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The EU taxonomy: the birth of a universal tool?

Helena BNP - Banner for 365 articlesAhead of FundForum International 2019, Deputy Global Head of Sustainability and member of the Technical Experts Group on Sustainable Finance of the European Commission, Helena Fiestas, discusses the birth of a new universal tool to analyse sustainability in investments.

An environmental measure is in the womb: the EU taxonomy. Aiming to dissipate widespread fears of greenwashing, the taxonomy will list all economic activities that can genuinely be considered environmentally sustainable by providing a common understanding of what is green.

Yet it is more than a regular dictionary. It aims to become a 'universal tool' that can assist and reward any industry in its efforts to green its activities by fostering investments where they are most needed, as well as encouraging R&D in green technologies.

What's the problem?

The climate-aligned bond universe has now reached USD 521 globally[1], and sustainability-themed investing represents more than USD 1 trillion billion worldwide [2]. Funds may be marketed as environmentally sustainable or green, without any universal standard being applied.

Financial institutions may judge what is green based on information from research providers, well-established taxonomies or by using their own classification, and this means that they can have as many taxonomies as they do business units that are developing green financial products.

"Easy access to a company’s breakdown of turnover by activity according to the classification provided by the taxonomy is fundamental."

These internal taxonomies may differ on what activities they include based on their different definitions. Some might include conventional gas as a transition energy source or flaring systems that reduce emissions to the environment.

Many would include neither in an environmentally sustainable fund. This nascent area suffers from serious definition issues. A standardised taxonomy that is science- and evidence-based will put an end to the discussions about grey areas.

Some critics claim though, that it will translate into higher costs, inefficiencies and a possible obstacle to innovation for industry and finance.

All change requires some effort and adjustment and many of these worries are either the result of a natural misunderstanding or are only valid in the very short term.

Key features of the taxonomy

The idea is simple. For an activity to be eligible, it needs to demonstrate that it makes a substantial contribution to one of the European Union’s six environmental objectives (climate change mitigation, climate change adaptation, water and marine resources, circular economy, waste prevention and recycling, pollution and healthy ecosystems), without having a detrimental impact on any of the other five.

The expert group takes guidance from existing EU legislation, and EU policy and goals; and bases the development of the taxonomy on the NACE codes. The group defines thresholds for the eligibility of activities according to metrics such as carbon intensity (gCO2/kWh) based on the best science available, with reference to existing recognised standards but balancing this against practical needs.

"The climate-aligned bond universe has now reached USD 521 globally[1], and sustainability-themed investing represents more than USD 1 trillion billion worldwide[2].

Easy access to a company’s breakdown of turnover by activity according to the classification provided by the taxonomy is fundamental.

In the case of projects or use of proceeds, the equivalent information should be disclosed to investors but most companies don’t provide such detailed information, so data availability remains probably the greatest hurdle to the fast implementation of the taxonomy.

With this in mind, the climate-related disclosures guidelines that will upgrade the Non-Financial Reporting Directive (NFRD) also developed by the expert group, specifically encourage companies to provide their turnover broken down according to the taxonomy’s classification.

But encouraging is not the same as making mandatory. This is why we, as an investor committed to aligning our portfolios with the Paris Agreement, are calling for the upgraded guidelines to be made mandatory and will leverage our power as shareholders to encourage the companies we invest in to disclose the necessary information.

A more transparent future?

The guidelines also recommend that companies disclose their capex investments in activities compliant with the taxonomy. This forward-looking indicator will help investors to better assess companies’ future performance and identify those that will have a competitive advantage in an environment of ever-stricter carbon regulation.

It is crucial to understand that, as with the adoption of the metre, there will be a period of transition. The taxonomy will not be implemented overnight. Companies will need to upgrade their reporting systems, and investors and other financial market participants will have to progressively replace their current classifications with the taxonomy.

Another precondition for the success of the taxonomy is to ensure that it is dynamic, integrating all advancements in green technologies.

As with the Paris Climate Accord, almost more important than the first version of the taxonomy - is the process put in place to 'ratchet it up' and constantly update it.

To ensure its evolution, the Commission has proposed the establishment of a Platform for Sustainable Finance that would promote the taxonomy within and beyond European borders and be responsible for overseeing, updating and assessing the taxonomy and its impact on the economy and the environment.

At FundForum International 2019, Helena Vines Fiestas, will be discussing a UN PRI Working Party update: Markets, Metrics and Benchmarks to enhance the distribution of low carbon investment products.

[1] Cumulative issuance since 2007. Climate Bonds Initiative (2019), Green Bonds: the state of the market 2018; available at https://www.climatebonds.net/resources/reports/green-bonds-state-market-2018

[2] Global Sustainable Investment Alliance, 2018 Global Sustainable Investment Review p. 10 available at http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf?utm_source=The+IIG+Community&utm_campaign=60a39c9e1c-EMAIL_CAMPAIGN_11_30_2018_11_56_COPY_01&utm_medium=email&utm_term=0_4b03177e81-60a39c9e1c-71997937

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