|Name||Wells Fargo Asset Management|
|Signatory type||Investment manager|
|Region of operation||United States|
|Assets under management||
$483 bn as of June 30, 2020
|COVERED IN THIS CASE STUDY|
|Name of fund||N/A|
|Asset class||Fixed income|
|Environmental objective||Mitigation and adaptation|
The EU taxonomy offers some key benefits for users, including guidance on activities to prioritize for decarbonization, climate change adaptation and other environmental goals. It also offers consensus-based technical requirements for decarbonization and adaptation and highlights potential negative consequences. For investors including asset managers, benefits include alignment with societal, and by extension governmental, goals, and facilitation of the creation of green labels – which should lead to improved transparency and accountability of financial products claiming to be ‘green’. Finally, it should encourage the creation of financial products with strong taxonomy alignment.
Other aspect you would like to mention?
We applied the taxonomy to a hypothetical high yield bond strategy whose performance is measured against the Bank of America Global High Yield Index. We paid close attention to practical challenges that arise due to limited disclosure by issuers, especially those operating outside the EU that aren’t subject to the Non-Financial Reporting Directive (NFRD).
Principles, criteria, thresholds
Step 1: Determined breakdown of company activities by revenue and whether any are eligible under the taxonomy per the technical requirements spreadsheet provided by the Technical Expert Group (TEG) on Sustainable Finance. We assumed the use of proceeds was general corporate purposes.
Data source: We used company filings, Bloomberg data, and TEG-referenced industry classifications to support the analysis.
Step 2: For each eligible activity, we determined whether it makes a substantial contribution to climate change mitigation or adaptation (“Substantial Contribution”) by reviewing the specific taxonomy criteria and thresholds. If relevant and trustworthy information about the activity and specific metrics and thresholds was not found, we assumed the activity was not taxonomy-aligned.
Data source: We reviewed the TEG taxonomy technical requirements spreadsheet, company filings and websites, and third-party ESG datasets. If the exercise was not hypothetical, company engagement would be an essential part of this process, as critical data would not otherwise be available.
Do no significant harm assessment
Step 3: If we found a company potentially making a Substantial Contribution, we evaluated whether the company’s operations may do significant harm per the taxonomy’s other environmental objectives. Where possible, we conducted reviews against quantitative thresholds, process-based questions, or qualitative criteria outlined by the TEG. We conducted due diligence at the company level rather than just the specific activity, except where the activities being considered were narrow in their scope and related Do No Significant Harm (DNSH) criteria could be concretely linked to them. We considered a company as not having passed the DNSH criteria if any ‘violation’ was found.
Data source: We reviewed the TEG taxonomy technical requirements spreadsheet. For quantitative and process-based thresholds, we used company filings and third-party ESG data. For qualitative criteria, we used our judgment and looked at third party information (e.g. controversy research, news reports, web search etc.). In running an actual portfolio, company engagement would be necessary to address questions for which no data is available.
Social safeguards assessment
Step 4: We considered to what extent minimum social safeguards are met. In running a real strategy, we would conduct similar qualitative research as described above for DNSH. This would include focusing on human rights, labor rights, combating bribery, bribe solicitation, and extortion, per TEG final report recommendations. We would also consider violations at the company, rather than activity, level, aiming to avoid grey areas in drawing up boundaries around activities.
Data source: Same as DNSH.
Step 5: We considered turnover/revenues of the corporate issuers in the Global High Yield index, but not capex. Revenue information was much more readily available and we assumed the use of proceeds of the bonds was general corporate purposes and therefore revenues would be more appropriate to consider. We generally did not find the necessary capex disclosures required to implement the taxonomy.
Consistent with this project’s goal to capture real-world applications of the taxonomy, we focused on companies most likely to be held in global high-yield investment strategies (rather than the entire index). We focused on the largest issuers whose bonds trade with most liquidity.
We also noted companies with low but improving ESG performance, and where company activities are not yet covered by the taxonomy, which would be useful in narrative disclosures supporting the quantitative results. For example, power generator Calpine is increasing its focus on clean energy and one day could demonstrate much greater taxonomy alignment. However, the pace of repositioning is not fast enough to argue to significantly higher alignment during, say, a three-year investment period.
We began our analysis by thoroughly evaluating the TEG’s March 2020 Report on Sustainable Finance. Our goal was to assess practical challenges that arise in implementing the taxonomy for a hypothetical Global High Yield strategy. High yield firms often have much more limited disclosure than larger, better-resourced investment-grade firms. We followed the TEG-recommended five-step process. We attempted to follow the process end to end, including assessing Substantial Contribution, DNSH, and Minimum Safeguards relating to climate change mitigation and adaptation.
We focused on larger companies in each industry sector. For each issuer, we conducted the above-mentioned steps. Most of the high yield fixed income market’s largest debt issuers that we looked at have no taxonomy-eligible activities. This precluded analysis related to Substantial Contribution, DNSH, and Minimum Safeguards. We then looked more deeply into the index and focused the bulk of our analysis on eligible firms to analyze.
Many, if not most, of the largest high yield firms that we looked at in each industry sector do not have eligible activities. We therefore looked more deeply into the index to find eligible firms.
Of those that have a higher percentage of revenues from eligible activities, while it is possible some of their activities are taxonomy-aligned, most do not disclose sufficient data to determine Substantial Contribution, DNSH, or Minimum Safeguard compliance. Third-party ESG data providers also currently do not provide that level of technical information about companies and their activities. Extensive engagement would be required to satisfy associated screening criteria and/or compliance.
We determined additional steps would be required for a fuller analysis. These included estimates and assumptions where necessary on revenue and capex segmentations. We also considered the forward trajectory of these segmentations, especially in the auto and utility sectors. Each is investing heavily in aligned activities.
In summary, high yield companies rarely disclose sufficient information to implement the taxonomy in the absence of extensive assumptions and estimates by investors. The unintended result of such subjective assessments will be disparate assessments of alignment.
High yield firms are improving disclosure but have more limited resources than larger, investment-grade firms. As a result, they may be slower to allow for efficient taxonomy implementation than larger firms. EU-focused firms may improve disclosure more quickly than those operating outside the EU that don’t report according to the NFRD. This could lead to an analysis imbalance within a global portfolio.
Policies are needed to encourage non-NFRD companies to report in ways that allow taxonomy implementation. To ensure consistency in implementation, appropriate conventions and related disclosures for revenue and capex segmentation estimates should be established. Specifically for fixed income portfolios, more guidance may be needed around circumstances in which capex is to be used for taxonomy alignment reporting rather than revenues.
Our analysis suggests that lack of disclosure at a sufficient level of technical and activity detail does not necessarily imply lack of Substantial Contribution. The percentage of taxonomy alignment that is possible to calculate may therefore under-represent the actual level of substantial contribution to climate change adaptation and mitigation.
Challenges and solutions
|1||Due to the complexity of the taxonomy requirements, the first challenge was to gain a deeper understanding and pull together disparate information to synthesize the main steps, data sources, processes that would need to be followed and outputs that would need to be created, for a specific use case, such as implementation in a Global High Yield strategy.||We reviewed in detail the TEG’s final summary report, annex, and technical requirements spreadsheet, as well as numerous resources and examples that the PRI provided us. We then put together a process for us to follow for considering Taxonomy alignment in the hypothetical Global High Yield portfolio.|
|2||To determine Substantial Contribution, there are two aspects investors need to assess for any given activity: Whether it passes technical thresholds or defined “allowed” activities, and what portion of overall or business segment revenues (or capex) gets allocated to that activity.
This can prove very challenging in the absence of additional company disclosures.
Revenue and capex information is today focused on the overall business or specific business segments, which may not necessarily align with distinct economic activities on which to assess Substantial Contribution.
|In the example of AECOM, an engineering services company, the company discloses business segment revenue information. These business segments cover several different economic activities that are included in the taxonomy. We looked at the company’s annual report and website for information on individual projects that would qualify as making a Substantial Contribution. Even where several of AECOM’s projects appear likely to be making a substantial contribution to climate change mitigation, such as wind farms or energy efficiency projects, we struggled to find related revenue or capex information that could readily be assigned to AECOM.|
The taxonomy includes very specific technical requirements, often referencing EU laws and regulations relating to metric calculations, benchmarks, or standards, as referred to in the exhibit to this case study. Unless a company reports information according to these requirements, it can be difficult to obtain, with reasonable effort, technical, activity-based data to assess whether Substantial Contribution thresholds are passed.
ESG information currently published by companies or provided by third-party data providers in many cases does not reveal specific calculation methodologies nor technical benchmarks, let alone disclose whether the metric/result adheres to a specific EU regulation, particularly for non-EU companies. Where information about calculation methodologies is discussed, if it is not related to EU laws and regulations, then it would require technical expertise to convert data to assess against the European benchmarks.
Where companies/data providers provide taxonomy-related information, we would be concerned about ensuring the information is accurate and audited.
|At this time, without company disclosure according to the EU taxonomy, where it was not possible to obtain information about adherence to EU standards, regulations, or calculation methodologies, or about results for specific steps of the production process, we assumed that the activity did not align with the taxonomy. Through company engagement we might be able to obtain additional information to fill some gaps, but it is unlikely that this will help fill all gaps due to the significant time and resources that it would take.|
The limited state of current disclosure makes taxonomy implementation resource-intensive and time consuming. Investors and managers with small teams may struggle to efficiently manage the process internally. Where reasonably possible, investors should make their own interpretations of company disclosures and not outsource them to third parties. At present, there is insufficient evidence that third parties can reliably verify Substantial Contribution, DNSH, or Minimum Safeguards in the absence of company disclosure. Absent reporting requirements for non-EU-NFRD firms, engagement will likely be essential to improve implementation. But engagement too has limits: firms cannot disclose selectively to those that engage. Firms can only clarify disclosures.
The taxonomy might be easier to implement for EU-based companies required to report per NFRD. Investors may want to begin with these firms. In any event, it makes sense to start preparing required data infrastructure.
Furthermore, as the current taxonomy addresses only two environmental objectives of the six, alignment results must be interpreted in appropriate context: current results won’t fully capture alignment.
We should not allow desire for perfect implementation to be the enemy of good implementation. We should seek to agree on best practice, given the taxonomy’s sound objectives, and clarify the data we realistically are likely to have and when.
EXHIBIT: Analysis of Tata Steel Ltd.
We chose to analyze Tata Steel Ltd. from the Global High Yield index universe, as an initial review of eligible revenues suggested that 100% of the company’s revenues would be eligible under the EU Green Taxonomy. We hoped this would allow sufficient scope for us to conduct additional steps relating to Substantial Contribution, DNSH, and Minimum Safeguards.
Main conclusions and challenges:
We estimate the percentage of taxonomy-aligned revenues for Tata Steel to be 0% for climate change mitigation.
Tata Steel produces an annual and integrated report, which for 2018-19 ran to over 400 pages. In the report, the company discloses several metrics relating to its different capitals, including natural capital, human capital, social and relationship capital etc.
However, these disclosures, which are typical of any large company, and perhaps better in some ways than other companies in the Global High Yield Index, are at an insufficient level of technical detail to assess GHG emissions intensity against the criteria outlined by the taxonomy.
Some observations related to Tata Steel’s activities as they relate to the taxonomy:
- Taxonomy-defined thresholds for Substantial Contribution are based on EU Emissions Trading System (ETS) benchmarks for iron and steel production, which are defined for specific types of production processes. The TEG itself notes, in the ‘rationale’ relating to these thresholds, that it might be useful to have thresholds defined that relate to an overall integrated plant. Even so, few companies today publicly disclose plant-by-plant emissions data.
- Tata Steel has a number of initiatives underway to lower emissions and use scrap steel in Electric Arc Furnace (EAF). No capex figures are associated as yet with these specific activities as they are exploratory initiatives that were recently launched. If capex is assigned, Tata Steel could be considered as taxonomy-aligned for some percentage of its activities in the future (pending DNSH and Minimum Safeguard assessments).
- Given current GHG emissions intensity figures disclosed by Tata Steel for two of its plants, we estimated, but were unable to confirm due to lack of relevant data, that Tata Steel’s iron and steel production likely did not pass the taxonomy thresholds for substantial contribution to climate change mitigation.
Determining taxonomy alignment:
We used the five-step process suggested by the TEG and described earlier in the case study to determine percentage alignment for climate change mitigation:
Step 1: Determining eligible activities
We reviewed revenue breakdowns using company data via Bloomberg and Tata Steel’s annual and integrated report for 2018-19, and found that 100% of the company’s revenues are eligible under the EU taxonomy category of “Manufacture of iron and steel.”
Step 2: Determining substantial contribution to climate change mitigation
For this example, we focus on the climate change mitigation objective.
Tata Steel’s annual and integrated report for 2018-19 discloses several useful data points and narrative disclosures relating to climate change mitigation. These include:
- Overall GHG emissions intensity (tCO2 e/t crude steel (tcs)) at 2.34
- According to Bloomberg information, the company uses the GHG Protocol for its emissions calculations.
- Without technical background or further research, an analyst would not know whether these are “calculated according to the methodology used for EU-ETS benchmarks,” per the taxonomy requirement.
- Tata Steel’s goals include <2 tCO2/tcs GHG emission intensity by 2025
- The company mentions that its Jamshedpur plant sets the Indian benchmark for CO2 emissions intensity, at 2.29 tCO2/tcs for steel production through Blast Furnace - Basic Oxygen Furnace.
- Tata Steel lists a number of climate-related initiatives that would not count as taxonomy-aligned at this point in time, but could be important for mitigation or could become aligned in the future. These include:
- An Internal Carbon Price in the company’s capex appraisal process with a shadow price of carbon at US$15 /tCO2.
- A “Centre of Excellence” created in FY 2018-19 to identify and implement projects for CO2 reduction. Some such projects are: Carbon Capture and Use (CCU) at Tata Steel Jamshedpur and at the Ferro-Chrome plant at Bamnipal and maximizing scrap utilization in steelmaking.
- Note that the TEG mentions “blast furnace top gas recycling with carbon capture and storage” as one of the breakthrough technologies the iron and steel industry should aim at implementing.
- Setting up of a steel recycling business, which can subsequently be useful for steelmaking through the EAF route.
The company provides the GHG emissions intensity for two of their plants in India.
Source: WFAM, Tata Steel Integrated Report and Annual Accounts 2018-19
TSJ = Tata Steel Jamshedpur plant
TSK = Tata Steel Kalinganagar plant
If these are assumed to be best in class plants for Tata Steel, then they don’t appear to pass the taxonomy thresholds for Substantial Contribution to climate change mitigation.
- Here we assume that calculation methods are per EU ETS benchmarks, which is unclear.
- We also assume that the overall GHG emissions intensity of the plant reflects similar intensities for specific processes.
- As such, the comparison with taxonomy thresholds is not like-for-like.
Steps 3 and 4 are not applicable and percent alignment with the taxonomy is considered to be 0% despite eligible activities of 100% of revenues.
The views expressed and any forward-looking statements are as of the date posted and are those of the Sustainable Investing Team and/or Wells Fargo Asset Management. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. Discussions of individual securities, or the markets generally, or any Wells Fargo Fund are not intended as individual recommendations. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. Wells Fargo Asset Management disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.