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Understanding and preparing investors for the EU Taxonomy: Meeting regulatory reporting

Min Qi is a product manager, sustainable investment at FTSE Russell

The greening of the global economy—a response to the threat of climate change and other environmental challenges—presents myriad opportunities to investors. However, investors and policymakers face a common challenge: How can green business activities be systematically identified, categorized, and measured across diverse sectors, supply chains and asset classes to mobilize investment at scale?

The EU Taxonomy is an ambitious regulatory initiative that aims to address this challenge. There have been a few iterations of the Taxonomy since the EU TEG report in March 2020. The latest Climate Delegated Act released in April 2021 lists 99 eligible economic activities. It provides details on technical screening criteria (TSC) for determining whether an economic activity makes a substantial contribution to climate change mitigation or adaptation (Objective 1 and 2) and does no significant harm (DNSH) to other objectives. TSC for activities with substantial contribution to other objectives were expected to be developed by the end of 2021, but this effort has been delayed to 2022.

Debating the debatable

There have been debates among various stakeholders and member states on the details of TSC and eligible economic activities such as natural gas, nuclear and agriculture. It is also questionable whether some entertainment and recreational activities under the EU Taxonomy Objective 2 – climate change adaptation, which admittedly have social values, can deliver genuine environmental benefits and contribute substantially to environmental objectives. The EU Taxonomy Regulation is still evolving as more activities might be covered, and more TSC will be developed, with potential delays on the timeline. This creates uncertainty in the financial market and complexity in data gathering.

The application of TSC is likely to pose challenges for different types of financial asset classes. In the listed equity market, given the wide range of products and services across broad value chains, it is difficult to fully implement such criteria in a consistent way due to the limited number of companies which fully disclose green revenues. The DNSH TSC makes it even more complicated, as it may vary with the types of activities and environmental objectives to which the activity is contributing: FTSE Russell identifies over 100 different DNSH requirements; an economic activity can be subject to 0 ~20 requirements.

Investors face a considerable practical challenge in meeting the legal disclosure obligations, whereby providers of financial products offered in the EU, that pursue sustainable investment or promote environmental characteristics, must demonstrate how they have used the Taxonomy and the proportion of underlying investments that are Taxonomy-aligned. Not to mention that investors also have to follow the EU’s Sustainable Finance Disclosure Regulation (SFDR) to disclose to what extent their financial products are environmentally sustainable and address adverse sustainability impacts.

While the EU Taxonomy will set out a catalogue of green criteria, it leaves it to markets to assess individual companies against these criteria.

FTSE Russell research shows that currently less than 30% of companies with green revenues provide disclosures that are granular enough to allow investors to systematically break out and quantify companies’ green business activities. These disclosures will improve over time, but this process is likely to be gradual, particularly for non-EU companies.

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Evaluating the green economy

In the meantime, rigorous estimates that can supplement disclosed data will have to play a key role in determining green revenues for individual companies, and to provide investors with robust datasets to measure the degree to which investment products and portfolios are aligned with the EU Taxonomy.

FTSE Russell’s Green Revenues data provides investors with a highly detailed dataset which assesses over 16,000 stocks for their exposure to green business activities. The data is based on FTSE Russell’s Green Revenues Classification System (GRCS)1, now covering 10 green sectors and 133 green micro-sectors. This classification system builds on earlier versions that have been used to track leading companies in the green economy for indexes since 2008.

The EU Taxonomy and the GRCS are highly aligned on core activities, offering investors an effective and transparent tool to evaluate the exposure of their equity portfolios to company revenues that are EU Taxonomy-aligned activities. The GRCS dataset can provide a steppingstone for investors to comply with the requirements of the EU Taxonomy regulation.

Demonstrating EU Taxonomy-aligned Green Revenues

This mapping demonstrates that GRCS is broader than the EU Taxonomy and therefore encompasses all the main sustainable activities covered by the EU Taxonomy. Core green economy activities that account for the lion’s share of green revenues − such as renewable power generation, low carbon transport or green buildings – are unsurprisingly eligible under both the EU Taxonomy and the GRCS, as they are making substantial contribution to climate change mitigation.

As already discussed, it is currently very challenging to fully implement TSC across the broad listed equity market in a consistent way, due to lack of disclosure. As such, FTSE Russell’s GRCS use the disclosed data available plus an activity-based approach to capture the degree of revenue exposure to the green economy.

The use of the GRCS is an initial step towards measuring potential alignment of portfolios with the EU Taxonomy. Further developments will be associated with checking that activities meet both the technical screening criteria for significant contribution and those for Do No Significant Harm (DNSH) and Minimum Safeguards as outlined in the EU Taxonomy Regulation.

Read the full FTSE Russell paper to understand the overlaps and points of difference between the EU taxonomy and FTSE Russell’s GRCS.

Look out for FTSE Russell’s upcoming analysis on DNSH and MSS on ftserussell.com.

1 The initial FTSE Environmental Market Classification System was developed by FTSE Russell in collaboration with Impax Asset Management and based on a precursor of the GRCS, the Environmental Markets Classification System (EMCS)

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