The EU’s New ‘Green’ Taxonomy Remains a Work in Progress

Last Thursday, the EU passed its initial rulebook defining what it considers climate-friendly and sustainable investments, slated to take effect January 1. The rulebook is part of the EU’s long-term plan to connect finance with the bloc’s sustainability goals. But as still-unresolved internal disagreements show, it remains very much a work in progress. In our view, the EU’s guidelines are noteworthy, but investors wanting to manage their funds according to environmental, social and governance (ESG) guidelines should still do their own due diligence if they want to ensure their portfolios align with their personal preferences.

One frequent question about ESG investing, which aims to make money while also targeting goals beyond traditional financial metrics, is how well it accomplishes its purported non-financial goals. Many decry what they call “greenwashing”—firms cloaking business-as-usual in environmentally friendly euphemisms to attract funds. The underlying problem as some see it: Without standardized ESG definitions and accountability, it is hard to separate the wheat from the chaff—the investment equivalent of “organic” food labeling before the US government stepped in to establish industry standards.

Enter the EU, which seeks to reduce greenwashing and meet its own sustainability goals, such as reducing net carbon emissions to zero by 2050. To do so, it created a classification tool for investments it thinks will help meet those objectives—the EU Taxonomy. To be labeled a “sustainable investment” by EU definitions, an investment must:

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, while upholding basic human rights and labor standards.

There are currently over 500 pages detailing these criteria. 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. To ensure compliance, the EU will require sustainability-related disclosures and reports from businesses on their alignment with the Taxonomy. 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 formalized technical screening criteria yet—moving targets make it hard for investors to know how aligned their portfolios are today. The upshot for ESG investors? There 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. Reports suggest we should know soon, as they indicate the EU will unveil its decision December 22, after extensive assessment and long deliberation. Some, like Germany, argue natural gas is a useful transitional energy source, but others believe no carbon-emitting fuel should qualify as “green.” Then, while 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.

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. It is just one of many current or future ESG frameworks out there, and other regulators are likely to follow over time. Yes, it has the EU’s official seal. But that doesn’t make it infallible.

It is also likely incidental to markets. While 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. Even beyond all this, once the rules are established, they will be well understood by investors who do care—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 scrutinize, 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 du jour.

Moreover, the Taxonomy’s advent has been glacial—eyed by markets for years. Many unfinished details remain left to fill in, but its broad outlines are well known and unlikely to shock stocks, which move most on surprise. There may be unintended consequences where regulatory teeth may begin to bite—which we are watching for—but at this point, we doubt it creates many ripples, much less a big splash.