To reshape investment markets, there are two main approaches for meaningful change: regulation, and incentives. No truer does this manifest than in the experiments being applied to the global sustainable investment landscape.
If you were to compare the two main approaches to this in the West, namely the EU’s Action Plan and the US’s Inflation Reduction Act, you can see that they both appear to take opposing directions of travel, while both seeking a way forward to mitigate the impact of climate change. The EU Taxonomy, implementation of the Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD) are stick-like methods driving corporate and investor behaviour through extensive disclosure and reporting requirements, whereas the tax incentives offered by the IRA demonstrate carrot-like pulling factors, without major overhauls to the regulatory playing field.
What’s yet to be proven, however, is which is more effective.
The EU’s regime has benefits that have had a broader global impact in terms of “raising the bar”. Its regulatory measures are driving greater transparency, aim to help the end investor make better decisions, prevent greenwashing, while showcasing what a best-in class sustainable investment fund should look like. Yet these measures alone have not been able to yet drive meaningful change and run the risk of producing unintended consequences such as uncertainty as the regulatory regime has changed multiple times, unnecessary costs and complexity.
According to Morningstar’s recent research on progress against EU Taxonomy shows a frustrating lack of progress. Approximately 1,300 non-financial companies now report on their taxonomy-aligned activities, but a full four in 10 (42%) report no alignment at all. And, while total EU Taxonomy-aligned capital investments in 2022 and 2023 were over $500bn, average alignment levels reported this year are quasi-unchanged compared to last year’s, with about 19% of reporting companies’ capex aligned with the Taxonomy, on average.
The report findings are not surprising as they are a snapshot of where European countries and their economies currently are in terms of the transition to a low carbon economy, mitigating and adapting to climate change risks and impacts.
However, it makes the point that potentially regulation is not enough to move the dial.
The United States Inflation Reduction Act of 2022 has promised to allocate $391bn in tax provisions toward domestic renewable energy and climate change initiatives including wind, solar, and nuclear power, as well as incentives for electric vehicle (EV) production and consumer rebates for energy-efficient home improvements.
The IRA has already successfully proved ways in which it can have far-reaching benefits, such as the $237.5m tax credit transfer deal between Schneider Electric and US household goods company, Kimberly-Clark. This deal was only made possible by Schneider Electric’s focus on supporting the energy transition, resulting in clean energy tax provisions offered by the US Inflation Reduction Act.
However, many argue that the IRA is still murky and needs clearer guardrails, particularly for the upstream energy sector, and there is a worry that a different administration could row back many of the incentives on offer, such as the $7,500 credit incentive per domestically produced EV. More broadly, recent litigation over corporate and investor greenwashing by the SEC shows that a tougher regulatory framework such as the EU’s might lead to better practices.
There is still plenty of uncertainty as to how these top-down agendas will play out for investors. What our latest research brings into sharp relief, however, is that there are still many blanks for investors to fill in themselves if they are to understand how their investments are driving sustainable change. An overwhelming 88% of non-financial companies subject to the EU taxonomy report inaccurate data or leave out required data points.
The question that I ask myself is whether we can accelerate progress though active ownership?
Morningstar’s Voice of the Asset Owner survey found that most asset owners surveyed (78% out of a pool of 500 global asset owners) view active ownership as driving the implementation of their ESG program overall. With direct engagement leading the way in North America, in Europe, direct engagement is closely followed by collective engagement with investee companies identified as the most important tools for active ownership tool.
As investors continue to engage with investee companies on their transition plans to net zero, this will over time materialise in capex and opex investment to finance the transition, and thus alignment with the EU’s Taxonomy framework will increase.
Over time my hope is that the EU taxonomy framework enables investors to increase capital allocation towards companies with ‘environmentally sustainable economic activities’. Currently, reporting using the EU Taxonomy classification system manages to identify small pockets of progress, as well as picture the vast amount of progress that needs to be made in order to meet Europe’s net zero goals. Achieving rapid and sustained progress will require a hybrid approach – one that finds the right balance between market forces and forcing the market.
