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Redefining ESG: A green taxonomy for Canada?

A lack of common ESG standards makes it difficult for investors to identify what can be classed as sustainable, responsible or ESG investing. In the absence of universally understood terminology, the EU’s plans for a green taxonomy provide a blueprint to Canada and countries around the world to standardize ESG and combat the greenwashing of ESG assets.

  1. Canada could draw inspiration from the EU’s plans for a green taxonomy, providing investors with clarity on activities deemed to be environmentally sustainable.
  2. A lack of common ESG standards and greenwashing, where issuers and investment managers claim an asset is more environmentally sound than it is, have been problematic for Canadian investors and regulators.
  3. A green taxonomy for Canada would support the country’s transition to more sustainable business practices.

Two years ago, Canada’s investment management industry reached a significant milestone when the Responsible Investment Association announced that more than 50 percent of the country’s assets under management — about C$2.1 trillion (US$ 1.6 trillion) — incorporated environmental, social and governance (ESG) factors.

This number demonstrates the significant growth in sustainable investing, given that in 2013 the total stood at about C$1 trillion ($770 billion).

Fast-forward to 2020, and while interest in ESG in Canada continues to soar, interpretation of what this acronym constitutes varies greatly among issuers, investors, and asset managers.

As Ian Russell, President and CEO at the Investment Industry Association of Canada, told the recent Refinitiv Toronto Summit: “The Canadian investment industry needs clarity over what can be classed as sustainable, and what can’t.

“We need to ensure that when capital is raised, the money goes to the project specified, and not elsewhere.”

Ian Russell quote about sustainable investment in Canada. Redefining ESG: A green taxonomy for Canada?

The problem of ‘greenwashing’

‘Greenwashing’, where issuers and investment managers claim an asset is more environmentally sound than it is, has been problematic for Canadian investors and regulators. Investors have commonly purchased financial products that are not as environmentally friendly as they are marketed.

The investment community continues to rely on varying — and often contradictory — standards and definitions, which were drafted by numerous NGOs, associations and ratings agencies.

Terms such as ‘sustainable’, ‘responsible’ or ‘ESG investing’ are commonly used interchangeably, and a lack of universally understood terminologies has led to caution among prospective investors.

The number of organizations offering ESG ratings and advisory services in Canada is seemingly unlimited.

In a recent article on ESG trends for 2020, Dustyn Lanz, CEO at the RIA, said: “Historically, there has been no standardized framework for corporate ESG reporting, or for defining sustainable business activities. As a result, investors have lacked comparable data from companies, while terminology has been a source of confusion. But the market is now moving towards standardization on both fronts.”

Launching a national taxonomy to address these issues through a standardized classification of ESG assets will be, however, challenging for Canadian regulators.

It will need universal buy-in from the market; require much time, money and effort to develop; and will have to be legislated by parliament, which could take several months — or years — to pass.

More than 50% if AUM in Canada incorporate strict ESG criteria. Redefining ESG: A green taxonomy for Canada?

The EU’s green taxonomy

Canada could draw inspiration from the European Union’s regulatory approach to sustainable investing.

In December 2019, EU Parliament negotiators reached an agreement with the European Council over the proposed EU green taxonomy — a classification system that provides investors with clarity on activities deemed by the EU to be environmentally sustainable.

The Taxonomy Technical Report published by the Technical Expert Group on Sustainable Finance, of which Refinitiv is a member, outlines screening criteria for 67 activities across eight industries: agriculture, forestry, manufacturing, electricity, water, transportation, information and communication, and construction.

Six environmental objectives contained in the EU taxonomy report on RSG. Redefining ESG: A green taxonomy for Canada?

Each activity listed must make a significant contribution to at least one of the six pre-defined environmental objectives without doing a significant harm to the others (the DNSH Principle):

  • Climate change mitigation
  • Climate change adaptation
  • Sustainable use and protection of water and marine resources
  • Transition to a circular economy, waste prevention and recycling
  • Pollution prevention and control
  • Protection of healthy ecosystems

Investment managers marketing products as ‘environmentally sustainable’ must specify how these align with the green taxonomy.

At the time of writing, it will impact about 6,000 EU-listed companies, banks and insurance companies that must disclose non-financial information under the Non-Financial Reporting Directive.

The EU taxonomy is expected to be passed into law by mid-2020.

Focusing on the ‘E’ first in ESG

The EU taxonomy is focused on environmental matters, rather than social and governance issues. Increasingly, investors request information about social matters such as gender equality in the workplace and measures that tackle slavery in supply chains.

Interest in corporate governance is also rising. Issuers must demonstrate the independence of board members, and create polices that monitor bribery and corruption, for example.

“Most of today’s conversations about ESG focus on the ‘E’ part, but we need to remember that the ‘S and ‘G’ factors are equally as important when assessing an investment opportunity,” cautioned Brian Minns, Vice-President, Sustainable Investing at Addenda Capital.

Transitioning to a carbon-neutral economy

The EU taxonomy aspires to recognize industries that are ‘transitory’ — sectors that are helping to move the EU towards a carbon-neutral economy.

However, projects and companies involved in the production and distribution of low-carbon natural gas and carbon-neutral nuclear power have been omitted form the taxonomy.

In doing so, industry commentators argue that the green taxonomy will make the EU’s transition to a carbon-neutral economy more challenging.

Currently, only 13 percent of the bloc’s energy comes from renewable sources, while coal, oil, natural gas and nuclear power collectively account for 87 percent of the EU’s energy needs.

According to Judy Cotte, CEO at ESG Global Advisors, investors must not only support industries that are carbon-neutral, but also invest in companies that plan to make their operations more environmentally friendly in the future.

This includes fossil fuel companies that are looking to diversify to alternative, cleaner sources of energy.

Impact on global financial markets

Opinions about the potential impact of the EU taxonomy on overseas markets are divided.

Principles for Responsible Investing (PRI) believes that the taxonomy should be imitated across jurisdictions globally, in a manner similar to how MiFID II and GDPR have become the gold standards within their respective regulatory spheres.

Climate Bonds Initiative (CBI), in turn, advises for the standard to be adjusted in light of local nuances. For example, the CBI has called for Japan to modify the EU’s taxonomy to account for the current practices of local farmers.

Both approaches hold pros and cons. A single, global standard builds investor confidence in ESG products, irrespective of market or sector.

Yet equally, varying standards allow industries and companies, which would otherwise be overlooked by investors, to attract capital. This capital can then incentivize these sectors and firms to adopt more sustainable business practices.

Watch: How will data & tech shape the financial ecosystem of the future?

Canada and a green taxonomy

A significant proportion of Canada’s industrial base, as it currently stands, would be excluded from the EU taxonomy — fossil fuels alone contribute almost 10 percent of the Canadian economy.

In early 2019, the Canadian government published a report highlighting the lack of recommendations for transitional activities for heavy industries within the country when applying taxonomies created by the likes of PRI and CBI.

The report, written by the Expert Panel on Sustainable Finance, concluded that the Canadian economy would benefit from a green taxonomy, but only if it incorporates features that are unique to the country.

A taxonomy would enable investment managers to put pressure on Canadian companies that have poor ESG track records, with the aim of elevating their ESG profiles.

Critics of the panel’s recommendation, however, argue that Canada will be viewed as being ‘green-lite’, which will discourage overseas investment.

The goal of a green taxonomy for Canada, however, is not to create a separate, lower standard.

Rather, it is about creating a system that will help transition Canada’s economy to more sustainable business practices, by leveraging the many positives of the proposed EU taxonomy, and including activities that heighten social and governance practices.

Creating such a taxonomy will enable Canada to participate in ongoing international ESG discussions — as both a pioneer and a key stakeholder.

For more information, download our Toronto Summit Industry Report