6 steps to solving the EU Taxonomy for investment funds
Did you know that the EU requires you to disclose how green your portfolio is, by January 2023?
For everyone who likes obscure abbreviations, sustainability regulations these days are a gold mine. NFRD, SFDR, CSRD, ESRS, TCFD – name a four-letter abbreviation and there’s a fair chance some organization or legislative body has already made use of it (my personal favorite is CSDDD: the Corporate Sustainability Due Diligence Directive. Just when we thought we’ve run out of possible (four-letter) abbreviations, the number of possibilities is increased to 7,893,600 by adding another letter!).
As an investment fund, one of the abbreviations you should really care about is SFDR: the Sustainable Finance Disclosure Regulation. Already in effect, the EU regulation requires alternative investment funds (AIFs) that market in the EU to classify themselves as one of the following:
Article 6 fund: Sustainability not considered as part of investing
This is the default classification for funds, and the one most appropriate for those with no ESG focus. This means funds that neither have a sustainable investment objective, nor do they embrace investment in assets with environmental or social benefits.
Article 8 fund: Sustainability is considered
While sustainable investment is not an objective of the product, it remains an aspect of the investment process. Under SFDR, Article 8 products promote investments or projects with positive environment or social characteristics and with good governance principles.
Article 9 fund: The fund has a sustainability objective (e.g. the fund was created to help reduce climate gas emissions)
This covers products that target a sustainable investment primary objective (e.g. the fund was created to help reduce climate gas emissions). A sustainable investment is an economic activity that contributes to an environmental or social objective. Products must comply with the ‘do no significant harm’ principle which means proving that the product does not in any way significantly harm any of the EU Taxonomy objectives.
Article 6 funds are required to disclose a statement on why sustainability is not considered. In a world where the sustainability focus increases – especially among institutional investors often investing in AIFs – fund managers are reluctant to stick the ‘Article 6’-label on their fund.
If you choose to classify your fund as article 8 or 9, there are three main groups of disclosure requirements:
- EU Taxonomy
- Principle Adverse Impact indicators
- Process and procedures disclosures, such as sustainability due diligence process, investment strategy, etc.
Of these, 1) and 2) will require data collection from your portfolio companies, with the EU Taxonomy being the most challenging (and the focus for the recipe to come, just hold on!). While you can always estimate a company’s EU Taxonomy score based on publicly available data, getting a correct and precise score will require accurate data.
For example, if you have invested in a wind power company, how do you know to what extent their wind turbines are of high recyclability? Or whether the company has assessed the climate risk to its operation? Usually, the only way to know is by asking.
So, let’s do it.
Now, ready to engage your portfolio companies, you’ve got to make the process efficient and hassle-free for them. You want to be a cool investor, adding more value than red-tape to your investees.
With these 6 steps, you’ll save both yourself time and money – and, not to forget, you’ll get it right:
1. Screen your portfolio companies for eligibility with the EU Taxonomy
Before finding a solution to your challenge, figure out how big the challenge is. You’ll only be able to get an EU Taxonomy score if the activities that you’re doing qualify for the taxonomy (eligibility). Most tech companies aren’t eligible for the taxonomy and won’t have to be assessed. Likely, somewhere between 10% and 40% of your portfolio companies may be fully or partially eligible.
Eligibility screening can be tricky and is done the fastest with the help of experts. In this step, you try to match what your portfolio companies do with one of the 115 activities defined in the EU Taxonomy. While matching a wind power company to the wind power activity is simple, most companies aren’t as straight-forward.
Be conservative when doing this exercise. The last thing you want is having an investor show up and complain to you about being misled about the sustainability profile of a fund and demand compensation.
Note: Step 2-4 will require data collection from / collaboration with portfolio companies.
2. Structure each company in reporting units and match with EU Taxonomy activity
The previous step gave you a shortlist of companies to progress with. Now, hit up those companies and verify that the activities that you mapped to them in fact represent the full extent of activities they conduct. Often, they do more.
Then, define the natural “reporting units” of the company. Typically, this should follow sites, product lines or projects. The greenness of the different reporting units may vary, and you save yourself trouble if you separate them from the start.
Before moving on to the next step, map the relevant activities to each of the reporting units. Now you’ve got the skeleton of the company’s EU Taxonomy assessment.
3. Match reporting units with financial data
The EU Taxonomy is linked to companies' financials in the same way that your fund’s performance is linked to your investment allocations.
Now, match each reporting unit with its associated turnover, capital expenditures (CapEx) and operating expenses (OpEx). Remember, no double counting!
4. Assess each activity against the technical criteria
Qualifying for an activity (thus being eligible) is not enough. You’ve also got to be compliant with the criteria. It’s nice and all that you own a wind farm, but if you haven’t assessed the potential biodiversity impacts of it, the EU won’t let you call it sustainable. If you’re both eligible and comply with the criteria, you’re EU Taxonomy aligned.
For an activity, there may be 20-30 criteria. Most of them, you as an investor very likely won’t be able to answer. So, if you haven’t already engaged them, get your portfolio companies’ operations folks to help you – or you won’t get past this step.
5. Aggregate fund results
You did it! You’ve assessed the eligibility of your portfolio companies and received the required data from the ones that qualified for the taxonomy. Based on each reporting unit’s EU Taxonomy alignment and the weights of turnover, CapEx and OpEx, you have calculated weighted average taxonomy scores for each portfolio company. It’ll get easier from here.
To get to disclosure-ready data, use each company’s score and the latest market value of each investment as weights to get the weighted average score for the entire fund. This is the fund’s EU Taxonomy score.
6. Report results as part of product and periodic disclosures
Hold it, you’re not done yet. Now you’ve got the data – the last step is to report it correctly. The EU has specified formats for how it should be done, in pre-contractual disclosures and for website and periodic reports.
As with financial reporting, taxonomy score data should be updated at least annually. If you’ve handled the process manually or with the help of consultants and not with a digital solution, this may also be a good time to tap out and set yourself up with a tool that can help you avoid repeating this process next year.
I know, it’s going to be a bit of work, but good tools can help you get it done correctly at a fraction of the time it takes without them. Not by cutting corners and potentially providing the wrong information to investors, but by easing data collection both for you and the portfolio company, and guiding them through what would otherwise be a long manual process, run by you.
Like financial accounting, the best way to avoid the EU Taxonomy assessment process becoming a painful black hole of time is to establish a clear methodology and a system for it. The steps above are the ones Celsia takes our clients through and that help investment funds take care of the most challenging piece of SFDR.
And, again like accounting: the job can be done in spreadsheets (which will be a lot better than slides and emails), but like accounting, a purpose-built tool will save you and your portfolio companies time (and frustration).