A precise definition of green investment is proving a challenge to the European Union as it attempts to develop a green financing classification for assets
Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.
This article was first published in the July/August 2018 International edition of Accounting and Business magazine.
In the forest of green finance, a single standard would fell all uncertainty. That is the aspiration of the European Commission as it lays out its plans for a regulation that will define once and for all what types of investments are green, as part of its ‘Action plan for a greener and cleaner economy’. In May it stated that its proposals ‘will allow the financial sector to throw its full weight behind the fight against climate change’.
The initiative is significant. At present, estimates show that global investment classified as socially responsible in 2016 amounted to US$22.89 trillion of assets, a jump of 25% over the previous two years. Of this, much is classified as green.
It’s an impressive sum, suggesting that many investors have already converted to socially responsible assets, leading to a better and more environmentally friendly society. But the figure is by no means reliable. Many asset managers have categorised their investments as green by using the most superficial of criteria to screen out a handful of sectors. Some will have adopted a standard to define their criteria, but the standards differ, and there is no rule to stop an organisation inventing one of its own.
For example, the classification for the Climate Bonds Initiative, a non-profit promoting green bonds, excludes fossil fuels and is currently undecided about nuclear power and carbon capture and storage. Another classification (or taxonomy, in the jargon) created by the International Development Finance Club, a network of national and regional development banks, includes carbon capture and storage but excludes nuclear power.
Yet it is not just the criteria for green investing that vary. Companies measure their pollution and environmental impacts differently too. For example, luxury goods producer Kering, owner of the Gucci brand, measures (and monetises) air pollution as well as carbon emissions from its activities, whereas jeans brand Levi Strauss measures carbon emissions and climate change impacts.
In the European Union, which has one of the strictest sustainability reporting regimes in the world, both the type of impact and how it is measured are voluntary disclosures. Disclosure is mandated through the EU’s 2014 non-financial reporting directive, which applies to larger corporations rather than specifically to financial services companies and intermediaries.
A green classification is targeted mainly at investors. It aims to shake out and challenge poor performers. But how could such a classification be constructed? In one model, policymakers draw up a list of greener industries. But difficult questions remain. Biomass combustion, for example, is carbon-neutral by convention, although the exact carbon emissions depend on the fuel used, and biomass can increase other types of air pollution.
These issues mainly concern the energy sector, but what about the classification of the chemicals sector, which may introduce green energy at individual plants but is still responsible for other types of pollution? A European Commission spokesman says: ‘The taxonomy is unlikely to allow measurement of the performance of a company or activity – ie whether that company is in a safely green industry. For that you need to go to the individual company level.’
One proposal is to introduce industry benchmarking – reviewing the averages across a sector. The European Commission spokesman says: ‘The taxonomy would define pollution benchmarks. There would be a metric, and this metric would be for a particular industry in terms of, for example, standard emissions for the sector. That means a classification of the company’s economic activity and of the investment in its economic activity.’
Other hazards exist, notably in the gaps between definitions of climate friendly and environmentally friendly activities, and between environmentally friendly and socially responsible investments. It is through such loopholes that irresponsible finance escapes. A taxonomy worked out in slices (ie using individual types of environmental impacts) could also drive asset stranding by prioritising one type of impact over another.
But at least the process has now started in an industry where environmental accountability has been previously ignored: the financial sector. It is attracting considerable controversy. Many asset managers run one or two environmental, social and governance (ESG) or pure environmental funds alongside conventional funds, and few are pure players. Intermediaries in the financial system, such as asset managers, have not been used to such scrutiny because they have traditionally focused on pension fund owners.
But the European Commission’s definitions will not be cast in stone. ‘The taxonomy will be widely reviewed,’ says the spokesman. ‘We don’t need to make it mandatory but need a clear steer on what is sustainable and what is not.’ The classification will allow investors to cross-reference during critical financial transactions, such as when a company preparing for a stock market launch issues a prospectus for an IPO.
However, the regulation introducing the taxonomy is accompanied by another rule: to bring consistency and clarity to how all asset managers, insurance companies, pension funds or investment advisers should integrate ESG factors in their investment decision-making process. Combined, the rules will stir the market in two different directions.
First, whatever shape it takes, the green financial taxonomy and disclosure standards will introduce a hierarchy from brown to dark green. Second, green will probably signify higher quality, separating environmentally friendly leaders from laggards, and drawing more capital towards greener products. For the first time, equity owners aiming for dark green investments will become aware of a wider pool to choose from.
Elisabeth Jeffries, journalist
CPD technical article
"Many asset managers have categorised their investments as green by using the most superficial of criteria to screen out a handful of sectors"