- Capital Monitor analysis has revealed major divergence between data vendors’ scores and company-reported data on taxonomy eligibility and alignment.
- The rules around this are both prescriptive and highly subjective, with contradictions, such as that investors currently need to rely on estimates and proxies, something the regulator says they should not do.
- Some investors will extrapolate an average score from multiple vendors, but some – most likely smaller firms – are likely to rely on one or two.
This is the second in a two-part series on taxonomy alignment assessments by ESG data vendors. Part one, which looks at the data, is available here.
When it comes to regulatory requirements, a degree of both precision and consensus is desirable. This holds particularly true for compliance with the EU’s landmark green taxonomy, which is billed by policymakers as a key tool for redirecting capital towards sustainable investments.
However, as Capital Monitor reported on Tuesday, data vendors’ initial assessments of the extent to which companies’ activities are either eligible for or aligned with the taxonomy have varied widely, leaving investors with little clarity. And the regulators’ approach to the situation is not helping resolve the situation quickly.
Taxonomy eligibility merely acknowledges that a company makes money from an activity that is included within the taxonomy, and is the first step on the road to mandatory disclosures of alignment with the taxonomy. Companies that were subject to pre-existing corporate reporting rules have been required, since the start of this year, to report the proportion of their revenues, capital expenditure (capex) and operating expenditure related to eligible activities under the taxonomy, while some others are doing so voluntarily.
Taxonomy alignment means an activity is compliant with the EU taxonomy’s requirements, and is far more complicated to assess. Most data providers and companies are using revenues as the primary metric against which to measure eligibility or alignment. But for some companies – notably those in the energy sector – using capex results in a higher score as it reflects the future direction of the business (see chart below), so there can actually be an incentive to use different measurements.
Hard to assess
The data collection and analysis process is highly labour-intensive because the EU taxonomy is quite prescriptive, investors say. Eligibility is calculated by mapping a company’s revenues to the dozens of categories under Europe’s Nomenclature of Economic Activities, then refining that selection to 101 activities, many of which are hard to distinguish between and appear to overlap heavily. For example, the following are all separate activities: afforestation, rehabilitation and restoration of forests, forest management, and conservation forestry. Each category has an explainer that runs to around 1,000 words, some of which reference other lengthy European policy documents.
To determine alignment, an activity or company must be considered to make a substantial contribution to one or more of the taxonomy’s environmental objectives and be assessed as doing ‘no significant harm’ to the environment. It must also meet so-called social safeguards such as the UN Guiding Principles on Business and Human Rights.
The problem is that there are differences between how data providers and companies themselves assess such thresholds. For instance, some would count any form of human or labour rights controversy as an immediate breach of the ‘do no significant harm’ principle, whereas others would not. German car maker Volkswagen is a good example: some data providers would automatically exclude it because of its 2015 emissions scandal, but others – including the three vendors (FTSE Russell, ISS ESG and Sustainalytics) that provided data to Capital Monitor – would not.
“The regulators have done their best to be as objective as possible, but each step of this [assessment process] is highly subjective,” says Alex Bernhardt, global head of sustainability research at BNP Paribas Asset Management (BNP Paribas AM). “And where there isn’t subjectivity, there’s often opacity at the corporate level, which requires estimation. That subjectivity in interpretation combined with estimation ends up with a lot of discrepancies.”
Reliance on proxies and estimates
All this – combined with data-sourcing difficulties caused by the timetable of the EU’s sustainable finance regulatory package – has left banks, asset managers and insurers having to rely on proxies and estimates, mostly sourced from independent ESG data providers.
And yet the European Commission has said estimates and proxies should not be used. A spokesman for the European Commission tells Capital Monitor that it introduced a phased entry “to take into account potential challenges faced by the industry”. This means that during the first year of disclosure, companies are reporting only on their taxonomy eligibility, with alignment reporting to come later.
Even so, once corporate reporting is fully up and running, only EU-headquartered companies will be subject to it. But hardly any investors are solely focused on European assets, leaving considerable room for gaps and reliance on estimates, says Bernhardt.
Three fund houses that Capital Monitor spoke to all queried the logic behind the sequencing of the regulation that will see financial companies forced to report inaccurate and missing data for some time. And they all plan to start reporting their portfolio taxonomy data at different times: the Netherlands' NN Investment Partners (NNIP) in July, BNP Paribas AM in August and Actiam in January next year.
BNP Paribas AM (with $571bn under management) will use an average of multiple data vendors’ views for its own EU taxonomy reporting. Actiam ($23.6bn) will use one provider but has not yet decided which. NNIP ($298bn) will do its own calculations because it says no vendor yet offers a taxonomy alignment service specifically for green bonds.
All being well, this will be a short-term issue that is mostly smoothed out once companies begin reporting themselves, says Arjan Ruijs, senior responsible investment officer at Actiam. Most portfolios will not initially receive a taxonomy alignment score higher than 5% or 10% – and some never will – given the limits of the framework.
“I don’t think this is the fault of the data providers,” says Ruijs. “The problem is the regulator tried to be prescriptive, but sustainability isn’t a natural science. You can’t say ‘this is good and this is bad’.”
But he also concedes that without the rules in place, “we wouldn’t have the innovation that will eventually make things easier to measure later”.
The sustainable investment community will be hoping the backlash against the ESG concept taking place now does not further complicate matters before then.