The EU Green Finance Taxonomy: What US Investors Need to Know
Friday, February 7, 2020
by: Chris Phalen

Section: Policy

The European Union’s Action Plan for Financing Sustainable Growth, announced in March 2018, set forth a process and a series of deadlines aimed at helping the European Union achieve its objective of net zero carbon emissions by 2050. The European Commission lists five key action areas for the Plan, the most well-known of which is the first – a classification system for sustainable economic activities, more commonly known as the “taxonomy.” Like the European Union’s 2018 General Data Protection Regulation (which affected websites globally), the effects of the taxonomy are likely to be felt across the Atlantic.

Therefore, we present here a brief overview of the taxonomy and its anticipated impacts.

On December 18 after months of political wrangling, the European Parliament and European Union member states reached a deal on what constitute sustainable economic activities and how to classify them. The deal is designed to help combat “greenwashing” by both the managers of financial products and the companies in which they invest.

Specifically, the climate rules stipulate that all EU-listed companies with more than 500 employees will have to disclose how much of their revenue is generated from green activities and to what extent their capital expenditures meet green criteria. Earlier in negotiations, the main sticking point between EU member states and the European Parliament was whether coal (seriously!), gas and nuclear power generation would count as green under the climate change mitigation and adaptation principles. The short answer is no. However, there is the possibility that under the final regulation, gas and nuclear could be considered “transition” energy sources towards achieving carbon neutrality.

Based on these disclosures, fund managers will then have to calculate how green their portfolios are, allowing investors to determine to what extent green-marketed products actually achieve sustainability. The expectation is that investment capital flows will move from poor performing companies to those that contribute to the EU’s green goals based on quantitative criteria.

Creating specific labels for financial products and funds is the second key action item of the Action Plan for Financing Sustainable Growth. The taxonomy (classification) of economic activities – the first key action item – will play a major role in defining these labels.

The taxonomy regulations will be developed and implemented in two batches. The first batch—focusing on climate change mitigation and adaptation—will specify the level of carbon emissions allowed to corporations across sectors; the second batch will address four other environmental objectives, which can be viewed here.

The specifics of the taxonomy’s first batch classification system will be completed in 2020 and will be released as part of a final regulation in December. The regulation will then take effect at the end of 2021, affording companies and managers time to adjust their business practices and portfolio allocations.

What will this mean for US investors?

First, and most obviously, portfolios including securities issued by EU-listed companies will have significantly greater “green” data that fund managers can include in their securities analysis and prospectus materials. This includes labels for economic activities undertaken by companies, such as the extent to which a car manufacturer’s revenue is derived from products that reduce carbon emissions.

Second, EU fund managers are likely to contact non-EU companies in their portfolios with climate-related disclosure requests. Although non-EU companies will not be obligated by EU law to disclose this data, they may decide to do so to justify or maintain their positions in European funds.

Third, the taxonomy offers a policy template around which the US sustainable investing community can coalesce and adapt to the US context. To wit, legislative proposals to increase climate-related financial disclosure are already pending in Congress. For instance, legislation introduced by Representative Sean Casten and Senator Elizabeth Warren – the Climate Risk Disclosure Act of 2019 – is a step towards realizing a comprehensive disclosure and ratings regime in the United States.  Even in the absence of regulations, US fund managers may face demands from clients to emulate the example of their European counterparts in providing data on the green-ness of their underlying securities.

Despite the political infighting and highly technical language surrounding the taxonomy, there is clear reason for the US sustainable investor community to cheer the forthcoming regulations.