Portfolio Taxonomy Alignment for Investment Firms

It is crucial to direct investments toward sustainable companies in order to create a low-carbon economy. The EU Taxonomy is a reporting framework that will help investors assess the environmental performance of companies and their products or services so they can make better investment decisions. In the following Use Case, we will tell you how the EU Taxonomy works and how you can use it to optimise your investment portfolio.

Requirements for the EU Taxonomy

The EU Taxonomy started out with a transition phase that has softer requirements than the final EU Taxonomy so all companies can get used to it. In the first year of application for 2021, only taxonomy eligibility was requested to be reported by companies, whereas in the following years taxonomy alignment is required to be reported. 

So, what does that mean?

• Taxonomy eligibility: A company is taxonomy-eligible if any of the economic activities of that company contribute to at least one environmental objective.
• Taxonomy alignment: A company is taxonomy-aligned if, in addition to being taxonomy-eligible, its activities also do no significant harm to the remaining objectives and meet minimum safeguards on human rights and labour standards.

The six environmental objectives are the following:

1. climate change mitigation, 
2. climate change adaptation,
3. sustainable use and protection of water and marine resources,
4. transition to a circular economy,
5. pollution prevention and control, and
6. protection and restoration of biodiversity and ecosystems.

How to Report EU Taxonomy Sustainability KPIs

Each of those environmental objectives has a list of respective sustainable activities and technical requirements for companies to match their own activities against. 

The procedure is hence as follows:

1. The company gets familiar with the EU Taxonomy and looks at the list of sustainable activities and the technical screening criteria to fulfil them.
2. The company checks whether any of their business activities match the EU taxonomy sustainable activities (for example activity “3.6 Manufacture of other low carbon technologies”), fulfils the technical requirements for this activity, meets the minimum safeguards and does not significantly harm the remaining objectives.
3. Once the company mapped all its activities based on the catalogue of EU Taxonomy activities, the company has to link these sustainable activities to its accounting. The respective accounts will then deliver the necessary financial numbers linked to that activity. 
4. The financials from the company’s accounts will be added up and put into relation to the total amount in three Key Performance Indicators (KPIs):

Turnover: The revenue generated from sustainable activities (according to EU Taxonomy) of the company divided by its total revenue generated.
Capital Expenditure (CapEx): The amount of money invested in taxonomy-aligned sustainability activities divided by all capital expenditures.
Operating Expenditure (OpEx): The amount of operating expenditure (non-capitalized costs) associated with taxonomy-aligned activities or to the CapEx plan divided by all operating costs.

(You can find an example from the EU on how the final result of this can look like here.)

      5. Lastly, the company reports its KPIs and gives further explanations on the procedure, context, and
          future plans.

Advantages and Challenges of Aligning Investment Portfolios with EU Taxonomy Data

After the companies report their KPIs, investment firms (PE, VC, M&A houses) can use such data to enrich their portfolio strategies. Investment firms can for instance compare portfolios with a high Green Asset Ratio (GAR) with brown portfolios, that is, portfolios that have a low green revenue (usually less than 1%). S&P Global Market Intelligence made such a comparison with 15,000 companies over a ten-year time horizon (also called “backtesting”). S&P found out that a portfolio of the top 20% of Green Revenue companies beats the bottom 20% of Green Revenue companies from that sample by 2.59% annually over a ten-year time horizon.

The advantages of using EU Taxonomy data for portfolio optimization are hence striking. Investment firms can…

1. … compare portfolios with different Green Asset Ratio and backtest the Green Revenue Factor.
2. … identify companies that are best placed for the low carbon transition.
3. … better forecast portfolio performance.
4. … conduct better scenario analyses to stress test the investment portfolio under different circumstances (such as climate change scenarios) and find ways for improvement and risk reduction.

However, one of the main challenges for investment firms when it comes to EU Taxonomy is collecting the data needed to assess their alignment. This data can be challenging to obtain, mainly if a large number of companies need to be evaluated (like in the example given) or companies of interest do not publicly share EU Taxonomy data.

Recommendations

‍There are a number of solutions to the challenges of EU Taxonomy portfolio alignment:

Firstly, you can appoint a lead person within your investment firm to coordinate the data collection process. Secondly, you can engage with external consultants to help you collect and assess the data. Finally, you can use software solutions to automate the data collection and assessment process. 

Daato can support you in sustainability data collection from your portfolio companies through simplified workflows and integrations into your portfolio companies’ software landscape to simplify and automate data collection. Also, for companies that do not publish EU Taxonomy data, Daato can use innovative technology to share data securely between the potential investee company and you, the investment firm, so that you can evaluate the company’s sustainability efforts hassle-free.

Daato can analyse all data points with intelligent algorithms to provide you with personalised insights on where your investments stand and how you can improve your sustainability and investment performance.