As the EU sustainable finance regulation keeps evolving and branching out, coordinating between its different constituents is becoming increasingly challenging. Take the EU Taxonomy and the EU Green Bond Standard, for instance. Although they both stem from the same grand Sustainable Action Plan, ensuring alignment between the two is far from a trivial exercise. European asset managers and investors who want to show that the green bonds in their portfolios are compliant with the green Taxonomy face a challenging manual task. Mostly, they need to do it alone, without the help of third-party data providers.
NN Investment Partners (NN IP) are known for not shying away from this type of sustainability challenge. The firm’s portfolio managers and analysts have been working tirelessly on assessing the alignment of their green bond portfolio with the Taxonomy since early 2021. To find out more about how they go about it and what they have learned in the process, NordSIP reached out to Isobel Edwards, Investment Analyst Green Bonds at NN IP.
“Green bond alignment will improve eventually, as the EU defines more eligible economic activities and project-level detail increases,” starts Edwards on an optimistic note. “For now, though, there is very little automated data and varying information quality to assess each activity financed by every bond in our portfolios,” she adds.
Edwards tells us that NN IP’s first green bond assessment round, completed in September 2021, was indeed challenging. “We were working under considerable time pressure as we thought we needed to be done ahead of the original regulatory deadline, January 2022. The issuers, however, were not held to the same deadline. They technically don’t need to report until a year after the asset managers and only certain companies need to report. Given this, some issuers hadn’t even started the work and couldn’t answer our questions. Luckily some had, so they knew what we were talking about and could help us. It is an unusual situation in which regulation calls for investors to go ahead of issuers in these disclosures,” she recalls.
“It is getting much easier, though, now that we are doing a new iteration of the assessment. Nowadays, some issuers even provide an EU Taxonomy assessment in their second-party opinion pre-issuance,” says Edwards. Although NN IP managed to compile the alignment data by the end of 2021, once the European Commission postponed the deadline to 2023, they chose to keep refining the assessment and are planning to release it in July this year.
Assessing the alignment, step by step
In 2020, NN IP designed a proprietary green bond EU Taxonomy alignment process, a series of steps that enables them to analyse each green bond’s use of proceeds and determine its compliance with the EU Taxonomy. Edwards guides us through this process, explaining pedagogically the importance of each step and what it means in practice.
“First, we take a green bond and look at which activities it finances,” she explains. “We go through the ‘use of proceeds’ section of the green bond framework of the issuer and check which activities are involved and if these would potentially qualify as eligible under the EU Taxonomy.”
The next step is to examine whether these activities contribute to one of the environmental objectives. At the moment, the majority of the activities in our fund are focused on climate mitigation with a minor focus on climate adaptation. If one of the activities in the bond does not pass, this reduces the percentage of the bond’s alignment to the Taxonomy but the 100% aligned activities can still be counted in the overall portfolio alignment to that objective.
The alignment to the objectives can be determined, first, through the technical screening criteria. These are all detailed in the Technical Annexes of the EU Taxonomy and are different for each economic activity in question. The second step is the Do No Significant Harm (DNSH) component of each activity. “There are environmental risk areas within each economic activity, also specified in the Technical Annexes. We check whether steps have been taken to assess these risks for each activity the bond finances and whether actions and infrastructure have been put in place to minimise them. Once we have determined that this is the case, the economic activity meets the DNSH criteria as the project is not harming any other environmental objectives,” says Edwards.
The analysts would then repeat these steps for each of the activities that the bond finances. At this stage, each bond in the portfolio will have certain economic activities that are 100% aligned with one of the EU Taxonomy’s objectives. Activities that are not at 100%, fall to 0% for reporting purposes, but not for engagement purposes. The green bond analysts would engage one-on-one with those issuers whose activities’ alignment is less than 100% and encourage them to boost their scores.
For those activities already at 100%, now comes time to calculate the fund’s alignment. The weighting of the activity within the bond comes first, followed by the weighting of that bond within the portfolio.
Repeat that for all activities and bonds within the portfolio and you will get your portfolio alignment to the EU Taxonomy.
Having done the same exercise numerous times, NN IP’s analysts are starting to discern some patterns. They have noticed that engaging in certain types of activities or being a particular type of issuer seems to positively affect the alignment score. “For instance, being a utility company was a positive factor for many of the issuers in the portfolio,” says Edwards. “Transportation companies also generally did well.” According to her, this is due to these sectors’ green bonds being heavily tilted towards renewable energy or electric transportation. Not surprisingly, certain aspects of these two sectors are considered favourably in the EU Taxonomy, with its current focus on climate change mitigation and adaptation as the first two published objectives.
EU-based projects also have a clear advantage when it comes to the DNSH criteria, as the criteria often consist of already existing EU Directives that are already being implemented in many areas in Europe. Of course, when EU issuers include projects outside the bloc in their bonds, they do not benefit from the same effect.
There are, however, green bond issuers who seem to struggle with the Taxonomy alignment. “Banks, for instance, often did not have enough information about the projects their bonds are financing to give us so we could perform the EU Taxonomy alignment exercise,” says Edwards.
Sovereign green bonds also generally performed poorly in the alignment assessment, perhaps even worse than the bank-issued green bonds, reveals NN IP’s analysis. “Here, the reason is not necessarily a lack of information, but rather the types of activities they finance and how they are documented,” explains Edwards. “If a sovereign green bond allocates 25% to the Ministry of Environment without specifying exactly where the proceeds will be directed, we label this as non-green as we cannot link the bond’s proceeds allocation to the EU Taxonomy criteria,” she clarifies.
Whenever the information is insufficient, NN IP’s philosophy prescribes taking a conservative stance and assuming that the activity is not aligned with the Taxonomy. “In the future, we hope that banks and sovereign issuers will take the EU Taxonomy criteria into account when developing their financing frameworks. Currently, it is hard for investors and asset managers to give them a high percentage alignment when they allocate proceeds in this way,” concludes Edwards.
The expanding Taxonomy
NN IP’s green bond funds will be releasing their EU Taxonomy alignment disclosures for their funds in July this year. “We are not concerned about not being 100% aligned for now, as the EU Taxonomy is still expanding to include new activities and being refined,” says Edwards. “For now, we still consider buying bonds that are not aligned. Partly because four of the six EU Taxonomy objectives have not yet been rolled out but also as the details for some industry categories are still being debated. Over the next few years, our approach is likely to become stricter, in line with the latest guidance from the regulators,” she adds.
However, issuers should bear in mind that once investors have disclosed their Taxonomy alignment, this can also include an alignment threshold which their fund cannot go below. This would mean effectively that if the fund is close to that threshold, a green bond with activities less than 100% aligned to the EU Taxonomy might be turned down.
According to Edwards, a binary categorisation of activities into green and non-green is not necessarily helpful. She, for one, is happy to see the recommendations for an Extended Environmental Taxonomy, just revealed by the Platform on Sustainable Finance. “Currently, it is quite vague what companies and other issuers mean when they say they are ‘transitioning’. The new ‘amber’ taxonomy might provide some guidance as to where they are exactly on their transition journey,” she hopes. “Although the relative ‘greenness’ of transitional activities would be difficult to assess on a general level, without considering the country-specific context,” adds Edwards.
Summing up, Edwards sounds favourable to the Taxonomy and pleased with the work she and her colleagues have done so far on the disclosures. “It is a work in progress, and there are still plenty of issues that need to be addressed,” admits the analyst. “Yet from our perspective, issuers are now providing much more information to investors upfront pre-issuance, and there is much less ambiguity on the shades of green in their projects. In that sense, for us, the main goal of the Taxonomy has already been achieved,” concludes Edwards.