Be under no illusion. Discussions around the EU green investing taxonomy are likely to go to the wire. Although April saw publication of a likely draft text, complex political discussions are set to continue. This will have implications for suitability assessments and product governance, which will impact the operation of Mifid companies, thus affecting UCITS Mancos, AIFMs and insurance companies.
Ideas are emerging from EU authorities about how to assess the green credentials of electricity producing industries as part of the environmental investment taxonomy. These proved to be a stumbling block for the Commission, with the status of the gas and nuclear energy industries having been left out of the original delegated directive published on 21st April.
Add more nuance
Advocates of gas produced electricity highlight that it has a much lower carbon footprint than oil and coal-based generation. Critics note that burning fossil fuels is fundamentally harmful to the climate. Advocates of nuclear power stress its low carbon footprint, while critics cite the other environmental challenges faced by this technology. These are highly political discussions, often going to the heart of EU member states’ national energy policy strategies. Little wonder the Commission found it easier to duck these questions for now. On gas, they had suggested classifying it as “green” but only in certain transitional scenarios.
Press reports have highlighted the idea to add nuance to these classifications, with a suggestion from the Platform for Sustainable Finance, a permanent expert group of the European Commission. Under this framework, the taxonomy would also feature a negative list of particularly harmful activities, such as electricity production from coal. The taxonomy would then highlight pathways away from these activities through “intermediate transitional investments” in technologies which would progressively render this production less harmful. How gas and nuclear fit into this can then be subject to more nuanced political discussion and compromise.
Communicating this complexity
The problem for the financial services industry is how to communicate this nuance to clients. The delegated directive leans heavily on concepts in Mifid related to client suitability assessments and product governance. Client’s “sustainability preferences” will need to be incorporated into Mifid suitability assessments. These are complicated and laborious related to clients’ financial goals, notions which are relatively easy to conceptualise compared to many shades of nuance at the heart of green investing.
The taxonomy regulation establishes a classification system against which investors and businesses can assess whether certain economic activities are or are not “sustainable”. It does not prohibit investment in any activity, but seeks to nudge economic activity towards being more sustainable over the long-term. It is part of a wider legislative framework.
There are four tests to be met: to contribute substantially to at least one of the environmental objectives; it must “do no significant harm” (DNSH) to other objectives; minimum social and governance safeguards must be met; and technical screening criteria must be followed. There are six environmental objectives: climate change mitigation; climate change adaptation; water; circular economy; pollution control; and biodiversity. Technical screening criteria need to detailed to describe what it means to substantially contribute to an environmental objective.
Legally this is being carried out through so called delegated acts, which are proposed by the Commission and then scrutinised by the European Parliament and the Council for four months. If there is no objection then they enter into force from 1 January 2022.
Client communication procedures
The delegated directive points to the need for a minimum proportion of taxonomy compliance or a minimum proportion of SFDR sustainable investments, with the share of this decided by the client. Alternatively this could be based on a consideration of the principal adverse sustainability impacts defined by each company within SFDR. If no product can be found to meet the client’s sustainability preferences, firms cannot recommend a product, and explain this to clients and document this process. If clients adapt their preferences, this too must be documented.
Product governance rules appear to be more broad and flexible as they refer to “sustainability related objectives” of the target market. AIFMs, UCITS ManCos, Mifid firms and insurance firms/distributors must also incorporate sustainability risks and considerations in their risk management and conflicts processes. AIFMs and UCITS ManCos also need to take this into account for investment due diligence processes. Unlike SFDR which is focused on disclosure, these measures require active obligations and decisions, with disclaimers not being sufficient to cover the product manufacturer.
Added social dimension
If this were not sufficiently complicated, the Platform for Sustainable Finance are keen for decision makers to move forward with suggestions to incorporate social investment dimensions into a future taxonomy. The expert group mentioned compliance with international labour standards and human rights by companies, and also corporate ethics, governance, the fight against bribery and even compliance with tax regulations. Yet they also noted the limited evidence base for encouraging the social dimension of investment. Other than work on the effect of microfinance, there is little to suggest how new investment rules could drive change.
“The EU Taxonomy is an extraordinary advance,” noted Sean Kidney, chief executive of the public-private advocacy group the Climate Bonds Initiative. “Does it need improvement? Yes it does. But we have managed to change the debate about the climate.” Explaining the nature of this debate to clients of Luxembourg-based funds and insurance products will be a major task for local players.