Implementation of the EU Taxonomy could weaken ESG incentives outside of Europe

• The complexity of the EU’s Sustainable Finance Disclosure Regulation will make taxonomy alignment a central focus for many end-investors, and this will affect how intermediaries invest
• The binary nature of the taxonomy will focus investor efforts on how to improve their taxonomy alignment at the margin, which could reduce the real economy impact of engagement
• As taxonomy alignment reporting is phased in, non-European investees may paradoxically benefit less in the short-run by aligning ESG practices with EU standards and by making national or regional efforts more important in the real economy impacts of their ESG practices

The PRI has released an overview of some best practices around how investors subject to the Sustainable Finance Disclosure Regulation (SFDR) have approached the challenging requirements of reporting taxonomy alignment, and it is instructive well beyond Europe. One of the most intractable challenges built into the EU Taxonomy’s application within SFDR is the tension between investors’ expectations, regulators’ and other stakeholders’ concerns about greenwashing, and asset managers’ justifiable focus on keeping pace with peers.

One of the biggest issues flagged in PRI’s summation of input from its investors group was that “in many cases, end-investors expect the taxonomy alignment KPIs of financial products to be higher than they currently are”. There are three reasons why the reported KPIs might lag behind expectations:

1. End-investors don’t distinguish between the technical screening criteria that define ‘taxonomy-aligned’ and ‘taxonomy-eligible’. The latter include companies in sectors that could qualify as ‘taxonomy-aligned’ but don’t currently meet the technical criteria;
2. Investor intermediaries don’t focus their approach to ESG solely on maximizing their degree of ‘taxonomy-alignment’; or,
3. Investors lack suitable data to evaluate many of their investments against the technical screening criteria, and possibly under-report their taxonomy-alignment.

For European investor intermediaries, competitive pressures to be compared based solely on taxonomy-alignment portfolio share will incentivize towards taxonomy-aligned investments, at least on the margins. This impacts investees operating outside of the European Union who aren’t subject to the same disclosure requirements as European companies under the Corporate Sustainability Reporting Directive (CSRD). They will have to decide whether the marginal investor demand that turns on the binary of whether or not they qualify as being taxonomy-aligned justifies investment to produce the data to show whether they qualify.

A lot of the benefit from the development of the taxonomy comes from its ability to ‘combat accusations of greenwashing’, although these gains will be principally around the margins of what the taxonomy defines as ‘green’ versus ‘not green’. Advocates highlight its use “to highlight the scientific foundations of sustainability claims made by investors” and it can do this to an extent among European investee companies subject to CSRD.

However, the fact that the investor feedback also includes a significant push to internationalize the EU Taxonomy or to develop “comprehensive correspondence tables […] to map EU standards referenced in the taxonomy to non-EU standards” starts to highlight some of its limitations and unintended consequences. As the report acknowledges, “significant divergences across jurisdictions would add extra complexity and expense to taxonomy implementation” and there is no guarantee that the EU Taxonomy will kick off a race to the top as harmonization efforts move forward globally.

The implementation of SFDR reporting is likely to be a very complex, costly and data-intensive process where investors will have to weigh alternative data sources that can boost their taxonomy-alignment ranking with the regulatory and reputational risk that will accompany it. In the process, many will take a conservative approach defined more by keeping pace with their peer competitors’ average taxonomy alignment ranking, and less focused on real economy additionality.

This approach will favor shorter-term strategies to engage for information rather than to drive change in the underlying businesses of their investees. The marginal cost of a short-term and narrow engagement to secure ‘good enough’ data to show taxonomy-alignment of an investee is likely to be much lower than engagement to change companies’ behaviors to move from taxonomy-eligible to taxonomy-aligned. The value of changing taxonomy-alignment scores at the margin will for most justify this type of nearer-term action that will have little if any impact on the real economy.

That may relax some of the pressure that non-European companies face from investors who have shifted focus towards the lowest-hanging fruit of non-disclosing European companies. It will also potentially make it harder in the short-term for non-European companies to justify some of their ESG efforts that have been driven by maintaining or attracting European investors, even if it makes that argument stronger over the long-term.

The good news is that the EU Taxonomy is no longer the only avenue of major global movement to formalize ESG reporting for investors and the financial sector. Although the complexity of differing frameworks will have an increasing cost as the number of taxonomies multiplies, these other efforts can backfill against short-term incentives that weaken the case for ESG reporting if investors on the margin make a ‘flight to safety’ in taxonomy & greenwashing risk terms as SFDR reporting is phased in.

Even as the incentive for better collection and more thorough use of ESG data increases, it is unlikely to move in a straight line in a race towards the top. More likely, it will zig-zag for each company based on the relative importance and ease it faces in meeting different ESG reporting frameworks and the expectations of investors. In the process, it adds weight to the argument that companies and policymakers should find reasons specific to their context to make an effort on ESG, and not outsource the process to press for adoption of the standards adopted in other regions.

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