The majority of European sustainable funds are unlikely to be highly aligned with the EU Taxonomy, an EU-wide reporting regulation which will start coming into effect from the end of 2021, according to Morningstar data director Tim Walton.
During a webcast entitled Finding your path in the upcoming ESG regulations, experts from Morningstar outlined details of two key pieces of future EU ESG regulation: the EU Taxonomy and the Sustainable Finance Disclosure Regulation (SFDR).
The EU Taxonomy is a classification framework, part of the EU Sustainable Finance Action Plan, designed to determine whether an economic activity is environmentally sustainable. Commenting on his expectations of what will happen when this regulation comes into force, Walton said “for most general funds you will see very, very low alignment when it first comes out, but even for most sustainable funds I don’t think we’ll have an immensely high level of alignment”.
“A) because of a lack of data, and B) because on a company level I don’t think there will be a huge amount of alignment of their revenues with EU taxonomy in the beginning, but I think it will change over time,” he said.
“I don’t think necessarily that to be an ESG fund you will have to have a very high level of alignment with the Taxonomy. Certainly not at the beginning.”
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Far more important, he said, is that funds managed continue to engage with companies in their portfolios, including those that belong to ‘brown’ industries, to help put them on a path to make themselves better aligned with green principles.
Andy Pettit, director for policy research at Morningstar, agreed “working together with companies to change things is a powerful mover”, saying the regulator won’t force investors to divest from less sustainable companies where engagement can lead to positive outcomes.
Walton added that the SFDR is intended to allow companies to “explain what their investment strategy is and what they are trying to do”, meaning engagement should be an acceptable strategy within the new framework.
Reporting hurdles
However, there are a number of issues that need to be ironed out when it comes to the new SFDR reporting requirements, which are expected to come into force by June 2022.
One of the key concerns is the 32+ principle adverse indicators (PIAs) on which firms will have to report, which according to Walton has seen a “fair bit of negative feedback from the industry”. “Most respondents say they want to see a tighter number of defined PIAs – six, seven, eight,” he said.
Pettit also noted there is as yet no clarity from regulators as to how the new reporting requirements will work with various types of assets outside the equity space, such as bonds, derivatives and real estate.
Meanwhile, when it comes to reporting, Pettit said Morningstar would like to see more “standardised reporting” from corporates, with requirements extended beyond the largest companies to include smaller businesses. “Many firms are publishing sustainable reports, but they are often long on context, short on metrics and not easy to compare,” he said.
Global consistency
He added while standards setting organisations and regulators are increasingly collaborating with each other, there needs to be more global convergence on regulatory matters, warning that “all positive momentum in Europe will be diluted if it is not reflected globally”.
Anne Schoemaker, manager of product strategy and development at Sustainalytics, said different regulatory requirements outside of Europe make it harder to see how companies listed outside of the EU fit inside the Taxonomy framework.
She added today’s corporate reporting “doesn’t allow for a full assessment of technical criteria” required under the EU Taxonomy.
“It is at this point in time not possible to assess some of the technical criteria in a scalable way until corporate reporting gets better,” she said. “Top down approaches could potentially be used for some sectors, but proxy approaches will be needed for some time until company reporting develops.”
Sustainalytics has launched a solution to help investors understand how their holdings and portfolio can align with the new regulation, providing ESG research and data that offers clients an “early signal on whether their holdings align with climate change mitigation objectives of the EU Taxonomy”.
