Creating the language of sustainable finance
The EU is creating a common language - or taxonomy - to discuss climate change matters in business.
While the absolute number of climate change legislations appear to be on the decline, in Europe at least, policy makers’ focus on sustainable investment is seeing increased momentum. Over the last few months, four linked policies have been proposed as part of the ongoing action plan on financing sustainable growth by the European Commission, largely based on the findings of the High-level Expert group (HLEG) on Sustainable Finance.
One item on this plan is a detailed EU classification system – or taxonomy – for sustainable activities, creating a common language for all actors in the financial system. In the first instance, the EU’s plans call for a focus on climate change, expanding to other aspects of sustainability in later stages. The HLEG working group included a draft on what the taxonomy could look like – while the actual proposal is unknown, that draft provides a guide to the working group’s initial perspective.
While a few subsectors are automatically deemed sustainable¹, most screening criteria appear to follow a formulaic carbon intensity logic - measured as gCO2e per kWh generated, km travelled, m3 or similar. Although the exact thresholds for what would be classified as a sustainable company have not yet been set , we assume albite somewhat presumptuously that these thresholds will follow a best-in-class approach, possibly along the lines of top-quartile inclusion or similar. While we support these objectives, two potential issues need to be kept in mind.
The EU Sustainability Taxonomy Framework
Source: Luxflag, January 2018
First, depending on the exclusion screening levels applied, investable universes might become artificially small, leading to an imbalance of investment demand and investment opportunities. Our rough assessment of the criteria outlined above might leave only between 10-20% of established benchmarks as investible1.
Second, there is still lack of clarity in some cases. For instance, nuclear power plants, which are currently defined as “automatically eligibly, but not universally acceptable because of other environmental and social risks”, and software companies, which have not yet been assigned a primary screening criteria.
In summary, it appears that the upcoming EU sustainable finance taxonomy will have a considerable impact on how financial resources seeking returns in line with the established classifications will be allocated. While its final version can provide clear and useful guidance on the distinction between sustainable and non-sustainable economic activities, defining investment universes too narrowly might lead to increased homogeneity among funds aiming to adhere to the taxonomy and hence artificially drive up prices of companies fulfilling the selection criteria.
1.We tested S&P 500, MSCI World Large Cap, and MSCI AC World Large Cap↩