The transition to a more sustainable economy, particularly in the European Union, places a key role on the financial sector in redirecting private capital into sustainable investments. However, ambitious sustainability goals face significant financial challenges. challenges, especially when the expansion of sustainable technologies often requires investments in assets that are not currently compliant with environmental, social and governance (ESG) criteria.

Tension between sustainability and ESG requirements

Study explores a fundamental contradiction: how ESG regulation of banks affects the provision of capital for the transition to sustainability, especially when scaling the necessary technologies requires investments in assets that (partly) do not meet ESG criteria. A typical example is the transition to electric vehicles (EVs), which requires a significant increase in the supply of raw materials for batteries, such as lithium, cobalt, manganese and nickelHowever, the extraction of these materials is often associated with serious adverse ESG impacts, including health risks for miners, child labor, corruption and conflict financing, as well as risks to ecosystems and extensive energy and water consumption.

There is currently a significant shortage of supply for these raw materials and insufficient investment in expanding mining capacity. If ESG regulation of the banking sector effectively redirects capital towards ESG-compatible activities and away from unethical ones, it could further constrain the supply of capital for these key raw materials.

EU regulations and their impact

The authors analyzed the impacts of two major European Union regulations: Sustainable Finance Disclosure Regulations (SFDR) of 2019 (effective from March 2021) and EU taxonomies for sustainable activities of 2020. These regulations represent a unique and legally binding breakthrough in ESG disclosure requirements for banks. The EU taxonomy specifically sets out criteria for determining whether an economic activity is ESG-compliant, with a strong focus on environmental sustainability.

Using two large data sets and a difference-in-difference approach, the study assessed how these initiatives affected public holdings of banks and their cost structure of loans.

Key findings: Shift in public shares, stable cost of capital Analyses revealed that the introduction of EU ESG regulations has observable dampening effect on public bank holdings in battery raw material companies, especially those with poor ESG performanceThis suggests that regulations are having the intended effects of redirecting banks' capital towards more sustainable practices.

Despite this shift in ownership structure, the share prices of the companies concerned remained generally unchangedThis leads to the conclusion that there is an “ownership substitution effect” where falling demand from EU banks is offset by growing demand from other entities, presumably investors who are not subject to similar ESG regulations. As a result The cost of capital and credit behavior of mining companies remained unchanged.

Policy implications and future challenges

These findings have several important implications:

• In the current setting of EU ESG regulation do not worsen the already existing underinvestment in sourcing raw materials for batteries.
• However, if EU banks reduce their public stakes in companies with poorer ESG performance, their influence and leverage to motivate these companies to improve their ESG performance is diminishing.
• The study also points out that the current global policy framework has legally binding ESG regulations for a minority of banksIf similar regulations were to be extended globally, the ownership substitution effect might not persist and aggregate demand could fall. This would then lead to a decline in stock prices and thus a potential increasing the cost of capital for mining companiesif they fail to improve their ESG results.

In conclusion, the introduction and implementation of ESG regulation has a dampening effect on public bank holdings in companies with poorer ESG ratings, while improvements in ESG ratings, in particular social ratings (S-ratings), may mitigate these effects. The research underlines the need for a balanced regulatory approach that takes into account the multifaceted nature of sustainable finance. Future policymakers should consider continuing efforts to incentivize companies to improve their ESG performance beyond the EU, for example through internationally harmonised regulations. JRi