The EU’s Fintech Action Plan (now Digital Finance Strategy) and the Sustainable Finance Strategy represent important pillars of the bloc’s current policy agenda. While the two areas have been treated as separate for a long time, they present certain common features and great potential if combined. The COVID-19 pandemic provides an opportunity for countries in the EU to re-think traditional models of finance and rely more on technology and sustainability (see also the recent UNDP report).
We explore the potential of connecting Fintech and Sustainable finance, with particular reference to the environmentally sustainable segment (a less discussed area), in our recent EBI working paper, “Sustainable Finance and Fintech: Can Technology Contribute to Achieving Environmental Goals? A Preliminary Assessment of ‘Green FinTech.’” We first analyse the most recent developments in EU sustainable finance regulation and identify key areas of concern. Then we explore Fintech areas that are available to respond to certain shortcomings in the current sustainable finance market and its legal framework.
Sustainable finance framework and its challenges
With the 2018 ‘Financing Sustainable Growth’ Action Plan, the European Commission pursues several goals, including reorienting private capital to more sustainable investments; managing financial risks stemming from climate change, environmental degradation, and social issues; and fostering transparency and long-termism in financial and economic activity. The Plan represents a pillar of the recent European Green Deal, functioning as an instrument to achieve the objective of becoming a climate-neutral economy by 2050, de-carbonising the economy, transitioning to clean energies, and favouring the circular economy.
As part of the Plan, the EU has been adopting many policy papers, legislative initiatives, and directives/regulations, including:
- Taxonomy regulation of economic activities to classify when an activity can be considered environmentally sustainable;
- Sustainable Finance Disclosure Regulation requiring financial markets participants and financial advisers to publish on their websites, and include in their pre-contractual documents, information on their policies regarding the integration of sustainability risks in their investment decision-making processes/advice. In addition, where a financial product is marketed for its ESG characteristics, the disclosure should include information on how those characteristics are met in relation to the EU Taxonomy (on this topic, see Siri & Zhu 2019 and Busch’s EBI working paper 70/20). The Commission is also considering clarifying within MiFID II and other relevant texts the fiduciary and organizational duties of financial services operators in relation to ESG factors (e.g. suitability test and product governance). Furthermore, the European Supervisory Authorities (ESA) and the European Central Bank are required to integrate ESG factors in their supervisory evaluations and other tasks;
- Regulation on EU Climate Transition and EU Paris-aligned Benchmarks and related disclosure, aiming to reduce greenwashing by setting minimum standards for the companies that can be included in benchmarks labelled as such;
- The Commission is also evaluating the adoption of technical standards for an EU Ecolabel for environmentally sustainable financial products. This would rely on a “pass-or-fail” system (without assigning different grades) and a “three-pockets” approach: for instance, an equity investment fund, to pass the test, would have to invest at least 60% of assets under management (AuM) in sustainable companies but only 20% of AuM needs to be invested in companies deriving at least 50% of their revenue from sustainable economic activities, while the remaining 80% AuM should be equally split between companies deriving at least 20% of their revenue from sustainable economic activities and companies deriving less than 20% from sustainable economic activities (when not excluded by certain ESG criteria). In addition, the Commission is considering the creation of a voluntary EU Green Bond Standard to address the lack of transparency and of supervised or regulated agencies rating the companies.
This constantly growing framework leaves some issues unanswered. For instance, investment firms and banks, in order to provide information on the integration of ESG factors in their decisions as proposed by the Sustainable Finance Disclosure Regulation, would need standardized reporting from firms and uniform indicators, ESG indexes, and ratings based on reliable data and information. However, existing ESG data and ratings are often considered untrustworthy and not comparable because they tend to rely on voluntary and un-checked information, disclosed through different reporting methods and metrics.
Furthermore, the EU Green Bond Standards initiative and the benchmarking regulation, which are both voluntary, require significant additional costs that firms may seek to avoid.
Finally, the ‘three pockets’ approach, ‘pass-or-fail’ system, partial misalignment with the Taxonomy regulation, and lack of disclosed data verification of the proposed Ecolabel might all facilitate greenwashing and investor confusion.
Fintech and its potential in the sustainable finance area
The use of technology in financial services and, in particular, in the sustainable finance area, has the potential to channel financial resources to environmentally sustainable firms more efficiently. Fintech could help record and convey extensive, accurate, and relevant data at a low price and at a fast pace, thus reducing research costs and improving the pricing of environmental risks and investment opportunities. The most promising Fintech areas in the sustainable finance sector are crowdfunding, tokens, distributed ledger technology (DLT), artificial intelligence (AI), and big data. We discuss a few aspects of these areas below.
While ‘green’ crowdfunding platforms can channel funds to sustainable projects in a quick, innovative, and affordable way, DLT systems have allowed the creation and exchange of ‘energy’ tokens, which may be exchanged for low carbon emissions (if the token holder is an energy producer) or traded in peer-to-peer networks.
Furthermore, the combination of DLT systems and AI can respond to some of the shortcomings related to ESG and green bonds disclosure, verification, pricing, and ratings. For instance, such technologies enable the collection and processing of large amounts of data about companies’ social and environmental impacts. They also allow investors to compare company disclosures with almost real-time data (instead of relying on annual reports only) and verify the information with Publicly Available Environmental Data from non-governmental organizations, and with specialized websites and satellites that track air pollution and emissions by single power plants. Rating agencies can also use AI technology to offer customized services and therefore analyses reflecting investors’ preferences in terms of sustainability factors without losing comparability. In addition, the technologies may improve the Ecolabel evaluation process by introducing a nuanced scoring system instead of a ‘pass-or-fail’ standard.
While these areas of Fintech have much to offer, they still face challenges such as certain technical obstacles, high energy consumption and operational risk in DLT networks, potential financial exclusion, and job losses from the increased digitalization in financial services. In our paper, we discuss these promising Fintech areas further and provide examples of projects and firms already operating in these areas.
There are important legal issues that need to be addressed before Fintech can fulfil its potential in the sustainable finance sector. In particular, Fintech raises special consumer and investor protection issues. Despite the EU defining its financial regulation and attitude towards fintech ‘technology-neutral’, ESAs have recognized the need to adapt certain financial rules or issue special regulations in the areas of ICOs, crypto-assets and DLT, crowdfunding, and cloud outsourcing (see for instance the approaches of the European Banking Authority and European Securities and Markets Authority and, more recently, the proposals contained in the Digital Finance Package).
Recent EU proposals, or soon to be approved regulations, will also affect the Green Fintech area. For instance, the European Crowdfunding Services Providers (ECSPs) Regulation (adopted by the European Council in July 2020 and very recently approved also by European Parliament in October 2020) might be able to solve the existing regulatory fragmentation problem and lead to increased investor protection for non-sophisticated investors (for a wider discussion on regulatory fragmentation in EU legislation, see Macchiavello 2017; for a detailed and updated comment of the ECSPs Regulation, see Macchiavello 2020). The resulting framework covers disclosure requirements and organizational and prudential requirements—especially for lending-based crowdfunding and complex models such as portfolio management of loans and pricing and scoring services (for a comment in this regard see also EBI Working paper 55/2019). This framework might appear disproportionate for small, local, or new platforms in the ESG field unless the proportionality principle (i.e. application of rules taking into account the different operators’ size, systemic importance, nature, scale and complexity of activities) is effectively applied and/or specific measures to promote sustainable crowdfunding projects are introduced (as foreseen under Art. 45(2)s ECSPs regulation). Additionally, the restrictions on bulletin boards (i.e. a platform’s system allowing users interested in selling with users interested in buying to meet but not consisting in multilateral systems that bring together selling and buying interests in a way resulting in a contract) might reduce the ability of these systems to convey more liquidity in such market.
The recent European Commission’s consultation on crypto-assets (as well as ‘Non-Paper on the legislative proposals for an EU framework for markets in crypto-assets’ and, more recently, Proposal for a Regulation on Markets in Crypto-assets) seems to suggest that the EU could apply, with some adaptions, (1) existing EU financial regulation (e.g. MiFID II, Prospectus, MiFIR, etc.) to security tokens and token exchanges and (2) a special regime for tokens (e.g. utility tokens) or entities (e.g. decentralized markets) otherwise not covered by EU law. While these recommendations are useful, there should also be special provisions for tokens issued to incentivize sustainable behaviours or to trade green energy in P2P networks.
Finally, certain interdisciplinary Fintech-related issues need to be addressed (see also the ROFIEG Report and Macchiavello 2019), such as the legal validity and effects of smart contracts, principles for blockchain governance, DLT and digital data protection, criteria to identify the competent jurisdiction and the applicable law, liabilities in an AI context, fairness, transparency and intelligibility of algorithms without endangering copyrights and innovation incentives, data for financial services, and Big Tech regulation.
In our working paper, we provide a deeper discussion of these and additional issues, presenting conclusions and proposals. The aim is to start a debate about “Green Fintech” in order to effectively connect the two worlds and spur additional research in a new and promising area.
Eugenia Macchiavello is Assistant Professor in Business and Banking Law at the University of Genoa (Law Department) and Academic Member of the Jean Monnet Centre of Excellence on Sustainable Finance – EUSFiL (University of Genoa) and Genoa Centre for Law and Finance.
Michele Siri is Full Professor in Business Law at the University of Genoa (Law Department; Genoa Centre for Law and Finance), Director of the Jean Monnet Centre of Excellence on Sustainable Finance – EUSFiL (University of Genoa; Genoa Centre for Law and Finance) and Jean Monnet Chair on European Union Financial and Insurance Markets Regulation.
This post is adapted from their paper, “Sustainable Finance and Fintech: Can Technology Contribute to Achieving Environmental Goals? A Preliminary Assessment of ‘Green Fintech,’” which is part of the European Banking Institute Working Paper Series and available on SSRN.