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EU Sustainable Taxonomy could help PE groups assess efficacy of corporate ‘green’ activities

Private equity groups keen to bolster their ‘green’ credentials may wish to consider how they might avail of upcoming Proposed Taxonomy Regulation in Europe, as they seek to standardise, and measure, the real impact of sustainable investments in their portfolios.

As part of its Action Plan on Financing Sustainable Growth launched in March 2018, the European Commission sets out the importance of establishing a classification system to encourage a common understanding of sustainable activity, and to regulate such activity within a framework: thereby making it easier for investors to benchmark financial products that fall within the Regulation.

This sustainable finance taxonomy (‘Taxonomy’) is part of a wider initiative in Europe to encourage private capital into long-term ESG-focused investment activities, to the tune of up to EUR290 billion per annum.

The proposed Regulation represents an important part of an ambitious EU project “with the laudable aim of increasing the amount of private investment in environmentally sustainable economic activities in the EU”, comments Leonard Ng, Partner, Sidley Austin LLP and co-head of the EU Financial Services Regulatory group.


Private equity groups will not, explicitly, fall within the proposed Regulations – which are broadly aimed at certain financial participants and issuers, such as banks and insurance groups offering ‘green funds’, and at companies issuing public market securities (equities and bonds). But that is not to say that such a framework could not be adopted by early movers as best practice to evaluate the performance of underlying portfolio companies.

“This is the first real attempt to put some definition around financial products and activities that claim to have an environmental benefit,” explains Matthew Townsend, Partner, Allen & Overy LLP.

“One of the criticisms of a variety of financial products is they claim to be green, but the reality is they apply a multiplicity of standards and benchmarks so there is no consistency across the market.”

There is no international standard for investors to benchmark performance of companies and while the Taxonomy is not perfect – it is currently a very high-level framework and there remains substantial work still to be done on potential guidance and screening criteria – it is nevertheless a good starting point. 

Ng highlights the limits of the Regulation by stating that it does not compel sponsors to comply with environmental sustainability targets and that the success of the Regulation will largely depend on the value which the market attributes to the ‘green’ labels deriving from the Taxonomy. 

“We have, however, already seen pressure on our clients from their investors regarding ESG values, including, in some cases, active critiques by investors of sponsors’ ESG policies. The Regulation is only likely to continue this trend of environmentally conscious investor behaviour. Naturally, if a PE firm touts itself as ESG-friendly, it is likely to be asked to justify that claim based on the Taxonomy Regulation,” comments Ng.


PE groups who take an interest in the framework, and how it might guide their pre-deal due diligence process (including assessing the quality of companies’ non-financial environmental disclosure reporting), should be aware that there are six main sectors that will fall under the Taxonomy with respect to climate change mitigation. These include:

  • Agriculture, forestry and fishing
  • Manufacturing
  • Electricity, gas, steam and air conditioning supply
  • Water, sewerage, waste and the related remediation
  • Transportation and storage
  • Information and Communication Technologies (ICT)

“The taxonomy is really designed to apply to certain types of financial products and issuers of securities; it’s quite targeted,” explains Townsend. “I do think there will be a significant ripple effect for all market participants offering sustainable, green products. Even if, in the short term, a participant falls outside of the scope of the Taxonomy, I do think it will drive a framework, which could be applied across sectors and investment activities, including PE-related activities. “The Taxonomy also proposes a significant step-up in environmental disclosure requirements. For now, this is more focused on certain large undertakings such as banks and insurance companies but it will inevitably drive wider changes to what others are reporting.”

In his view, the European Commission hopes that the Taxonomy could have a wide knock-on effect and provide some definition around environmental claims across different investment activities.
”The context to this is that many banks and other investors (including asset managers) are developing their own benchmarking criteria for ESG investing or financially sustainable investment products. As a result, the market is full of different standards and benchmarks. The Taxonomy has the potential to put some shape around this and provide a strong reference point in the market for a variety of investment activities,” adds Townsend.

Private equity groups intent on developing dedicated impact funds could use the Taxonomy as a blueprint, or a guide map, on how best to analyse target acquisitions, even though the Funds themselves are unlikely to fall under the scope of Regulation. 

Furthermore, particular focus might apply to those doing deals at the larger end of the spectrum including take-private deals – especially if target firms have issued green bonds or have a clear commitment to reducing carbon impact in value chains etc. Adopting the Taxonomy within the investment process could, in such circumstances, help to reinforce a GP’s ‘green’ investment philosophy. 

Ng explains that at the portfolio company level, although private companies may not be within scope of the Non-Financial Reporting Directive (which would otherwise require them to disclose information about the sustainability of their activities in accordance with the taxonomy), they could also adopt the taxonomy voluntarily. 

“Indeed, the Commission’s Q&A on the Taxonomy Regulation gives the example of SMEs as potentially wanting to publish information on their website regarding their alignment with the Taxonomy Regulation, as a way of helping such companies to raise finance for their environmental/sustainability-related investments,” he says.

For regulated Alternative Investment Funds in Europe which do not have sustainable investment as their objective, the pre-contractual disclosures and annual reports will need to include a statement that the investments do not take into account the EU criteria for environmentally sustainable objectives. But as Ng pointed out earlier, many investors are already showing signs of interest in ESG values “so funds taking account of the EU criteria could find this to be an advantage”.

In Guernsey, one of the reasons for introducing the Guernsey Green Fund regulatory regime was the need by investors for a trusted, transparent product. The Fund aligns with current global green standards. 

Dr. Andy Sloan, Chair, Guernsey Green Finance, says: “The EU taxonomy is to be welcomed as it will help move the globe to common standards and a common taxonomy for green investments, which is clearly required to help route capital to genuine climate change mitigation investments. Over the course of the last six months we’ve been developing green principles for private equity which Guernsey Green Finance will be publishing next month.”

Time to put greenwashing out to dry

One of the criticisms among investors is that some investment managers engage in ‘greenwashing’ activities: that is, they jump on the ESG/sustainability bandwagon and look for ways to market their funds more favourably to investors by referring to green investment policies. The extent of these activities is open to interpretation. What this Taxonomy will do, however, is bring any such claims under increased scrutiny. It will be the first real independent framework to do so.

Townsend says that one of his concerns in the growing market for green and sustainable products is mis-selling. If, for example, you label a fund or loan as green and this is based on somewhat generic or flexible criteria, or the activities aren’t effectively monitored or verified, the risk is that the green or sustainable tag doesn’t stand up to real scrutiny and potential investor claims follow. 

As banks and other investors come under greater pressure to enhance their ESG credentials and move away from investments linked to fossil fuel based activities, they are starting to look much more closely at this. “From a PE investor’s perspective, funds may want to know that their investment satisfies the criteria established by the Taxonomy. We’re also expecting the Taxonomy framework to be applied more broadly so PE may look to adapt their investment criteria and ESG policies to reflect this.  

“The Taxonomy will likely evolve over time so we may well see a significant expansion in scope such that PE is more directly targeted.  We’re very much at the beginning of journey,” Townsend concludes.
 

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