4 October 2019

ESG data files: Part five - the impact of the EU's taxonomy

Will the EU's sustainability taxonomy reduce the reporting burden on companies, or could it be another weight on their shoulders? Michael Hurley reports

The European Commission's ambitious Taxonomy of sustainable economic activities is expected to enter legislation next year.

The final draft of the Taxonomy, published by the Commission-appointed Technical Expert Group on Sustainable Finance (TEG) in June, gave a clearer indication of the stringency of technical screening criteria that will determine if an activity qualifies as 'sustainable'.

For example, cars or commercial vehicles that emit less than 50 grammes carbon dioxide (CO2) per kilometre are eligible until 2025. After that, only zero-emission cars and commercial vehicles will be eligible.

There are also thresholds for other emissions-intensive sectors such as steel and cement, which the TEG says have a role to play in the transition to a low-carbon economy, in addition to those that are dark green - such as renewable power generation.

It is hoped the classification tool will enable better-informed investment decisions on environmentally-friendly economic activities.

However, doubts remain about the extent to which financial institutions currently will be able to use the taxonomy.

In its June report, the TEG revealed: "From an investment perspective, the main usability issue related to the EU Taxonomy is whether the data needed to match a security or a project to a taxonomy-related activity is available, reliable and complete, and at what cost."

The taxonomy raises a number of questions about environmental, social and governance (ESG) data, including: to what extent it relies on companies to produce taxonomy-relevant disclosures; how ready companies are to disclose this information; and what role there will be for ESG data providers to fill any gaps in disclosure.

With companies already complaining about the reporting burden on ESG issues, could the Taxonomy be another weight on their shoulders?

Its proponents argue that, if it is adopted and implemented effectively, the Taxonomy could provide a framework that would supercede other demands for disclosure and potentially reduce the reporting burden.

To assess whether an economic activity is carried out in compliance with the Taxonomy, three types of information are needed, according to the TEG:

  1. Revenue or turnover breakdown by Taxonomy-related activity, or expenditure allocation to each Taxonomy-related activity;
  2. Performance against the technical screening criteria, or environmental management data where this is an acceptable proxy for compliance with the technical screening criteria including the criteria to 'do no significant harm' (DNSH) to any other environmental objective defined in the Taxonomy; and
  3. Management data on social issues including labour rights policies, management systems, audits and reporting.

The TEG's June observations on the usability of the taxonomy continue: "The main challenge the application of the taxonomy faces is that very few companies break out information on green revenues in line with any recognised framework.

"Many data providers collect information or estimate companies' exposure to green activities. For example, analysis based on FTSE Russell Green Revenues data model on more than 14,000 global listed companies – 2,771 of which are from Europe – shows that around 3,086 have exposure to green economy sectors, but only 28% of these companies actually disclose information on the share of their turnover deriving from green product and services.

"In its current form, investors would find it challenging to use. There is simply too much data missing with regards to companies' sustainability" Michel de Jonge, PGGM

"As such, the data is augmented by estimated green revenue percentages with maximum and minimum possible ranges for companies which don't disclose.

"Further, although most listed companies report revenue information broken down by activity or business line, this reporting – which is part of financial filings or annual reports – is not standardised and is not always easily accessible."

This has not been lost on major European investors. In a July blog post, Michel de Jonge, policy advisor on public affairs at €238 billion ($263 billion) Dutch asset manager PGGM, wrote of the Taxonomy: "In its current form, investors would find it challenging to use. There is simply too much data missing with regards to companies' sustainability.

"The reason for this is that companies do not report along the lines of the taxonomy. It not only uses indicators such as amount of carbon dioxide emitted per unit of production, but also refers to indicators for negative impact, like loss of biodiversity or noise pollution. In particular, negative impact is challenging for financial market participants to find out."

Figure 2: What Information is needed?

Reconstructing the foundations

In an effort to bolster the foundations of the bloc's reporting framework, the EU Parliament and Council in March agreed new rules designed to increase harmonisation of sustainability-related investment disclosures. The agreement is provisional and requires further technical work before the Parliament and Council formally adopt the regulation.

Under the rules, financial institutions must disclose details of their policies on the integration of sustainability risks into investment decision-making, and whether and how they consider the principal adverse impacts of their investments on sustainability (on a comply or explain basis for smaller firms). There are also requirements for funds and financial advisors.

In June, the EU presented new, voluntary guidelines on corporate climate-related reporting. The guidelines integrated the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), and updated advice on how to report in line with the EU Non-Financial Reporting Directive (NFRD).

Currently, the NFRD applies to about 7,400 listed companies, banks and insurance undertakings, which the EU defines as large 'public interest entities'.

Last year, the Commission launched a 'fitness check' on the broader EU framework for public reporting by companies, including on sustainability, which asked market participants to assess whether the framework is still fit for purpose. The Commission is expected to report its findings this year.

Coming to terms with change

Nathan Fabian, chief responsible investment officer at the Principles for Responsible Investment (PRI) and rapporteur for the TEG's working group on the taxonomy, tells Environmental Finance that while the TEG has not begun to weigh up responses to its consultation on the taxonomy - which closed on 13 September - there has been a common theme among his interactions with financial institutions in Europe.

"They are still coming to terms with the fact that there is going to be an obligation to disclose. They always ask: 'Are we going to have to do this?' and once they realise there will be some law on disclosure in Europe, the conversation quickly changes to: 'What do we have to do and how do we do it?', and then to 'Can I do that, will I have the data to interpret that?'

"Some rightly say the disclosure today on the taxonomy criteria is very low. We say: 'That's right!' We've only just released the criteria, so that's to be expected" Nathan Fabian, PRI

"Some rightly say they think the disclosure today on the [Taxonomy] criteria is very low. We say, that's right! We've only just released the criteria, so that's to be expected."

Financial institutions then typically ask what they should do in the absence of complete data. "That is the most important question we need to solve in the next couple of months," says Fabian.

"We all accept that, in reality, there will be some ramp-up period around the use of the Taxonomy as the data starts to come online. The fact that data is limited should come as no surprise to people – this is a new way of reporting. It's going to take us a couple of years to get the market moving, I think we all understand that.

"The question is, what kind of disclosure would be expected from investors in that period?"

Fabian says the TEG will seek to provide recommendations on this issue as part of its extended mandate.

The TEG has agreed to extend its initial mandate beyond June, to support the Commission until the end of 2019 "in preparation for the future development of a Taxonomy".

"This reflects the fact that... further refinement of the [mitigation and adaptation] criteria may be required after feedback from stakeholders," the TEG said. It launched a call for feedback on its proposals shortly after they were published.

Nathan Fabian, PRIIt is understood the TEG will not further expand the scope of the climate change mitigation activities covered under the Taxonomy, nor will it seek detailed feedback on screening criteria which have already been reviewed. Feedback received will be incorporated into a report submitted to the Commission in late 2019, but it remains to be seen how much of the TEG recommendations, and feedback, will be adopted by the Commission.

The Taxonomy so far covers just two – climate mitigation and adaptation – of the six environmental objectives it is intended to eventually cover.

A Platform on Sustainable Finance is expected to be appointed this year, which will which will be tasked with developing the Taxonomy to include sectors beyond those that have already been covered.

Taxonomy poses questions for ESG data providers

Meanwhile, ESG data providers have been told to be prepared to adapt to, and encourage development of, a new disclosure landscape.

According to the TEG report: "There is a clear incentive for data providers to adapt their questionnaires and systems to provide investors with the information they need to implement the Taxonomy.

"There is a clear incentive for data providers to adapt their questionnaires and systems to provide investors with the information they need to implement the taxonomy" The EU TEG

"The most streamlined way to accomplish this, short of mandating it for companies themselves, would be for data providers to use the Taxonomy criteria to build systems that would show what reporting is needed. Companies could have a Taxonomy profile and then it would be clear which companies are reporting in line with the Taxonomy and which are not," it suggested.

The PRI's Fabian believes ESG data providers like MSCI and FTSE Russell have a significant role to play in filling gaps in company reporting.

David Harris, London Stock Exchange GroupHe says they already have models to assess the extent to which companies derive revenues from sustainability-related activities – such as FTSE Russell's Green Revenues model – and can be expected to tweak their models to calculate this in a way that is consistent with the taxonomy criteria.

"We are going to have those services. I don't know when they're going to come to market - that is an important question for the data providers... but personally I think they've got a very important role to play in this transition and we know they have a stake in being able to do this."

FTSE Russell declined to comment on the implications for its Green Revenues model of the Taxonomy, when contacted by Environmental Finance.

However, in a blog post in June, David Harris, head of sustainable business at London Stock Exchange Group, which owns FTSE Russell, wrote that one of the main reasons investors should welcome the Taxonomy is that it encourages more corporate disclosure.

"The key challenge in making any green taxonomy useful to investors is a shortage of granular data. Among the over 14,000 listed companies we collect data on globally, more than 3,000 provide some green goods or services. But a majority of corporate disclosures are not granular enough to determine revenues from green industries. The EU Taxonomy could be a major incentive for companies to provide investors with more meaningful data on this," Harris wrote.

Remy Briand, head of ESG at MSCI, says the data provider is prepared to adapt, but is not entirely convinced on the stringency of the Taxonomy's eligibility criteria.

"The EU taxonomy could be a major incentive for companies to provide investors with more meaningful data" David Harris, LSEG

"We will adapt but that does not necessarily mean we will only use the EU framework. Generally, we support the overall effort, and as a consequence we will try to provide the data that is necessary for investors to either analyse or report against it. How exactly this will take place we are still analysing, and there are a lot of things that are not finalised in the EU's work.

"If we realise, for whatever reason, that the whole thing isn't going to work at all – which is not our assessment at this date – then we may decide not to do anything. We think this push for clarification and transparency is a good one, but it depends on implementation.

Briand says the current lack of data availability "is the real pain point! It is where things get problematic" with regards to the proposed Taxonomy.

"We will wait to see, but my assumption is it could take years and years to get companies globally to disclose on all the aspects of this Taxonomy – if ever!

"What is helpful in the Taxonomy is the clarification of [eligible] activities... What becomes complicated is when you put thresholds and requirements around that framework.

"It is clear that if a lot of the criteria are linked to company disclosure that does not exist, the consequence will be that a lot of companies that may be eligible, but do not report, will be excluded from the investable universe. In a sense, that would defeat the initial purpose of the Taxonomy, which is to help investors select companies that are helping make the transition."

Briand says this is illustrated by the results of MSCI research, which suggests that only 17% of the market value of bonds contained in the widely-respected Bloomberg Barclays MSCI Green Bond Index would meet the proposed EU Taxonomy criteria, and thus be eligible to be verified in line with the EU Green Bond Standard.

However, it is understood that this figure may have been affected by the fact that, so far, Taxonomy criteria has been devised for only two – climate mitigation and adaptation – of the six environmental objectives it is intended to eventually cover.

Briand continues by saying that companies cannot be relied on to provide all of the information necessary to determine the extent to which their activities meet the Taxonomy criteria.

"For example, on environmental fines – you will never see the list of fines that have been imposed, for example in the US by the Environmental Protection Agency (EPA), on a company's voluntary disclosures! That's why, for years, we've been going through EPA information to get those signals on fines.

"If you really want a proper assessment you need to look for as many other sources as possible."

He suggests that the Taxonomy could be more effective if it were more flexible.

"We think [it could be improved by] bringing some leeway in how you assess the criteria – rather than saying it has to be this particular disclosure on this particular topic. Giving latitude for the investor to make an assessment based on criteria that may evolve through time but are not part of regulation would be useful."

Rory Sullivan, co-founder and director of consultancy firm Chronos Sustainability, says: "As FTSE Russell's Green Revenues model has shown, lots of companies have green revenues but don't disclose that information. Companies are missing a trick.

"The likes of MSCI and Sustainalytics will have to start to estimate it," he predicts.

Sullivan suggests the Taxonomy will have a ground-breaking effect.

"There's no question in my mind that it's the framework that everyone will have to use" Rory Sullivan, Chronos Sustainability

"There's no question in my mind that it's the framework that everyone will have to use. It doesn't matter whether it's right or wrong, these are now the rules of the game. People will want to know how an investment stacks up against the Taxonomy. Investors will need to provide that information."

Meanwhile, the PRI's Fabian explains that, because the NFRD guidelines recommend disclosing earnings from activities set out in the Taxonomy, "we expect companies will start providing actual data on that... exactly when, we cannot be sure, but companies are already contacting me saying, we want to pilot the Taxonomy. There are companies that want to be the first movers," Fabian adds. He declined to provide names of these companies in advance of them publicly announcing such an intention.

Fabian also says the TEG members are in discussions with several specialist data providers that already provide good data sets on asset performance standards that he claims are "very similar to" the taxonomy criteria. This includes some in the real estate sector, specifically with regard to energy efficiency performance.

How green are you?

The updated NFRD guidelines ask that companies disclose either the percentage of turnover from products or services or the percentage investment and/or expenditures for assets or processes that comply with activities outlined in the EU Taxonomy, once it is adopted.

This was one of the main applications the TEG foresaw for the Taxonomy when it outlined its action plan in 2018. Its supporters say it will help galvanise greater investment in Taxonomy-aligned activities.

There is already demand from investors to be able to calculate this percentage.

Arnaud Faller, the CIO of €47.5 billion ($53 billion) Paris-based asset manager CPR, says: "We are happy to see the... TEG develop its sustainability Taxonomy... so we can identify the portion of environmentally sustainable companies in our investment universe and then [give an opinion on] the portion of greenness of our portfolio.

"For example, we might be able to say we have 75% of our portfolio in sustainable activities."

Faller says this is a calculation CPR is committed to perform in future – but concedes that the extent to which it will be able to do this effectively will depend on data availability.

"The first step before anything else [is that] companies will have to disclose their breakdown, in terms of economic activities, on a yearly basis, at the least.

"It will be very important that companies play their role, in all sectors," Faller adds.

He is optimistic companies will fulfil their side of the deal. He cites data from CDP, formerly the Carbon Disclosure Project, showing that last year more than 7,000 companies voluntarily disclosed information on how they are responding to environmental risks and opportunities to their business.

"We know that companies are ready to do this kind of reporting.

"Perhaps [widespread environmental disclosure] won't be done in a few weeks or months, but we are optimistic for the coming years."

The PRI's Fabian says how financial institutions will be encouraged to calculate percentage exposure to Taxonomy activities "is a work in progress... we are still working out how we would present that in percentage terms [and] we expect to make some recommendations on this in our final report in December".

This article is part of a series of features exploring ESG data.

  • To read 'The ESG data files – introduction, click here
  • To read 'The ESG data files – part one: reported data', click here
  • To read 'The ESG data files – part two: non-reported data', click here
  • To read 'The ESG data files – part three: ESG rating agencies', click here
  • To read 'The ESG data files – part four: fixed income data’, click here
  • To read 'The ESG data files – part five: the impact of the EU’s taxonomy’, please click here
  • To read 'The ESG data files – part six: TCFD and the challenge of looking forward’, click here