This is the eighth in RI’s ‘The EU Action Plan: What Matters To Me’ series, providing insights from market experts on the implications of the EU Action Plan on Sustainable Finance. Today, ESG disclosure expert Axel Hesse argues that the green taxonomy’s focus on economic activities, and the legislative proposal underpinning it, will stop it being adopted by the mainstream.
When looking at the current plans for an EU taxonomy, it’s important to look beyond the Technical Expert Group’s recent recommendations to the legislative proposal that’s underpinning it. It’s in that document that, vitally, you can see which asset classes are set to be effected by the taxonomy.
The most important asset classes in terms of volume are equities, corporate bonds (and government bonds, which are not yet considered in the taxonomy at all!) and real estate; followed by alternatives such as infrastructure investments, hedge funds and private equity.
But, as it stands, Article 1 of the taxonomy’s legislative proposal states that its scope is limited to:
- “…financial products or corporate bonds that are marketed as environmentally sustainable”
- “…participants offering financial products as environmentally sustainable investments or as investments having similar characteristics”
Financial products “means a portfolio management, an AIF, an IBIP, a pension product, a pension scheme or a UCITS” it adds — referring to the EU’s terms for Alternative Investment Fund, insurance-based investment products and the bloc’s funds regime.
This is a crucial stumbling block for the effectiveness and uptake of the EU taxonomy: if application will only be mandatory for sustainability funds, green bonds and debt for ‘pureplay’ environmental companies like wind and solar producers, then a great opportunity for integration into the mainstream would be wasted.
If conventional financial products are not included in the legislation because mainstream buy-in is expected to be voluntary, then the next question that should be asked is on granularity.
Should taxonomy be simple or complicated?
On this, Dietmar Horn, Head of Germany’s Directorate-General for Strategic and Cross-sectoral Aspects of Environmental Policy, Sustainable Development, Fundamental Social Policy Issues, made a handful of sensible requests during a discussion on the taxonomy last year. He called for a framework that was technology-neutral, practical for users and not too complicated. “A simpler taxonomy would also make it easier for small financial service providers such as savings banks, local cooperative banks and asset managers to understand and advise them,” he pointed out.
I would agree with him that a taxonomy with low granularity would be better suited to mainstreaming responsible investing – although, if necessary, higher or further requirements for the sustainable niche could be formulated.
A taxonomy based on economic activities can only work for certain green bonds or project financing for specific, clearly-defined and separable activities such as the construction of a wind farm or solar park.In theory, the ESG valuation of a company (and therefore security) would be based on the sum of all its economic activities, but that’s nowhere near being the reality of today’s sustainable or responsible investment decision-making.
If application will only be mandatory for sustainability funds, green bonds and debt for ‘pureplay’ environmental companies like wind and solar producers, then a great opportunity for integration into the mainstream would be wasted.
In conclusion, the current taxonomy is unsuitable for mainstreaming sustainable finance for two reasons: firstly, the legislative proposal only addresses those financial products that are branded ‘green’, and secondly, its focus on economic activities makes it too granular and complex for the large asset classes like equities and corporate bonds. The 414-page document from the TEG requires a level of commitment just to read, let alone adopt into strategy.
The legislative proposal specifies the need for “minimum” requirements, but the report from the TEG goes way beyond this. The legislative proposal also talks about identifying the most relevant contribution to the given environmental objective, but identifying the most relevant for financial performance would be more important for mainstreaming responsible investments.
In addition, the proposal suggests building upon existing labelling and certification schemes, such as the EU Ecolabel. However, it would be more effective – if these efforts are going to influence mainstream companies via their shares and bonds – to build instead upon existing ESG indicators, not labels, and not to “reinvent” standards completely with a new taxonomy. The Provisional Standards from the Sustainability Accounting Standards Board, for example, already lay out 79 industry standards across ten sectors.
SD-M’s own 2016-2021 ‘standard of standards’ is backed by the German Environment Ministry among others, and provides the three most relevant sustainability KPIs for 68 GICS Industries.
The Global Reporting Initiative’s 30 material indicators are also useful, although the KPI’s aren’t sector specific, for the most part, and companies should be free to determine their own materiality.
Ultimately, what’s required to mainstream the use of taxonomies is a sector-based classification system already common in the capital markets. This is likely to need to be the globally dominant MSCI / S&P GICS (Global Industry Classification Standard), or possibly the FTSE/STOXX ICB. Mainstreaming responsible investment needs such a market-dominant industry system, in order to plug-in with existing processes.
The possible ESG compromise could be an adapted version of GICS, via SASB and further subdivided into industries.
Dr Axel Hesse is the Founder of SD-M GmbH, which specialises in standardised KPIs for ESG integration. He was formerly the Director of ESG Integration at Metzler Asset Management.