Reporting and Governance

EU regulators are hoping to attract huge flows of private capital into green investments, through regulatory initiatives such as the green benchmarks, in a bid to create a more sustainable economy. By Daniela Klasen-Martin at Crestbridge

In July of this year, the EU Taxonomy Regulation came into force. These laws could be a revolutionary and important step forward towards a more sustainable future. Regulators in Brussels are hoping to establish a green investing benchmark which will encourage massive inflows of private money towards sustainable investments. 

Before the EU Taxonomy, funds and asset managers could label products as sustainable without external validation, which gives rise to the possibility of nefarious ‘greenwashing’ of offerings with the aim of attracting investors drawn to cultivating more sustainable investment portfolios.  

The laws were bought in to stop greenwashing activity and to address the growing clamour around climate change. The EU Taxonomy addresses six environmental objectives as laid out by the European Commission’s Technical Expert Group, which range from climate change mitigation to the transition towards a circular economy. Being enacted by a supranational body, the regulation will guarantee consistency across EU countries and set a positive precedent for more extensive adoption.  

The spirit of the Taxonomy is to determine to what extent economic activities enable emissions (and are therefore categorised as belonging to enabling sectors) or how far activities substantially contribute to climate change mitigation. NACE (Nomenclature of Economic Activities) codes are used to label and categorise sectors of the economy, in order to cover as many activities as possible.  

While being a pioneering initiative, which has risen from the best of intentions, the laws are not beyond reproach, and have been subject to often substantial criticism. One such example of this arises from the NACE categorisation just mentioned; namely, while these codes cover most sectors of the economy – and indeed NACE sectors represent 93.2% of greenhouse gas emissions – they don’t cover everything. Notably, there are no NACE codes for buildings. 

However, while this may be a slight issue now, it likely won’t be in the future. These laws are incredibly flexible, and built into them is not just the option to make revisions and amendments, but actually a strong recommendation to do so on a regular basis. Over time, the amount of activities and sectors of the economy they cover will expand, and hopefully eventually they will be able to encompass all areas of the economy. 

What is vital to recognise with these laws is that they represent a significant departure from ESG (environmental, social, governance) ratings. Historically, companies with high carbon emissions have been able to obtain ‘AAA’ ESG ratings with relative ease. This is due to the fact that ESG ratings commonly have a size bias, with larger companies able to obtain better ratings and thereby allocate more resources to bolstering ESG policies even if they are not actually having a positive environmental effect. 

Companies are graded within their sectors, so an oil company would be compared against another similar company but not against a renewable energy company. The best in sector oil business would then receive a top ESG rating despite being damaging for the environment overall. There are also problems with consistency and reporting standards among ESG ratings agencies.  

Demonstrating compliance 

With the EU taxonomy laws, firms will now be able to demonstrate how compliant they are with the new laws, creating a reliable standard of sustainability that investors can trust. The most sustainable will be awarded the green label which signals to allocators a gold standard, which may create a fundamental shift in how investments are allocated. The green label will be the highest standard available in Europe and is likely to be obtained by clean energy providers and renewables.  

This too though has given rise to criticism, with regulatory commentators being quick to point out that these laws may create a burden for the so-called ‘good guys’; this is because in initial drafts of the legislation, the law mandated that funds which market themselves as environmental must show alignment to the EU taxonomy. This means that funds without ESG allocations were under no obligation to show alignment, to measure the credentials of the investments, and to disclose how compliant with the laws they are. 

However, the EU’s Technical Expert Group amended this flaw in March of this year; under their final report, all firms must now declare how aligned with the regulation they are, and all firms must declare this in their marketing collateral. This means that firms with no alignment must now state this, which would deter environmentally conscious investors. Firms with good alignment may now boast about this, thereby attracting more capital to their fund.

In addition, getting the Taxonomy across the finish line had its challenges, and there were national agendas at play. France and several eastern European countries were keen to classify nuclear energy as ‘green’, all being large producers of nuclear energy themselves. Germany, a large gas producer was at loggerheads with other nations over its insistence to include natural gasses as green. This has now been resolved by the final proposal of the TEG; the eventual comprise has seen natural gas and nuclear energy excluded from the green label but recognised as technologies which help the transition from more damaging alternatives to truly clean energy. As the Taxonomy is open to revisions, it will be interesting to see if these debates resurfaces at future junctures and whether the laws will be subject to bias in favour of the main countries that have participated in bringing them into being.  

It is important to note at this point that fixed interest securities will not be specifically included but compliance is recommended. The exclusion of bonds is significant and unusual given the amount of work that has gone into establishing green bonds which attracted around $157bn worth of investment in 2019. Again, there is every possibility that future iterations of the laws will include the rising stars that are green bonds. 

Brexit considerations

There is an interesting observation to be made in all of this on the point of Brexit. The UK has agreed to subscribe to the overarching environmental objectives of the laws, as these come into force before the end of the Brexit transition period. Certain aspects of the taxonomy – notably the issues surrounding disclosure of alignment which has been previously mentioned – are not due to come into effect for a few years. The new disclosure requirements will apply from January 1, 2022, or January 1, 2023. This poses the risk of making the laws essentially redundant in the UK, as there is no obligation to disclose alignment and therefore no motivation or incentive to actually be aligned with the laws. We would hope, however, that the UK introduces their own proprietary disclosure requirements, which would be in line with the TEG’s recommendations. 

The EU Taxonomy is an admirable initiative and should go a long way towards making climate change fiscally as well as socially and environmentally desirable. There are some teething problems but regulators in Brussels are clearly working hard to rectify these, the UK position is unique and whether it chooses to accept and bolster the spirit behind the new laws remains to be seen.  

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