Stockholm (NordSIP) – According to the latest Trends, Risks and Vulnerabilities (TRV) report published by the European Securities Market Authority (ESMA), higher interest rates, greenwashing and ESG backlash are the main hurdles to the EU’s ability to galvanise the resources necessary to meet its EU Green deal objectives.
Looking over the horizon, ESMA notes that transition funds will play an increasingly important role in moving the agenda forward. However, for that to happen, the onus is also on companies to establish credible transition strategies.
Risks Undermining The EU Green Deal
According to ESMA, the last few years have witnessed strong interest in sustainable funds, suggesting that investors remain willing to finance the green transition. However, the field is still plagued by risks to its success.
“To achieve the EU Green Deal objectives, estimates suggest investment needs of €1.6 trillion annually on average until 2030, 67% above the €940 billion currently invested. (…) However, several recent developments have sparked concerns about the ability to mobilise private capital to finance the transition,” the report adds.
Looking at the hurdles behind the ability of financial markets to mobilise the necessary capital, ESMA notes the role of higher interest rates and associated higher costs of capital and greenwashing and the erosion of trust in sustainable finance that comes in its heels. “Greenwashing and related malpractices risk undermining investor trust and the credibility of green finance, impacting the ability of the financial system to finance the transition to a sustainable economy,” the report says. Moreover, ESMA also worries that political pressure in the USA, but also in Europe, introduces “a degree of uncertainty regarding the climate policy agenda for the upcoming years.”
ESMA argues that beyond the financing efforts contributed by sustainable funds, other financial vehicles investing in companies at an earlier stage of their climate and energy transition, represent the best hope for the remaining weightlifting. “Looking ahead, firms’ ability to announce credible transition plans could steer broader willingness to invest in transitioning firms, supported by transition finance instruments.”
Rising EU Climate Benchmark Funds
The Trends, Risks and Vulnerabilities report publishes data on the rising trend of funds that track EU climate benchmarks. “The number and size of funds tracking EU climate benchmarks – which can be used to construct portfolios with a decarbonisation objective – have been steadily growing over the last three years (to 182 funds with total assets worth EUR 156bn as of June 2024,” the report says.
However, there has been a slowdown. “Recent environmental, social and governance (ESG) related market developments have sparked concerns about the ability to mobilise private capital successfully, with green bond issuance slowing and sustainable funds facing outflows for the first time in 2H23,” ESMA notes.
According to the report, the beginning of 2024 saw an 17% annual increase in ESG bond issuance, leading the market to reach a total outstanding value of €2.1 trillion as of June. “This was mainly driven by corporate green bond issuance in 1H24, which rose 19% from 1H23 to EUR 109bn.”
The Emerging Role of Transition Finance
ESMA puts a lot of hope in funds targeting investments in transitioning firms or sectors. These funds are difficult to track because they are not yet clearly defined and regulated as a specific category, but ESMA points to evidence that there has been progress on this front.
“There are currently 136 EU funds that have a reference to ‘transition’ in their name. These funds, including 70% disclosing under SFDR Article 8 and 22% disclosing under SFDR Article 9, managed assets worth EUR 39bn in June 2024. This compares with 872 funds using other environmental words in their name (e.g. ‘green’, ‘low-carbon’, etc.) managing EUR 260bn,” the report adds.
It appears that such transition funds are becoming more appealing than their green counterpart. “ ‘Transition’ funds have, on average, attracted net cumulative inflows of EUR 27mn over the last two years compared to €14 million for ‘green’ funds. This highlights investor interest in these vehicles and confirms the signalling power of investment product names with a sustainability aspect,” the report explains.
Considering the data, ESMA’s TRV report notes that ‘transition’ funds seem to end up with a high level of sectoral concentration in their portfolios, particularly in the utilities sector. “Despite the absence of a clear framework or definition, a closer look at the portfolio holdings of ‘transition’ funds suggests a somewhat homogeneous investment approach, with the average similarity of these funds almost double that of ‘green’ funds,” the report adds.
“This higher similarity reflects to some extent a considerably higher portfolio concentration, driven in part by a subset of securities issued by utilities sector firms that are held by more than 15% of ‘transition’ funds,” ESMA argues. To an extent, this is natural given the role that utilities play in decarbonising electricity for the entire economy.
Credibility is Key
To ensure the continued and growing appeal of transition funds as vehicles for the goals of the EU Green Deal, credibility is key. “The 80% minimum threshold for investments used to meet the funds’ characteristic or objective and exclusions introduced by the ESMA Guidelines on funds’ names using ESG or sustainability-related terms should further strengthen the credibility of these funds and help contribute to their uptake in the future,” the report says.
But the onus is not just on funds to invest, but also on companies’ willingness to plan for the transition and highlight such efforts. “Looking ahead, firms’ ability to announce credible transition plans could steer broader willingness to invest in transitioning firms, supported by transition finance instruments,” ESMA argues.
