By: Anne Schoemaker, Associate Director, Product Strategy and Development, Sustainalytics

On May 7th, the European Commission published draft rules on how corporates and financial institutions should report on their alignment with the EU Taxonomy. The draft rules are a very technical document and not an easy read. This might explain why certain changes with significant impact on timelines and scope of the EU Taxonomy Regulation have flown under the radar of media and investors. Some of the impacts even escaped the attention of financial market participants responding to the consultation on the rules.

Our dedicated team at Sustainalytics is closely following the developments to uncover some of the most significant issues:

Implementation of the EU Taxonomy is delayed by a year, but the timeline misalignment for financial institutions has not been solved.  Corporates and financial institutions will have to abide by certain requirements by 2022, but mandated reporting on Taxonomy alignment will only start in 2023 under the current proposals. While this gives the market some reprieve in terms of preparation time, it does not solve the timing mismatch issue where corporates will start reporting in 2023, while asset managers would be required to begin reporting at the same time, but without the necessary reported data. Reporting by financial institutions would only include European large caps. Only reported data by corporates in the scope of the Non-Financial Reporting Directive would be allowed to be used by financial institutions to report their Taxonomy alignment. In other words, all other entities, such as EU mid and small caps, and non-European companies, must be excluded from the calculations for the next few years, even if these companies voluntarily report in line with Taxonomy requirements. This would lead to exceptionally low Taxonomy alignment numbers. The alignment target was already intended to be lower in the coming years because of a lack of investments with existing Taxonomy alignment in place. But by excluding all non-EU companies, the expected volumes of sustainable funds could drop further as most fund managers are invested globally.Estimates appear to be no longer permitted. There is no explicit mention of allowing for estimations for portfolio companies that don’t report on their Taxonomy alignment, but when looking at the rules carefully, it seems that reporting by asset managers only need to include data reported by corporates. While the European regulators’ proposal from earlier this year still allowed for coefficients or estimates on non-reporters, these now seem to be scoped out of the Taxonomy KPIs entirely.Government bonds are entirely out of scope. There is no Taxonomy for sovereign issuers yet, possibly because this is politically highly sensitive. The Commission proposes that asset managers leave sovereign issuers out of their numbers entirely, which may lead to distorted alignment numbers.

The recommendations made in 2020 by the Technical Expert Group and the proposals made by the European Supervisory Authorities in recent months were substantially different on most of these points, and it is unclear what brought the Commission to deviate so strongly this late in the process. Most likely, the widespread concerns around data availability led the Commission to reconsider the scope of application of the regulation.

It is also conceivable that Europe reconsidered exporting its regulation to other countries. European investors would have likely put pressure on non-European companies to start reporting Taxonomy numbers, but under the current proposals, there is no incentive for non-European companies to do so in the near term. A negative consequence of excluding non-European companies from Taxonomy reporting on funds in Europe could be that fund managers seeking to increase their Taxonomy alignment might favor a European cement manufacturer with 5% alignment, for example, over a US-based solar power company with 90% alignment. This would not ultimately promote capital flow to sustainable investments, one of the key goals of the EU Sustainable Finance Action Plan.

Another reason for the change in scope of application could be to avoid corporates having to report under multiple taxonomies in the future. Several countries, including the United Kingdom, Canada, Malaysia, and others, are in different stages of developing their own taxonomies. The International Platform on Sustainable Finance, set up by Europe and co-chaired with China and intended to harmonize and streamline sustainable finance issues between nations, may have pushed back on the EU Taxonomy becoming the de-facto standard. The Platform may be preparing for a patchwork of taxonomies with companies reporting under local taxonomy—many of which will be inspired by, if not primarily based on the EU Taxonomy. It will be a few years before this could be a reality, and until then, EU Taxonomy reporting may not be much more than a burden rather than a tool to stimulate environmentally sustainable investments.

By early July, the European Commission is said to be announcing several new plans, reports, acts, and answers to outstanding industry questions on the Taxonomy Regulation and the Sustainable Finance Disclosure Regulation. The exact scope of this package is not yet clear, but the market is craving more clarity on imminent regulatory obligations that will have significant investment impacts in the coming years.

About the author:

Anne Schoemaker leads the product strategy and development of EU Taxonomy and Sustainable Finance Action solutions for Sustainalytics’ investor clients. Anne transitioned into ESG and the development finance sector after starting her career in asset management.

About Sustainalytics

Sustainalytics, a Morningstar Company, is a leading ESG research, ratings and data firm that supports investors around the world with the development and implementation of responsible investment strategies. For more than 25 years, the firm has been at the forefront of developing high-quality, innovative solutions to meet the evolving needs of global investors. Today, Sustainalytics works with hundreds of the world’s leading asset managers and pension funds who incorporate ESG and corporate governance information and assessments into their investment processes. Sustainalytics also works with hundreds of companies and their financial intermediaries to help them consider sustainability in policies, practices, and capital projects. With 16 offices globally, Sustainalytics has more than 1000 staff members, including more than 350 analysts with varied multidisciplinary expertise across more than 40 industry groups. For more information, visit www.sustainalytics.com.

The post Sustainalytics Weighs in on EU Taxonomy’s State of Flux appeared first on ESG Today.