Mark Uhrynuk and Alexander Burdulia discuss taxonomies that have been developed, how asset managers are already applying them, and the associated challenges.
The sustainable investing market is witnessing remarkable growth, with annual cash flows into sustainable funds annual cash flows into sustainable funds increasing tenfold since 2018. Now, more than ever, investors and asset managers alike seek sustainable products and strategies offering robust financial returns.
The field, however, has been challenged by ‘greenwashing’ claims and a lack of consistency in identifying what, exactly, makes an investment “sustainable”.
To help resolve these sustainability challenges and inconsistencies, ‘green’ taxonomies developed by governments, international bodies and non-governmental organizations (NGOs) can identify specific assets, activities or projects that meet defined thresholds and metrics quantifying sustainability.
These systems can cover the full spectrum of sustainability issues, from achieving acceptable levels of greenhouse gas emissions to compliance with certain human rights standards. Among other benefits, sustainability taxonomies can:
- help investors, asset managers and asset owners identify sustainable investment opportunities and construct sustainable portfolios that align with taxonomy criteria;
- drive capital more efficiently toward priority sustainability projects;
- help protect asset managers against claims of ‘greenwashing’ by providing an independent benchmark for the sustainability performance of investments; and
- guide future public policies and regulations targeting specific economic activities based on taxonomy criteria.
This review first provides a brief overview of some of the key existing and developing taxonomies around the world.
Analysis follows of ways asset managers are already leveraging taxonomies in their businesses, based on a review of publicly available responsible investment reports. Finally, certain challenges that asset managers may encounter are highlighted, as these systems develop and interest in sustainable investing continues to grow.
Sustainability taxonomies are currently being developed by a range of organizations and governments at a rapid pace. NGOs are particularly active in the debt finance sector, with organizations like the Climate Bonds Initiative and the International Capital Markets Association developing leading green bond standards that define specific projects eligible for sustainable debt financing. In the public sector, more broadly-applicable taxonomies are often developed by multi-stakeholder working groups mandated by national or international authorities.
Many taxonomies refer to or emulate the existing European Union taxonomy (EU Taxonomy), widely regarded as the most developed system for sustainable finance investment classification and measurement. Formally adopted in 2020, the EU Taxonomy already informs related EU regulation like the Sustainable Finance Disclosure Regulation, which requires covered entities to disclose whether certain financial products align with the EU Taxonomy.
Under the EU Taxonomy framework, an economic activity is environmentally sustainable if it contributes to one of six environmental objectives; does not significantly harm the other objectives; and meets certain human rights-related “minimum safeguards”. Delegated Acts under the EU Taxonomy set out additional “Technical Screening Criteria”, or the specific thresholds and metrics used to assess whether individual economic activities are sustainable.
Numerous other jurisdictions are now developing sustainability taxonomies, while some have already put final systems in place. We discuss some, but not all, of these taxonomies below.
China – In May 2021, Chinese regulators announced an updated version of the Green Bonds Endorsed Projects Catalogue to help govern China’s green bonds market. The Catalogue sets out specific projects eligible for green bond financing in China.
Additionally, the International Platform on Sustainable Finance, which is co-chaired by China and the EU, has developed a Common Ground Taxonomy that identifies similarities between the EU Taxonomy and the Green Bonds Endorsed Projects Catalogue. The Common Ground Taxonomy can help international investors align activities across the EU and China.
Singapore – in January 2021, the Green Finance Industry Taskforce (GFIT), a multi-stakeholder group organised by the Monetary Authority of Singapore, released its proposed framework for a green taxonomy for Singapore-based financial institutions that is generally aligned with the EU Taxonomy framework.
Malaysia – in April 2021, Malaysia launched a Climate Change and Principle-based Taxonomy that helps financial institutions assess and categorize economic activities against five guiding principles that generally align with the framework of the EU Taxonomy.
South Africa – in July 2021, the South Africa Sustainable Finance Initiative closed a consultation on a Draft Green Finance Taxonomy, including metrics and thresholds to quantify sustainability, that is largely aligned with the EU Taxonomy.
United Kingdom – the UK Green Technical Advisory Group, a multi-stakeholder organization involving the public and private sector, is currently advising the UK government on the development of a green taxonomy that will build on existing systems, including the EU Taxonomy.
France – in December 2015, France established the Green Fin Label, which certifies investment funds that meet a range of “green” criteria. The Green Fin requirements set out a list of activities, including metrics and thresholds, that support the energy and ecological transition and may qualify a fund for green labelling.
Bangladesh – in December 2020, the central bank of Bangladesh adopted the Sustainable Finance Policy for Banks and Financial Institutions, which includes a national taxonomy in the form of a list of green products, projects and initiatives eligible for green financing. The policy is based on national regulations and international standards.
Russia – in September 2021, the Russian government approved technical criteria for sustainable projects involving waste management, energy, construction, industry, transport, water supply, biodiversity and agriculture, as well as verification requirements for sustainable financial instruments. Energy criteria, in particular, are based on the EU Taxonomy.
ASEAN – in November 2021, the Association of Southeast Asian Nations (ASEAN) released Version 1 of the ASEAN Taxonomy for Sustainable Finance, the initial framework for a system that will provide a common language for sustainable finance among ASEAN member states. The environmental objectives in the proposal are largely aligned with the EU Taxonomy framework.
Sustainability taxonomies have a wide range of applications, from informing public policy and regulation to efficiently allocating capital towards sustainable projects. But how are asset managers practically applying these new systems in their businesses?
To answer this question, we reviewed a sample of public responsible investment reports published by asset manager signatories to the United Nations Principles for Responsible Investment (UNPRI). UNPRI signatories commit to incorporating ESG issues into their investment practices and reporting annually on their responsible investment activities. Together, these reports provide valuable insights into the current state of sustainable investment practices around the world.
Based on our review, asset managers are already applying taxonomies in the following ways:
Integrating taxonomy criteria into investment selection processes – asset managers are integrating the taxonomy criteria they use to define certain activities as “sustainable” into their investment selection processes, including due diligence. Managers may generally refer to taxonomy criteria as a guide when developing their own bespoke, internal sustainability taxonomies, or more directly apply thresholds and metrics as they are set out in a taxonomy.
For example, one manager has generally referred to the EU Taxonomy to establish its own investment categorisation and due diligence processes, but does not commit to applying the taxonomy or its metrics in specific ways. Another manager takes a more specific approach and has committed to only invest in companies or assets that generate 50% or more of their annual turnover from activities identified in the Green Fin Label taxonomy.
Defining metrics and methodologies for monitoring and reporting purposes – asset managers are using taxonomy criteria to enhance ESG and sustainability-related monitoring and reporting to asset owners. Taxonomy criteria are used to set transparent KPIs to track, measure and report on sustainability topics, such as greenhouse gas emissions, on a portfolio-wide or an investment-specific basis. The resulting data can also be used to develop ESG or sustainability work plans for portfolio companies to improve performance on key topics.
For example, one asset manager tracks and reports both portfolio-wide CO2 emissions and the percentage of AUM invested in sustainable economic activities as defined in the EU Taxonomy. Another is tracking the carbon and environmental footprint of all portfolio companies and assesses their position against the EU Taxonomy.
Developing new taxonomy-aligned funds, investment strategies and policies – asset managers are capitalizing on the unprecedented interest in sustainable investment by strategically launching new products incorporating taxonomy criteria from the outset. New funds may be marketed as sustainable based on investment strategies and policies aligned with one or more taxonomies.
For example, one asset manager is now developing a sustainable fund with a “minimum EU Taxonomy eligibility target” that will focus on “certain sectors which are EU Taxonomy compliant.” Another is promoting a fund’s investment strategy focused on certain environmental objectives found in the EU Taxonomy as having “strong investment alignment to the activities defined under the EU Taxonomy”.
This analysis also shows that many asset managers are actively engaging with governments, other private sector players and international organisations through public policy avenues to join and guide the conversation as taxonomies rapidly develop. These avenues include participation in trade association working groups, consultation responses and direct engagement with public sector bodies.
The proliferation of taxonomies can benefit asset managers seeking to develop robust sustainable investment solutions, but this new landscape is not without its burdens.
Asset managers may encounter the following challenges when applying sustainability taxonomies:
Taxonomy fragmentation – the risk that “green” definition according to one taxonomy is not “green” according to another – must be monitored and addressed. This is particularly relevant for multinational asset managers seeking to apply national sustainability taxonomies to operations in multiple jurisdictions. As taxonomies proliferate, asset managers must ensure broadly applicable group-level frameworks are appropriately tailored for local regulations and circumstances.
There is a general lack of robust ‘brown’ or ‘transition’ taxonomies providing criteria and methodologies to help identify and incentivise companies operating in ‘brown’ sectors like oil and gas to transition to greener practices. Asset managers interested in investing sustainably in these sectors might consider developing their own internal ‘brown’ or ‘transition’ taxonomies.
Asset owners may expect or require alignment with certain “leading” taxonomies. As national taxonomies develop, it is important to note that expectations and requirements can be informed by regulation or policy in the asset owner’s home jurisdiction. For example, an asset owner headquartered in Europe may require its asset managers to incorporate or report on alignment with the EU Taxonomy, regardless of where an asset manager is headquartered. In this context, asset managers must engage their investors to understand their needs and respond accordingly.
Despite their challenges, taxonomies have the potential to significantly increase investor and other stakeholder confidence in sustainable investing by providing concrete, reliable definitions of sustainability principles, factors and activities.
Asset managers proactively addressing these challenges and effectively leveraging taxonomies in their own businesses can obtain a competitive advantage at a time when the market for sustainable products is rapidly expanding.
Most importantly, the end result of asset managers using taxonomies to develop more effective sustainable investing strategies is often a business delivering better outcomes for our planet and people.
This article was first published on Mayer Brown’s global ESG blog, Eye on ESG, by Mark Uhrynuk and Alexander Burdulia.