A guide to the EU taxonomy

Back after a short summer break, this week’s pod takes a close look at the EU’s green finance taxonomy and how its criteria on sustainable investments will impact the energy sector.

Listen to a discussion on whether nuclear and gas should be included and why some did not want to include hydropower as part of the criteria. 

Guest: 

• Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment.

Transcript

0:01

How do you mitigate your risk's? Forecasting services cover risks from hours ahead to years ahead. We welcome you to head your market exposure with our diverse forecasting portfolio. Contact us at sales@motelnews.com for more info and a free trial.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 0:28

Hello listeners and welcome to the Montel Weekly podcast. Bring Energy Matters in an informal setting. ESG or Environmental Social Governments is becoming increasingly important in the investor community with more scrutiny placed on sustainable investments. In this episode, we look in detail at the EU Taxonomy and what it means for the wholesale energy markets in Europe. Joining me, Richard Sverrisson is Nathan Fabian of PRI or Principles of Responsible Investment. A warm welcome to you, Nathan.

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 1:02

Hello, Richard. Good to be with you.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 1:03

I thought we could maybe start off by, you could tell us about PRI and what you do and what the organization does.

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 1:10

Yes, of course. The PRI is an investor association. And it includes asset owners, like pension funds and insurance companies, investment managers and service providers like investment consultants rating ESG ratings companies and the like. It's the biggest of its type in the world in that we focus on ESG or sustainability issues. There are over 4,000 investor members globally and over a hundred trillion. Of assets in their portfolios. It's been around for 15 years. And it's really starting to play a very important role in helping markets to understand how ESG and sustainability trends are coming into our market practices.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 1:53

If we come onto the EU taxonomy, what is that and why is it important? There may be some listeners who haven't heard of it, although it's, it's becoming, certainly this year was very prominent. But if you were to put it in a nutshell, Nathan, how would you describe the EU taxonomy?

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 2:08

So the taxonomy is, european Union Regulation, and it is essentially an environmental performance benchmark for different economic activities. And the benchmark is referenced to EU environmental goals, for example, on climate mitigation, the 2030 minus 55% goal and the 2050 net zero goal. And the idea is that you can work out. What level of emissions or energy performance and economic activity must have if it is to contribute to the achievement of these 20, 30 and 2050 goals? And so with this benchmark being developed by environmental and financial experts, it becomes a resource that's used as part of financial disclosure obligations. In Europe. And so this is where it becomes a practical thing for markets. Any issuer of a financial product that claims that they're considering environmental factors would have to disclose what proportion of their underlying investments meet the environmental benchmark in the taxonomy criteria. So typically if I had a, an equity or a debt portfolio fund, and I offered that to the market and I said, I considered ESG factors. I'd need to give an assessment, and I might find that 20% of my portfolio meets the, what we call substantial contribution criteria. The green criteria, if you like, in the taxonomy, and I use that statement to verify my claim that the product, the investment product, considers environmental factors. So it's not a risk return parameter, it is solely an environmental performance parameter. And it has to be conducted by every financial product issuer. From 2022.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 3:55

So interesting is, is this part of a greater emphasis on ESG within the energy sector?'Cause we've seen maybe, is it, does it lag behind some other sectors, would you say Nathan?

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 4:05

We've been talking for a long time in the energy sector about what the emissions goals are going to mean. But the energy sector I think has been a bit less precise on some of the short term steps that have to be taken. I think that if that was the past situation, the recent IEA 1.5 scenario. Lays bare some of the implications of what a net 0 20 50 world looks like. So I think this conversation's accelerating very quickly now. I draw a contrast, I guess sectors like transport, which, we've got a fairly quickly moving conversation around electric transport now. And in the building sector, I think we've been talking about energy efficiency in building for a long time. Emissions in energy use down, so I wouldn't say the energy sector is behind, but the implications of a net zero transition and whatever your view is on the realism of that. But as policy makers are starting to commit to it, I think that's what's changed. And now we're starting to see how steep some of these curves are for the energy sector.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 5:08

What the criteria for inclusion, if I can put it in that way, to, if you're gonna have gas or, wind or some of these investments into, say, a wind offshore wind park. What would be the criteria for in, in terms of the TA EU taxonomy rules?

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 5:22

The energy criteria in the taxonomy were basically a result of calculating. The potential intensity of each kilowatt hour generated by expected demand in 2030 and then considering the longer term 2050 goal and the expected life of assets. So that's the basic methodology. If you look at that maths, you end up with an average good intensity of a hundred grams per kilowatt hour by 2030 to be broadly consistent with. The E is 2030 goal. Our experts determined that if an investment in energy wanted to claim that it was environmentally friendly today, that it was making a substantial contribution that is to the 2030 target in Europe, it would need to operate below a hundred grams per kilowatt hour. Now we know that's basically renewables, it's some geothermal, it's most hydro. But of course combined cycle gas turbine can't get to that level at the moment. It may never, that's the question to be seen. And of course we know that well in the taxonomy at least solid fossil fuels like coal basically just been excluded. There they were not even a starter in the game. And so the energy criteria across all energy sources is a hundred grams to be substantially contributing or grain. And we have this additional layer, this do no significant harm criteria. That's currently sitting on 270 grams per kilowatt hour of CO2 equivalent gases. And that number was basically the average good intensity at the time the criteria developed, which is about a year ago now. So in late 2019. And so these criteria are quite straightforward, but they're meant to give an indication to the market about how well you have to perform environmentally to be able to claim that you're genuinely green. And so that is the basis of the energy criteria. And these types of criteria appear or are applied for every sector in the economy. It's not just the energy sector.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 7:16

We're also at a stage now where post COVID we have the recovery fund, the green deal. There's gonna be a lot of investment needed in the coming years. So these criteria are gonna be quite crucial for investors in choosing and what technology they'll put their money into.

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 7:33

I think they will play a part. Investors know that they need to transition their exposures, if you like, in their portfolios because they want to align with the long-term goals where possible. But let's face it, investors and banks, they're still there to earn financial returns. So they will consider these different aspects of their investment decision and they'll optimize. They might, they'll make the best possible judgment that will be different. Where an investor says we only com invest your funds in this product. Activities which we know are green, which we know are environmentally sustainable. Then it's quite clear it'll be a subset of technologies and energy supply. But generally the institutional market will consider a range of factors. My expectation is that investors, oh, sorry. Product issuers will start to try and ratchet up their exposure to the green performance level. But if there is still earnings to be made from fossil fuels or from higher emitting sectors, even if these technologies are going to be on a sort of retirement pathway or an exit trajectory, if you like, over the next decade. Investors will still find ways to invest. I think what we're going to see in addition is that there may be some reluctance to take the big multi-decade bets on the higher emitting technologies because once you see what those reduction curves look like, committing yourselves to yourself to infrastructure or assets that are gonna be around for a long time. Some stranded asset risk. And so that's where we'll start to see a little bit of shift as well, those longer term allocation decisions.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 9:16

You mentioned hydro Nathan, and you said most hydro meets the a hundred gram per kilowatt hour. A criteria. What'd you mean there? Most, not all.

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 9:26

They, so there is hydro criteria in the taxonomy. Included in the first legal text meeting, the substantial contribution of a hundred grams is actually relatively straightforward for hydro in Europe. There are some questions around what is called the do no significant harm criteria. Say around biodiversity, and that's a feature of the taxonomy. If you didn't think it was hard enough to say now we have an explicit environmental criteria on climate mitigation. There's also this obligation to do no significant harm to biodiversity, to water, to pollution, other pollution levels. And even to this idea of circular economy, which is not an issue so much for hydro, obviously. And so there's these two requirements, and so there is, there's been a debate in Europe around whether some of the hydro assets, whether they've got risks or issues around biodiversity, but that takes nothing away from the substantial contribu. Question and those assets qualify on that basis.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 10:28

I know there was some, in the Nordic region, there were some fears that, the hydropower production would be deemed unsustainable, which raised a few eyebrows and a number of concerns.

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 10:38

Yeah, I think this is an important thing to realize about the taxonomy. Not everything in the economy is gonna be classed as green. There's a lot of the economy, putting aside the services which have no significant footprint. A lot of the industrial activities might be operating in a reasonable, under reasonable parameters, so manufacturing, transport, and some energy activities as well. A geothermal facility that's operating at 150 grams per kilowatt hour for its lifecycle considerations. That's still got a clear role in the energy system. Now when we're getting close to net zero, unless they've dealt with their methane issues, then there's clearly not. But there's clearly a multi-decade potential there for that asset. Now that's just demonstrates that even though that geothermal facility, what wouldn't necessarily be called sustainable at operating below a hundred grams, there's still a clear role in the economy, in the energy system, and we're actually starting to propose some changes to the taxonomy just to make it clearer to everyone that just because you blow that 100 doesn't mean you don't have a role and it doesn't mean you're doing significant harm. And the platform on sustainable finance, which I chair and the European Commission is going to respond to this need on the taxonomy in July and by the end of 2021 with some proposals on how to better recognize these types of technologies and their performance.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 12:04

So that's the technologies that are in that corridor of a hundred to 270 grams then, is that what you're saying? Spot on. Yeah. Yeah.

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 12:12

That's the space we need performing at that level is a reasonable thing to do in energy transition. Consistent with the goals and the Paris objectives in the eu, 20 to 30 and 2050 targets, we need to clearly signal that. The other thing that's legitimate is if you're emitting above two 70 conducting investments to try and bring your performance below that do no significant harm threshold, and the market should see that as a valid environmental investment. And so we're developing the taxonomy to make sure that it's inclusive and it supports. Investments to improve emissions performance in this way.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 12:45

So what's been signed off already and what's the time schedule here?

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 12:48

So the criteria that we've been describing, and there's about 80 economic activity criteria for climate mitigation, and about the same again, for climate adaptation. They've been adopted by the European Commission, which is the. To before they become law, they're going through what's called now scrutiny period, which means the parliament and the member states could. Disagree with them, but not individual criteria. They basically have to say this whole regulation's off track, we don't support it, so that's not likely to happen. What will happen as a result is that by around about October, November, 2021, the criteria will finally be embedded in a legal instrument and reporting for companies and investors starts in 2022.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 13:37

Okay, so that, that's the timescale. There are two elements I'd like to focus on. One which have been quite controversial and that is with gas. So you mentioned cgt, cc, GTS earlier. What's the controversy around the inclusion of gas here or the non-inclusion even?

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 13:53

So the reason this is controversial in terms of the taxonomy is that it does this very specific thing. It tells you what the performance of the. Economic activity and the assets within it should be in order to contribute to the environmental goals. That's a reasonable question for somebody allocating capital to a new asset to look at. And that's why the taxonomy is set up how it's, but if you're thinking about the energy network as a whole, and you are maybe contemplating. Retiring, say coal assets as is happening in parts of Europe now, and you wanna replace it with gas, which has a much lower emissions level that on the face of it looks like a reasonable decision to make from an environmental perspective. The challenge, of course, arises that those individual assets, which might have a 20 year life or more, will be operating at an emissions intensity well above the average intensity, say in 10, 15 years time, that you can have in the grid. And then you've got this question of if we're allowing high emissions assets in some part of the energy system, we need to be zero or negative elsewhere. And then you start to lead to other, political questions that need to be resolved. So we just need to distinguish the fact that the taxonomy talks about economic activity level and asset level performance and averages and what's green from that perspective. And then the question of energy transition as a whole and how to use that overall budget. That's a different question and that must be solved separately by policy makers. But this is where the tension has arisen. Who gets to claim this environmental space and why?

Richard Sverrisson, Editor-in-Chief Europe, Montel: 15:24

And when you have the ETS, you think that should be enough then to deem, gas fire generation out of the money and uneconomic. So why do you need then these other criteria?

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 15:35

Yeah that's a really good question, and if the pricing reflects the expected trajectory, emissions trajectory, and this is not, it's not precise, but it is possible to model what the necessary pricing would be, of course. Then you'd argue that the pricing signal, the risk return trigger in the market is giving you the environmental outcome you want. I think that if you think about environmental issues broadly and mitigation is just the start. We're gonna be dealing by adversity. We're gonna be dealing with other forms of pollutants, we're gonna be dealing with water. The pricing signals don't always match the environmental goals, and I think this is the big awareness that's come into Europe is that not only do they need to price and regulate. They need to have a system where the market can make its own decisions on environmental grounds because they're setting the headline goals and targets, but they haven't got the policies to meet them yet, such as regulation and pricing. So they need markets to start taking some of the risk of the environmental performance on their own decision making, and I think that's why you're seeing this parallel transparency, greenwashing environmental performance benchmarking framework. Alongside the pricing, and we're gonna basically be living in a world with both of these things going forward,

Richard Sverrisson, Editor-in-Chief Europe, Montel: 16:46

but our market's gonna take the risk of investing in gas fire generation. It seems to, there are countries, as you've mentioned, eastern Europe, that need to transition away from coal, but you also have. Germany, which is suddenly having a little bit of a supply crunch in the coming years as it exits both coal and nuclear. But who's gonna invest in gas fired generation, especially if they're not gonna be included in the taxonomy criteria.

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 17:10

I think there's plenty of capital out there looking for home in, in the world at the moment. And if you look at the IEA forecast of early July, their forecasting, I think it was around 3.6% uptick in gas demand through the year. So there's going to, sorry, over 20, 20 levels. So there's going to be still price and demand elements here that influence the markets, and so there'll be some capital that finds that attractive. I don't see it any other way. I think that even institutional investors who are part of the PRI and make commitments to consider sustainability issues. They're still gonna judgments around the energy system as a whole and a transitional pathway. If they see some advantage in holding gas assets or supporting their development for a period of time, I imagine they'll be expect to be compensated for that if they see some risk at the end of the life of those assets. And I guess that's where it'll come through is a supply of capital. Maybe we'll start to see some pricing impacts on that capital.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 18:09

Interesting. At nuclear, where does that stand in terms of the U taxonomy? Nathan?

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 18:13

Yeah, nuclear is really interesting and I think it's got this obvious and undoubted substantial contribution for a climate mitigation perspective. But in addition to the mitigation question, we've remember we've got this do no significant harm, part of the taxonomy. There are these other risks, like a pollution risk, for example. And because it's very hard to say with certainty that when it comes to nuclear waste, the storage facilities, the long-term storage facilities will adequately address that because of the lack of evidence base, it's very hard for the scientists and the technical advisors to say with certainty that there's not a do no significant harm risk. Now, having said that. The European commissioners decided to take on additional studies and additional review processes, and in July will give further evidence and analysis on this, significant harm risk. So that sort of deals with the science dimension of it, and those reviews might allow nuclear to move forward in the taxonomy because of its obvious benefit for climate mitigation. The other layer, of course in Europe is that you've got these diametrically opposed political positions. Between different countries and so whether or not Europe can agree a framework which deals with the risk management questions around nuclear facilities and fuel cycle, and also allows the different political jurisdictions to maintain some autonomy over their energy policy and their outlook on European energy policy. That's still gonna be a challenging question. At least we should make some step forward on the technical side of this through July, 2021.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 19:50

So what are the likely outcomes for the end of this year?

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 19:53

So we should have criteria that are being prepared by companies as issuers and financial product issuers to make their disclosures in 2022. There also should be a resolution on this gas and nuclear question, or at least the contours of that should be pretty clear by. Of 2021. I think we start then to look into some of the broader issues that flow from this type of reform. And that becomes an international question. Which other jurisdictions are following similar approaches and are trying to harmonize and we're seeing some progress on that already. Countries have announced their own taxonomy work Canada being one of them. Japan is working on their own. The UK is developing but will probably closely follow the uk, pardon me, follow the eu. So that international question is quite important. And then believe it or not, we're going to be going into other areas of this ESG puzzle. So the potential for future social contribution criteria as well. Less an issue for the energy sector in terms of emissions, obviously, but potentially another avenue for the energy sector to demonstrate its social role. And when it comes to questions that are important to the investment sector, increasingly like just transition. Questions like dealing with the social issues around energy sector transition. This is something that really resonates with the institutional investment community. So the ability to bring in some kind of social contribution criteria as we deal with energy transition is gonna open up a new way of communicating. In the market about how we're contributing to sustainability objectives. So I know it can seem like a lot to deal with, but it's pretty clear that Europe at least, and several other countries are committed to this direction of travel. So anytime spent on this is well spent.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 21:42

Absolutely. And when you talk about social issues in the energy sector what do you mean there, Nathan? Specifically? What kind of aspects there? The environmental is clear to see, but what about the social parts?

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 21:54

So when we, changing our energy networks, if we're changing our access to our energy reserves. So fossil fuel reserves, for example, and you've got communities and workforces employed to produce these assets. But if you're changing the demand profile in the market for these sources of energy, then you change the where you need your workforces. Sometimes they're remote communities. There's a range of issues around, the value of the private housing in the local region to the re-skilling and redeployment of staff. And these are challenging questions. And so if we can work out a better way to think about the social transition around energy transition. It's likely we're gonna have a better chance at some kind of orderly transition. So these are some of the issues we're trying to unpack.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 22:45

Excellent. Nathan, thank you very much for enlightening us on the EU taxonomy and what it means for the energy sector.

Nathan Fabian, Chair of the European Platform on Sustainable Finance and Chief Responsible Investment Officer at the United Nations-supported Principles for Responsible Investment: 22:51

Good to talk to you, Richard.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 22:52

So listeners, you can now follow the podcast on our own Twitter account, aply named the Montel Weekly podcast. Please direct message any suggestions. Questions or, let us know if you think you have a good idea for a guest on the show, you can also send us an email to podcast@montenews.com. Lastly, remember to keep up to date with all that's happening in energy markets on Montel News. You can subscribe on Apple Podcasts and Spotify, or wherever you get your podcasts from. Thank you and goodbye.