EU Taxonomy: The Game Changer for Sustainability Reporting

As per European Commission, “the EU taxonomy is a classification system, establishing a list of environmentally sustainable economic activities. The EU taxonomy is an important enabler to scale up sustainable investment and to implement the European Green Deal. Notably, by providing appropriate definitions to companies, investors and policymakers on which economic activities can be considered environmentally sustainable, it is expected to create security for investors, protect private investors from greenwashing, help companies to plan the transition, mitigate market fragmentation and eventually help shift investments where they are most needed”.

On 21st April 2021, the European Commission announced a comprehensive package of measures to make the financial sector more sustainable. The twin objectives were,

a) The Investors, Citizens and Investment Managers would be able to re-orient their investments towards more sustainable businesses,

b) The Businesses would have access to new sources of funding through global capital markets.

The major steps in the 2021 Package include,

a) The New Corporate Sustainability Reporting Directive which would ensure that companies provide consistent and comparable sustainability information,

b) Six amending Delegated Acts to ensure that financial firms, such as advisers, asset managers or insurers, include sustainability in their procedures and their investment advice to clients.

The Catalyst behind the Change: Covid-19 Pandemic

In its report Statement of the EU Technical Expert Group on Sustainable Finance (TEG): 5 high-level principles for Recovery & Resilience on 15th July 2020, EU Technical Expert Group on Sustainable Finance (TEG) has written: COVID-19 will not be an isolated pandemic. The crisis has its roots in pathogens transferring between species in degraded ecosystems. Climate change and biodiversity loss are key drivers of environmental stress. Given the increasing pressure on our environment triggered by climate change and biodiversity loss, experts are warning that we should expect more pandemics. This pandemic is the first of what is likely to be a century of shocks related to environmental degradation.

As per TEG, the suggested principles for Sustainable Recovery and Resilience are;

• Plan a recovery that focuses on Building Back Better
• Build resilience into everything, so we are better prepared for a volatile future
• Ensure that recovery investments, grants and spending at least do no harm
• Apply all these measures to both private and public sectors
• Collaborate internationally to better serve resilience

All of this was linked by TEG to how the Taxonomy framework could help. The premise is that the EU Taxonomy Framework will impact the quantity of spending and investments, resulting in a substantial contribution. These investments which are contributing to sustainable finance, in line with the Taxonomy criteria and framework, should be prioritised provided the companies and investors adhere to them. The link between the Taxonomy and Green Recovery is that the EU Taxonomy was designed to help direct finance to support a sustainable investment system. This is because the EU Taxonomy has been precisely tailored to identify investments that can drive delivery of the EU’s environment and climate objectives.

Coronavirus pandemic was not just a Health or Economic crisis for the EU

With EU Taxonomy, the TEG’s opinion was that all investments need to consider issues of adaptation and resilience in the face of a rapidly changing climate and its increasing impacts. The TEG went a step further and said that this crisis was a reminder that we also need to be aware of Social, Economic and Ecological resilience factors and need to address those to be better prepared for future climate shocks. Accordingly, we must reduce the risk of extreme climate change with measures to reduce emissions. Granted, all these are necessary and noble thoughts but how the EU Taxonomy shall become an all-encompassing solution and more importantly, which are the areas where it can encourage investments. The following are the primary objectives that have been identified:

• Social resilience: Activities that enable social cohesion and co-operation and ensure that the most vulnerable are able to access social and health systems. This crisis has taught that building resilience to climate change and other shocks has to include health system resilience. Health systems need to be able to scale up quickly for future pandemics.
• Economic resilience: To effectively and efficiently handle any future situations like today’s, jobs need to be created in sectors that contribute the most to a more sustainable and resilient economy. There is massive opportunity for job creation in sectors such as energy efficiency, distributed solar power, afforestation and environmental remediation.
• Ecosystem resilience: Challenges like the current pandemic need to be fought with a holistic approach and a focus on healthy ecosystems is needed to reduce the risk of future pandemics. That will mean protecting and rebuilding natural capital and biodiversity in Europe while mitigating climate change to minimize climatic impacts on ecosystems.

How the thought process reflects in the April 2021 package

At EMAlpha, we have been tracking the major developments on the initiatives that the European Commission is taking to address the challenges especially on Climate related issues. For the April 2021 package which has been proposed and its linkages with previous proposals, we have looked at the major components and their implications. It is absolutely clear that what the European Commission has proposed will have an impact on all the companies, investors, advisors and other stakeholders. We also think that whatever happened globally in 2020 and so far in 2021, with some European countries getting devastated in the first half of 2020 by the pandemic, has an important role to play in shaping the EU’s thought process on Taxonomy;

• The Companies in the EU – The EU wants to expand the scope of coverage on the maximum possible number of companies that could be brought under the purview of new regulation, as per the proposed EU Taxonomy changes. Now, the onus will be on these companies to report sustainability information which would be of help to the investors. Going forward, there will be nearly 50,000 companies in the EU that will need to follow the detailed EU sustainability reporting standards, compared to the current 11,000 companies. Getting more companies to consider the Sustainability issues will be important towards making a positive impact and that is what the EU is trying to achieve.
• Investment Advisors – Changing the end-consumer’s behaviour, who in this case would be the investors, is always the most critical and important input because they are the source of fund. Since it is not feasible to reach out directly to the investors, numbering in millions, changing the way the investor advisors operate is essential. As per the April 2021 package, when an adviser assesses a client’s suitability for an investment, they will, from now on, also need to discuss the client’s sustainability preferences. As a result, the EU based investment advisors will also need to educate their clients on important sustainability considerations and how they can be achieved. Even a small beginning wherein thousands of these investment advisors, who talk to millions of investors, can help in spreading awareness on these issues.

How EMAlpha can help

The deadly Coronavirus pandemic has brought the need for Sustainability to be incorporated into the business operations for companies and the EU has taken a lead in ensuring that this opportunity doesn’t go waste. With the pandemic acting as a trigger, it is critical that the entire ecosystem thinks holistically about these issues. It is ironical in some ways that the Sustainability and ESG (Environmental, Social and Governance) issues have been more actively talked about as a result of this global health emergency. But if this leads to positive and sustainable change, the trouble that the world has gone through will, in the very least, amount to something.

The rapid developments in the EU Taxonomy and proactive stance of the European Commission on these Sustainability matters will completely alter the playing field for the companies in the EU, the investment managers and the investment advisors. Under the circumstances, there will be a need for a solution which not only will help the companies in effective and efficient reporting but also will help the investment advisors in educating their clients to better understand their sustainability preferences and the priorities they have.

At EMAlpha, we have always believed in the premise that for any product to work better for a client, ‘more power to user’ should always be the core principle that we must adhere to. Hence, we have incorporated a Flexible Framework Management System that is based on EMAlpha’s proprietary technology, thus making inferences framework agnostic. This also offers a quick adaptation for the users (both companies and investment advisors). As such, the EMAlpha’s ESG and Sustainability offering is centred around addressing some of the very critical issues as follows;

1. There is an unmanageable amount of subjectivity in what matters for individual investors when it comes to their sustainability objectives and it often becomes a confusing proposition. As always, it is the composition that makes the big difference and hence it calls the need for all the parameters that make up the EU Taxonomy to be evaluated separately. This is the core feature of EMAlpha’s product.
2. The EMAlpha algorithms provide a choice for separate relevant frameworks and these can be used to review the performance more transparently. This not only helps the investment advisors but also makes the clients understand the granular details which in turn is helpful for them to understand their preferences better.
3. A key characteristic of EMAlpha’s NLP algorithms is that the attribution analysis is fairly simple and straight forward. Investors need to be very careful in differentiating between actual improvement and progress which is balanced vs. fake and dishonest attempts like ‘greenwashing’ and disproportionate focus on one particular part in an unbalanced way.
4. The Sustainability is as much about intent as it is about execution. For this balanced evaluation, having an understanding of the local factors is very crucial. A good track record (probably driven more by excellent performance in certain areas) may hide serious lapses elsewhere and the investors can only ignore them at their own peril. EMAlpha analysis meticulously incorporates this critical part of the evaluation jigsaw puzzle.
5. EMAlpha has transparent and attributable ESG dictionaries which provide complete clarity on why a particular company ends up with a certain score. This is completely opposite to a ‘black box’ model widely prevalent in the market and in which the user has ZERO control or understanding of either input or output.

While it is easy to see the advantages of a flex framework and a transparent, attributable process, the important question to ask is that how does this help the user?

1. Quick mapping to any new framework allows for easy development of framework specific NLP tools and analytics. No more huge switching costs for the users.
2. For the investment advisors, ‘time taken to go to market’ leads to costs and significant loss of opportunity. EMAlpha Flex framework offers approximate 75% reduction in time to market.
3. EMAlpha product cuts down drastically human involvement and consequent bias in ESG score development. While machines can’t be allowed to run totally unsupervised, too much tinkering is bad and sub-optimal for results.