Nathan Griffiths: Are we really ready for EU Taxonomy?

1 oktober 2024

By Nathan Griffiths, Sustainable Finance, EY Netherlands

In June, as everyone was winding down ahead of the summer vacation, two of the European policymaking bodies responsible for shaping the sustainable investment sector published recommendations which potentially have significant implications if adopted.

In their Opinion on the future of the Sustainable Finance Disclosure Regulation (SFDR),  the Joint-ESAs – the three supervisory bodies for the financial sector – in recommended a singular definition of sustainable investments, with the EU Taxonomy being the preferred concept. Similarly, the Platform on Sustainable Finance has also pushed for Taxonomy definitions becoming the singular standard. In addition, both bodies have called for extension of the Taxonomy to social activities, which had appeared to be on indefinite hold.

The EU Taxonomy provides detailed technical screening criteria for activities which can be categorized as meeting one of the six environmental objectives. Furthermore, the activity must also be shown not to harm any of the other five objectives, as well as meet minimum social safeguards. To prove that the activity meets the strict requirements, companies are required to substantiate taxonomy alignment through documentation, and external verification where activities require specialist knowledge.

Why does this matter so much?

Currently under the SFDR, investment managers set their own definitions of sustainable investments and the criteria for determining whether companies qualify. The obvious criticism of this regime is that it leads to a wide range of definitions which simply confuse investors. It is also open to abuse with the potential for differing thresholds across competing investment products. Having the EU Taxonomy as a single definition would render this debate meaningless.

However, there are significant drawbacks to this proposed approach. The Taxonomy is an activity-based process. Under the SFDR, an investment is considered sustainable if it meets the ex-ante criteria that have been defined. If the threshold is 20% of revenues being aligned with a sustainable goal or activity, the whole of the company can be considered a sustainable investment.

In contrast, under the Taxonomy only 20% would be reported. This seems a reasonable threshold in fact. In its 2024 EU Taxonomy Barometer, EY calculates that the average alignment of reporting companies is 10%. If 10% is the average, then perhaps 20% is a reasonable benchmark for sustainability. Yet labelling an investment fund as sustainable with such a low proportion of revenues is unlikely to encourage investment flows.

Dig deeper and there are other fundamental concerns. The Taxonomy Regulation is only applicable to the largest EU companies. In total, those companies in scope total 386. In addition to standardization, a key positive of the Taxonomy in the eyes of proponents is that alignment requires significant levels of evidence and traceability. However, that in turn, means significant additional costs in reporting.

Whilst the CSRD disclosure regulations will expand the scope of reporting to ultimately cover all listed and larger non-listed entities, alignment reporting will lag. Even for those in scope, less than half of non-financials report percentage alignment across different sustainable activities. Differences in national requirements also mean that only 27% of disclosures have independent assurance, dominated by Spain where such assurance is mandatory. In short, it will take some years before Taxonomy reporting will provide a true and complete picture of all company’s level of alignment.

What other implications, intended or unintended, can we foresee from a move to the Taxonomy being the single definition of sustainability? It seems immediately clear that such an approach will have a meaningful impact on the structure of sustainable investments funds:

• Only activities currently covered by the Taxonomy Regulation can be considered sustainable. This will lead to inherent and significant sector bias in portfolios. According to the EY survey, 73% of reported mobility sector turnover is eligible whilst the number is as low as 3% for the consumer sector.
• This sector bias will also show through in country biases, depending on the structure of each economy. 1% of reported turnover in The Netherlands is Taxonomy Eligible whereas it is 20% in Spain and Austria and 49% in Romania.
• The US and other countries outside the EU will not adopt such a taxonomy. For non-EU companies not in scope, reported the Taxonomy alignment will be (very) low. Therefore, sustainable investment funds are going to have a heavy weighting to European companies in comparison to global benchmarks.

The asset management industry is likely to push back against these proposals, although the preference of policy makers is now clear. Given the significant implications to the sustainable investment sector, the consequences should be considered carefully. It is not obviously apparent we are ready for such a standardization in the definition of sustainability.