Creating a common language for sustainable investment

The EU Taxonomy, introduced in 2021, is a classification system seeking to boost sustainable finance within the European Union. It aims to direct investments towards sustainable projects and activities by establishing clear definitions of what is sustainable and green. It sets criteria for identifying environmentally sustainable economic activities, focusing on six key objectives such as climate change migration and biodiversity protection.

The “do no significant harm” principle prevents greenwashing by ensuring activities don’t harm other environmental goals. Applicable to financial market participants, it requires disclosure of sustainable investments, promoting transparency. The taxonomy evolves with regular reviews, adapting to scientific advancements and maintaining relevance in guiding sustainable investments.

Joy Kiely, head of Ireland for BNP Paribas, Securities Services and chief executive of BNP Paribas Fund Administration Services (Ireland) explains that the function of the EU Taxonomy creates a frame of reference and common definition for what sustainable investments are, thus enabling a greater visibility, transparency and comparability.

“It can contribute to reshaping investment allocation and strategy, helping direct capital flows towards sustainable activities. It impacts both access to capital, reputation and brand image,” says Kiely.

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One driver of the net zero trajectory is the adoption of Paris-aligned climate goals. For companies, the low-carbon economy means to cut and reduce their carbon footprint as close to zero as possible, either by reducing or sequestering their greenhouse gas emissions. This requires huge declines in the use of coal, oil and gas and a large transformation of the economy. Companies set net-zero target plans, which translate into aligning their investment strategy, integrating ESG (environmental, social, and corporate governance) criteria in their activity and their decision-making processes.

“For example, institutional investors are actively divesting from fossil fuels or high-intensive carbon industries and redirecting those specific funds to low-carbon energies. Key findings of BNP Paribas’s ESG Global Survey 2023 find that low-carbon transition strategies accelerate, despite pressure on investors’ external commitments to net zero targets: 41 per cent of respondents say commitment towards net zero is a current priority in their organisation, and 48 per cent say it will be within the next two years,” says Kiely.

“If you are looking to categorise your funds, through the sustainable financial disclosures regulation, as a light green fund or a dark green fund, the EU taxonomy is the mechanism by which it will help you assess that,” says Marc Aboud, director of Risk Advisory | Sustainability/ESG at Deloitte.

“And the difference with EU taxonomy is that it’s putting financial metrics to the environment. You’re actually saying how much of your revenue is actually environmentally sustainable,” he says.

Effective as of January 1st this year, companies are now mandated to divulge their adherence to the remaining four pivotal environmental objectives outlined in the EU Taxonomy. These encompass the “sustainable use and protection of water and marine resources”, aiming to ensure responsible stewardship of vital water ecosystems. Additionally, the “transition to a circular economy” emphasises sustainable resource use, while “pollution prevention” underscores the need for proactive measures against environmental harm. Last, “protection and restoration of biodiversity and ecosystems” focuses on safeguarding diverse ecosystems.

“The challenges around transparency for the EU Taxonomy include difficulties in obtaining high-quality data from investees, the need for a suitable process to identify and assess eligible activities, and the potential for inaccurate interpretation, which can lead to incorrect reporting and noncompliance with regulatory requirements,” argues Kiely.

The way the taxonomy is applied may change over time or have unexpected consequences, explains Aboud.

“I look at their revenue, and Capex [capital expenditure] and I might see that their revenue and Capex are highly eligible because they fall under certain activities within the regulation, but if their alignment scores are lower, then I need to think about the cost of capital that I provide to that organisation,” he says.

Patrick McLoughlin, head of SRI Multi Asset Solution, Davy Group, says that since August 2022 clients have been asked to express their sustainability preferences before entering into a new financial product.

“One of the ways they can express their preferences is by stating the degree of alignment with EU Taxonomy they desire from their investment product. It must be noted that at present a preference high degree of EU Taxonomy alignment leads to a constrained universe, failing to provide the level of diversification ideally desired for a long-term investment product – such as a pension,” says McLaughlin.