Green finance and the EU sustainable taxonomy

How will the EU Commission’s sustainable taxonomy affect the ability of investors to assess the green credentials of financial products and what impact will it have on the real economy?

The European Commission is reaching the end of its three-year project to develop a series of tools that will, its lawmakers hope, help to promote transparency, a substantial and urgent capital shift towards sustainable investments and a decarbonised economy.

Since the Commission first set out the legislative areas it hoped to develop in its 2018 Action Plan, the TEG, and later partially superseded by the PSF, has been dedicated to four particular areas of focus: EU Green Bond Standards (EU GBS), climate benchmarks, corporate disclosure and an EU-wide sustainability taxonomy.

In November 2020, the Commission published draft rules after spending months collecting feedback from participants across the capital markets, building on the TEG’s recommendations on the EU taxonomy across two environmental objectives – climate change mitigation and climate change adaptation.

Most welcomed the long-awaited publication. However, there have been some critical voices that say that the standards for some sectors, such as housing or shipping, still need some refinement.

What is the EU sustainable taxonomy?

Of all its considerations, the EU sustainable taxonomy is considered the backbone of the Commission’s green finance package: the objective is to develop a robust classification scheme for identifying and classifying investment opportunities that have a significant contribution to an environmental objective while minimising the negative impacts across other areas including social.

Regulators believe that such a science-based classification schema will inform and empower investors to “reorient capital flows towards sustainable investment, in order to achieve sustainable and inclusive growth.”

Another objective is to address the risk of ‘greenwashing’, where market participants label financial products as ‘green’ despite a lack of sustainable credentials and impacts

Put simply, the EU sustainable taxonomy will allow investors of all sizes, shapes and flavours to consistently classify financial products on their green credentials.

The Commission is developing detailed technical screening criteria that are science-based and intended to determine consistently what can be labelled as ‘taxonomy compliant’ or not, which is likely to include particular provisions for renewable technology, green energy such as wind and solar, and infrastructure.

TEG proposals for the sustainable taxonomy

There is a long list of criteria that can contribute to an asset’s positive environmental characteristics:

• Climate change mitigation
• Climate change adaptation
• Sustainable use of water
• Transitioning to the circular economy
• Pollution prevention and control
• Protection of biodiversity
• And a need to cause “no significant harm” to any of these environmental objectives.

For each of these criteria, the EU has proposed different “measures” of alignment to track an asset’s progress: aligned, aligned after passing a threshold, not aligned by failing the threshold, and not in scope.

There continues to be debate within the TEG around controversial technologies. The decision was made to create a complementary delegated act of the EU Taxonomy Regulation that covers activities such as agriculture, specific energy activities and certain manufacturing activities. The delegated act is to be released at a later date.

When implemented initially, it may be that alignment levels of portfolios may seem low, as the market shifts and issuers adjust the level of information they provide. Improving these levels of underlying disclosure and portfolio alignment will be a key sign of progress.

These key technical screening criteria are still being finalised, however. There is currently a legislative deadline of 31 December 2021 for the screening metrics for the first two taxonomy objectives to be published.

The process will be an ongoing one, however, as the EU is yet to cover four of the six environmental objectives identified, including key areas such as agriculture and aviation.

The road to compliance

As far as investors are concerned, the EU taxonomy will allow them to determine whether a portfolio’s underlying assets are really sustainable, by focusing on business and offering solutions to ESG challenges, albeit with an initial focus on climate.

It also has implications for those selling green products within the EU to further demonstrate their competitive advantage – as research has frequently shown that impact-focused funds outperform market benchmarks.

The final requirement will be for investors to ensure they are legally compliant, explaining exactly how the EU taxonomy’s requirements have been applied to their products.

The Corporate Sustainability Reporting Directive (CSRD), the Sustainable Finance Disclosures Regulation (SFDR) and the Taxonomy regulation itself will all commit market participants to explain how these sustainability criteria have been applied to their products.

It is important for market participants to consider holistically how investors need to comply with the EU taxonomy and CSRD disclosures, and consider using EU Climate Transition and Paris Aligned benchmarks. Furthermore, the expectation is that the underlying data will become more complete and consistently reported with issuer taxonomy and enhanced Corporate Sustainability Reporting Directive (CSRD) reporting requirements.

The EU is aiming for compliance to be achieved on a tight timeline. By 1 January 2022, asset managers will have to make disclosures according to the EU taxonomy for climate adaptation and climate mitigation, covering the 2021 reporting cycle. Compliant issuers will have to do the same by the end of 2022, also covering the 2021 reporting year.

How could the EU taxonomy impact the real economy?

In the feedback gathered, some investors also raised the question of how the EU taxonomy can identify which instruments or products could have a direct bearing on the real economy. In other words, will investments identified as ‘green’ make a material, positive impact on the world?

Some asset managers may also be surprised to see how companies are exposed to products with positive environmental characteristics, and how this in turn affects how sustainable their products are perceived to be by users.

The EU taxonomy also presents a further measure of the green worth of assets to investors. But there are a few questions still about how other market participants, such as local regulators or even ratings agencies, will integrate the taxonomy or use it effectively.

Despite this, there is widespread acceptance by EU member states – and internationally – that the standards will be a key decarbonisation tool.

How the EU taxonomy will be a “dictionary of reference”

Investors are already using the draft proposals to formulate their own green products and have welcomed the unified approach that will be available going forward.

The likes of Denmark’s Nordea have launched green bond funds that will be used to finance projects aligned with the objectives of the EU taxonomy.

Eurosif, which represents sustainable finance forums across Europe, welcomed the distinction made between identifying “sustainable investments” without tying it to the financial health of investee companies.

It hopes the EU taxonomy “will increase transparency through a harmonised nomenclature, helping to address greenwashing”. The group also shared its view that adopting the taxonomy would “gradually help steer capital to more sustainable economic activities”.

Many hope the taxonomy will begin to influence the sustainable investing landscape beyond Europe. Timothée Jaulin, head of ESG development and advocacy at asset manager Amundi, says that the EU’s package of sustainable regulations – including the taxonomy – will become the international “benchmark” for those efforts.

Antoni Ballabriga, head of responsible business at Spanish financial services giant BBVA, says the taxonomy will be a “dictionary of reference” for banks going forward.

BBVA has already forged ahead in its private and public green offerings, using its own frameworks informed by TEG’s models, including loans for sustainable property developers and green loans for electric and hybrid vehicles.

Fund managers who manage significant portfolios will have to use the EU taxonomy to work out how much of their holdings qualify as green or environmentally sustainable, too – an activity that is likely to take a great deal of time and effort.

Tools such as FTSE Russell’s Green Revenues 2.0 data model have already given investors a way to measure the green revenue exposure of thousands of listed companies, overlapping almost entirely with the EU taxonomy and already covering all six environmental objectives..

But there are also likely to be some teething problems as it is rolled out across the industry by the end of 2021. Investors must be sure they are not, for example, over-exaggerating their alignment with the EU taxonomy at an early stage, a move likely to draw accusations of greenwashing.

The effectiveness of the EU taxonomy will ultimately work in tandem with the requirement for EU organisations with at least 50 employees to disclose their exposure to green products from 2020 – leading to a much wider requirement for green disclosure.

Discover how LSEG can help you navigate the sustainable landscape as it continues to develop via Refinitiv data and solutions and FTSE Russell Green Revenues 2.0.