Why investors in non-listed assets should act on the EU Taxonomy

By Jens Riis

The EU Taxonomy has already had and will continue to have a significant impact on capital allocation for investors and valuation of investments. But what will the consequences be for investors in non-listed assets and how can they stay ahead on sustainability performance? Read on to get some of the answers.

The EU Taxonomy is the new sustainability tool of the day in the financial services sector. Given the increased attention from asset owners on bottom line sustainability and tightened regulatory oversights with the EU Sustainable Finance Action Plan, hereunder Sustainable Finance Disclosure Regulation (SFDR), it is paramount that sustainability impacts of investments are quantified and commercialised to gain value.

So the question is which consequences the EU Taxonomy will have and specifically how investors in non-listed assets can continue to be frontrunners on sustainability performance. This article tries to answer these questions with an explicit focus on the implications and opportunities for private equity and infrastructure funds.

ESG is increasingly being considered a value driver for private equities when evaluating possible acquisition targets and when implementing new strategies during ownership, often via designated sustainability programs.

This trend is largely stemming from changed market demands and an increased desire from asset owners to make sustainable investments, thus requiring private equities to enhance the sustainability profile of portfolio companies (PCs).

When combining this trend with SFDR’s requirements for the consideration of principal adverse impacts (PAI) on sustainability, private equities are more focused on delivering sustainable value, making ESG due diligence an integral part of pre-deal target screening.

Despite the magnitude of sustainability frameworks on the market (SASB, GRI, SBTi etc.) there is no standardized way for private equities in measuring the sustainability performance of their various investments, and for asset owners in evaluating sustainability performance of private equities.

However, with the implementation of the EU Taxonomy and reporting requirements under the SFDR, the actual performance on climate and environmental objectives will become a tangible KPI.

Asset owners who increasingly are allocating capital towards climate and environmental objectives, as illustrated by the reduction targets of members of NZAOA, will hence have measurable and standardized ways of evaluating the performance of private equities and underlying PCs.

It is therefore expected that valuation of companies which have high Taxonomy-alignment will increase, as the market demand for products and services will be greater, but also because investors increasingly push capital allocation towards such companies. The association between asset owners, private equities and portfolio companies is illustrated beneath.

Downward pressure from asset owners on private equities has implications for current and future fund strategy and consequently the size of the investment space, as criteria for investments in climate and environmental objectives is likely to become demand from asset owners. Fund strategy and the EU Taxonomy is detailed more in the below.

The SFDR has created a level playing field in terms of integrating sustainability into fund strategy, capital allocation and tracking sustainability performance. Now investors and underlying funds which consider principal adverse impacts, need to classify the sustainability statements and marketing of their fund with pre-defined fund characteristics, namely Article 6, 8 or 9 in the SFDR.

The downward pressure from asset owners for sustainability impact, which previously was discussed, will in our view require that private equities launch either Art.8 or 9 funds, and ultimately update current fund frameworks. Thus, satisfying investor sentiment through enhanced capital allocation to climate and environmental objectives and documenting impact by reporting on Taxonomy-alignment. In the section below, SFDR product classifications are outlined.

For financial market participants who invest in listed assets, getting access to Taxonomy-data and hence portfolio alignment information will be accessible through various data providers.

There is hence no immediate need for investors to engage with investee companies on requiring Taxonomy-alignment reporting for SFDR Art. 8 and 9 purposes (view reporting requirements further down in the article). However, in order for private equities to commercialize and gain value from their sustainability programs there is a need integrate the Taxonomy. Thus, contributing to effectful investor communication and valuation of portfolio companies.

Integrating the Taxonomy into sustainability programs entail that strategies needs to be revisited, with reflection in CAPEX, and a Taxonomy-alignment reporting exercise needs to be undertaken. The structure for reporting on Taxonomy-alignment for a financial product is outlined beneath.

Especially for investments in the hard-to-abate sectors (Heavy industry; cement, steel, and chemicals and heavy transport; bus transport, trucking, shipping, and aviation), the Taxonomy will play a pivotal role in determining whether sustainable fund strategies, cf. Art. 8 or 9, are implemented.

When conducting investments in hard-to-abate-sectors, investors should factor in the cost of developing and executing on a climate transition plan with the purpose of enabling the company to meet market demands for sustainable products and services. When the typical 5-year private equity ownership period ends, implementation of the climate transition plan will be reflected in Taxonomy-aligned CAPEX, as a testimony to strategy implementation.

In our view, this will not alone increase the Taxonomy-alignment share of investors sustainable fund strategies, but also contribute to greater valuation as there will be competition for allocating capital towards climate and environmental objectives. Below we have showcased an example of reporting requirements for Art. 8 and 9 products following latest ESMA guidance.

It is our expectation that public procurement increasingly will be allocated towards products and services that contribute to climate and environmental objectives. This is illustrated by the EU’s recovery plan following COVID-19. Here 30% of the €806.9 billion package will be assigned to such objectives. For companies who desire to get access to similar funds for projects, especially within transition technologies and hard-to-abate sectors, the ability to demonstrate and document Taxonomy-alignment will be an advantage and likely a criterion for applying going forward.

Further, when submitting bids for infrastructure projects (offshore wind, bridges, roads etc.) we also expect Taxonomy-alignment to be an important parameter for final selection, as it shows consideration for the actual sustainability impact of projects across climate and social objectives.

Governments thereby contribute to the business case for Taxonomy-alignment by integrating it into public procurement and bid evaluation, while making sure they deliver on national targets for CO2e-reduction and related goals on circular economy and biodiversity.

The EU Taxonomy and SFDR are fundamentally changing the playing field for how private and public capital is invested and measured on sustainability impacts. It is therefore important investors integrate sustainability considerations based on the EU Taxonomy into their fund strategy, sustainability programs for PCs and bid submissions for large infrastructure projects, as this in our view will increase returns and the probability of winning public tenders.

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