EMAlpha’s extensive coverage on EU Taxonomy

Among all the economic blocks globally, the European Union (EU) has been the most proactive in dealing with the challenges the world collectively is facing, in particular the challenge of ‘climate change’ which has been under focus for the EU. To address the issues related with damage to the environment and climate change, the European Commission has developed a classification system to provide more clarity to the companies on the economic activities in terms of where they stand on environmental sustainability.

This system is called EU Taxonomy and it has an objective to nudge the companies operating in the EU to report on and disclose how their business activities are aligned with the EU Taxonomy’s definition of what is sustainable and what is not. To the best possible extent, the EU taxonomy wants to create a level playing field for businesses in terms of how they report the information and relevant data. If done effectively, this will help investors in making better choices on the companies’ efforts to control damage to the environment.

EMAlpha has been actively tracking the major developments related with EU Taxonomy and we have also received a very encouraging feedback on our insights on EU Taxonomy. On the basis of many of our conversations, we realise that there is a very high level of interest among clients which include institutional investors and the companies which are making serious attempts to better understand this regulation. On EU Taxonomy, we have so far published.

• The next hurdle for EU Taxonomy may come as “requests for exemption”. Sweden’s Financial Supervisory Authority is already arguing that Sweden’s pension foundations should be exempted from the Taxonomy rules. It would be intriguing to see where the pendulum swings next. (EU Taxonomy: Will “Requests For Exemption” be the Next Challenge, 7th June 2021)
• As it happens with any deal involving multiple stakeholders who hold contrasting viewpoints on critical issues, developing a consensus is the biggest challenge. This was the case with EU Taxonomy too. Did ‘practical’ and ‘acceptable’ facet get precedence over what was ‘stringent’, ‘scientific’ and ‘effective’? (EU Taxonomy: Political Realities vs Positive Change, 13th May 2021)
• We discuss how the Coronavirus pandemic played a key role in shaping the thought process at the EU and how that may have impacted the EU Taxonomy proposed regulations. (EU Taxonomy: How the Covid-19 Pandemic triggered the April 2021 Package, 10th May 2021)
• It will be an understatement to make that the rapid developments in EU Taxonomy and the proactive stance of European Commission on Sustainability matters will alter the playing field for the companies in the EU, investment managers and investment advisors. (EU Taxonomy: The Game Changer for Sustainability Reporting and Investment Advice, 30th April 2021)

More challenges ahead for EU Taxonomy

There are already issues like lack of political consensus and requests for exemption that the regulation is struggling with, but the more serious challenges could emerge from the lack of popular support for EU Taxonomy. Although some states trying to find an escape route to exit due to internal pressure matters, what also matters is the ‘further dilution risks’ of the Taxonomy. The worst part is that if the EU Taxonomy proposals do not address the core issues in climate change, even the defenders might be repelled by the undertaking. From that perspective, some of the recent developments are concerning.

• On 9th June 2021, more than 90 environmental and consumer groups appealed to the European Parliament to do a rethink on logging and the burning of trees to be counted as green investments and hence, postpone their judgement on sustainable finance rules that would allow these activities.
• In an open letter, organisations such as BirdLife Europe, WWF and BEUC made this request. The letter highlights that the respondents asked for a science-based taxonomy. But intense lobbying by countries like Sweden and Finland has ensured that the science-based criteria be replaced by lobby-based approach for these sectors.
• The main argument is that the standards for forestry and bioenergy classify the burning of trees, clearcutting of forests, intensive mono-species plantations, use of chemical fertilisers and pesticides in forestry as “green” activities. This is hardly the ideal situation in order to protect the environment.
• This is very similar to the Civil Society Statement which talked about, a) Economic activities that were rightly excluded and should not be re-included (Fossil fuels including gas, Incineration), b) Economic activities to be improved with tighter criteria (Bioenergy, Hydropower, Forestry, Inland water transport, Biofuels and biogas use in transport, Hydrogen), and, c) Economic activities to be removed from the EU sustainable taxonomy (Sea and coastal water transport, Livestock).
• You Move Europe, an independent organisation that runs campaigns on behalf of people is currently running a petition ‘The EU must protect forests, not burn them for energy’ which urges EU policymakers and EU Member States to, a) end subsidies and other incentives for burning forest wood and redirect this critical support to energy efficiency and true low-emissions renewable energy sources, b) exclude energy generated from burning forest wood from counting toward renewable energy targets. It has already been signed by 237,272 participants (as on 23rd June 2021, 9am GMT) and plans to reach 300,000.
• There are also several organizations which claim that EU Taxonomy is hardly sufficient to fight the threat of climate change and many of them have even went to the extent of saying that the EU taxonomy itself is “greenwashing” because it is postponing decisions on several controversial issues including the status of economic activities like gas-based energy, nuclear power and forestry.
• On 21st June 2021, Greenpeace released an independent study claiming that Sustainable funds fail to redirect capital into activities that meet environmental, social and governance (ESG) criteria and there is a need for stricter sustainable finance rules. Inrate in its study analysing 51 sustainable funds available in Luxembourg and Switzerland, studied the capital allocation of these funds and also the funds’ ESG impact score, carbon intensity, revenue derived from critical activities and environmental controversies related with portfolio companies.

Multi-dimensional ‘pulls’ and ‘pressures’

There are also other areas where the European Commission faces tremendous pressure from industry lobbies to dilute the provisions under EU Taxonomy.

• There are reports that the Biofuel makers are protesting against EU taxonomy as the Biofuels made from food-and-feed crops do not meet the EU’s green taxonomy criteria. The EU Taxonomy proposals will make it difficult for the EU to meet green transport goals, as per these Biofuel makers. We think that since some of the more controversial industries have gotten away without much repercussions, many other industries might be tempted to think that the norms should be relaxed for them too.
• There have also been concerns over proposed disclosure rules in terms of scope of the disclosure, data availability and timing according to representative of banks and asset managers. The primary grievance, it seems is that the ‘cost-benefit analyses’ has not been carried out diligently and while the compliance burden would increase significantly for the banking and asset management industry, the benefits for ‘climate change’ risk mitigation are not very clear.
• Then there is competition for EU Taxonomy as many other countries are working on their own versions of regulation. Among all, UK’s green regulation is going to be a serious contender as the UK has already begun the process of creating its own local yet better versions of the EU’s sustainable finance regulations. It certainly can take the best practices from EU Taxonomy and get a little bit more stringent on some of the more controversial topics to present the UK Taxonomy as a better alternative to EU Taxonomy.
• There is also criticism of EU Taxonomy on its excessive focus on environmental issues and risks associated with climate change. While the sustainable finance initiatives and economic activities have an important role for environmental topics, the social and governance part can’t be ignored either. There are reports which call for more balance in EU Taxonomy among the environmental, social and governance parameters.

Civil Society vs. Industry and Political compulsions

EU Taxonomy is currently between a rock and a hard place. If industries see the compliance with these regulations as cumbersome or if industries realize that the EU Taxonomy will have a significant negative impact on their businesses, they will be apprehensive. It is possible that some of these fears might be totally irrational but if in their initial assessment, these industries think that the EU Taxonomy could damage them, either by making them less competitive or by impacting their profitability; they will lobby hard against the Taxonomy.

There is also support for the local industry from the political class which is natural. The administration has to take care of local interests. Industry pressure and resistance from political class means that there will be some dilution in the stringent proposals under EU Taxonomy. However, at the same time, while many of the NGOs and Civil society members may also be arguing on some of the less important issues, not everything that they have highlighted can be ignored if EU Taxonomy has to make a real difference in the EU’s fight against climate change. The viability of proposal and a pragmatic approach is required but allowing some of the obvious environmentally damaging activities and going against the ‘scientific evidence’ will be disastrous for EU Taxonomy.

How EMAlpha can help?

While the European Commission need to incorporate concerns of stakeholders, there will also be a need for a solution which looks at a more detailed classification for industries and sectors. At EMAlpha, we have incorporated a Flexible Framework Management System, based on EMAlpha’s proprietary technology 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 most critical issues. 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 make the clients understand the granular details better which in turn is helpful for them to understand their preferences better. To achieve this, we focus on the following;

• Go beyond the official reported version – The data source matters and there is a need to look beyond what the companies are reporting and what the official version is. It is essential to rely on the company reported data because other sources might not be collating as much information. Although often, there are other sources as well for environment related information. They include the information disclosure as mandated by regulators and the EMAlpha algorithms scan through unstructured data to pick the unofficial information too.
• No two ESG scores are same despite same headline figure – It is the composition that makes a big difference and all the three parameters that make up ESG need to be evaluated separately. The EMAlpha algorithms provide separate scores for E, S and G so that an investor can review the sectoral performance more transparently. Over and above, a key feature of EMAlpha’s NLP algorithms is that the attribution analysis is fairly simple and straight forward.
• An ESG score without context and background is meaningless – The ESG 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 very good ESG track record (probably more driven by excellent performance in E and/or S) may hide serious Governance related risks and the investors can only ignore them at their own peril. EMAlpha analysis meticulously incorporates this critical part of the ESG evaluation jigsaw puzzle.