A new EU classification system on climate-friendly investments will require companies and investment firms to radically change the way they report on their environmental performance and will weed out those who do not take their commitments seriously, experts said.
EU governments on Dec. 18, 2019, agreed to a common classification system to define environmentally friendly investments, a so-called taxonomy, which sets performance thresholds for companies and industries that seek to reduce greenhouse gas emissions or adapt to a changing climate. It also sets out criteria to protect water, biodiversity, reduce pollution and encourage the transition to a circular economy.
The taxonomy assesses 67 economic activities, spanning from manufacturing to transport, and is designed to steer companies to adapt their business strategies to climate change, and help investment funds judge sectors based on their environmental performance.
Under the new rules, all financial products will have to make a reference to the taxonomy. Funds will have to disclose to what extent they used the taxonomy in determining an investment's sustainability, its environmental objectives and what proportion of the fund is taxonomy eligible. Funds must include a disclosure notice if they do not adhere to the taxonomy.
"This is really a substantial reform. There has never been an environmental performance benchmark before and now there is one in law, and 6,000 listed European companies and every financial fund product in Europe will have to use it as a reference benchmark," Nathan Fabian, chief responsible investment officer at the UN-backed Principles for Responsible Investment and rapporteur for the Taxonomy Group at the EU's Technical Expert Group, said in an interview.
In the past, investors may have chosen to invest in a company that appeared to be well governed on climate risk or had made incremental improvements in its carbon footprint, but now they will be able to compare the actual performance on environmental records to the taxonomy thresholds, he said.
"If a company can't explain how they are going to bridge that gap over time, investors won't be taking them seriously," he said.
The taxonomy will aim to achieve six environmental objectives, including climate change mitigation and climate change adaptation. Both objectives will be established by 2020-end and applied by 2021-end. The four other objectives — sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention, and protection of biodiversity and ecosystems — will be established in the taxonomy by 2021-end and implemented by 2022-end.
The next two years will be a learning process as investment managers compare the environmental performance of their funds against taxonomy criteria, he said.
Funds that decide not to adhere to the taxonomy face a "hard decision" as they may not want to take that message to the market, Fabian said. Those that do need to look at their underlying holdings will need to gather data on their environmental performance levels against the taxonomy criteria, he said.
Currently investors take a fragmented approach to sustainable investing, and experts said the taxonomy would help overcome that dilemma because it provides a common framework at a time when investors are expressing a demand for funds with good environmental performance and pushing managers to speak to companies.
"So active ownership and stewardship start to take on real importance," Fabian said.
Aila Aho, a member of the European Commission's technical expert group for sustainable finance and an executive adviser for sustainability at Scandinavian bank Nordea Bank Abp, said the taxonomy would provide clarity for investors and direction for companies when making investment decisions and give them guidance on their long-term profitability.
It will give companies a new metric to work with and make it easier for them to compare themselves to the environmental performance of their peers, she said in an interview.
Under the taxonomy, large European companies will have to disclose how much of their revenues, capital expenditures and operating expenses are in line with the taxonomy.
The taxonomy will also clearly state whether an investment is "green or half green," Aho said, which will help investment managers do their job more efficiently as they will spend less time on research.
"It's an efficiency improvement tool for investor purposes," Aho said.
It also carries less reputational risk for investment funds because it sets out activities that are climate neutral, making greenwashing more difficult, she said. Greenwashing is when a financial asset is made to sound more environmentally friendly than it really is.