Faced with the acceleration of sustainable finance, in March 2018 the EU proposed the Sustainable Finance Action Plan, which aims to gradually put into place a binding regulatory framework. It was a step deemed necessary by most actors to avoid greenwashing practices and to appropriately respond to the Paris Agreement and the UN SDG goals. One of the first steps was to develop a common taxonomy, one that defines whether an activity is deemed sustainable and that provides a common language for actors across the EU to speak with one voice when discussing sustainable finance.
The need for a taxonomy is obvious. We need definitions to be able to say where companies are in relation to the targets set for 2050.
The taxonomy, which is currently being finalised, is an essential tool, but it is imperfect. Not least because it only provides the criteria for defining environmental activities that are expected to reduce greenhouse gas emissions to net zero by 2050. As of January 2022, it will also define activities that contribute to climate change mitigation and adaptation. Four other targets will be defined as from 2023 onwards, namely; water and marine resources, the circular economy, waste prevention and recycling, and pollution and healthy ecosystems.
“The need for a taxonomy is obvious,” says Eila Kreivi, Head of Capital Markets at the European Investment Bank, “we need definitions to be able to say where companies are in relation to the targets set for 2050.” She highlights that when green finance started to become institutionalised, anything that was considered marginally more environmentally friendly than the traditional approach was considered green. “Now that the market has developed somewhat, we understand that not everything that is slightly greener is enough to reach net zero by 2050.”
The taxonomy therefore acts as the basic index for better communication between companies, financial players, and investors. Under the rules being put in place, financial firms will need to publish the share of assets in their products that correspond to eligible economic activities aligned with the taxonomy. Non-financial firms will in turn be required to publish the sustainable share of their turnover, capital expenditure and operations. It is a time-consuming drive for transparency.
According to Martijn Oosterwoud, Head of SI Investment Specialists at UBS Asset Management, more clarity will soon be needed. “We are now in the awkward situation that corporates don’t disclose in the manner in which asset managers or wealth managers would need to be able to communicate to our clients on those metrics.” Oosterwoud believes that there is a clear need for regulatory pressure to ensure that companies deliver the data that is expected. “Even if, however, we can hope this comes to pass in the EU, it’s not enough. Our clients invest far beyond Europe’s borders and therefore we need the taxonomy to be worldwide.”
We are now in the awkward situation that corporates don’t disclose in the manner in which asset managers or wealth managers would need to be able to communicate to our clients on those metrics.
Beyond the geographic challenge, the strict definition of what constitutes a green investment within the taxonomy means that few activities truly fit the bill, meaning that investment products offered to clients can only display a minor proportion of sustainable investment. Asset managers are therefore developing products that they deem as sustainable, however which according to the taxonomy have a low green ratio. “If a product only shows a 4% to 6% sustainability rating, our clients assume that 94% of the product is not sustainable,” says Oosterwoud. This challenge is made ever more daunting by the fact that the taxonomy does not take into account businesses in transition: a narrow path that could make investors increasingly wary.
The institutional market has a greater capacity to understand what the taxonomy numbers are telling them and the context in which they are being communicated, however the numbers are more concerning when addressing retail investors.
This fear is echoed by Elizabeth Gillam, Head of Government Relations and Public Policy at Invesco. “The institutional market has a greater capacity to understand what the taxonomy numbers are telling them and the context in which they are being communicated, however the numbers are more concerning when addressing retail investors.” For example, a recent consumer survey by Invesco showed that just 14% of respondents understood the acronym ESG. “Clearly there will need to be significant work done to communicate and educate retail investors,” insists Gillam, “just presenting the percentage of taxonomy alignment will not help.”
Kreivi explains that taxonomy alignment is about showing a “significant contribution” towards a net zero economy. “This taxonomy’s purpose is not to provide different shades of green, rather it provides the best possible definition.” However, she notes that beyond the strict definition, work is currently underway at an EU level in order to prepare new definitions to better define the colour palette of environmental activities, from brown to dark green. The new definitions will also make it possible to better account for activities currently in transition.
Gillam emphasises the importance of this step, noting the importance of rejecting technologies that may not currently respond to the desired dark green, but which constitute an important springboard towards net zero. “Some intermediate technologies are currently excluded, even though they are necessary, to achieve the 55% reduction in emissions by 2030. Not least because technologies that would achieve net zero are not yet viable or simply do not exist.”
A subtle balance therefore remains to be defined between the players on the ground and working group experts in order to move forward on the path towards a decarbonised economy; one that has strong barriers but that does not discourage investors.