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Capital Markets weekly: ICMA conference highlights complexity of ESG fund-labelling initiative
The International Capital Market Association's Asset Management and Investors Council held its bi-annual conference on 27 November. It considered the impact of regulation on several areas of asset management, pension and insurance activity. Particular focus was given to the EU's efforts to establish an "Ecolabel" for environmentally-friendly investment vehicles.
Green, ESG, and "transition" finance
A panel discussion noted that there are currently 418 funds - representing less than 1% of assets under management- which specify environmental, social and governance (ESG) objectives, with these currently subject to 12 different badging labels. In some countries, more than one labelling mechanism is currently applied. Although in some areas - such as Green Bonds - there are clearly-defined guidelines regarding definition and monitoring, the wider ESG segment lacks common specifications.
The area of ESG labelling has been subject to EU focus, with its regulators currently working with interested parties to improve clarity and transparency by introducing a common "Ecolabel" for such funds across the bloc.
Panelists noted that the EU goal of establishing a clear definition and label for environmentally-sustainable funds within the bloc involves a long list of criteria. Those drafting are still to complete a final definition against the background of differing existing standards maintained by individual national governments. The process also is looking at developing an overall taxonomy which is looking to define specific areas for exclusion from under the Ecolabel umbrella and a framework to measure environmental contributions.
Overall, the creation of an EU Ecolabel was viewed by panelists as badly-needed to provide a common standard for EU-based ESG investment activity. Provision of common guidelines is viewed as likely to encourage companies to give greater focus to the topic, and to improve their reporting standards to reflect the new common framework.
Its precise definition appears to face political complexities. Petya Barzilska of our Country Risk team for Europe, who monitors EU regulatory initiatives, flags that within the EU efforts to develop a sustainable finance taxonomy, a contentious issue has been whether to regard nuclear energy as "clean energy". In October, Austria, Germany and Luxembourg wanted to exclude nuclear power activity from the taxonomy but the Council approved a draft proposal that includes it within the classification system. The Council wants the list to be ready by end-2021 and to be implemented in 2022 but we assess that there could be some delay given the nuclear energy issue: the Commission is likely to prepare the technical standards but since the European Parliament is a co-legislator and is likely to aim to exclude nuclear power from the taxonomy, this could prolong negotiations. The gas industry also wants to include fossil gases in the green classification system, adding further complexities to the process.
Despite this, a Morningstar representative noted that the proportion of assets that would qualify for the future Ecolabel is likely to prove limited, potentially representing just 9% of total assets given the likelihood that the eventual new standard would include "no-harm" environmental requirements.
Overall, in our view, the proposed new standard appears likely to have several key flaws:
- Future Ecolabelling will identify investment areas that are environmentally-favorable in composition, rather than focusing on the actual degree of environmental change potentially achieved by a project or investment. "Transitional" projects that may reduce carbon usage substantially - such as moving from coal to gas-power generation or using aircraft with lower fuel consumption - may well have a greater overall environmental benefit than assets that qualify for the Ecolabel but would not qualify as they involve becoming "less brown" rather than Green.
- Environmental change ultimately needs to impact all firms and governments, not just a narrow segment. As such, while welcome, the proposed Ecolabel is highly unlikely to be sufficient. Over time, a further standard that looks on a transaction-specific basis at environmental impacts would be a key second measure - particularly given that moving larger parts of the aggregate economy from "brown" to "less brown" practices may well provide far greater aggregate carbon savings than the "greenest, environmentally-friendly" projects fitting under the Ecolabel. Improved environmental practices will need to be encouraged in all segments, not just a modest part of the corporate sector. In this context, prior comments by Bank of England Governor, Mark Carney, favoring "50 Shades of Green" within the range of environmental finance criteria - rather than only a narrow definition - would seem justified.
- Primary investment - buying new shares or debt to fund environmental improvement - provides a direct financial contribution to supporting climate-friendly investment. However, secondary investment does not: it simply moves an existing asset from one asset manager to another. Undue focus on what a fund holds thus might fail to capture its actual direct capital contribution to new climate-positive investment in a given period.
In previous reports, we have commented several times on the extensive market discussions regarding the relative merits of the well-defined and externally-monitored Green Bond framework, and the wider area of ESG finance. In both segments, there has been controversy over whether companies linked to high carbon-footprint activities - such as Schiphol Airport and Brazilian meat producer Marfrig - should have been able to access these segments even if the specific use of proceeds was presented as environmentally beneficial. The effectiveness of monitoring in some geographies also has been subject to adverse focus, as in the Marfrig case. Such aspects of Green/ESG finance are yet to be resolved.
In recent months, the topic of "Transition finance" also has featured heavily, with French multinational insurer Axa presenting its own initial proposals for a taxonomy that looks at environmental benefit as a key measure, spanning firms that would not qualify for the Ecolabel. It argues that covering this segment - roughly 90% of the total market - is potentially of considerably greater overall benefit than the current focus on "clean activities".
Broadening labelling standards to the wider "Transition" area is still at a very early stage. As such, it appears unlikely to benefit near-term from defined standards, but we would assess that this is likely to change in coming years. The area is the subject of dedicated focus by ICMA's ESG Principles Committee, but such work started relatively recently. Meanwhile we would expect more companies to use the wider ESG label employed earlier this year by Enel, with more issues which specify environmentally-positive applications for the proceeds of issuance and individual criteria for environmental impact measurement. Assessing and monitoring such projects is likely to be easier for larger and more sophisticated investors, with sufficient internal capacity to undertake such work, than for smaller or retail buyers for whom the eventual Ecolabel would represent an important starting point.
Growing focus on climate change makes the EU's Ecolabel project of considerable importance for asset managers, giving a "seal of approval" for specific types of activity. It is also widely viewed as offering guidance and precedent at a global level, potentially helping US classification, which is at an early stage.
Over time, however, we would this initiative as positive but insufficient. A Transitional Finance taxonomy that considers net environmental benefit even where a new process remains partially "brown" is a crucially-important addition to the range of classificatory tools, but this area is still at an early stage of development.
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