Designed to deter greenwashing, will the new classification system release asset owners to invest sustainably?
The European Union has admirable ambitions. In its European Green Deal, the 27 member states collectively aim for net-zero carbon emissions by 2050. A key component of the deal is the bloc’s plan for a sustainable finance sector capable of channelling private capital to support the transition to and construction of a climate-neutral economy.
To help investors identify investments that will contribute to this objective, the EU has drafted its Taxonomy Regulation, a crucial (and lengthy, at 600-odd pages) classification framework which attempts to define the environmental impact of economic activities across a range of industries.
Behind the taxonomy is the fundamental concept of doing “no significant harm”. If an economic activity substantially contributes to one environmental objective but also significantly harms another, it is not considered sustainable. Further, the activity only qualifies as sustainable with reference to a specified performance benchmark, for example only emitting a certain level of greenhouse gasses.
The six objectives are climate change mitigation; climate change adaptation; sustainable use and protection of water and marine resources; transition to a circular economy; pollution prevention and control; protection and restoration of biodiversity and ecosystems. In addition, the activities must also meet minimum standards on safety and human rights.
Disclosing against the taxonomy
Asset managers with European clients will need to disclose against the taxonomy if they market a fund as supporting an environmental objective. The first set of taxonomy disclosures will be required by 31 December 2021. From then, if you claim a product will contribute to an environmental goal, you will need to reference to the taxonomy’s criteria.
Proving compliance – such as measuring or calculating revenues from eligible activities – is not for the faint of heart. According to Orith Azoulay, global head of green and sustainable finance at Natixis, “Demonstrating compliance will be costly, demanding [and] game-changing. Third-party certification audits performed by accredited bodies are to be required for several activities, at regular intervals.”
The Taxonomy Regulation also updates and amends the EU Disclosure Regulation, which covers products including investment and mutual funds, insurance-based investment products, private and occupational pensions, individual portfolio management, and both insurance and investment advice. A ‘comply or explain’ requirement means investment firms must articulate how a product aligns with the taxonomy, or explain why, if it does not.
The overarching aim is transparency and comparability. Many asset owners have only cautiously allocated to sustainable financial products due to the multiple concepts and definitions of what sustainable is. The taxonomy is the EU’s antidote to greenwashing. By providing asset owners with the data they need, it will unleash a flow of capital to sustainable investments.
Closely involved in its creation, Eila Kreivi, head of capital markets at the European Investment Bank, compares the taxonomy to a second language. “The taxonomy is a bit like English for me. It’s not my first language, but I understand the structure. When I need to know something specific, I will look it up in the dictionary.”
Nevertheless, the asset owner may need to familiarise herself with the full scope of the taxonomy to appreciate what is or is not within its reach. Although the compliance burden sits with the supply side of market, asset owners will find it valuable in understanding whether and how their portfolios meet their own investment objectives and values.
For asset owners anxious to get to grips with the taxonomy, UN Principles for Responsible Investment (PRI) has published a series of case studies showcasing the approaches of early adopters. “The first thing investors [should] go through in their taxonomy implementation is an assessment of eligibility,” says Will Martindale, director of policy and research at the PRI.
“Take a part of the portfolio you want to measure for the taxonomy and understand whether or not the assets you’re investing in undertake economic activities that are covered by the taxonomy process. An example I always give where taxonomy just doesn’t cover it is pharmaceuticals.”
AP Pension: A case study
One early adopter is AP Pension. With US$22 billion in assets under management, the Danish pension fund focused on a portfolio of 40 equity holdings to implement the taxonomy. It concluded that roughly 20% of the portfolio’s revenue was eligible for the taxonomy, but with the data available it calculated only 0.24% of eligible revenue was aligned. Using Bloomberg data, it found nine companies had eligible revenue but only four – all in the industrials and materials sector – met the criteria for alignment.
Pre-existing tools and services supported AP Pension’s process. The fund used Bloomberg’s EU Taxonomy tool to establish the percentage of eligible revenue and extract data for each holding. To identify the proportion of eligible revenue aligned, it applied Institutional Shareholder Services’ (ISS) Assessment of the UN Sustainable Development Goals, which yielded a number score and percentage of revenue as measures of adherence.
ISS’ SDG Assessment also supported AP Pension’s ‘do no significant harm’ test while its social safeguards analysis leveraged Sustainalytics’ Global Standards Screening, which assesses compliance with UN Global Compact Principles.
The fund explained: “We focused on the contribution of ISS’ SDG Solutions Assessment methodology to the environmental objectives. On an aggregated level it can be used as a proxy for climate adaption. We then estimated what parts of the eligible revenue were taxonomy-aligned. However, we could not measure if each activity met the technical thresholds, but rather used ISS methodology as an estimate.”
A long road
Designed as a tool to help the investor to invest sustainably, the EU Taxonomy Regulation is not yet the finished object. Although it covers around 80% of listed securities, lawmakers acknowledge there is still a long road ahead.
For climate change mitigation, for example, sectors responsible for 93.5% of direct greenhouse gas emissions in the EU were prioritised when identifying economic activities for which technical screening criteria were developed. As progress is made in the biggest emitting sectors of the economy, two types of change to the taxonomy are envisaged. First, scope will broaden to encompass a wider range of activities; second, performance benchmarks will alter, as acceptable emissions levels evolve, for example.
One pressing operational issue, however, is the question of data quality and methodology, the absence of which has the potential to compromise the overall objective of transparency. A further concern is the risk of arbitrage.
“One of the things that we did recommend to the European supervisory authorities is that they do provide some clear guidance on this,” said Martindale. “Because one of the concerns that investors have was that there may be risk of arbitrage, in which some investors take a slightly more conservative reading than others.”