Our understanding of planetary boundaries has never been greater. And yet finding new desirable and sustainable ways of living remains a journey that requires a compass.
This is the daunting task that the European Commission has undertaken by developing the first Taxonomy, a set of rules to characterize the sustainability of financial assets and corporate activities. This seminal work is now being relayed in many jurisdictions and coordinated through the International Platform on Sustainable Finance[1]. In Europe, companies have started reporting their share of alignment to the Taxonomy and investors can assess such information for their portfolios. The development of the Taxonomy has, however, proven to be a challenging process[2] and, as of today, only the Environmental pillar is covered and only partly so.
Until the Taxonomy is fully developed, the European Commission has introduced a complementary concept to serve as an alternative compass: “Sustainable Investment” (SI). To classify as a SI, shares or bonds must be issued by a company[3] that follows good governance, does no significant harm and can demonstrate positive contribution to environmental or social objectives.
‘Mirror, mirror on the wall, who is the prettiest of them all?‘
The big issue is that the European Commission has delivered a half-baked definition of SI, leaving to Financial Market Participants (FMPs) the responsibility to devise ways to concretely implement this broad concept.
“Mirror, mirror on the wall, who is the prettiest of them all?” This seems to be the question that the market at large has asked over the last months, in an attempt to figure out which SI methodology would maximize the SI% of existing financial products, while at the same time steering clear of greenwashing criticisms.
Looking at our indices, we have found that SI% figures can vary by a factor of 5 depending on methodological assumptions. The stakes are high, as under MiFID II, final investors can now define their sustainability preferences by highlighting the share of SIs they expect for their portfolio.
The most problematic unanswered question to date is whether the classification as an SI should be binary (0% or 100%) or not (gradient). In the former case, above a given percentage of a company’s revenues having a positive contribution to society (say, for instance, 20%), the whole company would be classified as an SI. In the latter case, one would only account for the share of revenues having a positive contribution. Companies’ SI% could then be any figure ranging from 0% to 100%.
The gradient approach is used for measuring the alignment to the Taxonomy. SFDR regulation,[4] however, requires that all Article 9 funds constituents should be SI[5], a condition that can only be met if the definition is binary. Whereas defining a threshold above which companies qualify as SI might sound arbitrary and not provide enough discrimination, empirical evidence can support such a choice.
A recent study conducted by the Platform on Sustainable Finance[6] has found that less than 1% of 12,000 companies have more than 10% of their revenues aligned with the Taxonomy.
Considering this 1% of top performers as SI should therefore be acceptable, even though such a classification does not distinguish between companies that are 11%-aligned with the Taxonomy and those that are 100%-aligned.
The second issue is the lack of clear guidelines[7] on how to articulate the two components of a company’s potential positive contribution: the products and services they sell (i.e., revenues alignment) and the way they operate. SI should indeed also account for operational performance, as many sustainability objectives depend on it: biodiversity, gender equality, human rights in the supply chain, to name a few.
One major drawback of the characteristic of Art. 9 products being exclusively composed of SIs, as seen above, is that it dramatically restricts the investable universe. Driving high-impact investment demand to such a narrow segment might lead to liquidity and price issues. Neither it reflects the fact that environmental and social objectives can also be achieved by fostering the evolution of companies that are not pure players but have a large environmental or social footprint through their operations. Paris-aligned benchmarks, Europe’s best-of-breed climate indices, are a good example.
A way forward for the regulator would be to set an SI threshold at financial-product level, rather than at constituent level. The minimum weighted average SI% level of a fund to classify as Art. 8 or 9 could be fixed at a certain threshold, while their constituents’ individual SI% could range from anything between 0% to 100%. This would yield a double dividend: it would allow a consistent progressive measurement of the positive contribution and it would open the possibility for Art. 9 products to include a much broader range of companies. Another option would be to provide clarity on the use of capital expenditure (capex) and operating expenses (opex) to identify companies that are making the transition to SI.
Last, the implementation of SIs in an efficient manner is also significantly hindered by the lack of reported data at company level. According to the sustainable finance platform Good Governance, a prerequisite for all Arts. 8 and 9 products should be measured through Principal Adverse Impact (PAI) 11. This indicator identifies the share of investments in companies with due diligence processes to ensure compliance with the UN Global Compact and OECD Guidelines for Multinational Enterprises. Alas, in that instance, data availability for some 11,000 companies considered lays below 20% among ESG data providers that we have assessed.
‘Not all those who wonder are lost’
Clarification by the European Commission is urgently needed to end the current state of confusion and allow FMPs to reallocate time to sustainability integration in their investment processes. In the meantime, Qontigo has chosen to rely on core principles to implement a progressive approach to measuring SI for its indices:
- A 20% threshold on revenues making a net positive contribution[8] to fully classify as SI. Under that threshold, companies do not qualify as SI.
- Sustainable Development Goals (SDGs) as a relevant framework to account for sustainability objectives not covered by the Taxonomy.
- A commitment to account for companies’ operational performance as soon as clear regulatory guidance becomes available.
- Regular methodology updates to account for improvement in data availability supporting better granularity in sustainability assessment.
- Flexibility to support clients in the calculation of their own approach of sustainable investment.
While the universal sustainability compass is not available yet, the work in progress has already delivered very valuable learnings:
- The SI% or Taxonomy% of broad portfolios is below 10%. This should not come as a surprise given the trends of biodiversity loss, deforestation, greenhouse gas emissions, reduction of life expectancy in developed countries[9], and more than 300 million new people suffering from hunger since 2019. This signal should rather be heard loud and clear, pointing how far we still are from a regenerative economy[10], whereby we live from the interests of growing capital stocks[11] rather than from depleting them[12].
- Both regulations have made clear that sustainability will be delivered in two ways: through positive contributions and by refraining from causing significant harm. SI and PAIs are thus the two sides of the same coin. This should provide a clear signal to investors and companies to simultaneously improve their products and services and the way they run their businesses.
Going forward
The transition pathway to SI mainstreaming has just begun. It requires nothing less than augmenting the industry’s DNA. The ambition, efforts and vision that regulators and early adopters have demonstrated to kickstart this (r)evolution must be acknowledged. The whole industry is now in motion and there is no turning back.
Going forward, however, stakeholders will still have to face uncertainty and frequent headwinds. Defining what is sustainable is often the outcome of a difficult compromise between two evils,[13] or the resource-constrained arbitration between desirable objectives[14]. Individual values then play a key role as there is no obvious objective solution. The sustainability north star, in that sense, would be the outcome of a well-informed and transparent, collective choice[15].
Qontigo’s open architecture is a pledge to that customer centricity from product design to reporting of outcomes. As our clients’ views on SIs evolve, it is our responsibility to provide them with the most robust and yet highly flexible solutions.
* Antonio Celeste is Director for Sustainability Product Management at Qontigo, and Saumya Mehrotra is Associate Principal, Sustainability Product Management.
[1] Members of IPSF represent 55% of world GDP and GHG emissions.
[2] Including a heated debate on the inclusion of nuclear energy and gas as ‘green.’
[3] It is unclear how government bonds should be considered there (under the Taxonomy, two reports are expected: one including and one excluding government bonds).
[4] The European Commission’s Sustainable Finance Disclosures Regulation (SFDR), from 2019, sets out sustainability-related disclosure requirements for financial market participants, advisers and products. SFDR Level 2 Regulatory Technical Standards (RTS) come into effect on Jan. 1, 2023.
[5] European Commission, Q&A on Sustainability-related Disclosures (July 2021).
[6] European Union, ‘Platform on Sustainable Finance,’ October 2022. No explicit reference to the PSF test of 12,000 companies appears in the report, but this was mentioned during a Principles for Responsible Investment (PRI) workshop.
[7] See European Banking Authority, ‘List of additional SFDR queries requiring the interpretation of Union law,’ Sept. 9, 2022.
[8] We identify the maximum share of revenues that have a positive contribution and deduct the maximum share of revenues that have a negative contribution.
[9] See Case, A., Deaton, A., “Deaths of Despair and the Future of Capitalism.”
[10] WEF, ‘What is regenerative capitalism and why is it important?’ Jan. 24, 2022.
[11] Human, natural, financial and manufactured capitals as illustrated by the Inclusive Wealth Index.
[12] See also Global Footprint Network, ‘Earth Overshoot Day.’
[13] For combustion engine cars, improving CO2 comes at the expense of NOX emissions, for instance. For electric cars, the no-emissions benefit is in balance with the battery recycling issue and the need to open new mines.
[14] Investing in pollution reduction or increasing minimum wage, for example.
[15] To fully close the loop, SI solutions should not only reflect final investors’ broad preferences but also actively involve them by relying on assets’ sustainability ratings defined by all relevant stakeholders Just Capital in the US or Impaakt in Europe are emerging solutions addressing these needs.