As one of the first investors to try to get to grips with the new EU taxonomy, Suzanne Tavill has one big take-away.
“This is complicated, whichever way you slice it.”
Tavill is the Head of Responsible Investing at private market specialist StepStone. She is also part of a working group – hosted by the Principles for Responsible Investment (PRI) – focused on sharing lessons and experiences from applying the taxonomy to portfolios.
She read the 600-page guidance issued by the EU’s Technical Expert Group in March, describing it as “dense”, but adds that the group also released a shorter document outlining simple steps investors should take to integrate the framework.
“That felt a lot more manageable,” she says. “But then you go to try and implement it…”
The biggest challenge encountered by investors trying to grapple with the taxonomy is the lack of data. Data will be needed to capture numerous aspects of company activities under the regulation, but first and foremost what is needed is information on revenues. To comply with the rules, investors are expected to identify the percentage of company revenues generated from taxonomy-aligned business activities across a portfolio or strategy.
“We started with what theoretically should be the easiest application,” Tavill explains. “We looked at a number of co-investments where we have better access to information, including where we sit on the board. And then, with this information, we looked at whether we could calculate how compliant they were with the taxonomy.”
"There will need to be an understanding that managers are complying on a best efforts basis" – Marjorie Winfrey, Wellington
One of the issues with private markets though, she observes, is that getting all the relevant information is impossible without the cooperation of the general partner. And that may be a hard sell.
“Some of this information is commercially sensitive, and all of it costs money for the GP and the underlying company to gather and disclose. So there is work to be done on convincing private companies that the benefits outweigh the costs.”
One way the European Commission is dealing with frustrations over data availability is to widen the taxonomy rules to cover the 7,000 public interest companies covered by the EU Non-Financial Reporting Directive (NFRD) – but that doesn’t include any private companies.
The Commission is also in the process of revising the NFRD, and that may involve widening its scope to cover more companies, but it could prove controversial. As Tavell points out, the cost of meeting these disclosure requirements is not insignificant, and while it may not be financially material for large-cap companies, there is a risk that smaller ones would be disadvantaged if they were subject to overly complex disclosure requirements.
Marjorie Winfrey, a Research Analyst at investment giant Wellington Management, and another member of the PRI working group, highlights the “potential challenges of applying a taxonomy lens to a global business or one operating entirely outside the EU”, too – as those companies simply cannot be captured by EU regulation. The taxonomy’s success therefore, she says, will be reliant in part on its adoption by other jurisdictions.
“We started by applying the framework to some of our existing approaches that are most closely aligned with the philosophy behind the taxonomy,” explains Winfrey, referring to three global equities strategies: a climate-focused portfolio with around 40 stocks; a diversified low-carbon portfolio with 175 positions; and an “adaptation-oriented” portfolio with around 20 holdings.
“We assessed how aligned these portfolios were [to the taxonomy] and what the weighted average revenue alignment ranges were,” she continues. “To the extent that questions arose about the nature of a company’s business, we earmarked for follow up with the company management team directly.”
Wellington used a variety of information sources including annual reports, sustainability reports, third-party reports from research houses and organisations like the CDP, and ESG data.
Winfrey says that, given the incomplete data, “there will need to be an understanding that managers are complying on a best efforts basis”.
And it isn’t just managers, its asset owners too. Dutch pension giant PGGM is exploring how to apply the taxonomy to its mainstream portfolios.
Brenda Kramer, Senior Responsible Investment Advisor at PGGM and a member of the Technical Expert Group that is advising the European Commission on the taxonomy, says the pension fund already has an impact target – focused on the Sustainable Development Goals – with a similar approach to the taxonomy.
“We use revenues to calculate that target, so we have been collecting that kind of data for our portfolio for a while,” she says. “And we have come to learn that, although it isn’t easy, it isn’t impossible. It just takes time.”
PGGM has a partnership with fellow Dutch pension heavyweight APG, and together they are launching a platform for asset owners to generate the relevant SDG data. But Kramer acknowledges that successful adoption of the EU taxonomy “will definitely rely on stricter disclosure rules” for companies to make compliance affordable for investors.
Morgan Stanley has used a combination of company disclosures, in-house research and estimates from its stock analysts, to conclude that, from its universe of 500 European listed companies, there are 94 with exposure to taxonomy-aligned climate mitigation business activities.
“We took the climate mitigation pillar of the taxonomy and looked to see which companies currently have eligible revenue exposures, and which would have them by 2022,” explains Jess Alsford, Global Head of Sustainability Research at the bank. The proportions vary wildly across the 94 companies: German auto-part supplier Hella, for example, has just 1% exposure to “green” revenues according to the analysis, while insulation specialists Kingspan has 100%.
“The results show there is very clearly a sector bias,” Alsford continues, pointing to the high proportion of utilities and capital goods companies on the list. The 94 companies currently identified don’t include any from Metals & Mining, Oil & Gas, consumer goods or media – although no sector is automatically ruled out from the analysis, and the only areas explicitly excluded from the taxonomy regulation are coal and lignite.
The technical guidance for the taxonomy states that capital expenditure should be considered in addition to revenues, in a bid to better reflect companies’ strategies, and encourage transition planning: if a firm is spending a lot of money on developing wind farms, for example, then it’s fair to assume it will be more supportive of the EU’s climate goals than its current revenues might suggest.
For now, Alsford says Morgan Stanley doesn’t have access to robust green capital expenditure data, which is why it opted for a 2022 business revenues prediction – also from company disclosures and stock analyst expertise – to capture the transition of companies in its universe.
And as the framework rolls out to cover other environmental areas, the data may prove even more complex.
“I think now there is a clear understanding of the technologies that contribute to decarbonisation, and lots of those are already investable,” says Alsford. “When it comes to some of the other topics, like protection of water and marine resources, it will be interesting to see if the taxonomy criteria remains focused on the products that contribute to those objectives, or whether it will look more at how a company impacts those issues. I imagine it will be a combination of the two.”
All business activities will also have to be screened against social safeguards, and a study published today suggests that even companies with 100% green revenues might not make the cut. Analysis of 16 of the biggest listed wind and solar producers suggests that none fully comply with the UN Guiding Principles on Business and Human Rights – one of the standards expected to be baked into the taxonomy screening process.
The PRI working group will publish case studies and findings from its work later in the summer.