The increased market focus on ESG investing has led to the proliferation of ‘sustainable’ funds - from those that refuse to invest in certain sectors, to those with limits on the total carbon emissions, to thorough due diligence and ESG performance measurement.
In the absence of a standard for sustainability at asset and fund level, asset owners may assume that some of those funds do not live up to their promise of sustainability. It is not uncommon to find 'sustainable' funds with a high exposure to the oil and gas industry – a paradoxical situation arising from 'green-washing', the practice of marketing an activity as 'sustainable' while it does not meet common expectations of sustainability. Asset managers also struggle to create credible methodologies that filter out the false ESG leaders. This information asymmetry creates a 'market for lemons', where it is difficult for fund managers to prove the sustainable credentials of their products and clients refrain from investing in them for fear of being deceived. Moreover, even if the market for so-called 'sustainable' funds is growing, the contribution to truly sustainable outcomes is hindered by the flaws in their methodology: the presence of 'green-washed' activities in the portfolio undermines the goal of a genuine contribution.
The EU Sustainable Finance Taxonomy
This has led to the rise of taxonomies, as frameworks attempting to define what can be considered a sustainable investment, and perhaps even more importantly, what cannot. Most prominent among those is the European Commission's (EC) proposal within the Sustainable Finance Action Plan, which identifies investments that contribute to environmental goals. To qualify as 'sustainable', an economic activity must comply with the three following criteria:
- 'Substantially contribute' to an objective: each goal has its own decision tree to establish this contribution, and each activity must meet thresholds (the 'technical screening criteria') such as greenhouse gas emissions reduction, based on current best practice
- 'Do no significant harm': an activity should not harm other objectives, regardless of its contribution to one objective. For example, an activity that contributes to waste reduction by pumping tons of GHG emissions into the atmosphere does not qualify as sustainable
- 'Meet minimum safeguards': the social aspect is included via due diligence on the possible human rights consequences of the activity, which for instance may not involve forced labor
The intention of this process is to increase investor confidence about whether a product is sustainable. It will follow a market-based mechanism, where funds marketed as 'sustainable' must disclose the proportion of assets that meet the EC taxonomy's criteria. The idea is to let investors decide whether they are satisfied with a fund's sustainability credentials, giving those funds that follow the EC taxonomy's methodology a competitive edge. Funds that are not marketed as 'sustainable' are not affected. The taxonomy thus functions on a voluntary basis, to the extent that it only applies where a fund is sold as sustainable or 'similar characteristics', and even in this case, the only obligation is the disclosure of the taxonomy's use in selecting assets.
One major issue arising in the implementation of the taxonomy is the lack of data, as the technical screening criteria require quantitative indicators for all sectors. There have been warnings that the indicators proposed by the EC's Technical Expert Group, tasked with developing those criteria, are not readily available in standard datasets. Those fears tend to be exaggerated, as companies have been reporting an increasing number of non-financial statistics recently, and many of the taxonomy's indicators are already disclosed. The use of a standard taxonomy can help harmonize and encourage disclosures by companies. It is also worth noting that data providers such as Bloomberg, MSCI, CDP and Thomson Reuters are part of the Technical Expert Group, which should provide comfort that data requirements are realistically included in the final legislation. Finally, the gradual entry into force of the taxonomy in three phases, from July 2020 to December 2022, aims to ensure that asset owners and managers have sufficient time to familiarize themselves with the framework and that companies have time to update their disclosures.
Supporting investor confidence
The taxonomy is an opportunity for asset owners and managers to clarify the process through which 'sustainable' financial products are created. It provides a clear framework to determine which economic activities are truly sustainable. While it has met with some resistance from financial actors anxious to keep their procedures as they are, the taxonomy does not introduce any concept that is not already part of environmental law, sound ESG processes or risk management. It is thus a good compromise between the existing leading market practice and regulation, providing a much-needed harmonization that has the potential to boost investor confidence and support the transition to a sustainable economy.