The requirement is part of the European Sustainable Finance Disclosure Regulation (SFDR). It aims to ensure that more capital flows towards sustainable investments and that investors can adequately assess the sustainability of, for example, an investment fund. Sustainable funds labelled as SFDR article 8 or 9 – article 9 funds having a clear sustainable objective and article 8 funds taking ESG criteria into account – are facing an enormous challenge, says Kuiper.
Sustainable funds must demonstrate the extent to which the business activities they invest in align with the framework of green activities in the Taxonomy. "This is a good thing because it is important to prevent greenwashing and to offer transparency to sustainable investors. But, unfortunately, the implementation of the EU Taxonomy comes in fits and starts, which can lead to counterproductive effects."
Kuiper gives some examples: company data is not yet sufficiently available which can lead to distorted sustainability scores, some environmental activities are not yet final, and a social Taxonomy is still to be developed. "We, therefore, doubt whether the main objective - more capital flowing into sustainable activities - will be achieved in first instance. However, we are not in favour of postponing this measure. On the contrary, we would rather take this important next step towards making our economy more sustainable and limiting climate change. But it does mean that sustainable funds have something to explain to their investors."
A major stumbling block: the EU Taxonomy is not yet finalised
The EU Taxonomy determines which economic activities, specified by sector, are sustainable. The European legislator distinguishes six environmental objectives, each covering dozens of activities. The first two of them are climate change mitigation and adaptation. The other environmental goals include, amongst others, transitioning to a circular economy and pollution prevention and control.
"At the moment, only the first two goals have a completed activity classification," says Nikkie Pelzer, impact manager at Triodos IM. This can lead to a considerable distortion when looking at the percentage of a portfolio that is sustainable according to the Taxonomy. For example, a sustainable fund with limited exposure to renewable energy but significant exposure to other environmental objectives of the taxonomy that still lack a classification, will currently have an unexpectedly low score in the perception of investors."
In Triodos’ portfolios, for example, sustainable agriculture is strongly represented, Kuiper says. "Here, topics such as biodiversity and pollution prevention play a major role. We hope that we will be able to include these issues next year, but that depends on the finalisation timelines of the Taxonomy."
Meanwhile, funds that invest in gas or nuclear may even score higher than truly sustainable funds because these activities fall within the European sustainable framework as of June this year. Pelzer: "Triodos IM was strongly opposed to this. We are in favour of a more scientifically based taxonomy. For various reasons, gas and nuclear do not fit into the sustainable economy we need to move towards."
Implementing the rules is a significant challenge
The Taxonomy describes whether an activity contributes to one of the six goals. Moreover, an activity that supports one of the goals may not harm any of the other five goals. Finally, a minimum safeguards assessment needs to be performed on procedures to comply with OECD Guidelines for multinational enterprises and the UN guiding principles on business and human rights.
The reporting requirements for sustainable funds are substantial, Pelzer continues. "This is also a challenge for us, although we have already integrated sustainability into every step of the investment process. However, different requirements apply to each activity and especially for small organisations these are not always feasible nor meaningful. At Triodos IM a substantial team is working on the implementation almost full time."
Another problem is that the whole exercise depends on sound business data. Large companies will only start reporting this data from next year onwards, whereas small and medium-sized companies fall outside the obligation for the time being. The same goes for companies outside Europe which is challenging in relation to investments in developing countries and emerging economies. Besides the scope and timelines of reporting, there is a data problem with government bonds. Many issuing countries still offer too little concrete information, so investors cannot compare the bonds with the sustainable activities in the Taxonomy. A portfolio containing only green bonds may therefore still receive a low sustainability score.
No level playing field with mainstream funds
An additional issue is that grey, conventional funds – which fall under non-sustainable article 6 funds in the SFDR – do not have to make the additional reporting efforts, for instance for the Taxonomy. Pelzer: "Their reporting effort is considerably less. This explains why you now even see sustainable funds opting for article 6, leading to green bleaching. That's the world upside down."
The reporting obligations come with higher costs for sustainable funds. Kuiper: "The audit costs alone are expected to be up to six times higher because you have to prove that you are sustainable according to SFDR article 8 and 9 and fulfill the requirements of the Taxonomy. This leads to a disproportionately high cost-pressure for sustainable funds. Non-sustainable funds will have a cost advantage. Isn't that the opposite of what this legislation was intended for?”
In this light, Kuiper advocates making at least the lower limit of the legislation - being transparent about the broad, negative impact of a portfolio on people and planet - mandatory for all mainstream funds as well. And, if we aim to be fully transparent, there should also be a brown Taxonomy on which all financial market participants should report. "It seems to me that all investors should know whether their investments are causing serious harm to people and the environment."