|Region of operation
|Assets under management
|$1,142.5bn (May 31st 2020)
|COVERED IN THIS CASE STUDY
|Name of fund
|Industrials, renewables, steel, regulated utilities
The taxonomy can be a valuable reference point for investors and companies measuring sustainability and translating this into financial value (revenues, capex, opex). If successfully implemented, it could send a strong price signal through capital markets, creating winners and losers. Indeed, understanding which companies stand to benefit helps investors make future valuations. The taxonomy will be more effective if it is widely adopted. Therefore, the way the framework operates is critical; and in particular the ease of access to relevant and audited company data.
Other aspect you would like to mention?
We have implemented processes to raise awareness and knowledge of the taxonomy, particularly amongst our investment teams. Our portfolio managers have produced qualitative evidence that shows how they dealt with the challenges of implementing the taxonomy.
First, we ran in-house sessions exploring the context and application of the taxonomy, based on the initial Technical Expert Group (TEG) report and an internal analysis. This process flagged up the lack of reliable data and the need to use proxies, such as the Transition Pathway Initiative, to identify companies that may be taxonomy-eligible. We then explored how the taxonomy could be integrated into our analysis of holdings, and engaged with investee companies to better understand their positioning given the lack of available data. Currently, we are setting up a taxonomy working group to identify investment opportunities and portfolio options, as well as identifying third parties that can provide taxonomy data and screening tools.
Principles, criteria, thresholds
We identified sectors that are in scope of the taxonomy and leveraged data, such as the Transition Pathway Initiative, that could determine taxonomy-aligned companies. We faced a number of challenges, including finding indicators and proxies to screen investments for taxonomy compliance, and assessing data sources to ascertain whether their taxonomy data and indicators could be mined. There was a lack of clarity both for financial institution applications and for engaging with corporates/issuers. We noted a bias towards pure players, regional players and small caps because alignment was measured as a percentage of revenues. A further concern was the low number of companies with high taxonomy alignment (50%+).
Do no significant harm assessment
We tied many of the Do No Significant Harm (DNSH) criteria to European law, as the final TEG report had not yet been published. Given the lack of verified data from companies, we adopted a conservative approach and assumed that operations within the EU met the DNSH criteria - unless the company had been subject to environmental controversies - while non-EU operations did not. We believe that ESG ratings could also be leveraged for this assessment.
It was difficult to assess non-EU operations against DNSH criteria in the absence of verified reporting from investee companies, though we noted that the final TEG report sought to address some of these challenges. For example, we experienced some difficulty in identifying suitable data points and proxies to carry out the assessment, with doubts around the extent to which existing ESG ratings and controversy screens can act as proxies. These screens showed some discrepancy between the company and the economic activity levels. Further, as criteria reference EU law it was problematic to evaluate DNSH for activities outside the EU.
Social safeguards assessment
Due to the lack of verified company data, we used the UN Global Compact (UNGC), alongside ESG controversy screens and ratings, as proxies for the social safeguards assessment. However, as they apply at the company level, while the taxonomy is at economic activity level, we were not fully convinced that ESG controversy screens would be sufficient.
We identified a risk of favouring smaller and less diversified businesses by focusing on percentage of turnover. Meanwhile, capex can be highly variable year-on-year, leading to volatility in taxonomy alignment. Also, we think that more work is required to bring companies fully on board. For example, some companies with high eligibility do not see the taxonomy as relevant because their business is in emerging markets, outside its scope, while others have significant alignment potential that is not currently reflected in the technical screening criteria.
A lack of clarity around which measure (capex, opex, or revenues) investors should be referencing when reporting may be confusing. Current ESG company disclosure can be fragmented and inadequate, partly due to associated costs, the often voluntary nature of disclosure and a lack of standardization. Criteria that are too stringent may impact companies that are transitioning (not yet aligned) to a lower carbon approach, resulting in a decrease in investor demand, a fall in share price or higher capital costs. Potentially, not all regulators will sign up, due to the European rather than global focus, and we also need to further explore how to assess DNSH and minimum social safeguards. Further, we believe there is a fiduciary risk that fund managers’ estimates may be inaccurate, particularly when a company is not required to report due its location or size.
Company 1 – Nordic renewable
This company has perfectly aligned taxonomy revenues, but operates in emerging markets, where the taxonomy is not applied. Consequently, the company has stated that it does not consider the framework or regulatory developments as particularly significant for its business.
The company manufactures solar panels, operates in a sector classified under the taxonomy and 90%-100% of its revenues are considered “green”. The operating model focuses on producing and installing panels, as well as fulfilling long-term maintenance contracts, which account for most of its revenue and cash flow. The company benefits from large mandates often commissioned by governments or development banks in emerging markets and therefore benefits from low-cost financing with high probability of long-term revenues. The investment team have some concerns around the company’s ESG performance in terms of governance structure.
Company 2- German manufacturer
This company is set to benefit from increased taxonomy alignment and also demonstrates valid ESG qualities.
The company, a significant innovator in green lighting, is highly rated by many ESG research bodies and has a strong reputation for sustainability. We believe it benefits from strong management and delivers a positive impact as most of its revenue is derived from LED lighting, which improves energy efficiency. Its products contribute to SDG 14 on climate action and SDG 11 on sustainable cities. Though its activities do not directly fall into a sector covered by the taxonomy, we believe that the company will have high levels of taxonomy alignment due to its involvement in buildings efficiency.
Company 3 – Southern European utility company
Less than 30% of this company’s revenues are taxonomy-aligned but it is committed to a transition plan and therefore we believe it has long-term ESG value.
The focus of our recent meeting with the company’s CEO was its transition to become a leading renewable energy player. The company has committed to exit coal by 2025 in Europe and 2030 globally, although it highlighted government constraints to meeting this objective based on energy security commitments. The company has benefitted significantly from borrowing at very low rates as a result of green bond issuance. Though the specifics of the new EU bond standard have yet to be defined, the direction of travel is clear. Our view was that the company was undervalued and that its assessment by some ESG ratings agencies was too severe.
Company 4 – Global steel company
Though the company operates in a high emission sector it has a clear transition strategy; however, it may be excluded from the taxonomy due to its global operations and markets.
After discussing climate change strategy with briefly with the Chairman and then with the Head of Sustainability, we engaged with Climate Action 100+ to explore these issues further with other investors, focussing on the company’s opportunities and costs to achieve a reduction in carbon emissions in line with the Paris Agreement. Potential technologies include the substitution of coal for biomass and adopting carbon capture technology, but meeting these goals will not be financially or technologically feasible without significant regulatory support. Management is well aware of the taxonomy and is committed to working with external stakeholders to develop a credible transition approach.
Challenges and solutions
|Not able to fully challenge company disclosure.
|Currently we rely on company engagement, but until disclosure is mandatory our aim is to identify data sources that may help to sense- check information.
|No screening tool to help identify relevant companies.
|Our approach was per sector and discretionary, engaging with management as part of the core investment process.
|Lack of reporting and clarity.
|Though not perceived as a valuation premium, we will form a working group as we expect higher pricing in the future.
Though we understand that companies will need to report revenue, capex or opex, the language used in fund disclosures around the proportion of the fund that finances sustainable activities is vaguer. Therefore, if we have to pick a single metric to report on, the fund will need to be clear which metrics it’s using. Pricing issues and opportunities exist in sectors not yet included in the taxonomy or those transitioning to a lower carbon approach, and they may face a fall in investor demand and share price, and/or higher capital costs. It is important to address inclusivity, as the taxonomy will increase the reporting burden, driving up costs, and smaller companies may be disadvantaged. Questions remain around whether other jurisdictions will implement the taxonomy and what the potential effects may be, and also how to deal with practical issues around assessing DNSH and ensuring “minimum social safeguards”. Finally, there may be a need to consider the fiduciary risks incurred in making estimates that may then be criticised as too light or too heavy.