The EU Taxonomy Regulation:
Economic Justification, Challenges and The Way Forward
Master Thesis
LL.M Law and Finance
Academic Year 2019-2020
Author: Sofia Gagani
Student Number: 12797650
Email: s.gagani@hotmail.com
Supervisor: Jennifer De Lange
Second Reader: Prof. Rolef de Weijs
Submission Date: 30 June 2020
1
ABSTRACT
By signing the Paris Agreement on Climate Change and the UN 2030 Agenda for Sustainable Development in 2015, the European Union committed to take actions so as to enable a transition to a low-carbon, more sustainable economy. Finance has a key role to play in delivering this transition by providing funding to economic activities and ultimately supporting sustainable growth. Although public funds will be deployed to this end, a large amount of capital will have to come from the private sector. Against this background, in June 2020 the EU adopted the Taxonomy Regulation, an EU-wide classification system of sustainable economic activities. The Taxonomy Regulation sets uniform criteria based on which economic activities can be considered as sustainable and requires large listed companies and financial market participants to disclose how and to what extent their economic activities/financial products meet those criteria. The ultimate goal of these provisions is to help re-orient private capital towards more sustainable investments. From an economic point of view, the main question that arises with any regulatory intervention in financial markets is whether there is an economic justification for such intervention. Since the Taxonomy Regulation is a newly adopted law, this question remains unanswered. Thus, the purpose of this thesis is to explore whether there is an economic justification for the adoption of the Taxonomy Regulation. The analysis shows that currently in the context of sustainable investments, there is a problem of information asymmetry in the market, which leads to an inefficient allocation of resources and requires regulatory intervention. The thesis then explores whether the Taxonomy Regulation is an appropriate response to this market failure. In particular, it discusses to what extent the Taxonomy Regulation, being a disclosure-based regime, is capable of addressing the problem of information asymmetry and facilitating an efficient allocation of resources to sustainable assets. The analysis follows an interdisciplinary approach; it discusses the potential benefits and the challenges of mandatory disclosure in the context of Taxonomy Regulation, using insights both from law and economics, as well as from behavioural finance literature. With regard to the challenges, the thesis discusses the risk of creating inconsistent incentives due to the costs of mandatory disclosure and the limited ability of disclosure-based regulation to operate as an information tool to retail investors due to problems of bounded rationality and information overload. To address these challenges, the thesis makes certain suggestions of ways to fine-tune the content of mandated disclosures, and makes the case for the development of an EU Ecolabel for retail financial products based on the Taxonomy criteria. The thesis concludes that the economic justification of the Taxonomy Regulation will ultimately depend on how the final disclosure framework will be designed.
Keywords: Taxonomy Regulation; Sustainable Finance; Mandatory Disclosure; Information
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TABLE OF CONTENTS
LIST OF ABBREVIATIONS……….3
CHAPTER 1: INTRODUCTION………...4
1.1 Introduction………... 4
1.2 Outline and Methodology………..5
CHAPTER 2: THE TAXONOMY REGULATION………...7
2.1 Background………7
2.2 The Taxonomy Regulation: Main Elements and Objectives...…….………..8
CHAPTER 3: SUSTAINABLE INVESTMENTS: MARKET FAILURE AND THE NEED FOR REGULATORY INTERVENTION………...……...…..11
3.1 Introduction………. 11
3.2 Growing Investor Demand for Sustainable Investments………..11
3.3 Market Failure: The Lack of Consistent Definitions on Sustainability and the Problem of Asymmetric Information...……….13
3.4 Insufficient Self-Regulatory Measures………16
3.5 Conclusion………...17
CHAPTER 4: THE POTENTIAL OF THE TAXONOMY REGULATION TO ADDRESS THE MARKET FAILURE AND TO MOBILISE PRIVATE CAPITAL TOWARDS SUSTAINABLE INVESTMENTS………...……....………..……….18
4.1 Introduction……….18
4.2 The Potential Benefits of the Taxonomy Regulation ………..…19
4.2.1 Addressing Information Asymmetries in the Context of Professionally Informed Trading………...…………..…..19
4.2.2 Affecting Behaviour in the Market………...………..21
4.3 The Challenges of the Taxonomy Regulation……….23
4.3.1 The Risk of Creating Inconsistent Incentives……….23
4.3.2 Addressing Information Asymmetries: The Problem with Retail Investors…..24
4.4 Conclusion………...28
CHAPTER 5: THE WAY FORWARD - ADDRESSING THE CHALLENGES OF THE TAXONOMY REGULATION………29
5.1 Introduction………... ..29
5.2 Fine-tuning the Content of Mandated Disclosures………..29
5.3 The Case for an EU Ecolabel for Retail Financial Products……….30
5.4 Conclusion………...33
CHAPTER 6: CONCLUSION……….35
3
LIST OF ABBREVIATIONS
AIFMs Alternative Investment Fund Managers
UCITS Undertakings for Collective Investment in Transferable Securities Commission European Commission
CoEU Council of the European Union
eds Editors
EIB European Investment Bank
EU European Union
HLEG High-Level Expert Group
GSIA Global Sustainable Investment Alliance IDFC International Development Finance Club MDBS Multilateral Development Banks
n Footnote
NFRD Non-Financial Reporting Directive
OECD Organisation for Economic Co-operation and Development SDGs Sustainable Development Goals
TEG Technical Expert Group
UN United Nations
UNEP FI United Nations Environment Programme Finance Initiative UNTS United Nations Treaty Series
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CHAPTER 1: INTRODUCTION
1.1 Introduction
The world of the 21st century is faced with an environmental degradation of an unprecedented scale, which seriously threatens human civilization.1 By adopting the Paris Agreement on Climate Change2 and the UN 2030 Agenda for Sustainable Development3 in 2015, governments from around the world agreed that there is an urgent need to step up their efforts in order to ensure a transition to a low-carbon, sustainable economy.
To achieve the 2030 targets, the EU will have to fill an estimated investment gap of EUR 180 billion per year.4 To fill this gap the EU is taking steps as part of the Commission’s ‘Action Plan: Financing Sustainable Growth’ (2018)5 in order to mobilise private capital
towards more sustainable investments. In this context, the Commission has proposed the adoption of a Regulation on the Establishment of a Framework to Facilitate Sustainable Investment (the ‘Taxonomy Regulation’).6 The Taxonomy Regulation is an EU-wide
classification system intended to provide firms and investors with a common framework for determining which economic activities can be considered to be ‘environmentally sustainable’. The Taxonomy Regulation also imposes certain obligations on market participants. In particular, it requires financial market participants (such as fund managers and institutional investors) that offer financial products in Europe to disclose how and to what extent the criteria of the Taxonomy Regulation have been used to determine the environmental sustainability of an investment.7 Moreover, it requires large public-interest companies that are subject to the
1 World Economic Forum, ‘Global Risks Report 2020’ available at https://www.weforum.org/reports/the-global-risks-report-2020: climate change is ranked as the biggest global threat.
2 Paris Agreement (adopted 12 December 2015, entered into force 4 November 2016) UNTS (‘Paris Agreement’). 3 UNGA ‘Transforming Our World: The 2030 Agenda for Sustainable Development’ (25 September 2015) A/RES/70/1 (‘UN 2030 Agenda’).
4 Commission, ‘Impact Assessment: Accompanying the document Proposal for a Directive of the European Parliament and of the Council amending Directive 2012/27/EU on Energy Efficiency’ COM (2016) 761 (‘Commission Impact Assessment’).
5 COM (2018) 97 (‘Action Plan 2018’).
6 Commission, ‘Proposal for a Regulation of the European Parliament and of the Council on the Establishment of a Framework to Facilitate Sustainable Investment’ COM (2018) 353 final (‘Commission Proposal’); For the final text of the Taxonomy Regulation see CoEU, ‘Position of the Council at First Reading with a View to the Adoption of a Regulation of the European Parliament and of the Council on the Establishment of a Framework to Facilitate Sustainable Investment, and Amending Regulation (EU) 2019/2088’ (COD) 2018/0178.
7 Taxonomy Regulation Articles 5, 6 (any reference to Articles is based on the final text of the Regulation – see CoEU n 6).
5 Non-Financial Reporting Directive8 (‘NFRD’) to disclose how and to what extent their activities are aligned with the Taxonomy Regulation.9
As is the case with any regulatory intervention in financial markets, in order for the adoption of the Taxonomy Regulation to be economically justified, two conditions must be met. First, there needs to be a market failure that cannot be corrected by the market’s self-regulatory mechanisms, and second, regulation must be capable of addressing this market failure.10 The purpose of the present paper is to examine whether, in the case of the Taxonomy Regulation, these two conditions are met. In other words, this paper explores whether there is an economic justification for the adoption of the Taxonomy Regulation. To answer this question, the analysis is divided into three sub-questions: a) Is there a market failure that requires regulatory intervention? b) Is the Taxonomy Regulation capable of addressing this market failure and of mobilising private capital towards sustainable investments? What are the challenges in this context? c) What measures could be taken in order to address those challenges?
It is noted that at the time of writing of this paper, the Taxonomy Regulation is not yet into force. Its final text was adopted by the European Council and the European Parliament in June 2020 and remains to be published in the Official Journal.11 The Taxonomy Regulation will apply partly from January 2022 and partly from January 2023.12 To the knowledge of this author, there is no paper so far that explores the economic justification and the challenges of the Taxonomy Regulation, which is what constitutes the contribution of the present paper.
1.2 Outline and Methodology
This paper is structured as follows. Chapter 1 begins with an introduction to the topic and sets out the research question(s) and the methodology that will be followed to answer those. Chapter 2 gives an overview of the background and the main elements and objectives of the Taxonomy Regulation. Chapter 3 explores the first condition for the economic justification of
8 Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups [2014] OJ L330/1 (‘NFRD’).
9 Taxonomy Regulation Article 8.
10 Reinier Kraakman, ‘Disclosure and Corporate Governance: An Overview Essay’, in G Ferrarini, K Hopt, and E Wymeersch (eds), Reforming Company and Takeover Law in Europe (2004) 95; Niahm Moloney, EU Securities
and Financial Markets Regulation (3rd edn Oxford University Press 2014) 2.
11 See CoEU (n 6); Commission, ‘Sustainable Finance: Commission Welcomes the Adoption by the European Parliament of the Taxonomy Regulation’ (Press Release June 2020) available at https://ec.europa.eu/commission/presscorner/detail/en/ip_20_1112.
6 the Taxonomy Regulation, namely whether there is a market failure that requires regulatory intervention. In particular, it identifies the lack of harmonised standards on what is considered to be ‘environmentally sustainable’ as the main obstacle in mobilising private capital towards sustainable investments and highlights the inability of the current self-regulatory mechanisms to address this problem. The analysis is based on recent reports published by the financial industry, as well as on the economics literature regarding the effects of information asymmetries (as a market failure) on market efficiency. Chapter 4 examines whether the Taxonomy Regulation, being a disclosure-based regime, is capable of addressing this market failure and achieving the objective of mobilising private funds to sustainable investments. This Chapter is divided into two parts: The first part discusses the potential benefits of the Taxonomy Regulation associated with the provision of information in the context of professionally informed trading and its ability to drive market behaviour towards more sustainable practices. The second part draws the attention to the challenges of the Taxonomy Regulation, in particular the risk of creating inconsistent incentives due to the costs of disclosure and its limited ability to operate as an information tool for retail investors. Here, the analysis follows an interdisciplinary approach: it builds on traditional law and finance literature regarding the role of disclosure-based regulation in regulating financial markets, as well as on behavioural economics literature about the effects of information provision on investor behaviour. Having established the extent to which the Taxonomy Regulation is capable of dealing with this market failure, Chapter 5 explores how the weaknesses of the Taxonomy Regulation could be addressed. In particular, Chapter 5 begins by making certain suggestions for the improvement of the mandated disclosures based on behavioural insights aimed at addressing problems associated with retail investor decision making, while reducing unnecessary costs. Chapter 5 also supports the use of a supplementary regulatory tool, namely the creation of an EU Ecolabel for retail financial products based on the Taxonomy criteria. This part is linked to the literature on the effects of labels as information tools, as well as tools that influence consumer behaviour. Chapter 6 concludes.
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CHAPTER 2: THE TAXONOMY REGULATION
2.1 Background
In 2015 two milestone international agreements set the path for the transition to a more sustainable economy: the Paris Agreement,13 a global effort to combat climate change by keeping the global temperature levels well below 2 degrees Celsius above pre-industrial levels, and the UN 2030 Agenda,14 which set 17 Sustainable Development Goals (‘SDGs’) including the fight against poverty and inequality and the protection of the environment.
Finance has a key role to play in delivering this transition by providing funding to economic activities and ultimately supporting sustainable growth.15 As already mentioned, it is estimated that the EU will have to meet an investment need of EUR 180 billion per year in order to meet the 2030 climate and energy targets,16 while in the transport and resource
management infrastructure sector this gap reaches a yearly amount of EUR 270 billion.17 Public
funds are not sufficient to fill this gap, which means that a large amount of capital flows needs to come from the private sector.18
In this context, in December 2016 the Commission appointed a High-Level Expert Group (‘HLEG’) to provide recommendations on the development of a sustainable finance strategy. According to the HLEG’s final report, sustainable finance is about two urgent goals: ‘(1) improving the contribution of finance to sustainable and inclusive growth by funding society's long-term needs, and (2) strengthening financial stability by incorporating environmental, social and governance (‘ESG’) factors into investment decision-making’.19 Following the HLEG’s recommendations, in March 2018 the Commission published its ‘Action Plan: Financing Sustainable Growth’,20 which aims among others to align EU financial
policy with the climate goals of the Paris Agreement and the UN SDGs by re-orienting capital towards sustainable investments. According to the Action Plan 2018, achieving this goal requires a common understanding on what constitutes ‘sustainable’, which is currently lacking
13 n 2.
14 n 3.
15 Action Plan 2018 (n 5).
16 Commission Impact Assessment (n 4).
17 EIB, 'Restoring EU competitiveness' (2016) available at https://www.eib.org/en/publications/restoring-eu-competitiveness.
18 Action Plan 2018 (n 5).
19 HLEG on Sustainable Finance, ‘Financing a Sustainable European Economy: Final Report 2018’ available at https://ec.europa.eu/info/publications/180131-sustainable-finance-report_en (‘HLEG Final Report 2018’). 20 n 5.
8 among market participants.21 Thus, the most urgent action is to develop a unified classification system – a Taxonomy- for sustainable economic activities.22 Given the complexity and the resources required for such a project, the Commission suggested the gradual development of a Taxonomy, beginning by focusing on climate change and environmental considerations and moving on to include also social considerations in the characterization of an economic activity as sustainable.23
2.2 The Taxonomy Regulation: Main Elements and Objectives
In May 2018, the Commission published a Proposal for the adoption of a Taxonomy Regulation,24 an EU-wide classification system which sets uniform criteria on which economic activities can be considered as ‘environmentally sustainable’ for the purpose of establishing the environmental sustainability of an investment. In June 2020, the European Council and the European Parliament adopted the final text of the Taxonomy Regulation, which remains to be published in the Official Journal.25
The Taxonomy Regulation’s main objective is to establish a common understanding on what constitutes environmentally sustainable economic activities so as to help re-orient capital towards more sustainable investments.26 In particular, the Taxonomy Regulation is expected to help investors better compare financial products so as to enable them to make informed decisions.27 Moreover, the establishment of uniform criteria is intended to address concerns about ‘greenwashing’, which refers to ‘the practice of gaining an unfair competitive advantage by marketing a financial product as environmentally friendly, when in fact it does not meet basic environmental standards’.28 This is expected to enhance investor confidence, thereby stimulating sustainable investments.29 Finally, the Taxonomy Regulation aims to give more clarity to economic operators, in order to incentivise them to adapt their economic activities to the Taxonomy. This will help them attract funding more easily while improving their environmental performance.30 Ultimately, the Taxonomy Regulation is expected to have a
21 Action Plan 2018 (n 5). 22 ibid. 23 Action Plan 2018 (n 5). 24 Commission Proposal (n 6). 25 CoEU (n 6). 26 Commission Proposal (n 6). 27 Taxonomy Regulation Recital 6. 28 ibid Recital 11.
29 Taxonomy Regulation Recital 13. 30 ibid.
9 positive indirect environmental impact, thereby contributing to the envisaged transition to sustainability.31
The Taxonomy Regulation sets out 6 environmental objectives: (1) climate change mitigation, (2) climate change adaptation, (3) sustainable use and protection of water and marine resources, (4) transition to a circular economy, (5) pollution prevention and control, (6) protection and restoration of biodiversity and ecosystems.32 According to Article 3 of the Taxonomy Regulation, an economic activity is considered to be environmentally sustainable if it: (1) contributes substantially to one of the above environmental objectives, (2) does not significantly harm any of these objectives, (3) complies with minimum safeguards laid down in Article 18 (such as the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights) and (4) complies with technical screening criteria specified by the Commission.
The technical screening criteria will be gradually established via delegated acts by the Commission and are intended to be updated regularly so as to adapt to scientific and technological developments.33 To this end, the Taxonomy Regulation provides for the
establishment of a multi-stakeholder Platform on Sustainable Finance, consisting of experts who will advise the Commission on the development of the technical screening criteria.34
Besides setting the framework for a unified classification system, the Taxonomy Regulation also imposes certain obligations upon market participants. To begin with, it requires financial market participants35 offering financial products36 as environmentally sustainable to
disclose how and to what extent they have used the Taxonomy criteria to determine the sustainability of the underlying investments, to what environmental objective(s) the investments contribute, and the proportion of the investments that relate to environmentally sustainable economic activities.37 If the environmental sustainability of the financial product has not been determined with reference to the Taxonomy, then the product must carry a disclaimer to this end.38 This disclosure obligation supplements the rules of the Disclosure
31 Commission Proposal (n 6). 32 Taxonomy Regulation Article 9. 33 ibid Recital 38, Articles 19(5), 23. 34 Taxonomy Regulation Article 20.
35 As defined in Article 2(1) of the Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector [2019] OJ L317/1 (‘Disclosure Regulation’); Article 2 includes investment firms and credit institutions offering portfolio management, AIFMs and UCITS management companies.
36 As defined in Article 2(12) of the Disclosure Regulation. 37 Taxonomy Regulation Articles 5, 6.
10 Regulation,39 which requires financial market participants to make sustainability-related disclosures in their pre-contractual documents and periodic reports.40
Moreover, the Taxonomy Regulation requires large public-interest companies (including listed companies, banks and insurance companies) with more than 500 employees that are subject to the NFRD41 to disclose into their non-financial statements how and to what extent their activities are aligned with the Taxonomy Regulation.42 In particular, non-financial companies will have to disclose the proportion of their turnover, capital expenditures and operational expenditures that is associated with environmentally sustainable economic activities.43 By 1 June 2021, the European Commission will adopt a delegated act specifying
how the disclosure obligations should be applied in practice for financial and non-financial undertakings.44
In order to give market participants sufficient time to familiarise themselves with the Taxonomy criteria and the relevant disclosure obligations for each environmental objective the Taxonomy Regulation will apply 12 months after the relevant screening criteria have been adopted.45 In particular, with respect to the objectives of climate mitigation and adaptation, the
disclosure requirements will apply from 1 January 2022, whereas with respect to the other environmental objectives they will apply from 1 January 2023.46
39 n 35.
40 See Disclosure Regulation Articles 6(3), 11(2). 41 n 8.
42 Taxonomy Regulation Article 8(1). 43 ibid Article 8(2).
44 Taxonomy Regulation Articles 8(4), 23. 45 ibid Recital 57.
11
CHAPTER 3: SUSTAINABLE INVESTMENTS: MARKET FAILURE AND THE NEED FOR REGULATORY INTERVENTION
3.1 Introduction
The starting point in economics for regulation in financial markets is that, absent any market failures, markets should be left to operate freely without interventions from regulators.47 This is based on the idea that in well-functioning markets, perfect competition will guide market participants to allocate scarce financial resources to their most efficient use.48 However, this does not always happen since markets are prone to market failures, that is, situations where markets fail to achieve economically efficient outcomes.49 Regulation is then advocated as a corrective response to such failures. 50 Thus, the first step in determining whether a regulatory
measure is economically justified is to identify the existence of a market failure that cannot be corrected by the market’s self-regulatory mechanisms.51 This Chapter explores what the market
failure is in the context of channelling capital towards sustainable investments that justifies regulatory intervention.
3.2 Growing Investor Demand for Sustainable Investments
Traditionally, investors had believed that the best investment strategy is one that maximizes financial returns for a given level of financial risk.52 According to this view, non-financial considerations, such as environmental and social factors, were considered to be incompatible with the aim of profit maximization.53 However, over the last years there has been a shift in investor beliefs and investments that incorporate ESG factors have become increasingly popular. According to a report of the Global Sustainable Investment Alliance,54 between 2012 and 2018 global sustainable investment has grown by 43%, reaching USD 30.7
47 John Armour, Dan Awrey, Paul Davies, Luca Enriques, Jeffrey N Gordon, Colin Mayer, Jennifer Payne,
Principles of Financial Regulation (Oxford University Press 2016) 51.
48 Armour et al. (n 47) 52. 49 Armour et al. (n 47) 51. 50 ibid; Moloney (n 10) 2. 51 Armour et al. (n 47) 51.
52 Joakim Sandberg, ‘Towards a Theory of Sustainable Finance’ in T Walker, S D Kibsey, R Crichton (eds)
Designing a Sustainable Financial System (2018) 329.
53 ibid.
54 Global Sustainable Investment Alliance (‘GSIA’), ‘2018 Global Sustainable Investment Review’ available at http://www.gsi-alliance.org/trends-report-2018/.
12 trillion in assets under management in 2018.55 Europe is well ahead of the sustainable investing curve with USD 14.1 trillion in sustainable investments in 2018.56
One of the factors that triggered this shift is the gradual realization that environmental and social challenges can be sources of financial risk that affect investment returns.57 Especially environmental and climate-related risks may have damaging effects on the financial performance of firms. This can happen through the physical channel (eg. due to natural disasters) or through the transition channel, (eg. due to the inability of certain firms to adapt to the transition to sustainability). 58 Investors are inevitably exposed to those risks, not only by
investing in firms that may be affected, but also because of the externalities that such risks can have for the economy as a whole should they materialise.59 Thus, incorporating sustainability-related factors into the investment process can help mitigate such risks.60
Besides seeing the integration of ESG risks as a risk mitigant, investors also increasingly consider it as an opportunity to improve financial performance. According to a global survey, the vast majority (82%) of investors that use ESG information suggest that they do so because it is financially material to investment performance.61 This belief is perhaps
grounded in the fact that there is a growing body of literature and industry research supporting this proposition. For instance, a meta-study of more than 2000 empirical papers shows that 63% of the studies report a positive correlation between ESG and financial performance, whereas only 8% report a negative correlation.62
The increase in sustainable investments seems also to be driven by strategic motives among institutional investors and fund managers, who are making their investments more sustainable to meet growing client demand.63 Finally, other considerations, such as ethical
55 The report covers assets under management in Europe, U.S., Japan, Canada, Australia and New Zealand. 56 GSIA (n 54).
57 Principles for Responsible Investment, ‘The SDG Investment Case’ (2017) 16 available at https://www.unpri.org/download?ac=5909.
58 Barbara Lambert (ed), ‘How sustainable finance can tackle the climate emergency’ (The Social Market Foundation 2019) 26, 38.
59 Andreas Hoepner, Ioannis Oikonomou, Zacharias Sautner, Laura T Starks, Xiaoyan Zhou, ‘ESG Shareholder Engagement and Downside Risk’ (2020) Finance Working Paper No 671/2020 available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2874252.
60 Remmer Sassen, Anne-Kathrin Hinze, Inga Hardeck, ‘Impact of ESG factors on firm risk in Europe’ (2016) 86 Journal of Business Economics 867.
61 Amir Amel-Zadeh, George Serafeim, ‘Why and How Investors Use ESG Information: Evidence from a Global Survey’ (2018) 74 Financial Analysts Journal 87.
62 Gunnar Friedea, Timo Busch, Alexander Bassen, ‘ESG and financial performance: aggregated evidence from more than 2000 empirical studies’ (2015) 5 Journal of Sustainable Finance & Investment 210.
13 reasons, seem to be driving the interest in sustainable investments mostly among retail investors.64
3.3 Market Failure: The Lack of Consistent Definitions on Sustainability and the Problem of Asymmetric Information
Even though investments in sustainability are increasing, the scale and pace of this transition seems to be insufficient to meet the amount of capital flows needed to achieve the 2030 global sustainability targets.65 Various factors are being reported as delaying the transition, such as the potential misalignment of investors’ preferences for short-term profit with the longer-term investment horizons required for sustainable investments and the difficulty in pricing sustainability risks.66 However, according to the views of market
participants, far and away the biggest barrier to sustainable investing is the lack of harmonised standards and definitions on what can be considered as ‘sustainable’.67
In particular, the rise of sustainable investing has also given rise to various terms approaching sustainability. Terms such as ‘socially responsible investing’ (‘SRI’), ‘impact investing’ and ‘ethical investing’ are often used interchangeably under the umbrella of sustainable investing,68 yet providing for distinct definitions that cause great confusion among market participants. A good illustration of this can be found in the following definitions: ‘Socially responsible investing, also called ethical investing and green investing, is an investment that is considered socially responsible because of the nature the business company conducts’,69 ‘Green investing refers to investing activities aligned with a commitment to the
promotion of environmentally friendly business practices and the conservation of natural resources’,70 ‘Impact investing is the art of investing with an intended social impact while also achieving a positive financial return’.71 Although most of the time these terms advocate the
integration of ESG considerations into the investment process, there is no common
64 ibid.
65 Commission Impact Assessment (n 4).
66 KPMG, ‘Sustainable investing: Fast-forwarding its evolution’ (2020) available at https://home.kpmg/xx/en/home/insights/2020/02/sustainable-investing.html 43.
67 ibid.
68 Cary Krosinsky, ‘The Seven Tribes of Sustainable Investing’ in C Krosinky, S Purdom (eds) Sustainable
Investing: Revolutions in theory and practice (Routledge 2017) 7; Quintin Rayer, ‘Exploring Ethical and
Sustainable Investing’ (2017) The Review of Financial Markets available at https://p1-im.co.uk/wp-content/uploads/2017/01/TRoFMJan17-p4-10-QR-online-version.pdf.
69 H Kent Baker, John R Nofsinger, Socially Responsible Finance and Investing (John Wiley&Sons 2012) 3. 70 https://www.investopedia.com/terms/g/green-investing.asp.
71 Wolfgang Spiess-Knafl, Barbara Scheck, Impact Investing Instruments, Mechanisms and Actors (Mario La Torre (ed) 2017) 7.
14 understanding on what ESG factors actually entail, and thus, which economic activities can be considered sustainable.72
This situation entails significant costs for market participants. In particular, the lack of clarity makes it difficult for economic operators to adapt their decisions as well as accounting and performance measurement tools to comply with sustainability criteria and disincentives them from making their activities more sustainable.73 Moreover, the lack of uniform definitions leads to inconsistent sustainability-related disclosures, opaque research methodologies and unreliable ratings that hamper comparability.74 This means that financial institutions have to
engage into costly processes and develop their own methodologies in-house in order to identify sustainable investable assets.75 It also makes it disproportionately burdensome for investors to check and compare financial products, which in the end discourages them from investing in sustainable assets.76
To better understand the consequences of the above situation, one can look at the economics of information asymmetries as market failures. The problem of asymmetric information refers to a situation where a party in a transaction possesses less information than its counterparty.77 In such a case, the less informed party may face a problem of adverse
selection. George Akerlof first described this problem in his famous paper ‘The Market for “Lemons”’.78 Akerlof presented a case where there are two types of second-hand cars being
sold: good cars (‘cherries’) and bad cars (‘lemons’). Sellers know which type they are selling, whereas buyers cannot ascertain the quality of the car before purchasing it. Given the possibility that they might purchase a lemon, buyers will be willing to pay no more than the price of an average quality car and, accordingly, sellers will offer cars of average or most likely even worse quality. Akerlof showed mathematically that in equilibrium the only cars sold will be lemons, causing the market for second-hand cars to collapse.79
72 HLEG on Sustainable Finance, ‘Financing a Sustainable European Economy: Interim Report’ (2017) available at https://ec.europa.eu/info/publications/170713-sustainable-finance-report_en 49 (‘HLEG Interim Report 2017’).
73 HLEG Interim Report 2017 (n 72) 48. 74 KPMG (n 66) 6.
75 ibid.
76 Commission Impact Assessment (n 4). 77 Armour et al. (n 47) 53.
78 George Akerlof, ‘The Market for “Lemons”: Quality, Uncertainty and the Market Mechanism’ (1970) 84 The Quarterly Journal of Economics 488.
15 To explore this point further, one can look at a classic distinction between types of goods used by economists based on how easy it is for consumers to determine their qualities.80 ‘Search goods’ are the goods whose qualities can be determined before they are purchased (eg. fruits and vegetables).81 ‘Experience goods’ are those whose qualities can be identified only upon consumption.82 Finally, there are some cases where it might not be possible to identify the characteristics of a good even upon consumption; these are called ‘credence goods’.83 Financial products are considered to be ‘credence goods’, since ‘there are no benchmarks against which to evaluate performance’.84 Thus, in the absence of any information provided to
investors, they will be unable to assess the characteristics and risks of an investment.
In the case of sustainable investments, this situation is aggravated by the lack of harmonised criteria on what can be considered as sustainable. This exposes investors to the risk of ‘greenwashing’,85 on the one hand, which, as mentioned before, refers to the promotion of
financial products as environmentally sustainable when in reality they are not, and, on the other, to the risk of ‘whitewashing’,86 which is the selective disclosure on the part of corporates of
good sustainability scores, while ignoring the others. This fact has further implications on market efficiency. In particular, this information asymmetry results in a mispricing of securities, meaning that securities prices do not reflect the real value of the investments.87 As a result, investors anticipating that they will be systematically cheated by better-informed parties will either charge more in order to invest or will refrain from investing at all.88 Both cases reduce the number of parties willing to trade and, thus, reduce liquidity in the market.89 In the end, this information asymmetry results in an inefficient allocation of resources,90 since investors are either prevented from investing in sustainable assets or they allocate capital to activities that are mistakenly identified as sustainable.
80 Philip Nelson, ‘Information and consumer behaviour’ (1970) 78 Journal of Political Economy 311; Michael Darby, Edi Karni, ‘Free competition and the optimal amount of fraud’ (1973) 16 The Journal of Law & Economics 67.
81 ibid.
82 Nelson (n 80); Darby, Karni (n 80). 83 ibid.
84 Armour et al. (n 47) 54.
85 Taxonomy Regulation Recital 9. 86 KPMG (n 66) 44.
87 Armour et al. (n 47) 105. 88 Armour et al. (n 47) 60. 89 ibid.
16
3.4 Insufficient Self-Regulatory Measures
An attempt to deal with this market failure has been made through self-regulation. In particular, market participants have developed voluntary standards and taxonomies with the aim to drive the provision of information needed to increase capital allocation towards sustainable investments. The most developed standards have been those for green bonds, mainly the Green Bond Principles, which provide process guidelines for the issuance of green bonds and related disclosures. 91 Another initiative has been the creation of the Climate Bonds Taxonomy, which sets criteria for the characterisation of assets as aligned with climate goals laid down in the Paris Agreement. 92 Another example is the Common Principles for Climate Mitigation Finance Tracking, which set definitions and guidelines for tracking climate change mitigation activities. 93 Other generic principles have been developed, such as the Principles
for Responsible Investment including guidelines for the integration of ESG factors into the investment process, 94 as well as the UNEP FI Principles for Positive Impact Finance, which
aim to provide rigorous definitions and guidelines related to positive impact finance. 95
However, the existence of various different standards and taxonomies seems to rather aggravate the situation than improving it. Their heterogeneity in terms of objectives and methodologies leads to fragmentation and does not facilitate comparability.96
Even if we assumed that there existed harmonised self-regulatory standards, their voluntary character makes it doubtful whether an optimal level of disclosed data could be achieved. One reason for this is that the disclosure of information creates positive externalities.97 This means that the disclosure of information by one firm might give a benefit to other firms without them paying for it.98 For instance, disclosure of R&D-related information, such as the development of a new sustainable (financial) product on the side of
91 International Capital Market Association, ‘The Green Bond Principles’ (2018) available at https://www.icmagroup.org/green-social-and-sustainability-bonds/green-bond-principles-gbp/.
92 Climate Bonds Initiative, ‘Climate Bonds Taxonomy’ (2019) available at https://www.climatebonds.net/standard/taxonomy.
93 MDBS/IDFC, ‘Common Principles for Climate Mitigation Finance Tracking’ (2015) available at https://www.eib.org/attachments/documents/mdb_idfc_mitigation_common_principles_en.pdf.
94 Principles for Responsible Investment, ‘Principles for Responsible Investment’ (2019) available at https://www.unpri.org/download?ac=6303.
95 UNEP FI, ‘Principles for Positive Impact Finance’ available at https://www.unepfi.org/positive-impact/principles-for-positive-impact-finance/.
96 HLEG Interim Report 2017 (n 73) 49.
97 Frank H Easterbrook, Daniel R Fischel, ‘Mandatory Disclosure and the Protection of Investors’ (1984) 70 Virginia Law Review 669; Luca Enriques, Sergio Gilotta, ‘Disclosure and Financial Market Regulation’ (2014) ECGI - Law Working Paper No 252/2014 available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2423768.
17 corporates or financial services firms might give useful information to their competitors, thereby reducing the disclosers’ competitive advantage.99 Another reason why market
participants might be induced to disclose less information is due to agency problems.100 In particular, in an agent-principal relationship, agency problems arise when the agent departs from the principal’s interest and acts in its own interests.101 Accordingly, in the agency
relationship between companies/financial market participants and investors, the former may act opportunistically towards investors and withhold some information that would reveal, for example, the unsustainability of an activity or a product.102 Thus, in the case of voluntary
disclosure private incentives might lead to the disclosure of less information than it is socially optimal.103
Based on the above, due to the fragmentation and the voluntary character of current market standards and taxonomies related to sustainable investment, this self-regulatory mechanism seems to be an insufficient response to the problem of information asymmetry explained earlier.
3.5 Conclusion
Based on the above analysis, it follows that the lack of harmonised standards on what can be termed as ‘sustainable’ and the resulting inconsistency of reported data related to sustainable activities and investments amount to a market failure by creating an information asymmetry in the market. Self-regulatory mechanisms, such as the development of voluntary standards and taxonomies prove to be insufficient to address this market failure. This, in turn, leads to a market inefficiency since private funds are not efficiently allocated to sustainable investments. Thus, the presence of this market failure requires regulatory intervention. The next step is to determine whether the Taxonomy Regulation is capable of addressing this market failure and facilitating the allocation of funds to sustainable investments. This is discussed in the following Chapter.
99 Wolfgang Schön, ‘Corporate Disclosure in a Competitive Environment – The Quest for a European Framework on Mandatory Disclosure’ (2006) 6 Journal of Corporate Law Studies 259.
100 Easterbrook, Fischel (n 97); Enriques, Gilotta (n 97); Merritt Fox, ‘Retaining Mandatory Securities Disclosure: Why Issuer Choice is not Investor Empowerment’ (1999) 85 Virginia Law Review 1335.
101 Fox (n 100).
102 Easterbrook, Fischel (n 97); Enriques, Gilotta (n 97); Fox (n 100). 103 ibid.
18
CHAPTER 4: THE POTENTIAL OF THE TAXONOMY REGULATION TO ADDRESS THE MARKET FAILURE AND TO MOBILISE PRIVATE CAPITAL TOWARDS SUSTAINABLE INVESTMENTS
4.1 Introduction
The existence of a market failure is a necessary, but not sufficient condition for regulatory intervention in financial markets.104 What is also required is that the suggested regulatory measure is capable of addressing this market failure.105 Traditionally, regulators have attempted to deal with problems of asymmetric information by mandating the disclosure of information from market participants. For instance, in the context of trading securities on a regulated market, regulators require initial disclosure of information regarding the issuer in the form of a prospectus, as well as periodic disclosure of information in the form of annual financial statements.106 The Taxonomy Regulation follows a similar approach: it sets uniform
criteria for the characterisation of economic activities as environmentally sustainable and it requires economic operators and financial market participants to disclose information in accordance with those criteria. This Chapter explores to what extent the Taxonomy Regulation, being a disclosure-based regime, is capable of dealing with the information asymmetry problem and mobilising private capital towards sustainable investments. Section 4.2 begins by laying down the potential benefits of the Taxonomy Regulation associated with the mandatory disclosure of information in the context of professionally informed trading and its ability to influence market behaviour. Section 4.3 discusses certain challenges of the Taxonomy Regulation, namely the risk of creating inconsistent incentives due to the costs of mandatory disclosure and the limited ability of the Taxonomy Regulation to operate as an information tool for retail investors.
104 Kraakman (n 10) 101.
105 ibid.
106 Armour et al. (n 47) 174; Regulation (EU) 2017/1129 of the European Parliament and of the Council of 14 June 2017 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/71/EC [2017] OJ L168/12 (‘Prospectus Regulation’); Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards [2002] OJ L243/1.
19
4.2 The Potential Benefits of the Taxonomy Regulation
4.2.1 Addressing Information Asymmetries in the Context of Professionally Informed Trading
The various effects of mandatory disclosure regimes in terms of addressing the problem of information asymmetries have long been discussed in economic literature and can be applied also in the context of the Taxonomy Regulation. To begin with, by setting a robust template of definitions and mandating disclosure in accordance with this template, the Taxonomy Regulation could perform a standardisation function.107 In particular, the fact that it creates an obligation to report according to the Taxonomy criteria, rather than being another voluntary taxonomy, can help overcome the problem of fragmentation that arises due to the existence of various self-regulatory standards. In other words, the mandatory character of the Taxonomy Regulation makes it capable of bringing uniformity in disclosure format, which in turn facilitates the comparability of data.108
Moreover, the Taxonomy Regulation can operate as a credible commitment by those subject to disclosure requirements to ensure the quantity, quality and permanence of information.109 As it was shown in the previous Chapter, in the absence of an obligation to
disclose according to specific criteria, private incentives might lead to a selective disclosure of data.110 By making disclosure mandatory, the Taxonomy Regulation could commit market participants to an optimal level of disclosure, thereby increasing the credibility of available information.111
The above considerations are particularly important in the context of professionally informed trading. By mandating sustainability-related disclosures in accordance with uniform criteria, the Taxonomy may alleviate professionally informed traders from the cost of developing their own methodologies in order to evaluate the sustainability of economic activities and investments, as well as the cost of searching for relevant information.112 To
107 Enriques, Gilotta (n 97); Kraakman (n 10). 108 ibid.
109 Edward Rock, ‘Securities regulation as a Lobster Trap: A Credible Commitment Theory of Mandatory Disclosure’ (2002) 23 Cardozo Law Review 675.
110 Enriques, Gilotta (n 97); Fox (n 100). 111 Rock (n 109).
20 understand why this would be an important function of the Taxonomy Regulation, one can look at the role of professionally informed investors as the main contributors to market efficiency.113
The term ‘professionally informed trading’ refers to trading by institutional investors, asset managers and investment analysts.114 In particular, these market participants engage on a professional basis into gathering, evaluating and pricing firm-specific and general market information as a basis for their investment decisions.115 Given the fact that they possess the knowledge to engage into this process and the resources to trade in big volumes, these traders can cause prices to rapidly adjust so as to reflect accurate information about the value of investments.116 As already mentioned, accurate pricing is an important parameter in achieving
efficient allocation of resources, which is why professionally informed trading is considered to be a mechanism of market efficiency.117
It is important to note that this rapid assimilation of information into prices is not necessarily undermined by the existence of other less informed traders, who might be biased relative to newly available information.118 This is because accurate pricing does not require
widespread possession of information by all traders; the existence of a group of knowledgeable traders, who control a critical volume of trading activity is sufficient.119 Of course, the wider
the dissipation of information among professionally informed traders, the more rapidly this mechanism will operate.120
However, this process of searching for and analysing information entails costs for professionally informed traders, which are disproportionately large in the context of sustainable investments. The mandatory disclosure duties laid down in the Taxonomy Regulation could reduce these costs, effectively operating as a subsidy for professionally informed investors.121 This could, in turn, enhance their incentives to engage into analysis and trading in sustainable assets, thereby increasing the volume of sustainable investments.122
113 Zohar Goshen, Gideon Parchomovsky, ‘The Essential Role of Securities Regulation’ (2006) 55 Duke Law Journal 711; Ronald Gilson, Reinier Kraakman, ‘The Mechanisms of Market Efficiency’ (1984) 70 Virginia Law Review 549.
114 Goshen, Parchomovsky (n 113). 115 ibid.
116 Gilson, Kraakman (n 113).
117 ibid; Goshen, Parchomovsky (n 113). 118 ibid.
119 Gilson, Kraakman (n 113). 120 ibid.
121 Enriques, Gilotta (n 97). 122 ibid.
21 At the same time, this would accelerate the process of accurately incorporating information into prices regarding the value of sustainable assets.123 Thus, the Taxonomy Regulation could address the problem of mispricing that arises from the presence of information asymmetries with regard to sustainable investments and which, as explained earlier, may discourage investors from investing.124 Therefore, in the context of professionally informed trading, the Taxonomy Regulation has an important role to play in facilitating the allocation of resources to sustainable investments.
4.2.2 Affecting Behaviour in the Market
Besides the potential benefits that disclosure-based regulation may have in the context of professionally informed trading, mandatory disclosure is said to also have a function of affecting the behaviour of market participants.125 When the goal is to bring about a change in
behaviour, mandatory disclosure is said to have a ‘therapeutic function’.126 Particularly in the
context of sustainability reporting, research shows that mandatory disclosure is capable of forcing market actors to act more sustainably.127 For instance, in their paper ‘The Consequences of Mandatory Corporate Sustainability Reporting’ (2011), I. Ioannou and G. Serafeim show that ‘mandatory disclosure of sustainability information leads’, among others, ‘to a prioritization of sustainable development’ and to an improvement on ESG performance.128
The main reason why mandatory disclosure may bring a change in market behaviour is what could be term as ‘the strategy of shaming’.129 In particular, mandatory disclosure can influence behaviour due to the negative reputational effects associated with the disclosure of a different course of action than the desired one.130 Indeed, many authors have concluded that mandatory disclosure may increase ‘embarrassment costs’, and this is why it is capable of deterring undesirable behaviour.131 The Taxonomy Regulation could also perform this
123 Enriques, Gilotta (n 97).
124 ibid; Armour et al. (n 47) 60, 105. 125 Enriques, Gilotta (n 97).
126 Stephen M Bainbridge, ‘Dodd-Frank: Quack Federal Corporate Governance Round II’ (2011) 95 Minnesota Law Review 1779.
127 Ioannis Ioannou, George Serafeim, ‘The Consequences of Mandatory Corporate Sustainability Reporting’ (2011) Harvard Business School Working Paper No 11/100 available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1799589; Patrycja Hąbek, Radosław Wolniak, ‘European Union Regulatory Requirements Relating to Sustainability Reporting. The case of Sweden’ (2013) 34 Scientific Journals Maritime University of Szczecin 40.
128 Ioannou, Serafeim (n 127).
129 David A Skeel, ‘Shaming in Corporate Law’ (2001) University of Pennsylvania Law Review 1811. 130 Enriques, Gilotta (n 97).
131 See for example John C Coffee, ‘Beyond the Shut-Eyed Sentry: Toward a Theoretical View of Corporate Misconduct and an Effective Legal Response’ (1977) 63 Virginia Law Review 1099; Joel Seligman, The
22 function; By mandating the disclosure of information regarding the sustainability of economic activities and investments, the Taxonomy Regulation could drive a more sustainable behaviour among market participants.
In particular, in the context of corporate disclosure, the requirement to disclose the extent to which issuers’ activities are Taxonomy-aligned could induce issuers to improve their environmental performance.132 This is easily understood if one considers that during the recent years more and more pressure is being exerted on organizations to respect the environment and avoid polluting activities.133 Therefore, in order to avoid having to disclose bad environmental
performance, issuers will have to make their activities more sustainable.134 By setting uniform
criteria on what can be viewed as sustainable, the Taxonomy Regulation can bring more clarity to companies on how to adjust their activities, thereby facilitating this process. Moreover, given the increased investor demand for sustainable assets, disclosing that their activities are Taxonomy-aligned would enable companies to raise funding more easily.135
The Taxonomy Regulation could perform this ‘therapeutic’ role also in the context of pre-contractual disclosures by financial market participants. It is noted that the Taxonomy Regulation does not impose an obligation on financial market participants to invest only in sustainable assets.136 However, as mentioned earlier, if their investments are not Taxonomy-aligned they have to bear a disclaimer to this end.137 This disclosure obligation is likely to induce financial market participants to increase the proportion of their investments in assets that comply with the Taxonomy criteria. The argument is the same as above: due to pressures for sustainable investments, reputational concerns may force them to increase the sustainability of the investments.138
In the end, the ability of the Taxonomy Regulation to influence market behaviour has the potential to facilitate the allocation of resources to sustainable investments by increasing the amount of sustainable economic activities and at the same time by increasing incentives of financial market participants to invest in such activities.
Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance (Houghton Mifflin Harcourt 1982) 40.
132 Ioannou, Serafeim (n 127).
133 Stephan Vachon, ‘International Operations and Sustainable Development: Should National Culture Matter?’ (2010) 18 Sustainable Development 350.
134 Ioannou, Serafeim (n 127).
135 Beiting Cheng, Ioannis Ioannou, George Serafeim, ‘Corporate Social Responsibility and Access to Finance’ (2014) 35 Strategic Management Journal 1.
136 TEG on Sustainable Finance, ‘Frequently Asked Questions’ (2018) available at https://ec.europa.eu/info/files/sustainable-finance-teg-frequently-asked-questions_en.
137 Taxonomy Regulation Article 7. 138 Ioannou, Serafeim (n 127).
23
4.3 The Challenges of the Taxonomy Regulation
4.3.1 The Risk of Creating Inconsistent Incentives
The previous Section has discussed the potential benefits that the Taxonomy Regulation may have by reducing information search costs for professionally informed traders and driving market behaviour towards more sustainable practices. It must be noted, however, that the ability of the Taxonomy Regulation to bring about those benefits is not unconditional. Rather it depends on whether those benefits are not outweighed by the costs of mandatory disclosure.
More specifically, mandatory disclosure entails both direct and indirect costs for disclosers.139 With regard to the direct costs, these include costs of data gathering, document management and report preparation.140 Taking into account that in the context of corporate
disclosure under the Taxonomy Regulation, the disclosure obligation applies only to large listed companies, the direct costs will probably not be overly burdensome. Indirect costs, although not easily measurable, are normally said to be higher.141 These include those
associated with revealing information to rivals.142 For example, economic operators might have
to disclose important information about practices they follow in order to make their activities more environmentally friendly. Rival firms may free-ride on such information and adapt their economic activities accordingly, thereby putting the discloser at a competitive disadvantage.143
The costs of the mandated disclosures might create inconsistent incentives.144 For instance, disclosing how and to what extent a fund is compliant with the Taxonomy is costlier than limiting oneself to only including a disclaimer. This might make a financial market participant reconsider whether it is beneficial to offer more sustainable financial products. Accordingly, high costs or competition concerns might prevent companies from making their activities more sustainable.145 Therefore, it is apparent that whether the Taxonomy Regulation will be able to drive market behaviour towards more sustainable practices will ultimately depend on whether the benefits for market participants outweigh the costs of disclosure.146
It is noted that the Taxonomy Regulation explicitly mentions that this risk of creating inconsistent incentives will be taken into account both in the development of the technical
139 Easterbrook, Fischel (n 97); Enriques, Gilotta (n 97). 140 ibid.
141 Easterbrook, Fischel (n 97); Enriques, Gilotta (n 97). 142 ibid.
143 Easterbrook, Fischel (n 97); Enriques, Gilotta (n 97). 144 ibid.
145 Easterbrook, Fischel (n 97); Enriques, Gilotta (n 97) 146 ibid.
24 screening criteria, as well as in determining the final scope of the mandated disclosures.147 As already mentioned, the Commission will issue delegated acts that will determine the exact scope of disclosure obligations. Taking into account that disclosure costs, particularly indirect costs, are not easily measurable,148 finding the appropriate cost-benefit balance will be a challenging task. In any case, it must be said that the Commission’s commitment to minimise administrative burden on disclosers149 is moving on the correct direction of enabling the Taxonomy Regulation to achieve its objectives.
4.3.2 Addressing Information Asymmetries: The Problem with Retail Investors
Besides the potential benefits of the Taxonomy Regulation discussed earlier, what is mostly envisaged by regulators is that the Taxonomy Regulation is going to have an investor-empowering role. In particular, through the provision of information it is expected that it will help investors better compare financial products and enable them to make informed decisions.150 In this way, it is believed that investors will allocate funds to sustainable
investments.151 As the HLEG mentioned in its report in 2019 ‘there is an important role for practical, disclosure-based regulation to help inform financial decision making and enable market participants to respond to the EU’s goals for financing sustainable growth’.152
This empowerment role of disclosure-based regulation relies on the assumptions of traditional law and economics theory that investors are rational, self-interested agents that make decisions with the aim of maximizing their utility.153 Based on these assumptions, it is believed that if provided with all relevant information, investors will be able to make optimal decisions.154 As it was shown in the previous Section, when it comes to professionally informed traders, they have the knowledge and the expertise to analyse and compare information as a basis for their investment decisions.155 In this context, mandating the disclosure of information may indeed facilitate comparability and informed decision making. However, when it comes to retail investors, the assumptions of the empowerment model do not seem to hold. As more
147 Taxonomy Regulation Recitals 46, 47, 52 and Article 19(1)(i). 148 Easterbrook, Fischel (n 97); Enriques, Gilotta (n 97).
149 Taxonomy Regulation Recital 29.
150 Taxonomy Regulation Recital 6; Commission Proposal (n 6). 151 Commission Proposal (n 6).
152 TEG on Sustainable Finance, ‘Taxonomy Technical Report’ (2019) available at https://ec.europa.eu/info/files/190618-sustainable-finance-teg-report-taxonomy_en.
153 See for example Gilson, Kraakman (n 113); Goshen, Parchomovsky (n 113). 154 Enriques, Gilotta (n 97).
25 recent evidence from behavioural finance shows, problems of bounded rationality156 and information overload157 may prevent retail investors from correctly processing information and from making optimal investment decisions.
To begin with, the problem of information overload refers to mandates for the disclosure of lengthy and technical information.158 Investment decision making is complex in nature and many factors need to be taken into account before making the decision to invest. To address this complexity, disclosure-based regulation has required lengthy explanations on an increased number of aspects that are relevant for an investment decision.159 An example of this
can be found in the context of issuer disclosure, where regulators mandate the provision of information regarding the issuer in the form of lengthy prospectuses.160 Research has shown that the provision of too detailed and dense information has the consequence of preventing retail investors from reading the prospectuses carefully or at all.161 This is because, if provided
with too much information, people become overwhelmed and confused, and this discourages them from engaging into to the process of reading the information.162
Even if some of them do read the information provided, retail investors have limited ability to process and understand this type of information. This is mainly due to problems of financial illiteracy and innumeracy, as well as due to the unfamiliarity of retail investors with the mechanics of investing.163 In particular, various studies show that, in contrast with professional investors, retail investors have difficulties in understanding even basic financial concepts such as interest rates, inflation and risk diversification.164 Moreover, most retail investors do not fully understand mathematical calculations, such as discounting and
156 Herbert A Simon, ‘Rationality as Process and Product of Thought’ (1978) 68 American Economic Review 1; Emilios Avgouleas, ‘Reforming Investor Protection Regulation: The Impact of Cognitive Biases’ in M Faure, F Stephen (eds) Essays in the Law and Economics of Regulation: in Honour of Anthony Ogus (Intersentia 2008) 143; Niamh Moloney, How to Protect Investors: Lessons from the EC and the UK (Cambridge University Press 2010); Robert Prentice, ‘Whither Securities Regulation? Some Behavioural Observations regarding Proposals for Its Future’ (2002) 51 Duke Law Journal 1397.
157 Troy Paredes, ‘Blinded by the Light: Information Overload and its Consequences for Securities Regulation’ (2003) 81 Washington University Law Quarterly 417.
158 ibid.
159 Omri Ben-Shahar, Carl E Schneider, More Than You Wanted to Know: The Failure of Mandated Disclosure (Princeton University Press 2014) 14.
160 See Prospectus Regulation (n 106). 161 Paredes (n 157).
162 ibid.
163 Lachlan Burn, ‘Capital Markets Union and regulation of the EU’s capital markets’ (2016) 11 Capital Markets Law Journal 352.
164 Anthony Bellofatto, Catherine De Hondt, Rudy De Winne, ‘Subjective Financial Literacy and Retail Investors’ Behaviour’ (2018) 92 Journal of Banking and Finance 168.
