Sustainable Investment Taxonomy - the end of the beginning?

Reaching political agreement in December 2019 on the so-called ‘taxonomy regulation’ marked an important milestone in the EU Sustainable Finance Action Plan. The taxonomy is a highly ambitious initiative, straying beyond the boundaries of mainstream financial services regulation by establishing four criteria for determining what constitutes environmentally sustainable activity in the real economy. Firms will welcome the clarity this will bring, given the role it will play in helping them meet new regulatory obligations being introduced under the Action Plan. But while the process may be politically complete, there is still much work to be done as regulators move onto Level 2 technical standards.

Clearer criteria for sustainable investing

Under the rules, asset managers, institutional investors and wealth managers must disclose how and to what extent the taxonomy criteria has been used to determine the environmental sustainability of an investment. This will serve as a framework to help firms meet their obligations under other key elements of the Action Plan, such as the Environmental, Social & Governance (ESG) disclosure regulation. It will allow them to determine the environmental credentials of investee companies, an essential prerequisite for integrating sustainability considerations during investment decision-making and wider processes.

Navigating data challenges

For the taxonomy to function effectively, firms will need high-quality data to support their assessments of investee companies, which isn’t always readily available. However, various initiatives should help with this, including the taxonomy regulation itself, which will require companies to publish financials associated with sustainable activities on an annual basis. In the meantime, firms should be looking at ways to supplement formal reporting by investee companies through ongoing dialogue, or by harnessing innovating techniques such as natural language processing to scrape data from a broader range of sources.

Don’t forget ‘S’ and ‘G’

Another issue with the taxonomy relates to its scope. As it stands, the taxonomy focuses on environmental issues and, with the exception of criteria on minimum social safeguards, ignores social and governance issues. However, the Commission has stated that it will commit to exploring how the framework could be extended to non-environmental sustainability objectives by December 2021. Until then, firms would be wise to consider how they could rely on available proxies, including the UK Corporate Governance Code and the Modern Slavery Act, to support their assessments of social and governance criteria in the absence of a broader taxonomy.

What’s next?

Finally, the real detail will only become clear once we have Level 2 measures at the end of 2021. The Technical Expert Group’s report on the taxonomy should give a signal of the direction of travel for this technical work, so firms should look to this to get a head start with their implementation.

Political agreement on the taxonomy is a vital first step in providing a framework to support firms in integrating sustainability considerations into the investment process and wider approaches across their business. However, it’s clear that they will need much greater clarity if the taxonomy is to be truly effective. With practical challenges that firms need to work through, and further detail to be ironed out by the regulators, the road ahead is long. But by laying the groundwork for a ‘common’ language for identifying sustainable activities, the taxonomy represents a critical opportunity for firms to assess the sustainability credentials of investments with confidence.

Lucas Penfold

Lucas Penfold | Manager
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