financial and traditional objectives of financial regulation, one would conclude that the proverbial new kid on the block is not capable of unseating the incumbent objectives. So far, the Sustainable Finance Action Plan has not resulted in measures that can be regarded as the expression of an autonomous sustainable finance objective. We have argued that potential future sustainable finance rules should not undermine the traditional objectives.
However, even if the nature of financial regulation remains, so far, unaffected on the level of its autonomous objectives, our research has revealed a fundamental change in nature on another level. Financial regulation is no longer merely a tool to ensure that the financial sector can fulfil its role as an engine of economic growth, but it has taken on a new role, beyond economic imperatives. Today, financial regulation as a whole is also instrumentalised to advance the constitutionally enshrined sustainable development principle.
The Commission’s sustainable finance policy, then, is an intermediate means to nudge companies to already apply higher environmental, social and governance standards than legally required, pending stricter environmental, social and governance regulation. Companies have an incentive to live up to such higher standards, in order to more readily secure funding.
Veerle Colaert is a Professor of Financial Law at KU Leuven and Co-Director of the KU Leuven Jan Ronse Institute for Company and Financial Law.
This post summarises the author's presentation of her homonymous working paper at a workshop held at the University of Oxford on 19 January 2022.
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