The BBC Radio 4’s ‘Costing the Earth’ programme recently hosted a discussion on why environmental issues seem to have become more prominent in public debate recently. The programme’s focus was specifically on environmental policy, but the question could have just as reasonably been focused on the investment community. Why has environmental and sustainable investment become such a hot topic of late?
Clearly there are many reasons for this, but a big contributor must surely be the work of the High-Level Expert Group (HLEG) on Sustainable Finance[i]. This group issued its final set of recommendations to the European Commission earlier this year and many of the recommendations have subsequently been adopted by the European Commission in its action plan on sustainable finance[ii]. These proposals are far-reaching and, without hyperbole, seem likely to have a profound impact across the whole financial services sector for years to come.
A sustainable finance taxonomy
One of the most significant recommendations made in the HLEG report is for the EU ‘to introduce a common sustainable finance taxonomy to ensure market consistency and clarity’. The report indicates that HLEG’s vision is ‘of a taxonomy that provides a shared EU classification of sustainable activities that is applicable for all types of assets and capital allocation’.
Overall, we strongly welcome the work of the HLEG. The scope and ambition of the report will, in our view, do much to ensure that sustainability becomes embedded in the activities of the finance sector. The taxonomy is an obvious starting point in determining what kinds of activities the financial sector should be focused on.
At WHEB we have spent 15 years working on this question. During this time, sustainable investment opportunities have changed dramatically. As the global economy has progressively orientated itself towards a more sustainable and low carbon basis, so the types of businesses that seek to enable and benefit from this transition have grown considerably.
A burgeoning and dynamic opportunity set
Ten years ago, the opportunity set was largely confined to industrial and manufacturing sectors where low carbon and efficient technologies had been developed. Today, the opportunity set includes a whole host of sectors and subsectors. Software businesses for example that are helping to make almost all aspects of the economy more energy efficient, consumer goods companies that have built portfolios of low impact products, miners with exposure to metals and minerals used in electric vehicles, financial institutions with loan portfolios focused on low carbon sectors, speciality chemicals that are used as foundation materials across a range of low carbon technologies and the list goes on. What is more, the universe is highly dynamic and changes constantly as new technologies and business models emerge.
This evolution is, in our view, a sign of a dynamic, vital part of the economy. It is a sign of success as low carbon and sustainable businesses have attracted entrepreneurs and innovators who are driving rapid progress and change. The taxonomy will need to not just accommodate this vigour, but should enable and support it. It will need to be flexible but will also need ‘sustainable integrity’ if it is to fulfill its objective as a ‘classification system identifying activities, assets and revenue segments that deliver on key sustainability goals’.
Avoiding a ‘list-based’ taxonomy
We would caution against a taxonomy that is founded upon on a list of products and technologies. While this approach appears to be the most straightforward, we believe that, on its own, it would be both incomplete and quickly obsolete as the economy evolves. Even worse, the taxonomy could become a brake on innovation as the list would lag behind the real economy.
Instead, the focus of the taxonomy should be on the underlying impact, such as carbon emission reductions, or solid waste recycling. Under each of these ‘impact categories’ indicative lists of the types of business and product that delivers this impact could be constructed. These would not be exhaustive and the onus would be on companies to demonstrate – and ideally quantify – how the positive impact is generated by the business or technology in question. With this evidence, companies and/or technologies could then be considered to be part of the taxonomy.
This approach would still have sustainable integrity and could be clearly aligned with the sustainable development objectives contained in public policy. It would accommodate new technologies where positive sustainable impact could be demonstrated. And it would have the added benefit of building an impact data set that investors and downstream users of the products could utilise in assessing and reporting their own impact.