The investment world is changing colour as it takes chameleon-like steps towards a greener future. Environmental, social and governance (ESG) performance is a growing consideration – but determining just how green each investment is can be a bewildering process.

ESG criteria for assessing non-financial performance embrace a diversity of elements which can be difficult to quantify, meaning that reaching an accurate measurement or assessment is far from simple.

The Financial Stability Board created the Task Force on Climate-related Disclosures in 2015 to attempt to develop a set of consistent financial risk disclosures for use by companies, banks, and investors.

Meanwhile, the Sustainability Accounting Standards Board was set up in 2011 to develop a global set of sustainability accounting standards.

Challenges remain, however, in ensuring the data collected is relevant, material, and comparable for quantifying a company’s ESG position, and investors must sometimes navigate a vast array of ESG information in weighing up their options.

Numerous ESG ratings systems have emerged over the years in an attempt to distinguish between consistent sustainability performers and companies that greenwash their image with suspect ESG credentials. 

By studying annual financial and non-financial reports, investment analytics, management data, and relevant media coverage, investors can produce numeric scores to judge companies’ sustainability performance and exposure to ESG risks. 

The dangers of deceptive data

However, as not all ESG ratings have the same set of focuses due to disparate contexts, metrics, and methodologies, they may at times be considered subjective, incomparable, or even misleading. 

This can lead to discrepancies where companies that score highly with one rating agency receive a lower score from another. The focus of some agencies may even lead to investment decisions that favour companies involved in greenwashing.

To tackle these discrepancies, investors are increasingly relying on their own proprietary ratings and vetting systems to assess and analyse the raw ESG data they collect from companies across their extensive portfolios. 

In cases where ESG ratings are used, investors will also need to thoroughly understand the methodologies and process of data collection used by rating agencies. 

To cut through the noise, sustainable finance taxonomies are being established globally. Europe, for instance, has introduced tougher regulations to provide investors with clear guidance on how to assess companies against new sustainability disclosure guidelines, ESG product definitions, and ESG fund requirements. 

In Asia, finance ministers and central bank governors from members of the Association of Southeast Asian Nations (ASEAN) have announced their support for an ASEAN Taxonomy for Sustainable Finance (ASEAN Taxonomy).

This will serve as ASEAN’s common language for sustainable finance and account for both international goals and ASEAN’s specific needs, and its development progress is expected to be updated by the end of 2021.

In China, meanwhile, the People’s Bank of China, the National Development and Reform Commission, and the China Securities Regulatory Commission recently launched China’s updated Green Bond Endorsed Project Catalogue.

This initiative aims to direct domestic green bonds towards green and low-carbon development strategies, based on China’s Green Industry Guiding Catalogue which defines green industries and has a focus on pollution prevention and control.

Foundations of a global green framework

The European Union (EU) has introduced three disclosure tools which form one coherent sustainable finance framework. 

Of those tools, the EU Taxonomy, which went into operation in July 2020, is a science-based classification system for green economic activities that contribute to the EU’s climate and energy targets for 2030, as well as the objectives of the European Green Deal – the EU’s strategy to transform into a sustainable economy. 

The EU Taxonomy complements the Corporate Sustainability Reporting Directive (CSRD), which is an amendment to the Non-Financial Reporting Directive (NFRD), and the Sustainable Finance Disclosure Regulation (SFDR). 

It aims to help companies and investors identify, report on, and finance sustainable economic activities while eliminating greenwashed investment risks.

The EU Taxonomy will not only serve as a central resource for foreign companies that conduct business in the EU or with European investors to ensure their economic activities are EU Taxonomy-aligned, but also as a model for taxonomies elsewhere. 

Globally, the EU is also co-leading an International Platform on Sustainable Finance (IPSF) working group with China to establish a common taxonomy, which identifies common ground between different taxonomies and supports the advancement of cross-border green investment.

To assess if activities are in alignment with the EU Taxonomy, companies should consider whether their economic activities substantially contribute to at least one of the six environmental objectives defined under the regulation.

At the same time, they should do no significant harm to the other environmental objectives, and comply with minimum social safeguards of the OECD Guidelines on Multinational Enterprises and UN Guiding Principles on Business and Human Rights. 

This process will allow companies to consider adjusting their activities to reduce potential regulatory and financial risks and to achieve taxonomy alignment.

Walking the taxonomy tightrope

Ensuring that the EU Taxonomy is holistic in every regard can be a challenge, particularly in the classification of gas and nuclear power. 

A phased implementation has been adopted for each of the environmental objectives to give participants the opportunity to get used to them and provide feedback. 

Some countries in eastern and southern Europe threatened to veto the draft of the framework as gas was not labelled as a green or transition investment. France and six other countries also lobbied to make nuclear power a recognised green technology. 

While lax criteria for a green label does carry the risk of allowing greenwashing, ruling out investments that may be necessary for moving toward climate neutrality could obstruct the transition to a sustainable economy. 

A lack of gas-fired power could lead to a more expensive energy transition and intensify climate change if coal-firing persists, for instance. With the emergence of green hydrogen, there are also benefits to building gas-fired plants which in future could be gradually switched to hydrogen.

Following the debates, the European Commission formally adopted the first delegated act on sustainable activities for climate change adaptation and mitigation objectives in June 2021. Both gas and nuclear power are to be reviewed for inclusion in a complementary delegated act.

A further delegated act for the remaining environmental objectives is scheduled to be published in 2022, providing investors and companies with clearer guidance on how to responsibly direct their investments.