The recent update surrounding the EU Taxonomy should augur well for the progress towards a green future.
But for issuers and investors who must traverse that journey, it also raises certain concerns around the companies’ sustainability reporting practices and the ESG investments that uses sustainability disclosures as the basis for their investing decisions.
Quick Overview of EU Taxonomy
Let us take a step back to see quickly what the EU Taxonomy strives for. It enables companies and institutional investors operating in the EU or the UK to classify projects to be able to define the environmental performance of those economic activities.
As per the Taxonomy, each project needs to be classified into one of the six broad economic activities namely climate change mitigation, adaptation, pollution, circular economy, water, and biodiversity, while ensuring no major damage to the other five.
The projects must also comply with the basic safeguards and EU’s technical screening criterion. The Taxonomy obliges issuers to disclose their turnover/costs and investors to disclose the extent of their investments that are in line with this classification.
The broad motive is to align projects better towards a low carbon future and enable better decision-making for economic activities.
How does this impact sustainability reporting and ESG investing?
While some details are awaited before the taxonomy becomes mandatory from next year, it might be opportune to see how sustainability reporting practices and ESG-oriented investing might get impacted.
The first and foremost challenge for issuers is about the reporting frameworks. An issue with sustainability reporting globally are the varied standards and frameworks, and the ensuing confusion on what to adopt whilst balancing transparency and compliance costs.
The EU taxonomy may add to that. One difference worth mentioning here is the taxonomy is a mandatory disclosure while most other frameworks are not. Mandatory compliance might position the taxonomy as a more generally accepted non-financial reporting standard, with the others layering over it.
For instance, EU companies that want to report further on climate risks may add TCFD or CDP disclosures to their EU taxonomy reporting on green projects. Voluntary nature of other frameworks often results in inconsistencies in the disclosures across companies, making sectoral comparisons tough for financiers.
This may be partly rectified if the taxonomy’s methodology is followed consistently across. Of course, a lot depends on item-wise comparison of the reporting requirements between the taxonomy and other frameworks, to understand how much of it overlaps.
The other is about data. The taxonomy encourages more disclosure, reducing greenwashing by the issuers and investors. But more disclosure implies more data.
The challenge is whether granular data required to assess a project are available and accurate; and if not, the cost to prepare such taxonomy relevant data could be a daunting exercise.
As it is, revenue/cost segmentation by business-lines is hardly standardised across companies, and segmentation on green and non-green basis may be unavailable in most cases. Mid to small sized firms may find limited resource and ability to compute it.
Moreover, the taxonomy involves metrics very few companies might be reporting currently, say biodiversity loss or noise pollution, which are tough for companies and investors to compute.
Such companies may need the help of ESG research and consulting firms, who have the expertise to collect or estimate a firms’ performance on focused metrics and can assist in filling the gaps in disclosure, which will naturally come at a price.
In any case, disclosure per taxonomy-criteria will be necessary for companies so that they do not end up being excluded from the investment universe for the lack of proper reporting.
ESG-oriented funds must disclose their policies on how they integrate sustainability risks into their investing decisions and how they look at the sustainability impacts. This transparency might help further filtering of greenwashing tactics.
However, ESG rating models are not standardised and each fund or rating agency prefers its proprietary models, making ratings incomparable for the same company.
Thus, the taxonomy may force them to adapt their ESG-data questionnaires and processes in a way that brings more consistency in the way the data is used and modelled, improving comparability.
Again, matching the taxonomy’s criteria to the model’s variables might require specialized consulting assistance.
While ESG-oriented investing assets have grown steadily to over $40 trillion, mostly centred in the developed markets, surveys show millennials are evincing interest in sustainable and values-based investing, implying adherence to frameworks like the EU taxonomy might bode well for companies and investors who are mindful of the growth drivers.
While the taxonomy adds compliances and a hunt for granular data, it clarifies eligible activities so that capital flows can be reoriented to hasten the long-term vision of a green Europe.
Greenwashing and inconsistent disclosures were making this road longer. Private capital is only going to come into more demand to meet the SDGs, since public spending, aid and philanthropy remains woefully short.
Strengthening the sustainability yardsticks for capital, which the taxonomy aspires for, may be an apt thing in such circumstances. If implemented effectively, the taxonomy might supersede or streamline other disclosures, easing compliance in the long-term.
With the Commission expected to publish a report by December 2021 on the provisions that would be required to extend the scope of the Taxonomy to social objectives, the direction in which EU policymakers are thinking is clear.
Those adapting their data processes and ESG questionnaires quickly, be it with external assistance or internally, might enjoy the first-mover advantage in Europe’s rapidly evolving responsible investing landscape!