EU’s push for a common language in sustainable investing: a new taxonomy and standards

The green market, a strong potential 

Over the past ten years, the global green market has expanded at an impressive pace, with a market cap worth $4tn dollars in 2018, weighted by green revenue share. According to the Global Sustainable Investment Alliance, 7 out of 10 asset owners are integrating sustainability in, by taking into account environment, social and governance (ESG) issues, across all assets because they have understood that these have the potential to outperform benchmarks. 

Moreover, a new asset class is emerging: green bonds, bonds whose proceeds are used to fund environment-friendly projects, are experiencing a strong issuance growth since 2014, mainly from Europe as well as Asia. Issuance in 2018 was $167 billion, a 3% increase compared to 2017. 

Yet, while the progress in sustainability and the role of the private sector has been significant, the road is still paved with uncertainty. 

Indeed, most European institutional investors believe that sustainable investing is going to be more important over the next five years, but 82% find it very challenging, according to a Schroders report, mainly due to poor metrics for ESG compared with financial information. 

Investors’ skepticism 

A few factors are still blocking the progress to sustainable investments, due to investor doubt and uncertainties and without any progress from the institutional side, the momentum that has been created in sustainable investing might stall. At the moment, investors are mainly concerned with the following aspects: 

  • No common definition of sustainable investments
  • Lack of accepted data-reporting standards makes it hard to compare or combine insights across providers and gaps in the data makes historical analysis challenging 
  • Fear of investing in “greenwashing” products
  • Too little consideration to environmental risks given from banks and insurers
  •         No clear fiduciary duty on sustainable finance 
  • Poor or incomplete disclosure on non-financial information

Three historical strategies stand out in the sustainable investing sector. The first one is “negative screening”, which excludes assets that are perceived too harmful , such as shares in so called “sin industries” like tobacco companies, gunmakers, gambling... This is one of the earliest methods to fight against practices that are seen are unjust and while it is still appropriate, today investors might try to consider positive screening, meaning aligning stocks with values rather than excluding those that do not. Therefore then came “ESG integration”, that involves taking into account ESG factors in the investment process (in practice, firms do this very differently one from another). The last one, and maybe most interesting is “impact investing”, which is the smallest by asset but the most ambitious. It aims to invest in projects where the precise impact can be measured and quantified, such as the number of people lifted out of extreme poverty or the reduction in tonnes of carbon dioxide. But, if investors have doubts on what counts as “sustainable investment” in the first place, how can they make thoughtful decisions? 

A one-size-fits all scorecard might not be the solution for investors. A notable example is Volkswagen that was ranked by Dow Jones Sustainability Indices the most socially responsible carmaker in 2015. When the emission scandal exploded, the company had to be taken out from the Index as quickly as it was introduced. 

The numerous amount of competing corporate sustainability standards initiatives, including the GRI (Global Reporting Initiative), TCFD (Task Force on Climate-related Financial Disclosure), IIRC (International Integrated Reporting Council), SASB (Sustainability Accounting Standards Board) and many more is also an issue. This proliferation only creates confusion among investors when trying to assess the relevant ESG risks and opportunities. A lot of companies report suffering from “survey fatigue”. (“Building Sustainable Markets: What Is Needed For A Transformation To A Sustainable Market Place?, 2018) 

EU’s strategy on sustainable finance

The European Commission has understood that smart policy will be needed to incentivize the private sector toward sustainable investments. Indeed, the yearly investment gap to meet the EU targets for 2030 is estimated to be between €175 to 290 billions and these cannot only be met with public money. 

The EC has therefore published and initiated an action plan on financing sustainable growth with three main objectives and ten actions:

1. Reorienting capital flows 
2. Mainstreaming sustainability into risk management 
3. Fostering transparency and long-termism

The most challenging and urgent action from this plan is the establishment of an EU sustainable taxonomy, aka a common language that would set out criteria to determine the environmental sustainability of an economy activity. This taxonomy will reflect technological and policy developments by being regularly updated, it will build on market practices and existing initiatives, and will be technology neutral. It has to be remembered that will not be defined as green by the “list” should not be necessarily seen as polluting or environmentally harmful, rather the list will focus on activities that really substantially contribute to environmental objectives. This new taxonomy should help to clarify which activities are “green” and make it easier for market participants to finance these activities. 

The main risk with this colossal work is that the new taxonomy is not well understood by markets and  hinders participants to invest. Regulatory requirements linked to the taxonomy should also remain voluntary until the taxonomy is mature enough so that players are not exposed to legal risks. 

Another important action from the plan is a regulation regarding the investors’ duties and disclosures: more clarity will be brought on how institutional investors should integrate ESG factors in their decision making process. The law aims to clarify the investors’ exposure to sustainability risk and such clarifications will also apply to credit rating agencies and research providers.

Another action from the 10 subgroup of activities is the development of sustainability benchmarks. The EC has proposed to create a new category of benchmarks, comprising of the low carbon benchmark or “decarbonized” version of standard indices and the positive carbon impact benchmarks (which would allow an investment portfolio to be better aligned the Paris Agreement objective of meeting the 1.5° target). 

Another notable action is the amendment of existing laws regarding financial advisory: investment companies and insurance sellers will have to include sustainability preference in their products in order to meet their client’s needs. Such policy might help to boost the retail market in the future since by 2025, millennials will form 75% of the labor force and the 84%  of them view sustainability as key factor when taking investment decisions (Seeking Alpha, 2018). 

This action plan sets a precedent for sustainable finance and establishes Europe as a reforms’ pioneer. Better data and transparency will, hopefully, help investors to seize the existing opportunities in the green market and make the private sector the catalyst for the sustainable revolution. 

 Written by Marie Giesler