Is your financial firm getting started with EU Taxonomy reporting for Article 8, 8+ and 9 funds? Here's all you need to know about before diving into it.
Dec 20, 2022
Tobias Sparwasser Soroka
Is your financial firm getting started with EU Taxonomy reporting? Here is all you need to know
The reporting of financial KPIs based on the EU Taxonomy does not only apply to companies in the real economy.
Fund providers must report on the Taxonomy alignment of every portfolio company included in their Article 9 funds (also sometimes referred to as “dark green funds”), while credit institutions need to be aware of the proportion of their Taxonomy-aligned assets to compute the Green Asset Ratio.
EU Taxonomy reporting requirements add up to the many disclosure obligations already faced by financial market participants. This article will guide you through the key steps involved in EU Taxonomy assessments for financial institutions and firms, as well as of the challenges and best practices that come along with them.
This piece benefits from the valuable contributions of:
Joshua Brunert, Global Head of ESG Product at Apex Group LTD
Dorit Schulte, Director at Frank Partners
Johann Weicht, Principal Consultant and EMEA Co-lead EU Green Deal and Taxonomy Services at ERM
Lukas Simon, Sustainable Finance Solutions Manager, Frankfurt School - UNEP Collaborating Centre for Climate & Sustainable Energy Finance
The article is the third in our series on how to get started with EU Taxonomy reporting: We have previously published two guides focusing on Taxonomy eligibility and alignment.
STEP 1: Identify your sustainability goals and the type of financial products your firm deals with
When you are just getting started on your EU Taxonomy journey, it's essential to consider the following points carefully:
The strategic considerations behind these assessments
The requirements associated with your financial product: Green Bonds and sustainable funds come with different reporting requirements. These also evolve over time.
If you plan to set up a SFDR-labeled fund, make sure you are aware of the two main challenges associated with this task
Create a clear strategy plan
Before getting started on EU Taxonomy eligibility and alignment assessment, it is important to take a closer look at the type of financial products your firm deals with. Also, it can be helpful to think strategically about your Taxonomy assessment needs, e.g. on the products your firm offers or plans to offer in the future.
For example, it might be worth investigating the extent to which your firm intends to focus on impact investments (in addition to or instead of SFDR Article 8 and 9 funds). As stressed by Johann Weicht (ERM), “It is important to understand how in-depth you want to integrate the Taxonomy criteria into your investment processes.
We are not only talking about the risks and opportunities that come with having Taxonomy-aligned or non-aligned investments, but also about the cost of integrating these assessments into the processes at certain points in time, and the speed and cost at which they can happen.”
Diverse practices are emerging in the market: according to Dorit Schulte (Frank Partners), “For some private equity investors, eligibility or alignment with the EU Taxonomy is just one of many factors to take into account when evaluating investment targets from a sustainability point of view. Other investors formulate their ESG impact thesis around Taxonomy criteria and specifically look for industries or target companies where they expect to see a high degree of Taxonomy eligibility or alignment.”
As a general trend, however, “We are seeing that investors are increasingly incorporating considerations around the EU Taxonomy into their investment decisions, both in the sourcing phase, when they look for investment targets, and during the pre-acquisition due diligence process.”
Bond or debt instruments?
If you are investing in a bond or debt instrument, you must assess the EU Taxonomy eligibility of that specific product.
This can be calculated based on whether the proceeds of that asset are allocated to a Taxonomy-eligible project.
Once eligibility has been proven, all that is left is calculating the Taxonomy alignment score of that specific project.
To prove that a fund qualifies for the Article 9 label, fund managers and financial service providers will need to scan portfolio companies for eligibility and alignment with the EU Taxonomy.
The process entails calculating the aligned revenues and capital expenditures of portfolio companies and then weighting the result against the percentage of the fund allocated to each investment.
Even before creating a financial product, it is worth keeping in mind that the portfolio companies will not only have to be assessed against the Taxonomy before the investment but also periodically afterward. Hence, fund managers should not only check the requirements already in place for the industry or industries in which the investment is made but also those that are going to enter into force in the long term.
For example, currently, for the "Manufacture of Low-carbon Technologies for Transport" to be Taxonomy-aligned, CO2 emissions of new cars or vehicles must not exceed a certain threshold. After the 1st of January 2026, though, only zero-emission vehicles will be considered compliant.
This initial step poses two main challenges for financial firms:
Challenge 1: Determining The Existing Needs In Terms Of Taxonomy Assessment From A Strategic Perspective.
It is important to remember that Taxonomy assessment is entirely separate from internal impact assessment methodologies. Moreover, impact-focused firms should realize (and make clear to investors) that Taxonomy assessments are necessary beyond impact – and primarily for compliance reasons.
This also highlights the final goal of the Taxonomy regulatory framework: that all impact investment funds are subject to the same, science-based requirements.
As Joshua Brunert (Apex Group Ltd) puts it: “Every impact investment is now regulated by a unique framework against which investors can compare it. This goes beyond the peculiar methodologies used by individual funds to evaluate impact. And this is exactly how the EU Taxonomy contributes to preventing greenwashing.”
In order to determine your Taxonomy assessment needs, you can reason around the following questions:
What are the strategic implications of the financial products being built?
Does your firm have the capacity to build an Article 9 fund that is, and will remain, Taxonomy-aligned? Or is it better to stick with the Article 8 label?
When trying to answer, reputational risks for the firm should also be factored in.
Challenge 2: Dealing With Unclear Regulations
The second is determining exactly, what your firm must assess between eligibility and alignment amidst regulatory uncertainty. Unfortunately, there has been some confusion as to the exact requirements for the Article 8 SFDR label and whether a Taxonomy eligibility assessment is needed for these funds.
Additionally, because of the current regulatory limbo, and the fact that Level 2 of the SFDR is not in force yet, many fund managers have been left in the dark as to whether an assessment of Taxonomy exposure, a full alignment assessment, or simply Do No Significant Harm (DNSH) compliance is necessary for an Article 9 fund to comply with SFDR label requirements.
Regulatory uncertainty can be palliated through a “best practice” approach. Eligibility assessment is not necessary by law for Article 8 funds, but providing a justification of the environmental and social characteristics of the fund by relying on Taxonomy eligibility, alignment and DNSH criteria is a fool-proof and science-based way of demonstrating goodwill.
Moreover, Art. 8 funds need to complete Taxonomy disclosures where they “promote environmental characteristics” and commit to making environmentally sustainable investments as defined by the Taxonomy. For Article 9 funds, thorough due diligence must be conducted on every potential portfolio company.
Therefore, it might in some cases be safer to secure an “ambitious” Article 8 fund, than to overreach by trying to certify a fund as Article 9 when the probability it achieves a satisfactory level of alignment is low. Lastly, full Taxonomy alignment assessments will be necessary for Article 9 due diligence and reporting from the entry into force of SFDR Level 2.
“The Article 8 and Article 9 give you a pretty straightforward picture of what should be included and what should not. But one thing is the theory and another one is how you incorporate the EU regulations in the practice when you have several hundred funds” adds Lukas Simon (Frankfurt School - UNEP Collaborating Centre for Climate & Sustainable Energy Finance).
STEP 2: Eligibility and alignment assessment
Once you have determined the type of financial product you are dealing with, and the requirements applicable in the investment industry, you can start to assess the economic activities for EU Taxonomy eligibility and alignment.
Asset managers who wish to determine the alignment of their Article 9 fund should first check whether target portfolio companies already have mandatory disclosure requirements. If this is the case, eligibility and alignment scores can be gathered directly from annual or sustainability reports. For a comprehensive timeline of how these requirements will unfold upon non-financial undertakings, check this article by Simmons and Simmons on the EU's provisional agreement on the CSRD.
In reality, obtaining up-to-date and complete information could be challenging, especially in the following cases:
The company has published a report that is mainly qualitative, and not fully compliant in terms of alignment disclosures (for instance, because of missing data).
The company only had to report on eligibility for the previous financial year. This implies that the data is outdated and cannot be used to prove the alignment of the fund.
The company has not published a report yet or is still not impacted by reporting requirements. This is currently the case for companies that do not fall under the scope of the Non-Financial Reporting Directive (NFRD).
Many companies might still be in the process of perfecting their reports, as stressed by Johann Weicht (ERM): “Even though the first eligibility reporting might be over or almost over for most companies, many are still working their way toward solid eligibility reporting. Alignment is the next big step.
Obviously, all the challenges that investees or portfolio companies have, are multiplied by the number of such companies that your fund deals with”. If it is not possible to gather data from the company’s public reports, the asset management firm will have to perform the assessment on its own. For the purpose of this article, we will not go through the details of the process.
The financial sector faces a specific challenge with regard to Taxonomy assessments: data gathering from portfolio companies
Most companies will already have a decent amount of data on hand.However, this is very often unstructured and disorganized.
The lack of data could lead to a wasteful back-and-forth between financial firms and their investees. As stressed by Dorit Schulte (Frank Partners), “One of the main challenges private equity investors are facing is access to relevant information. With investments in smaller, non-listed companies that don’t fall under Taxonomy or other reporting obligations themselves, there often is a lack of structure and internal capacities to efficiently collect relevant data.
Even private equity investors – who, as active owners, have comparatively good access to their investee companies – are one layer removed from the day-to-day business and often struggle to obtain the numbers they need.” This issue is especially acute in the following cases:
Companies that do not yet have to comply with Taxonomy-disclosures (privately-held companies and start-ups). Previous compliance data is probably non-existent or not granular enough for Taxonomy assessment
Publicly listed portfolio companies based outside of the EU. These companies face no mandatory Taxonomy reporting obligations (yet). This problem might be mitigated by the fact that the data reservoir of these businesses is typically larger. However, it is important to keep in mind that their existing data structures and available assessments might not fit EU standards, on which the Taxonomy is based.
There is no out-of-the-box answer to these challenges: Sometimes, it can be worth trying to communicate directly with the company and pressure them to launch a Taxonomy assessment set-up and process. For funds dealing with European companies with upcoming Taxonomy obligations (such as those that will enter the scope of the CSRD, that will enter in force as soon as next year), this can be relatively easy.
A greater challenge is posed by unlisted SMEs and startups that fall outside of the scope of the CSRD criteria (250+ employees, €40m balance sheet total and/or €20m annual turnover). These firms are less incentivized in terms of getting ahead for Taxonomy reporting. However, there is a chance for them to be more responsive to the favorable capital advantages they can gain from being included in an Article 9 fund.
“The principle of this regulation is not to catch people out, but rather to enable companies and investors that are doing good to stand out from the crowd and to access greater sources of capital” says Joshua Brunert (Apex Group Ltd).
“At the end of the day, smaller companies with a higher Taxonomy alignment will get a competitive advantage even without the sustainability marketing clout of a big multinational.”
According to Lukas Simon (Frankfurt School - UNEP Collaborating Centre for Climate & Sustainable Energy Finance), a good approach is making sure to “have some kind of guidelines in place, and ask the client only the specific information that you really need for the dedicated purpose.”
Finally, publicly listed non-EU companies are most likely to be able to provide adequate and sufficiently granular financial data. The same does not apply to many of the assessments required for alignment analysis, many of which are fundamentally based on EU standards.
With these companies, it can help to stress the efficiencies that will be created once these assessments are conducted for the first time and the ESG data structure of the company is adapted to the law applicable to the EU Member States. Data gathering issues affect almost every financial market participant. To obtain the required data, it can be worth considering the provision of external help and expertise.
This can be done through the use of reporting software and/or external financial services providers. The input of external experts can not only help you better understand the regulatory requirements, but also avoid potential rabbit holes and pitfalls.
STEP 3: Calculate the final eligibility and alignment percentages of your financial products
Once all the Taxonomy compliance data has been gathered from portfolio companies, it is necessary to check and regroup the evidence in order to estimate the fund’s overall alignment percentage. The fund’s overall alignment score will stem directly from the alignment data of portfolio companies.
It is essential to make sure that all relevant KPI data such as aligned and eligible Turnover, CapEx, and OpEx have been gathered. In fact, even if a company or activity is not fully aligned with the Taxonomy, asset managers still have the option to account for Do No Significant Harm or eligibility as part of Taxonomy disclosures.
For example, some Article 9 fund managers may lack complete data for Taxonomy reporting this financial year, but have the option to use estimates (see below) and still-to-disclose DNSH and eligibility-related data to make their disclosures as reliable as possible in spite of data gaps.
As the extent of Taxonomy-disclosures requirements for Article 8 funds does remain ambiguous, publishing compliance information on DNSH and eligibility may also boost (on a voluntary basis) the quality of Article 8 disclosures.
STEP 4: Create the final report evaluating your entire fund or portfolio
To report against the Taxonomy, asset managers must first differentiate between the disclosures that are required of them at the product and the entity level. Taxonomy disclosures mostly concern the product level. However, at the entity level, a weighted average of Taxonomy-aligned investments has to be disclosed.
The creation of this final report is challenging due to the volume of disclosure data that must be handled and synthesized. Within the data of Taxonomy-aligned portfolio companies, funds must also differentiate between turnover-related KPIs and expenditure-related KPIs. These will have to be reported separately.
Since no EU Taxonomy periodic reports have been published by asset managers yet, no “best practices” are yet available. At the moment, financial market participants are still gathering data from portfolio companies – which, as we have seen, is a very challenging process.
Nevertheless, it should be stressed that reporting this data according to Taxonomy standards will benefit any asset manager that wishes to preserve the SFDR labels associated with its funds in the future, and also other financial institutions. As stressed by Lukas Simon (Frankfurt School - UNEP Collaborating Centre for Climate & Sustainable Energy Finance), “Surely the quality of information will improve in the upcoming years, if the upcoming CSRD goes in the right direction."
"Having a good overview of the ESG performance of companies will be valuable not only for investors but also for banks. In turn, this will also enable SMEs to know which kind of information they need to report.”
That is also part of the reason why, according to Johann Weicht (ERM), in the long run, proxy data won’t do:
“While using proxies or estimates might seem like a very natural approach, the question is always about gauging risks and benefits from a methodological perspective.”
In a recent reply to questions from the European Supervisory Authorities (ESA), the European Commission clarified that financial market participants that cannot provide data on the Taxonomy alignment of portfolio companies must report zero Taxonomy alignment, even if they provide one or several Article 9 funds. The FAQ also specified that estimates based on external information may only be used in exceptional circumstances for activities for which “complete, reliable, and timely information” could not be obtained over the financial year 2022.
Financial Market Participants dealing with EU Taxonomy disclosure or planning to do so in the future should be aware of a number of compliance requirements, as well as strategic considerations.
In particular, they should consider:
The kind of financial product in question. Different products might face different reporting requirements under EU regulations
Whether portfolio companies' sustainability data are already at their disposal, and to what extent they can rely on them
To what extent will they need to conduct assessments on their own, and how to efficiently communicate reporting requirements to their investees
What the final report should look like, and what data shouldn't be missed
Why should you lay down the foundations of Taxonomy reporting right now?
Filling the existing gaps both in eligibility and alignment assessment will make fund creation and due diligence process easier and more streamlined in the future, allowing organizations to save significant time and resources.
According to Johann Weicht (ERM), “A final theme for investors is: what is a sustainable investment in the meaning of the SFDR when the investee and their activities are not covered by the Taxonomy itself? What follows from this question is a highly conceptual process: to take the Taxonomy’s key concepts, i.e. significant contribution, doing No Significant Harm, and the Minimum Social Safeguards, and to apply them to one's own investment themes and sectors in a way that is ambitious enough and yet remains attainable, to avoid greenwashing.”
In the long run, virtuous companies and funds will inevitably stand out from the crowd.
As Joshua Brunert (Apex Group Ltd) highlights: “As the dust starts to settle, people will start to get more practice in Taxonomy reporting using the expertise that is out there. Companies and financial products which can demonstrate high levels of alignment are going to be able to access green and social bonds, while also marketing themselves as positively impactful. That is why everyone needs to understand the opportunity that this regulation represents: the Taxonomy enables you to improve your environmental performance whilst still making returns.”
Briink's software is designed to give investors a clear overview of their EU taxonomy reporting requirements under the SFDR, and to help them and their portfolio companies gather and analyze large volumes of data.
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