How can Taxonomy be leveraged in asset management?

Market players are still reluctant to make real commitments based on the Environmental Taxonomy. So how can we turn this regulatory constraint into a real asset in portfolio management?

‍3years after its adoption, it's time for the first assessment.

The background to Taxonomy

The Green Pact for Europe, also known as the European Greendeal, was launched in 2019, three years after the Paris Agreements. At the time, the aim was to define the foundations of the EU's policy on ecological transition. A major lever was identified: directing capital towards activities that enable environmental transition. This led to the creation of the European Taxonomy, a regulation designed to provide a common framework for classifying sustainable activities in the environmental, social and governance sense. However, to date, this Taxonomy has only been developed for the environmental and climatic aspects, and does not exhaustively include social and governance criteria.

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In short, what are the principles of Environmental Taxonomy?

The common framework set by these regulations thus makes it possible to determine whether an activity is aligned with the Taxonomy, i.e. whether it is a "green" activity, in the following way:
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Step 1: Eligibility

The economic activity must be one of the evolving list of activities eligible for the Taxonomy (around 90 activities to date), as defined by the regulations.

Step 2: Alignment

The economic activity must then verify 4 steps in order to be considered aligned with the Taxonomy:

And meet our 6 environmental commitments:

1. Climate change mitigation
2. Adapting to climate change
3. Sustainable use and protection of water and marine resources
4. Pollution prevention and reduction
5. Transition to a circular economy Waste prevention and recycling
6. Protecting healthy ecosystems

The various stages are then verified using measurable indicators and regulatory thresholds for each activity, enabling companies to calculate their alignment with the Taxonomy. Non-financial companies can thus publish the proportion of their activities aligned according to sales, Capex and Opex. In particular, this will enable companies to include in their investment committees the question of what they need to spend to "green" their sales.

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How does it work in practice?

The use of the Taxonomy for financial players therefore relies heavily on the publication of companies' taxonomic alignment, made possible by the CSRD, which comes into force from 2024. However, the large companies that have already initiated the exercise feel that the framework set by the regulations is too complex and difficult to decipher, resulting in poor appropriation of the standards set by the Taxonomy. As a result, there is a significant risk that the information published will be of poor quality, and therefore unusable by financial players. Now more than ever, regulators need to explain and define the concepts behind these regulations.

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What about financial players?

Management companies are then required to publish the proportion of investments made in companies aligned with the taxonomy, at fund level in the SFDR appendices (minimum commitment in the pre-contractual and result obtained in the periodical), as well as at entity level in Article 29 LEC.

Results are mixed, despite Taxonomy's initial potential

Taxonomy is the answer to 3 major challenges:

1. Providing a common language
2. Classify green activities using technical selection criteria
3. Ensure full transparency of the environmental impact of corporate activities

However, to date, the initial objective has not been achieved, as players are using it for reporting purposes rather than as a means of selecting stocks. What are the reasons for this?

• Unavailable data - Poor coordination with CSRD has led to a mismatch in reporting schedules (corporate vs. financial institutions), impacting short-term data accessibility.
• Incomplete regulations - Multiple shortcomings due to poor coverage of certain sectors and the absence of Brown and Social Taxonomies.
• Debated regulations - Consensus on environmental issues is not always easy to reach, and debates are still ongoing (e.g. aviation).
• Taxonomy is not sufficient in itself to qualify an asset as sustainable

As a result, commitments by financial players to align with the published Taxonomy are currently very low, if not non-existent. According to the Barometer published by WeeFin in January 2023, only 3% of funds declare a non-zero rate of alignment with the European Taxonomy (between 0.5% and 4%)[1].

And where does Social Taxonomy fit in?

The social taxonomy aims to become a common frame of reference to improve the transparency of activities labelled as "social" and avoid " social-washing ", as well as directing a greater share of investments towards those activities that contribute to the European Union's social objectives.

The social share will be calculated on the basis of three objectives:

• Ensuring decent work throughout the value chain
• Promoting consumer interests
• Fostering inclusive and sustainable communities

Although initially scheduled for the end of 2023, the social taxonomy is not expected to see the light of day until 2024 or 2025. Why is this?

Efforts have focused mainly on the environmental criterion because it seems less random and does not depend as heavily on cultural norms as the social criterion!

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How to make Taxonomy a guarantee of quality?

Don't limit Taxonomy to a simple "green stamp"...

WeeFin's vision of sustainable finance is to involve as many investors as possible in integrating ESG into their strategy, and thus direct investments towards green assets.

How to achieve this goal using Taxonomy?‍

Taxonomy should become a selection criterion, through the application of thresholds (as proposed by the AMF / LabelISR). However, major obstacles remain, such as a lack of education on the part of regulators, a still non-exhaustive scope of coverage (social funds, small/mid-cap or PE), a lack of data and the risk of ESG polarization through the application of strict criteria based on Taxonomy.

... and turn it into a lever for differentiation

So in practice, in order to use Taxonomy properly, we advise you to :

1. Initially, make the Taxonomy a binding element (i.e. selectivity or exclusion criteria through the application of a minimum alignment threshold or progress targets over time) for environmental/climate funds, then extend this scope as data becomes available.
2. Complement the binding thresholds for alignment with the taxonomy with other indicators (brown share, emissions reduction commitment, etc.).
3. Use the taxonomy to assess the relevance of the internal proprietary analysis carried out on Pillar E (combine Pillar E evaluation criteria with the taxonomy to highlight significant discrepancies).
4. Make the Taxonomy a lever for corporate reporting and capitalize on the 'Driving Group' effect, in particular by encouraging companies to report more and turn to taxonomy-aligned activities.
   

[1 ] Analysis of 124 funds marketed in France by 46 SDGs