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Implementation of EU ESG taxonomy in 2020 will set up clear and defined rules for the entire region, which many asset managers in Asia and elsewhere will want to comply with
When it is implemented in 2020, the European Union’s (EU) taxonomy on environmental, social, and governance (ESG) will be the first time 28 countries belonging to a common area will have clear and defined rules on ESG investing and transitioning to a low-carbon economy. This is likely to put pressure on Asia and the US to do the same otherwise their asset managers and asset owners may be marginalized.
The main issue with ESG investing is that at present, there is a lack of common standards for defining it. The “Taxonomy on Sustainable Finance” issued by the EU on June 18 brings ESG investing one big step closer to this goal.
The taxonomy has its roots when the EU started its ESG journey following the Paris Agreement within the United Nations (UN) Framework Convention on Climate Change, dealing with greenhouse-gas-emissions mitigation, adaptation, and finance. The agreement was adopted by consensus on December 12 2015.
The long-term goal of the Paris Agreement is to limit the increase in global average temperature to 1.5°C since this would substantially reduce the risks and effects of climate change.
Following the Paris Agreement, the EU wanted to transform its economy into a low-carbon economy. To achieve this, EU members agreed to adopt the Sustainable Development Goals (SDGs), a set of 17 global goals set by the UN General Assembly in 2015, with the target of achieving these goals by 2030.
To implement the SDGs, the EU Commission, its executive branch, adopted an “Action Plan on Sustainable Finance” on March 2018 as part of a strategy to integrate environmental, social and governance considerations into its financial policy framework and to mobilize financing for sustainable growth. This action plan will become the basis for a new regulatory framework on ESG for the financial sector.
On June 2018, a Technical Expert Group (TEG) with 35 members from civil society, academia, asset managers, and asset owners was put together to provide a broad representation. The TEG is tasked with producing the framework for the action plan by the end of 2019.
The objective is that with this framework, the EU will be able to attract between 175 and 290 billion euros (US$196.15 billion and US$325 billion) extra in private investments to finance the transition to its low-carbon economy.
On June 18 2019, the EU Commission published guidelines to improve how firms report climate-related information as part of its Sustainable Finance Action Plan. These guidelines will provide companies with practical recommendations on how to better report the impact that their activities are having on the climate as well as the impact of climate change on their businesses.
On the same day, the TEG also published three “expert reports.” The first is a classification system – or taxonomy – for environmentally-sustainable economic activities.
The second expert report, on an EU Green Bond Standard, recommends clear and comparable criteria for issuing green bonds.
The third expert report is on EU climate benchmarks. It sets out the methodology and minimum technical requirements for indices that will enable investors to orient the choice of investors who wish to adopt a climate-conscious investment strategy, and address the risk of greenwashing.
This article focuses on the taxonomy which is a classification tool designed to help investors and corporates identify low-carbon economic activities. The concept of the taxonomy is that when investors start to align their portfolios more with low-carbon activities, it will transition the European economy towards the target of achieving net-zero CO2 emissions by 2050.
On June 18, three drafts of the taxonomy were published containing information about a wide range of issues including climate mitigation, agriculture, renewable energy, transport, water, waste management, and buildings.
The drafts, consisting of 400 pages, have been widely distributed among all the EU stakeholders for feedback. The objective is to come up with a final draft that will be acceptable to all stakeholders by the end of 2019.
One important thing that makes the taxonomy and new regulations relevant to Asian and other non-European asset managers and investors is that it will require the increased disclosure and transparency of their portfolios.
This means that any Asian and other non-European asset manager or investor who wants to do business in the EU has to make their portfolio more transparent to comply with the taxonomy and new EU regulations even if these are not yet required by the regulators in their home countries.
The EU is effectively using increased disclosure as a tool for measuring how portfolios are positioned to achieve its goal of a low-carbon economy.
“Transparency is a very powerful tool as we all know because it’s going to be very difficult to hide. When regulators adopt this new regulation, they will be demanding disclosure from all the asset owners based on new criteria, for example, the CO2 footprint of your portfolio. This will be a game-changer in how large investors will position their portfolios,” says Pieter Furnee, global head of sustainable investing, DWS.
Another thing that makes the taxonomy and the action plan of interest to Asian and non-European investors is that their introduction will redefine the concept of “fiduciary duty” of asset managers and asset owners. In the past, “fiduciary duty” was often presented as an excuse by asset managers and owners for not taking ESG-related action on the portfolios that they manage.
But according to a study by the Principles for Responsible Investment (PRI), “fiduciary duty” is not the obstacle to incorporating ESG issues into investment processes that it is commonly assumed to be.
Though regulatory authorities generally do not take a view on whether or not asset owners should invest in particular sectors or activities, they do expect asset owners to be aware of and to manage ESG risks, and to pay close attention to decisions that lead to skews in portfolios. Regulatory authorities will tend to look closely at investment decisions that expose funds to particular risks (eg. a high-carbon portfolio or a portfolio with a weighting to renewable energy) and will expect them to explicitly assess the implications for the overall risk profile of the fund, according to the PRI.
The EU taxonomy and action plan will make it much easier for regulators to assess and monitor how asset owners and asset managers position their portfolios, their level of awareness on ESG risks and issues, and how they manage these risks.
Although it’s still a draft, there is also a provision in the taxonomy that will make it mandatory for a sustainable portfolio to be the default portfolio for investors although they can have the option to choose a traditional/non-sustainable portfolio (as their default portfolio) if they want to. This is not the case at present.
“This would mean that asset managers and other intermediaries who are advising private clients have to provide a sustainable portfolio as a default option though clients can choose to opt out for a traditional portfolio. This is completely different from what it is today. If this is all adopted into law, this could be quite a big change,” Furnee says.
In terms of global impact, the EU’s ambition of moving to a low-carbon economy will effectively become a tool for measuring how asset managers and asset owners have to position their portfolios in the future when the taxonomy is implemented.
Essentially, what will happen is that regulators in EU member countries will implement the new regulations which European asset managers and asset owners will have to comply with. The regulators will be demanding more transparency and greater disclosure to determine whether the asset managers and owners comply with the new taxonomy and regulations. Likewise, non-European asset managers and owners who want to invest in Europe will have to comply.
It also means that Asian and non-European asset managers and asset owners who are seeking European investors have to offer assets that comply with the taxonomy and new regulations.
Asian and non-European asset owners and managers who do not wish to comply with the new regulations can simply seek to invest in other non-compliant assets. While there will always be assets that will be available to investors who may not wish to comply with the new EU regulations, Europe still accounts for a huge chunk of the global asset management market and cannot be ignored.
Assets managed in Europe reached a record high of 25.2 trillion euro in 2017, according to EFAMA. This amounts to 40% of the 63.3 trillion euro in assets managed by the top 400 asset managers worldwide in 2017, according to IPE.
“All asset managers who want to target or are already targeting these EU clients need to change the way they design their strategies, the way they disclose how these portfolios are managed,” Furnee says.
Also, there is a strong possibility that once implemented across the EU, the taxonomy can become the basis for the global standard for ESG investing because the huge size of the asset pool will push all global asset managers to adhere to these new rules.
In due time, these EU standards will be exported to Asia and the US. Asset managers and owners who do not wish to comply may be effectively marginalized in due course.
Following the consolidation of all the drafts by the end of 2019, the taxonomy is scheduled for implementation in 2020. It is not yet clear whether the implementation will be done in phases or through a “big bang” approach. What is known is that each EU member country will have to adopt the taxonomy into their local ESG regulations.
Also, in theory, the taxonomy can only work when companies start to report and publish their own sets of ESG data. While many of the larger European corporates are already doing this, there is still a lot of work to be done across all sectors especially in the mid-cap and small-cap spaces.
For this to happen, stock exchanges and regulators across Europe will have to require the reporting and disclosure of ESG data by all corporates so that asset owners and asset managers will have the needed information for making ESG investing decisions.
It remains to be seen how soon this will happen but when it does it is likely to change the way investment is done in a big way.