The European Securities and Markets Authority (ESMA) has produced useful work quantifying the proposed extension of the voluntary EU Ecolabel to retail financial products.
Only 16 out of some 3,000 sustainability-orientated UCITS equity funds – i.e. funds reporting under the Sustainable Financial Disclosures Regulation (SFDR) Article 8 and 9 – are estimated to meet three main quantitative criteria set forth in the latest report from the European Commission.
The quantitative criteria are:
Minimum investments in environmentally sustainable economic activities – based on EU Taxonomy-alignedturnover/capital expenditure) – with a 50% threshold to be achieved at fund level
Environmental exclusions (companies deriving more than 5% of their turnover from environmentally harmful activities)
Social aspects and corporate governance exclusions (minimum social and governance safeguards, i.e. excluding companies deriving any revenue from socially harmful activities)
The assessment of funds against the first criteria relies on proxy data. As per the ‘cart before the horse’ principleof good regulatory management enshrined in recent European Commission sustainability work – undoubtedly under political pressure to perform in the financial sphere while action in the real economy is postponed – the European regulator has imposed reporting obligations upon institutional investors before imposing these on corporates issuing the underlying securities.
It follows that investors will have to rely on estimates rather than reported data.
By employing a proxy for EU Taxonomy revenues, ESMA found only 26 sustainability-orientated funds have an average portfolio greenness ratio of above 50%. If this threshold is lowered to 30%, just 136 funds make the cut.
Given the limited supply of 'pure-green' issuers and the state of belated transition towards 'greener' activities, setting high thresholds results in lowered funding extended to 'green' activities.
As the ESMA analysts write: “Under the proposed 50% greenness threshold and a fossil fuel exposure limit of 5%, the total value of green assets financed by funds eligible to the Ecolabel would amount to just €3bn.
“Under a minimum greenness threshold of 20% and fossil fuel exposure limit of 15%, this value increases to €27bn – at the expense of more money financing fossil fuel activities.”
This is consistent with recent empirical work showing that the simplistic energy exclusions rules built in the EU’s Paris-aligned benchmarks lead to structural underfunding of transitioning utilities and of the green activities undertaken by other energy companies.
In this respect, ESMA hints that thresholds should be relaxed in combination with strict oversight and materialisation of transition promises.
The regulator's study confirms the reasonable practitioner's concerns about the proposed calibration of the idea of extending the EU Ecolabel to retail investment funds.
The pool of eligible investment opportunities is simply too narrow to support the proposal at this stage of the transition.
The procurement of reliable and fit-for-purpose sustainability data is a challenge and will remain so in the medium term due to poor regulatory scheduling, indicator inflation, lack of definitional clarity and sometimes wilful ignorance of data limitations or downright design flaw metrics.
The benefits of the choices made by the regulator are very clear for commercial data providers but far less so for investors and investee companies – the over-representation of providers of ESG data, analytics and consulting services in technical committees should warn the European Commission of the risks of regulatory capture.
These aspects further contribute to establishing that the Ecolabel proposal needs a rethink if it is to make a meaningful contribution to the transition.
First and foremost, thresholds could initially be lowered to account for the current state of the transition and ramped up over the medium-to-long term to remain sufficiently challenging as the transition is implemented in the economy.
Second, the necessity of applying ESG exclusions beyond what is already required under the EU Taxonomy should be challenged.
Third, activity thresholds and engagement policy should be approached together to allow for a wider range of sustainability investing and impact strategies.
Finally, the data and administrative burden should be kept fit-for-purpose and reasonable. The regulator should make every effort to develop the public and truly open-source provision of sustainability data.
Frédéric Ducoulombier is director of the EDHEC-Risk Climate Impact Institute