Disclosure drives divestment and has a global impact

• Research has found that French institutional investors have reduced their exposure to fossil fuel investments in response to climate and ESG disclosure requirements
• Although the regulation was domestic, it has had a global impact on non-euro investments, and those subject to more activist engagement have seen the greatest divestment
• New sustainable finance disclosures — and the trend towards more ESG and climate-related disclosure — will increase the significance of responsible finance for financial institutions around the world

Climate disclosures are becoming more common globally and this is bringing greater clarity to the risks that financial institutions face. New research has found that the imposition on financial institutions of France’s Article 173 law mandating disclosure on a ‘comply-or-explain’ basis led to a nearly 40% decline of investment in fossil fuel investments, which is both statistically and economically significant.

The findings should be of interest to financial institutions whether or not they are currently subject to climate-related disclosures, because the research found an impact that was stronger for financial assets outside of the euro area than within it. With new European disclosure regulations coming into force in 2021 and more likely to be added in coming years, the research indicates that the reallocation of funding based on ESG and climate considerations is only likely to pick up steam.

For example, the report found a greater reduction in investment in fossil fuel assets outside of Europe than inside, as well as a greater reduction of investment in unconventional fossil fuels and coal compared to conventional oil & gas. This helps to explain some of the operating mechanism for how disclosure impacts investment in economic activities that are unsustainable in the context of meeting Paris Agreement targets on climate change.

First, greater disclosure has had the intended impact of highlighting transition risks and supported some re-allocation towards other sectors. Second, the divestment was greater in sectors where there has been public pressure on investors to divest (coal and unconventional oil & gas). And third, divestment was greatest from non-European issuers.

The geographical impact may reflect home country bias, or it could reflect expectation of lower climate risk for European issuers that are likely to face stronger regulations around greenhouse gas emissions than non-European issuers. Regardless, these findings mean that the impact of Article 173 and ESG / climate disclosure regulations is likely to be greater for non-European issuers, which means the same is likely to be true when other European disclosure regulations come into force.

With the European Green Taxonomy now adopted for ESG reporting by asset and wealth managers under the Sustainable Finance Reporting Directive (SFRD), the impact of Article 173 in France could be replicated Europe-wide. NGOs have advocated an update also to the Non-Financial Reporting Directive (NFRD), which could further expand reporting requirements in Europe.

Financial institutions and asset managers outside of Europe or those financing assets outside of the EU shouldn’t think they are insulated from the effects of these regulations — if anything, the evidence shows they could affect their investments and financing more. The impact on shares and fixed income instruments won’t be random. It will be driven in line with what is visible today from ESG and climate risks.

The channel for analyzing the risk exposure is a combination of looking at the ESG-related risks most looked at by European investors and identifying those where a change in investor sentiment could have the greatest financial impact. Climate change is probably an issue where both conditions are met, and we are releasing a series of reports — beginning with Malaysia — to trace where climate-related exposures are the greatest.

Financial institutions outside of Europe should take this new evidence as further support to what they’re already hearing from stakeholders. It’s not a data point that calls for a new approach; it just reinforces what has been clear all along. The main change that can be taken away is more data providing clear evidence that financial assets’ value — driven by the sensitivity of investor demand for them — is linked with ESG and climate characteristics.

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Republished from the RFI Foundation’s weekly newsletter. Subscribe for free here!