Will the EU’s New Sustainable Finance Taxonomy Pave the UK’s Way?

Back in October, in the run-up to the United Nations’ climate conference in Glasgow, UK Chancellor of the Exchequer Rishi Sunak published a “roadmap” for new rules that will eventually require businesses to “start disclosing their environmental impact.”^[i] As the country awaits more details, the EU is progressing on its own green taxonomy defining what investments qualify as climate-friendly and sustainable—perhaps offering a preview of how effective forthcoming UK regulations might be. On 9 December, the EU passed its initial rulebook—the EU Taxonomy, slated to take effect 1 January—on what activities officials think will help the bloc meet its environmental objectives.^[ii] The rulebook is part of the EU’s long-term plan to connect finance with the bloc’s sustainability goals, which Sunak has pledged the UK will emulate.^[iii] But as we think still-unresolved internal disagreements show, the EU’s effort remains very much a work in progress, and the questions perplexing officials there could very well complicate any forthcoming UK rules. Overall, regardless of how these efforts pan out, we think investors wanting to manage their funds according to environmental, social and governance (ESG) guidelines will likely benefit from performing their own due diligence if they want to ensure their portfolios align with their personal preferences.

One frequent question we hear about ESG investing, which aims to make money whilst also targeting goals beyond traditional financial metrics, is how well it accomplishes its purported non-financial goals. Many commentators we follow decry what they call greenwashing—firms cloaking business-as-usual in environmentally friendly euphemisms to attract funds. The underlying problem as some of them see it: Without standardised ESG definitions and accountability, it is hard to separate the wheat from the chaff—the investment equivalent of organic food labelling before the government required producers and sellers to register with the UK’s organic control bodies.

Many countries are now pursuing new rules to standardise ESG, with the EU’s being the first major effort to cross the finish line. The bloc seeks to reduce greenwashing and meet its own sustainability goals, such as reducing net carbon emissions to zero by 2050.^[iv] To do so, it created a classification tool for investments it thinks will help meet those objectives—the Taxonomy. To be labelled a sustainable investment by EU definitions, an investment must:^[v]

1. Contribute to at least one of the following six environmental objectives.
   1. Climate change mitigation
   2. Climate change adaptation
   3. Sustainable use and protection of water and marine resources
   4. Transition to a circular economy (meet certain recycling requirements)
   5. Pollution prevention and control
   6. Protection and restoration of biodiversity and ecosystems
2. Do no significant harm to the other objectives, whilst upholding basic human rights and labour standards.

There are currently over 500 pages detailing these criteria.^[vi] More technical specifications are on the way to implement screens determining Taxonomy eligibility—and that is all just to set up the new regulatory framework.^[vii] To ensure compliance, the EU will require sustainability-related disclosures and reports from businesses on their alignment with the Taxonomy.^[viii] However, requirements for asset managers to disclose details on their portfolios’ taxonomy alignment have been delayed to 2023 (and could be pushed back further), partly because the EU hasn’t formalised technical screening criteria yet—moving targets likely make it hard for investors to know how aligned their portfolios are today.^[ix] The upshot for ESG investors, in our view: There probably won’t be a good way to know the degree of alignment with the EU standards for some time.

Also to be decided: how the EU will classify natural gas and nuclear energy.^[x] Reports initially indicated the EU will unveil its decision on 22 December, after extensive assessment and long deliberation.^[xi] But recent reports suggest this may prove too optimistic, as talks reached an impasse last week.^[xii] Some, like Germany, argue natural gas is a useful transitional energy source, but others say no carbon-emitting fuel should qualify as green.^[xiii] Then, whilst countries like France think nuclear will play a critical role toward net-zero emissions, there is disagreement over its operational risks and the radioactive waste it produces.^[xiv]

However they resolve, we think these dilemmas highlight how the Taxonomy comprises a series of judgment calls. If its members don’t always agree, you may not either. This is why the Taxonomy isn’t necessarily the be-all, end-all answer to ESG investors’ prayers, in our view. It seems to us just like one of many current or future ESG frameworks out there. The Taxonomy has the EU’s official seal, but that—or any other government’s—doesn’t make it inherently infallible.

We think it is also likely incidental to markets. Whilst whether or not a company is Taxonomy-aligned may impact sentiment toward it to some extent, it doesn’t automatically make it any more or less profitable over the 3-to-30 month time frame stocks care about, in our view. Besides, even if all ESG investors in the world agreed with the assessment—far from given—there are many more non-ESG investors globally who may not even care that there was an assessment.^[xv] Even beyond all this, once the rules are established, we think they will probably be well understood by investors who do care—in our view, this makes them more likely to fade into the background than sway stocks materially (for better or worse).

As ESG standards evolve, we think their development is worth following if you are interested in the ESG arena. But as the EU Taxonomy shows, many are still works in progress—something to scrutinise, not accept blindly, in our view. If ESG doesn’t interest you, we don’t think there is anything here likely to materially impact stocks. The EU may be large and influential, but global capital markets are vast and deep, dealing regularly with regulatory shifts and new classification systems, in our experience.

Moreover, the Taxonomy’s advent has been glacial—eyed by markets for years.^[xvi] Many unfinished details remain left to fill in, but its broad outlines are well known and therefore unlikely to shock stocks, which move most on surprise, in our view. There may be unintended consequences where regulatory teeth may begin to bite—which we are watching for—but at this point, we don’t think it will create many ripples, much less a big splash. If the UK charts a similar path, investors would probably find the situation familiar, in our view—green guidance’s general proliferation in recent years has become part of the background regulatory landscape that markets have navigated with seemingly little trouble.^[xvii]