Nathan Fabian: In Europe, there’s a fairly high-level understanding by member state governments but also by citizens, I think, that there needs to be investment into their economy in a way that respects environmental issues and conditions through the growth of, say, the PRI and responsible investment generally, and it’s been growing rapidly for over a decade. Policy makers are much more confident that investors and financiers know what they’re talking about when they’re trying to link sustainability to economic development, and so this need for environmentally sensitive economic development and this recognition that markets are getting the idea encouraged the European Union to move forward with really clear policies.
Michael Torrance: Welcome to “Sustainability Leaders.” I am Michael Torrance, Chief Sustainability Officer with BMO Financial Group. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment, business practices and our world.
Legal Disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries.
Michael Torrance: I’m speaking with Nathan Fabian, rapporteur for the taxonomy group of the European Union technical expert group on sustainable finance. The taxonomy group is developing a green taxonomy for sustainable finance products that will form part of the EU’s action plan to promote sustainable finance and investment. Nathan is also Chief Responsible Investment Officer of the United Nations Principles for Responsible Investment, PRI. He was also an observer on the EU High-Level Expert Group on sustainable finance which developed the action plan recommendations that are now being implemented. Nathan also serves as part of the secretariat for the UK Green Finance task force and was formerly CEO of the Investor Group on Climate Change. We’ll be discussing Nathan’s insights into the work of the EU taxonomy group gained from his role as rapporteur and the implications for global sustainable finance. Nathan, you were an observer with the EU High-Level Expert Group on sustainable finance. What was the HLEG?
Nathan Fabian: It was a group of experienced finance people who are experts in sustainability issues, and it worked for over a year as a think tank, essentially, to bring together the best ideas on bringing sustainability issues into financial markets, and we worked through meeting every month and with subgroups through the whole year on specific policy ideas that the European Union could take forward. At the end of that period, we produced a report with a really extensive set of recommendations, and that report was then taken into the policy making processes in Europe.
Michael Torrance: You were part of the High-Level Expert Group as an observer. What was your role as an observer?
Nathan Fabian: So we were there to provide … Or, I was there, and my team that supported me were there to provide technical input to the recommendations, and so we, for example, did very detailed design and legal assessment of the fiduciary duty recommendation that was made in the HLEG report. We also provided input on the taxonomy and the governance areas, and we supported where we could on a range of the recommendations in the report, so that would mean using case studies and the experience that we’ve gained in talking to signatories of the PRI on these issues and contributing evidence from our reporting and assessment framework into the considerations of the HLEG group.
Michael Torrance: Was there a role for the private sector in the HLE’s work, and if so, what was it?
Nathan Fabian: So nine of the members of the HLEG were investment organizations. They’re signatories of PRI as well, so they’re all private sector, and there were other financial organizations that were part of that grouping, so there was a high representation from finance. There wasn’t a lot of industry representation, so it’s important to recognize that most of the deliberation of the HLEG was about financial policy and financial regulation. Even though there are implications for where capital is allocated in the economy, the view was that we didn’t need a lot of the industry voices or industry input into that development process, so there was private sector represented but mainly financial actors.
Michael Torrance: And the final report of the High-Level Expert Group was released on January 31, 2018. What can you tell me about the recommendations?
Nathan Fabian: Well, it’s really important, that HLEG report, because the recommendations were trying to take a comprehensive or a system view about how you align finance with sustainability, and it’s this idea in policy making that not any one individual policy solves all the problems. We made over 30 recommendations about how to tweak and nudge and marginally adjust financial system, and the idea is that these will support each other and reinforce and create progress in the way the financial system works on sustainability, so that’s an important framing idea. So the individual recommendations included points like developer taxonomy that explains what economic activities are sustainable and work on benchmarks that are used in tracking financial performance of funds so that it’s transparent when sustainability factors have been included, and even there was a consideration of whether there should be some capital requirements that would influence the cost of capital on sustainability performance or risks for assets, so the idea is that all these different types of interventions would work together to give a better alignment of financial activity with sustainability, and in this case, the European Union has a very specific goal in mind. They’re trying to improve or increase the flow of funds into sustainable activities, and the targets that were set at the start of our process with a goal of around an extra 290 billion of sustainable financial flows from the private sector every year to 2030. So we knew exactly what we were trying to achieve, and the idea was that all these different policies would work together to help realize those targets.
Michael Torrance: And was that $290 billion goal for Europe specifically, or was it beyond Europe?
Nathan Fabian: No, that’s a European figure, and it comes from modeling on meeting climate transition target, so reducing emissions in different sectors, and the level of investment that is likely to be required in, say, transport and infrastructure or energy sectors and how much of that likely investment was going to be provided by governments and how much of it would probably be need to be provided by private investors. So there was some good modeling and analysis that sat below those numbers, but it’s for Europe only.
Michael Torrance: And what happened following the release of those recommendations?
Nathan Fabian: Very quickly after the release of the report by HLEG, the commission responded with an action plan for sustainable finance, and it had 10 recommendation areas covering a majority of the ideas that had been put forward by the HLEG group. Taxonomy was number one. Fiduciary duty was included, and there were, as I say, eight other areas that were taken up that would set the plan for how the Europeans would implement policy change for the next couple of years on sustainable finance. Now, that plan was released in early 2018, soon after the report of the HLEG was published, and the commission has been working … the European commission that is, has been working ever since that time to bed down the specific legislation and policy tools that are needed to implement that action plan.
Michael Torrance: So, Nathan, the action plan itself and the work of the EU are really much tied to the objectives of the Paris Agreement. You’ve mentioned climate change, UN sustainable development goals, which are also trying to increase private sector and public sector investment towards the goals, but can you, elaborate on the connection between things like the Paris Agreement targets, the UN sustainable development goals and the role that sustainable finance plays more generally?
Nathan Fabian: Hmm, yes. So Europe has been a leading policy maker on environmental and social issues for some time, and so in European law and policy, there are goals or objectives around environmental outcomes, for example, on clean water or biodiversity or ecosystems. Now, these laws or policy areas have been developing over many years, and so it’s important to recognize that there’s existing work there. The thing about the STGs is that they’re a global set of goals that cover similar issues. They’re expressed a bit differently, but the intent is ultimately the same, and so there is a very strong relationship between the STGs and the policy goals in Europe. Now, properly aligning those and using the same language, that’ll … is something that will take some time, and all countries around the world, just like all corporations and all investors who care about the STGs, will need to align their policy tools and their strategies with those STGs, but that’s a process that’s underway in Europe, but I would say to you there’s a very high degree of alignment there. In order to realize those goals, we need public investment and policy, and we need private investment, so the truth is government balance sheets are never going to be able to cover the costs of investing to meet the STGs. We know we need good policy. We need some public investment, but we’re going to need a lot of private investment as well to meet the goals and to support economic growth and sustainable economic growth, so the question for investors is, how do they allocate their capital, and how are they good stewards of their investments to ensure that the money is flowing to corporations and projects if you like, that are supporting the STG outcomes.
Michael Torrance: So one of the key elements of the action plan is the discussion around classification schema for sustainable activities, and you mentioned it about defining what is sustainable business activity and then also standardization of sustainable labels and that sort of thing. What would that mean, to create a schema for sustainability, and how does it tie into the work of the taxonomy group that you’re involved in?
Nathan Fabian: Yeah, so the primary output of the taxonomy group will be a list of economic activities that meet environmental objectives in Europe, and the task of the taxonomy group is to work out what level of environmental performance these different economic activities should have. So if we’re talking about energy generation, what level of emissions are acceptable basically if the environmental targets, so that is the emissions reduction targets, in Europe are to be met, and it’s possible to work out the threshold, say in tons of emission per kilowatt hour, that investors can then use to find assets that are environmentally … that are performing well environmentally and those that are not performing well environmentally, and so it’s very simple. In the end, we hope to have a list of activities with thresholds that investors can then use to identify which assets and which companies should come into their portfolios.
Michael Torrance: And how is that being developed?
Nathan Fabian: So we have a large group of both experienced finance people and technical experts in the different industries that we’re looking at, so we’ve got cement people. We’ve got steel people. We’ve got transport people, people who have worked in these industries for a long time and understand how the different technologies that are used in these industries work in practice and the level of environmental performance that’s possible. So, for example, if we’re setting a threshold for an energy efficient building, we need to know from people who work in the building industry about what level of building efficiency can be achieved, how hard that is to achieve, what proportion of the stock of buildings can achieve those high levels of performance just so that we set thresholds that are both realistic for the industry or that sector but also which can adequately respond to the environmental objectives.
Michael Torrance: And how did you select which industries to look at, or are you looking at every industry you can identify?
Nathan Fabian: We started with a map of European emissions, and we went for the six sectors that are responsible for over 80 percent of European emissions. Then within each of those sectors, we identified specific economic activities where there was some potential to reduce emissions, and so the taxonomy work is starting with climate mitigation and climate adaption. In time, it will look at other environmental objectives, but we’re starting on these climate issues, given the urgency and the fact that the data is often much better in this area than on some other environmental issues, and so using those emissions measures, we found it relatively easy to work out how to have the biggest impact in terms of finding activities where emissions reductions could be achieved.
Michael Torrance: And what will be the end state of this taxonomy when it’s developed?
Nathan Fabian: Well, the simple version of it is a list. The first iteration of the taxonomy, which will be in a report from the technical expert group to the European commission in the middle of 2019 will have around about 50 activities in it that should be considered to contribute substantially to environmental objectives. Now, if you want to actually make an investment, you need the list as a starting point, but then you’re going to want to go a level deeper and find out what those metrics and thresholds are for each activity, and so a user of the taxonomy will be looking for companies that have assets and provide services in a way that meets those thresholds, and so you can see how the investment question would be asked and how the taxonomy should be able to provide the information that’s required.
Michael Torrance: So beyond the list that it would provide, what other information would it provide an investor?
Nathan Fabian: So an investor ultimately will need information from companies. The taxonomy is best understood as a tool, and we will need companies to disclose both which industries and sectors that they’re working in, which isn’t too hard. That’s a relatively easy disclosure, and many of them provide it already. The second part, though, is they’ll need to describe what proportion of their business’ activities meet the thresholds, and so there is some additional disclosure there, and investors will need that information to make a good judgment about the company’s environmental performance. We know already that there are service providers in the industry, so the ESG rating houses that attempt to assess green revenues, and so we’ve got a way to get to this data relatively quickly in the market, but for the long-term, we are going to need more information from companies. That information from companies, along with the classifications in the taxonomy should give an investor enough to understand how to best allocate their money. And there is one further point here that is that there’s going to be an obligation on an investor if they wish to offer an environmentally sustainable investment product to the market, they’re going to need to disclose how they worked out that it was environmentally sustainable, and that should be done with some reference to the taxonomy. For example, we invest in taxonomy activities, or we invest in some taxonomy activities, or we try and identify the companies that are going to perform taxonomy activities in future. Any of those methodologies would be reasonable, and so to offer that product, you need to articulate your approach, and so that is intended that that will become a requirement under European law.
Michael Torrance: So what would then this mean for companies that are seeking investment? I guess you’d say issuer companies in terms of public companies. What would they have to do in light of the release of this taxonomy? Would there be enhanced disclosure requirements, or what other steps would you expect they’d have to take?
Nathan Fabian: Well, if the company is seeking capital to grow in a clean industry, then hopefully they’re going to articulate that to the market. Hopefully that’s something they already plan to do, but they would need to say that we perform some of these taxonomy activities, and we want to grow, so we want to attract capital, so hopefully a company will want to do that, but just in case they don’t, we are intending to include guidelines around disclosure of taxonomy related activities in the non-financial reporting directive in Europe, and so companies that use that, and it’s mainly larger companies to be honest, but companies that use those nonfinancial reporting guidelines will be strongly encouraged to provide some data on which of their activities relate to the taxonomy, and so hopefully that’s going to help kick-start the market.
Michael Torrance: Does the taxonomy take account of transitional issues? I think you mentioned that it does, so could companies that are engaged in activities that don’t make it onto the taxonomy still benefit from investments that would reduce their emissions for example?
Nathan Fabian: Yeah, this is a really important question. We want to encourage all meaningful or substantial mitigation efforts to be invested in. When it makes sense financially and it reduces emissions, we clearly want it to happen, so we are going to try and set out a category of activities that contribute to an economic transition on climate change, but it’s really important that we distinguish between those fairly short-term activities and activities which we think are making a sustainable contribution to meeting those goals in the long-term. Now, for example, if we increase the energy efficiency of a building in a fossil fuel sector, this is a relatively short-term benefit. We still might want that energy efficiency investment to take place because it can provide a small emissions reductions, but ultimately this is not going to help us meet our goals in the long-term, and so that kind of activity might be considered a transition activity, whereas changing an energy supply unit to something that’s powered by a zero-emissions fuel source of some kind or an energy source that is very low emissions clearly is a long-term sustainable solution from a climate mitigation perspective, and so we will try and distinguish. The second example would be something included in the taxonomy. The first example is being a very short-term step that will be considered in this class of so-called transition activities. We know they’re important, and we’ll try and make a really constructive comment about those kinds of activities.
Michael Torrance: When do you anticipate that the recommendations or the work of the technical working group will be released?
Nathan Fabian: So the mandate of the group is for a 1-year to 1-1/2-year period. We’re at the 1-year period in June 2019, and our aim is to make a report to the commission at that time. The commission has committed to then conducting a public consultation on anything that they think about our report, so it’ll include our recommendations and anything else they want to say, and we can expect that to take place in the middle of the second half of the year, so I don’t know the precise month yet, but after the Northern Hemisphere summer.
Michael Torrance: And then what would follow that consultation?
Nathan Fabian: Well, the most important step after that will be passage of the legislation, and so we don’t know the precise timing of that. It will depend on the new European Parliament, the member states and, of course, a European Commission under new leadership as well, but our hope is that by the end of 2019, we’ve got a clear arrangement in legislation, and then that would enable the taxonomy to be taken up into law late 2019 or early 2020, and then it would be a legitimate tool for use by the market.
Michael Torrance: And there’s other existing sustainable finance taxonomies out there, like the Green Bond Principles of the International Capital Markets Association, Social Bond Principles and the like, Climate Bond Initiatives work around taxonomies. What will the relationship be between what the EU is developing and these other taxonomies?
Nathan Fabian: Well, one of the guiding principles for the work of the Technical Expert Group and for the EU is to build on existing industry initiatives. So the Climate Bonds Initiative and the ICMA Green Bonds Principles’ representatives are members of the TIG, so in fact today they are working out criteria and activities for inclusion in the taxonomy, and they’ll continue to do this through the mandate period, so the relationship is very close, but we’re also going beyond that. We’re looking at the new Chinese taxonomy. We’re looking at other taxonomies that are being developed by members states and by large private investors who are trying to solve the same problem, and this starts to give you a picture and the reason why some larger institution needs to invest in a taxonomy that can be a common language for everyone because we run the risk of having a very fragmented view in investment markets about what is environmentally sustainable, and ultimately we don’t need all of our financial people to be environmental scientists. We need them to focus on finding and making good investments, and we can help them do that if we have a common language on what types of activities are environmentally sustainable. So that’s why this investment by the European Union to develop a very wide-reaching taxonomy, if you like, that incorporates all of the important taxonomy work that’s been taken up by other actors to date is worthwhile.
Michael Torrance: What’s your sense of how this might inspire other regulators to do something similar or even to adopt the recommendations of the EU? How do you see this going from a global regulatory perspective?
Nathan Fabian: Well, it’s already clear to us that several countries think they need taxonomy, too, so the Canadians, for example, they have a high-level expert group on sustainable finance, and they’re thinking about what taxonomy would look like for a Canadian investment context. The Chinese have taxonomy. We think that other countries as well, like Japan and ultimately, in time, the United States, even though it’s not a popular conversation at the moment, are going to want to have tools that make it easy for investors to find investments that are environmentally sustainable. So this is a type of tool and a type of investment approach which I think is here to stay, and so we think this is going to be relevant to all major financial centers in time.
Michael Torrance: And what impact do you think that this EU taxonomy will have for global sustainable finance activity outside of Europe, if anything?
Nathan Fabian: So there are some obvious advantages, and that is, if you want to sell a financial product in Europe and say that it’s environmentally sustainable, everyone will know because of your disclosure and the taxonomy whether or not in fact it is environmentally sustainable. So this good for buyers of financial products, so investors, individuals or institutions, and it really helps you reduce that transaction cost of selling a financial product to these interested buyers, so I think that’s the obvious benefit. The other thing is that it should enable … If other countries take on this taxonomy approach, it should build some confidence for investing in other markets, and we know especially in Europe that exposure or investments in especially infrastructure in markets around the world is going to be essential to meeting climate objectives and having access to growth in these new markets, and so there are more investment questions than just environmental characteristics, let’s face it, when you invest across borders in emerging markets. But nonetheless, having more confidence in this aspect, the environmental performance of the asset is at least one important thing to get right, and so we think the taxonomy from Europe will be very influential, and it can be a useful tool for investors all around the world.
Michael Torrance: And from your perspective with the Principles for Responsible Investment, what would you recommend to investors to do to prepare for the eventual implementation of the EU’s action plan, including the taxonomy?
Nathan Fabian: Well, the first thing that they should do is monitor the activities that are coming up in the taxonomy. We’ve already disclosed the first activities that we think are likely to be in the taxonomy, and by the middle of 2019, there’ll be more. The second thing is to think about the approach that you’re taking in any funds that you want to market as being environmentally sustainable, so is there a clear process now? How do you judge the environmental characteristics of the underlying assets, and do you think that approach would change when there’s a clear list of activities that you’ve made that are available in the taxonomy? That’s getting your house in order, really, for the taxonomy to come into law and be a requirement. After that, I think it’s a case of thinking about where the opportunities for additional investments are going to come. The truth is, we do expect growth in these markets. We do expect new investment opportunities, and police change and consumer preference change is going to drive a lot of this to respond to these environmental drivers. So having the ability to offer new funds and investment products is going to be quite important for many PRI signatories, so we encourage them to do their homework in what they’re doing now and then to think about what they can do in future around these new opportunities.
Michael Torrance: Now, what about corporates? What recommendations would you have for them?
Nathan Fabian: The number one recommendation for corporations on this is, always get out there and tell your story. If you’re undertaking some activities which you know have got good environmental characteristics, provide the information to the market. We know that institutional investors especially, but also increasingly in retail markets, investors are looking for investment opportunities that have genuine environmental and social performance elements in them. So if you’re a company, you want to attract that capital. There is capital available, so tell your narrative. Make the disclosures. Say what proportion of your business is meeting the taxonomy activities, and more importantly, if you’re not doing those activities today, have a think about how you’re going to transform your business. If you’re in emissions-intensive sectors and you haven’t got a plan to transition your business, then clearly you’re going to come under negative scrutiny from investors as these environmental issues play out.
Michael Torrance: Do you have any concluding thoughts about sustainable finance, where it’s going and what we should be looking out for?
Nathan Fabian: Yeah, I think it’s important to realize that the fundamental drivers here that are driving secular change in industries are unfortunately unavoidable trends. We have to do something about climate. We have to do something about biodiversity. We have to do something about water, and the reason is because these … call them services to society if you like or resources, natural resources or stocks of value in the earth are required to run our economies efficiently and support our communities, and so these underlying drivers are not going away. Now because that is the state of play, we need to invest in our expertise, in our investment product development, in using tools like the taxonomy, in making disclosures to the market, in talking to our beneficiaries and clients, and so we need to prepare for the opportunities that are coming, but also the fact that the regulatory net is tightening around that environmental performance for companies, and ultimately that’s going to affect earnings of companies and the returns of investors. So have a look at the big picture, see where we’re heading, and find the places to invest in your business so that you’re prepared for what is unavoidable transition that we’re coming to.
Michael Torrance: Thanks a lot, Nathan. Thanks for your time.
Nathan Fabian: My pleasure, Michael.
Michael Torrance: And good luck with all of the great work you’re doing.
Nathan Fabian: Yeah, thank you.
Michael Torrance: Thanks for listening to “Sustainability Leaders.” This podcast is presented by BMO Financial Group. To access all the resources we discussed in today’s episode and to see our other podcasts, visit us at bmo.com/sustainability leaders. You can listen and subscribe free to our show on Apple Podcasts or your favorite podcast provider, and we’ll greatly appreciate a rating and review and any feedback that you might have. Our show and resources are produced with support from BMO’s marketing team and Puddle Creative. Until next time, I am Michael Torrance. Have a great week.
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