A sustainability taxonomy for investors

On June 18, 2019 the EU expert group for sustainable finance (TEG) published a proposal for a European definition of environmentally sustainable activities. The taxonomy is best compared to a green encyclopedia for financial market participants. An encyclopedia that provides guidance to investors that are looking to finance the transition to an  economy in line with the goals of the Paris Climate Agreement.

The TEG’s proposal is a major step towards a European definition of sustainable economic activities. It has the potential to be a real game changer in the long term through more transparency, lower transaction costs and better dialogue between investors and investees.

Standardisation as an accelerator

The Dutch financial sector has long been active in responsible investment and standardisation of the market for sustainable investments. As a large €250 billion ($280 billion)  pension asset owner and asset manager PGGM and PFZW have been using a taxonomy for impact investments for almost 10 years. The taxonomy for impact investments was developed by a team within PGGM and was initially aimed at four impact themes: climate change, water scarcity, healthcare and food security. Three years ago this initial taxonomy was extended to a taxonomy for investments in the UN Sustainable Development Goals, in cooperation with APG. Based on our experience and as the only representative of the pension sector, we were able to play an active role in the TEG and the development of the EU taxonomy.

Being a global investor, we believe that further standardisation and comparability of sustainable investment will enable the upscaling of investments that yield financial returns as well as positive societal impact. Like the Taskforce for Climate-related Financial Disclosures (TCFD) has done for disclosures on climate-related risk, a European taxonomy could set the standard for ‘green’ investments.

Transparency

We are facing major environmental and social challenges that require us to rethink the status quo of our economy. To mitigate climate change and adapt our economies to in a transition towards a low carbon – and eventually carbon neutral – economy is vital. The financing gap that the EU’s public sector is facing for this transition is currently estimated between $200-$300 billion of private capital annually. The aim of the  EU action plan for sustainable finance published in May 2018 is to get capital flowing to the economic activities that can contribute to goals of the Paris Climate Agreement and the EU’s goals of a carbon neutral economy in 2050.

At its heart the action plan aims to create a universal understanding and classification of these activities –  the taxonomy. The European Commission’s reasoning is that a definition of “green activities” – shared by companies, governments, financial institutions and researchers could increase confidence and decrease ‘green washing’. Consequently resulting in more private financing for the transition to a carbon-neutral economy by 2050.

The proposed legislation for a EU taxonomy is therefore focused on transparency requirements: financial institutions that offer green financial products must provide insight into the degree to which their offerings are in line with the taxonomy. This provides asset owners with better insight into how green a product actually is. It will also result in better offerings and better substantiated choices on the part of customers. The taxonomy also provides the basis for future labelling schemes for example to classify investment funds and bonds on their alignment with the EU environmental goals.

Less reputational risk

Even though the legislative obligations focus on transparency, the benefits of a common standard for financial market participants is much broader. The taxonomy reduces transaction costs and reputational risk for asset owners and investors, now working with their own taxonomies. In the current market investors have to make their own judgement call on what they deem “green”. Making such a call requires substantial research capacity. For some activities it might also include taking some reputational risk through including or excluding certain activities. This last part is particularly applicable for activities that are supporting the transition but are “not yet green”, such as the use of gas, the production of certain chemicals and the renovation of buildings.

The taxonomy includes specific guidance on transitional activities and high-emitting sectors; reducing emissions in these sectors could make a substantial contribution towards achieving the Paris climate objectives and the EU targets for 2050. By also giving these sectors direction, the TEG intends to move sustainable investments from a green niche to a broad investment universe. Because the classification is created through cooperation between policy makers, scientists, companies, civil society and investors, it can be seen as a broadly shared definition that investors can rely on.

Better Dialogue

All activities in the taxonomy are based on existing standards and scientific scenarios, such as those of the IPCC. The criteria for all activities are in line with existing EU legislation, policy and objectives. There are threshold values for almost every activity. This could include, for instance, a maximum gCO2/kWh for energy production, or references to recognized norms or certification schemes. Every activity also includes criteria for limiting negative impact on the other EU environmental objectives concerning climate change adaptation, waste, water, circularity and biodiversity.

The detailed information provides a starting point for the dialogue between investors and their investees on environmental performance. The criteria and metrics give guidance on what should be expected from a certain sector. By suggesting pathways for high emitting economic activities, the taxonomy enables a constructive dialogue on long-term sustainability goals. A dialogue that is essential for the transition to a cleaner economy.

What’s next?

The report of the TEG is only the first step in the classification of environmentally sustainable activities. The mandate of the TEG in its current form runs until December 2019. After that the TEG will be followed – most likely – by a permanent platform that will finish the taxonomy and monitor the uptake of the tool. In the remainder of the mandate, the TEG will focus on analysing data availability and increasing the accessibility and user friendliness of the tool  to enable an easy uptake by investors, lenders and issuers alike.

Brenda Kramer is a responsible investment adviser at PGGM. She is also one of 35 members of the European Commission’s sustainable finance technical expert group, TEG.