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EU Taxonomy: The Game Changer for Sustainability Reporting and Investment Advice

Synopsis: Among all the economic blocks showing an inclination to fight the global sustainability challenges, the EU has been the most proactive. The immediate priority of the EU’s actions is to make Europe climate neutral by 2050. The European Commission believes that at the very basic and fundamental level, Sustainable Finance is about re-orienting investment towards sustainable technologies and businesses. This is where EU Taxonomy plays an important role. The EU taxonomy is a classification system, establishing a list of environmentally sustainable economic activities. In a 21st April 2021 press release, the European Commission announced a comprehensive package of measures which include, a) The EU Taxonomy Climate Delegated Act which will classify the activities that best contribute to mitigating the effects of climate change, b) The new Corporate Sustainability Reporting Directive which will ensure that companies provide consistent and comparable sustainability information, and c) 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. These steps taken by the European Commission have major implications for EU based Corporations, Investment Advisors and Investment Managers.

It will be an understatement to say that the rapid developments in EU Taxonomy and the proactive stance of European Commission on 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 on understanding their Sustainability preferences and the priorities they have. At EMAlpha, we have always believed in the premise that for any product to work meaningfully for a client, ‘more power to user’ should always be the core principle we must adhere to. Hence, we have incorporated a Flexible Framework Management System that is based on EMAlpha’s proprietary technology which makes 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 these very critical issues.

EU: The Front-runner in dealing with the Challenges the Planet faces

Among all the economic blocks, the EU has been the most proactive. Primarily because of political consensus, relatively low disparity in economic and cultural factors, along with an elevated sensitivity towards environmental issues, the EU has been making the sincerest effort towards tackling the sustainability challenges. It is moving forward with a well thought out and well-coordinated plan. And this requires looking beyond petty political bickering and an inclination on richer nations’ part to take everyone along. The EU leaders have been able to do this very successfully.

The idea and the immediate priority behind EU’s efforts is to make Europe climate neutral by 2050 and the EU is backing its plan with action. By firmly and decisively directing the flow of investments, which in turn is important for achieving the desired objectives in tangible terms, the European Commission has adopted a set of measures to help improve the flow of capital towards sustainable activities across the European Union. A real difference can be made by enabling investors to re-orient investments towards more sustainable technologies and businesses. Needless to say, once done, all of this will make the EU a global leader in setting practical global standards for sustainable finance.

Enter EU Taxonomy

The European Commission believes that at the very fundamental level, Sustainable Finance is about re-orienting investment towards sustainable technologies and businesses and hence, it is an essential part of the European Green Deal, the core plan to achieve climate neutrality by 2050. The European Commission believes that major public and private investment is needed to make financial system sustainable. And this is where EU Taxonomy plays an important role. Because it is the basic fundamental over which this entire premise of promoting Sustainable Finance in EU is built.

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.

The European Commission also believes that EU Taxonomy is a practical, scientific and evidence-backed tool that provides market participants, investors and companies with a common understanding of green economic activities: activities that make a substantial contribution towards mitigating the climate change impact and help in protecting the environment. To ensure that there is alignment between what the stakeholders are reporting and what they are actually doing, the purpose of this EU Taxonomy classification system is also to avoid greenwashing. Greenwashing is a major challenge for assessing the actual quality of claims and is equivalent to making an unsubstantiated claim, intended to deceive regulators, stakeholders, investors and consumers into believing that a company is more environment-friendly than it truly is. And this has become an important challenge to deal with in recent times.

The road so far for EU Taxonomy

In 2018, EU had launched a sustainable finance action plan which set out a list of actions to ensure that the financial system supported the EU’s climate and sustainable development agenda. The major milestones have been:

  • July 2020 – The Taxonomy Regulation entered into force on 12 July 2020. It created the “green list” – a classification system for sustainable economic activities.
  • December 2020 – The Climate Benchmarks Regulation which commenced on 23 December 2020, increases transparency and the disclosure of sustainability information, making the comparison of different financial products easier.
  • March 2021 – The Sustainable Finance Disclosure Regulation (SFDR) came into effect on 10 March 2021. It aims to trigger changes in behavioural patterns in the financial sector, discouraging greenwashing, and promoting responsible and sustainable investments.

The European Commission announcement of April 2021

On 21st April 2021, the European Commission announced a comprehensive package of measures to make the financial sector more sustainable. The twin objectives are, a) the Investors, Citizens and Investment Managers will be able to re-orient their investments towards more sustainable technologies and businesses, b) the Businesses will have access to new sources of funding through global capital markets and the financial sector worldwide.

The major steps in the 2021 Package include:

  • The EU Taxonomy Climate Delegated Act will classify which activities best contribute to climate change mitigation and adaptation.
  • The new Corporate Sustainability Reporting Directive will ensure companies provide consistent and comparable sustainability information.
  • Six amending Delegated Acts will ensure that financial firms, such as advisers, asset managers or insurers, include sustainability in their procedures and their investment advice to clients

Why this matters for companies, investors, advisors and other stakeholders?

The new proposals under the April 2021 package have far reaching implications with an increase in compliance requirements. The proposals can be divided into different categories in terms of how they will impact different set of stakeholders.

  • New Corporate Sustainability Reporting Directive (CSRD) – This ensures that the companies report reliable and comparable sustainability information that the investors need. All large companies and all listed companies, except listed micro-enterprises will need to comply i.e. Nearly five times more companies in the EU will now need to follow detailed EU sustainability reporting standards, as compared to 11,000 companies subject to the current requirements. The CSRD proposal was adopted by the European Commission on 21 April 2021.
  • EU Taxonomy Climate Delegated Act – This is to help companies and investors make sustainable investment decisions. The Taxonomy Climate Delegated Act defines criteria to help determine what can be considered as Taxonomy. It lists a number of economic activities (e.g., manufacturing, buildings, etc.) and sets criteria to determine whether each activity can be considered to make a substantial contribution to climate change mitigation and climate change adaptation and to not cause significant harm to environmental objectives. The Delegated Act has been adopted by the Commission on 21 April 2021 and applies from 1 January 2022.
  • Sustainability amendments of rules on fiduciary duties – It clarifies obligations of a financial firm when assessing its sustainability risks. UCITS management companies, AIFMs, insurance and reinsurance companies, MiFID firms would need to comply. These were adopted by the Commission on 21 April 2021 and the Rules are expected to commence from around October 2022.
  • Suitability assessments – When an adviser assesses a client’s suitability for an investment, they will now also need to discuss the client’s sustainability preferences. As a result, the MiFID firms and insurance distributors will have to comply. These were adopted by the Commission on 21 April 2021 and the Rules are expected to come into effect from October2022.
  • Product governance rules – The Sustainability factors and sustainability related objectives are to be taken into account in product oversight and governance process for products and instruments. As a result, the MiFID firms and insurance intermediaries/insurance companies (in other words product manufacturers and advisers) will need to comply. These were adopted by the Commission on 21 April 2021 and the Rules are expected to begin from October 2022.

The Major Implications

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 the implications. It is absolutely clear that what European Commission has proposed will have impact on all the companies, investors, advisors and other stakeholders. In our view, the major changes can be classified under three categories;

  • EU based Companies – Since the onus is on the companies to report sustainability information, from the perspective of investors, this will lead to a massive explosion in the number of companies which will have to report this information. Nearly 50,000 companies in the EU will now need to follow detailed EU sustainability reporting standards, compared to 11,000 companies now. This will lead to an immediate need for these companies to follow the new reporting requirements and they will need support on this initiative.
  • Investment Advisors – When an adviser assesses a client’s suitability for an investment, they will now also need to discuss the client’s sustainability preferences. As a result, the insurance distributors will have to carefully assess the clients’ requirements on what they think are the most important sustainability objectives for them. The advisors will also need to educate their clients on important considerations and how they can be fulfilled.
  • Investment Managers – As per the April 2021 package, the Sustainability factors and sustainability related objectives are to be taken into account in product oversight and governance process for the investment products and instruments. As a result, all the MiFID firms and insurance intermediaries/insurance companies will have to ensure that their products are compliant with the regulation.

How EMAlpha can help

The rapid developments in EU Taxonomy and proactive stance of European Commission on these sustainability matters will completely alter the playing field for the companies in 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 with effective and efficient reporting but also will help the investment advisors in educating their clients on understanding 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’ is always the core principle we must adhere to. Hence, we have incorporated a Flexible Framework Management System that is 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 very critical issues as follows;

  1. There is an unmanageable amount of subjectivity in what matters for individual investors among the objectives in Sustainability and it often becomes a confusing proposition. As always, it is the composition that makes the big difference and as such there is a need to evaluate all the parameters that make up EU Taxonomy, separately. This is the core feature of EMAlpha 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 details better which in turn is helpful for them to have a clearer understanding of their preferences.
  3. A key characteristic of EMAlpha’s NLP algorithms is that the attribution analysis is fairly simple and straightforward. 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 more driven 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 flexible 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 Flexible 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 completely unsupervised, too much tinkering is bad and can have sub-optimal results.

References

  1. Sustainable Finance and EU Taxonomy: Commission takes further steps to channel money towards sustainable activities https://ec.europa.eu/commission/presscorner/detail/en/IP_21_1804 (Accessed on 28th April 2021)
  2. Sustainable finance package https://ec.europa.eu/info/publications/210421-sustainable-finance-communication_en (Accessed on 28th April 2021)
  3. Implementing and delegated acts: Find links to implementing and delegated acts for Regulation (EU) 2020/852 (Taxonomy) on the establishment of a framework to facilitate sustainable investment https://ec.europa.eu/info/law/sustainable-finance-taxonomy-regulation-eu-2020-852/amending-and-supplementary-acts/implementing-and-delegated-acts_en (Accessed on 28th April 2021)
  4. Questions and Answers: Taxonomy Climate Delegated Act and Amendments to Delegated Acts on fiduciary duties, investment and insurance advice https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_1805 (Accessed on 28th April 2021)
  5. Questions and Answers: Corporate Sustainability Reporting Directive proposal (Questions and answers, 21 April 2021 Brussels) https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_1806 (Accessed on 28th April 2021)
  6. EU SUSTAINABLE FINANCE, April package: Channelling money towards sustainability and the European Green Deal https://ec.europa.eu/info/sites/default/files/business_economy_euro/banking_and_finance/documents/sustainable-finance-communication-factsheet_en.pdf (Accessed on 28th April 2021)
  7. Sustainable finance: The EU is examining how to make sustainability considerations an integral part of its financial policy in order to support the European Green Deal https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance_en (Accessed on 28th April 2021)
  8. EU taxonomy for sustainable activities: What the EU is doing to create an EU-wide classification system for sustainable activities https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/eu-taxonomy-sustainable-activities_en (Accessed on 28th April 2021)
  9. (Accessed on 28th April 2021) (Accessed on 28th April 2021)

EMAlpha Products and Services

In most Emerging Markets, information discovery is a major challenge. For example, even if global investors do show interest, how do they solve the problem of timely access to information? The world’s largest capital allocators hold USD 60 trillion and they include GPIF (Japan), GPF (Norway), ADIA (Abu Dhabi), GIC (Singapore) etc. However, only 10% of the capital gets allocated to EMs and ~90% goes to G10. The big hurdle for EMs is: Foreign investors cannot access relevant local information in a timely fashion.

Most market participants and investors from across the world realise that the low rates in G10 makes EM attractive for investors. But, a) Information access is usually a cost and time intensive process for investors, and b) In many EMs, language is a big barrier and because of multiple regional languages, there is a significant delay before news makes it to the mainstream English language. To address these issues, you need solutions like, a) Real time news collection from multiple languages and, b) Instantaneous machine translation and text analytics leading to actionable recommendations for investors.

There are further challenges such as ensuring that companies behave responsibly and that they adopt sustainable business practices. There is a need to ensure that the investors are contributing towards making the world a better place by making investment decisions which reward responsible behaviour of companies. Case in point, ESG (Environmental, Social & Governance) which is increasingly being used as a filter for investment decisions. There are other issues as well such as which data to use and a lack of a standardized framework for evaluation.

Some of these issues are too important to be postponed to a later date and it is in this regard that EMAlpha is making its contribution. EMAlpha has developed a Flexible ESG Framework Management System which is a proprietary technology that makes ESG scores framework agnostic, thus allowing for quick adaptation. In addition, the users decide what matters to them and the EMAlpha system does a classification into E, S, G and more granular categories.

EMAlpha also has solutions for Multilingual data collection and real time targeted information which are based on proprietary processes to collect relevant data across multiple markets. The coverage expands across emerging market equity, currencies and commodities and the work has also been very successful in testing the signals in some key markets for live trading strategies. This is a continuous cycle and a virtuous loop that allows for iterative improvement through AI-human feedback.

With developments in AI and technology in areas like NLP, there are considerable new possibilities to bridge the gap in information between Emerging Markets and the more Developed Markets. This is an area which is turning out to be very exciting because some of the tools mentioned were not available even a couple of years ago. This implies that the evolution in the field will only get faster as time goes on. While the Emerging Markets and the Capital Flow Conundrum is a complex one, there is now much more hope and optimism that with the usage of technology, things will only get better.

At EMAlpha, the ESG team is doing further research on why some issues like Social get more prominence as compared to others like Environmental or Governance issues. To look at specific cases in the context of ESG is a very intense yet interesting exercise and this has been an incredible learning experience for the EMAlpha Research team. The data, information and ratings are a humongous challenge for ESG and it takes time to reach to the depth of the issues as the field is evolving very quickly.

EMAlpha is making a solid contribution in tackling these challenges. EMAlpha has solutions for ESG which are practical, user friendly and although not too simplistic yet easy to use. EMAlpha has developed a Flexible ESG Framework Management System which is a proprietary technology that makes ESG scores framework agnostic, thus allowing for quick adaptation. In addition, the users decide what matters to them and the EMAlpha system does a classification into E, S, G and more granular categories.

We strongly believe that the entire ESG ecosystem requires multiple stakeholders to pull in the right direction in order to make it operational and that will be the most critically determining factor for ESG’s success in making the corporate responsibility actually work. Most importantly, the investors should view ‘E’, ‘S’ and ‘G’ individually and should not confound issues when it comes to the comprehensive ESG evaluation. It is important to understand the right reasons behind ESG investing because this bias could hurt their investment decision making and portfolio performance.

Research Team
EM Alpha LLC

For more EMAlpha Insights on Emerging Markets, please visit https://emalpha.com/insights/. To know how you can use EMAlpha’s unstructured data and ESG (Environmental, Social and Governance) solutions for better investment decisions, please email us at research@emalpha.com.

About EMAlpha:

EMAlpha, a data analytics and investment management firm focused on making Emerging Markets (EMs) more accessible to global investors and unlocking EM investing using machines. EMAlpha’s focus is on Unstructured Data as the EMs are particularly susceptible to swings in news flow driven investor sentiment. EMAlpha works on information discovery and ESG solutions for Investors in Emerging Markets, using AI and NLP tech. Our mission is: “To help increase capital flow, in terms of FDI and FPI, to Emerging Markets by lowering information barriers using AI/NLP”. EMAlpha Products help achieve both alpha and ESG solutions and the idea is to help asset allocators, asset managers, banks and hedge funds along with companies with cost and time efficient access to relevant information. We use thoroughly researched machine learning tools to track evolving sentiment specifically towards EMs and EMAlpha pays special attention to the timely measurement of news sentiment for investors as these markets can be finicky and sentiment can be capricious. Our team members have deep expertise in research and trading in multiple Emerging Markets and EMAlpha’s collaborative approach to combining machine learning tools with a fundamental approach help us understand these markets better.

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