ESG taxonomies

The search for common global definitions, corporate reporting standards and metrics has gathered pace, with more jurisdictions joining the debate and an important initiative by the IFRS Foundation. Will one global set of definitions, reporting standards and metrics emerge?

There is progress, but there is still a long way to go. Political and social momentum is on the side of policymakers seeking to reach agreement on standards, but the journey to convergence will not be easy. The more detailed standards and rules become in one jurisdiction, the more difficult it may be for others to converge with them.

At each stage of the convergence journey, a balance needs to be struck between detail and flexibility. Regulators and standard-setters need to be aware of the risk of over-stepping their mandates and over-directing capital flows. Industry is calling for clarification of minimum standards in order to help capital flow to carbon-intensive developing economies, which cannot yet reach global or European standards and which need capital to transition to a sustainable future, and quickly.

Principles for taxonomies

A BIS paper entitled “a taxonomy of sustainable finance taxonomies” develops a framework to classify and compare existing taxonomies. Several weaknesses emerge from this classification and comparison, it says, including the lack of usage of relevant and measurable sustainability performance indicators, lack of granularity and lack of verification of achieved sustainability benefits. The paper therefore proposes key principles for the design of effective taxonomies:

1. Taxonomies should correspond to specific sustainability objectives
2. The development of transition taxonomies, which focus on alignment with the objectives of the Paris Agreement, should be encouraged
3. The evolution of certification and verification processes should be monitored and supervised
4. There should be a shift to mandatory impact reporting for green bonds

Given global concerns about the diverse range of sustainability standards, standard setters are joining forces to strive for consistency in corporate reporting. The IFRS Foundation Trustees are establishing the International Sustainability Standards Board (ISSB) which will propose financial and non-financial reporting standards related to climate change. In addition, the Carbon Disclosure Project (CPD), Climate Disclosure Standards Board (CDSB), Global Reporting Initiative (GRI), US Integrated Reporting Council (IIRC) and the Sustainability Accounting Standards Board (SASB) are working together. 

A definition of what and how to measure it?           

A fundamental difference between existing taxonomies is whether they cover climate change, environmental risks more widely or the full set of environmental, social and governance (ESG) factors. The UN Sustainable Development Goals (SDGs), the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD), the EU Taxonomy Regulation and the US SASB framework all focus on different aspects. They are also a mix of definitions, metrics and reporting standards, as are the various industry initiatives, including the WEF metrics and the UK Climate Financial Risk Forum's guides. And some jurisdictions, such as the UK, are indicating that they intend to write their own taxonomies.

The highly charged debate in the EU about how to define environmentally sustainable activities demonstrates how difficult it will be to deliver common global standards. The Taxonomy Regulation covers six environmental objectives, but detailed technical screening criteria have so far only been issued for the first two — climate change mitigation and adaptation — and debate continues about key sectors such as nuclear energy and agriculture. However, the Commission estimates that the rules issued so far cover 40% of EU-domiciled listed companies, in sectors which are responsible for almost 80% of direct greenhouse gas emissions in Europe. 

In order for financial firms and institutional investors to measure their ESG exposures, they need data from the companies and projects they fund, insure or invest in, including other financial firms and products. Without mandatory and consistent definitions, metrics and reporting, it is difficult for firms to obtain the data they need, let alone verify their accuracy. 

Listed corporates are responding by improving their ESG reporting and credentials. Around the globe, the TCFD recommendations are being incorporated into corporate reporting requirements, but there are still many data gaps, a lack of consistency and differences across asset types. For the latest on reporting and disclosures, see our separate article.    

What is material?

The EU Taxonomy Regulation enshrines a “double materiality” concept, which requires consideration of how an activity is helping to meet one or more of the objectives and that it does no significant harm (“DNSH”) to the other objectives. Firms must look in two directions and must also decide whether any indicator or data point is material. This construct feeds through to consideration of principal adverse impacts (“PAIs”) in the EU Sustainable Finance Disclosures Regulation (SFDR), which impacts investors and their intermediaries (the buy-side). It has significant ramifications for data needs and operations. 

Within international discussions on corporate reporting, the IFRS Foundation has said the ISSB's work will be based on the existing and long-developed IFRS concept of materiality and will not adopt the EU's double materiality concept. Simply put, corporate reporting standards are concerned about a company's own financial health and risks to it, not about what impact the firm is having on the planet. The Foundation has said, however, that the ISSB's standards will not preclude the EU from adhering to the double materiality concept within the bloc, or preclude similar concepts being adopted elsewhere.

Don't forget good governance

The EU Taxonomy Regulation says that even if an activity supports at least one of the environmental objectives and does no significant harm to any of the others, it cannot be classified as environmentally sustainable unless the company also follows good governance principles (the same holds for socially-sustainable activities). In other words, the EU framework is not E and S and G, but EG and SG. 

In addition to further technical screening criteria to come on the sectors mentioned above and the other four environmental objectives, the EU is working on a social taxonomy and may provide further articulation of what good governance looks like.