Luxembourg’s place in sustainable finance: Private sector involvement as a key factor in fighting global warming

Agefi Luxembourg – Décembre 2019 :

The shift towards a sustainable financial marketplace

Several significant events marked a turning point in the debate towards global sustainable development. Among others, the Sustainable Development Program by 2030 of the United Nations and its 17 sustainability goals, the Paris Agreement on Climate Change and the United Nations Conference in Addis Ababa on the financing for development. These consultations enabled to raise awareness of the emergency to introduce radical changes in our institutional, financial and economic models. 

Luxembourg being one of the richest countries in the world and identified as an efficient financial center in Europe, could take advantage of its position to foster the development of sustainable finance and promote it in the global financial system. The country has taken a phased approach to address the potential reduction in competitiveness the mainstreaming of environmental considerations could generate in the short term, but which is able to create long-term ripple effects.

To achieve these goals, Luxembourg has been building a conducive environment to transform its financial marketplace and assist other nations in the transition to a sustainable global economy by leveraging international public and private sector investment. The country is respectively ranked 2nd in Green Finance penetration and 6th in Green Finance quality according to the Green Finance Index (GGFI). 

As a result of the political will in the fight against risks associated to environmental degradation and a thriving global financial center, Luxembourg has already engaged in numerous initiatives. In 2016, the Luxembourg Stock Exchange (LSE) launched the Luxembourg Green Exchange (LGX), the world’s first trading platform dedicated exclusively to green bonds accounting for almost half of green securities listed worldwide in 2019. 

The State of the Grand Duchy of Luxembourg also collaborated with the European Investment Bank (EIB) to set up an investment platform in which the Luxembourg government will invest € 30 million as a first loss guarantee for projects with a strong impact in the fight against climate change. The purpose of this kind of financial instrument is to encourage the engagement of the private sector in sustainable investing. Their participation is essential to reach the COP21 goal of mobilizing $ 100 billion per year by 2020 to support climate action investments in developing countries. In this project, Luxembourg will benefit from the expertise of the EIB in selecting appropriate investments which has committed to provide $ 100 billion in climate finance until 2020.

The need for standards and labels 

The country is also home of the LuxFLAG, a labelling agency that ensures the effective climate focus of investment funds in the implementation of their investment policies. As a matter of fact, as capital flows towards this sector, it is of paramount important that investors can obtain reliable recommendations from independent agencies able to review the investments realized by sustainable funds. As highlighted in a previous Square Groupe article “The stakes of green finance”, a number of these agencies do not genuinely pay attention to the environmental dimension but only measure the ability of the debtor to pay its financial obligations in the end. 

Therefore, it is primordial to establish a regulatory framework for labelling agencies in sustainable finance as well as to set up universal standards to determine the eligibility to receive funding via green financial products. The current rules have been proven insufficient to provide guarantees to investors. The European Commission had identified this need and therefore published an EU Taxonomy, a classification tool to help investors and companies identify environmentally friendly economic activities. In the same report the TEG (Technical Expert Group on Sustainable Finance) also presents the works to be conducted in order to build a suitable environment for investors to direct their funds in sustainable finance. Furthermore, the European Commission and the TEG have been working on two additional projects: the EU Green Bond Standard which defines the requirements to qualify a bond as a “EU Green Bond” and the creation of climate benchmarks to enable comparability of investments under the dimension of sustainability.

The traditional business model in investment management has to change

To conduct change within the fund management industry and establish more sustainable business models will require lots of effort. A key challenge is to change the mindset of the majority of investors and asset managers when we can observe that numerous market players have short-term strategies such as momentum-only funds, high-frequency traders and hedge funds. These price-only investors are often looking for quick wins with only two drivers for managing clients’ money: cash flow generation and price appreciation. The investment management industry must reference itself to fundamentals of value creation and increase funds allocation to companies with long-term perspectives putting forward business models with an impact on society. If the shift in mindsets is undoubtably a key lever to transform the fund industry, it would also require investment companies to commit to sustainable practices and conduct a revision of its fund managers contracts to minimize the importance of quarterly performance-chasing.

As investors have become increasingly interested in the impact of their investments’ money, some funds have worked to create a rigorous framework to measure social and environmental impacts. For instance, the Rise Fund, a $2 billion impact-investing fund managed by TPG Growth, and the Bridgespan Group, a global social impact advisory firm have worked with the Harvard Business School to develop a new metric: the impact multiple of money (IMM). The methodology employed estimate the financial value of the social and environmental good that is likely to result from the money committed. The Rise Fund has adopted this metric and set a threshold of $2.50 in social return for every $1 invested. 

Even if this approach is not an exact science, the IMM is used as a directional measure. Indeed, as with any financial valuation method employed, the output from the computation depends substantially on the assumptions of the model. Therefore, it is important to make all the steps in the calculation transparent and to foster feedback to refine the original assumptions and generate more-robust numbers that will be communicated to investors. Social-impact investors are in demand for these rigorous methodologies that will promote the allocation of capital to achieve sustainable projects.  

To assist investment managers in their re-allocation towards sustainable investments, the TEG established two climate investment benchmarks as the current methodologies and available information do not enable to incorporate climate scenarios into portfolio construction methodologies. These two benchmarks, the EU Climate Transition Benchmark (EU CTB) and EU Paris-aligned Benchmark (EU PAB), incorporates next to financial investment objectives, specific objectives related to greenhouse gas (GHG) emission reductions and the transition to a low-carbon economy through the selection and weighting of underlying constituents as defined by the climate experts group from the EU Commission. These two indicators have been created to help institutional investors to hedge against climate transition risks but also to invest in value opportunities related to the energy transition. The climate benchmarks have a similar objective but differ to some extent as the EU PAB has stricter requirements in order to meet the Paris agreement goal of maintaining climate warming below the 1.5°C scenario while the EU CTB is more dedicated to help institutional investors in their core allocation to hedge against the risks of climate change and the transition to a low-carbon economy.  

Innovation in finance and the engagement of the private sector

Assets dedicated to tackle climate change are gaining steam. The EIB issued the world’s first Green Bond, labelled a Climate Awareness Bond (CAB) in 2007. Since then, the green bond universe amounts at around $ 221 billion, a quarter of the total climate-aligned bonds market worth $ 895 billion. With EIB’s green financial instrument, the proceeds of the issue are ring-fenced in a segregated sub-portfolio within EIB’s Treasury. Since the creation of the CAB, the bank has enabled the issuance of more than € 18 billion which have helped to finance 160 projects supporting renewable energy and energy efficiency all over the world. From 2021, the EU’s lending arm will end financing of fossil fuel projects and align all its financing activities to Paris agreement goals. 

The EIB has paved the way in green finance but the amounts raised remain insufficient to make a substantial impact against climate change and achieve a sustainable society. In the same vein, the International Energy Agency (IEA) identified that investments in renewable energy have been stalling in 2018 after two decades of strong expansion.Currently, only 60 per cent of renewable energy capacity is added to meet Paris climate agreement’s goal.

Fatih Birol, the IEA’s executive director, described these data as “deeply worrying” and a sign that “governments need to act quickly to correct this situation and enable a faster flow of new projects”. 

The International Energy Agency estimates that $ 1 trillion a year has to be spent between now and 2050 to fund low-emission projects, therefore it is imperative to engage the participation of the private sector in this mission. The creation of a regulatory framework at the European and Luxembourg levels will reassure investors leading to the launch of a multitude of financial products. Nonetheless, the transition to a greener financial marketplace requires strong commitments to foster investors’ appeal for sustainable financial assets. The latest decision of the EU’s lending arm to end financing of fossil fuel projects from 2021 sets an example of required measures to steer investments in the green direction.

Par Gautier Fraiture, consultant Square



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