A Cardo AI long-read analysis on the EU Taxonomy and what questions LPs need to start asking their fund managers.
Investment leaders know that sustainable finance matters as a macro trend that is reshaping financial regulation and the real economy. Whether or not all global investors asked for it, the European Sustainable Finance Disclosure Regulation (SFDR) and accompanying taxonomies are transforming the way investment products are labeled and reported on in the EU, and beyond.
Driven by new taxonomy regulations and the energy transition imperative, sustainability is moving from traditional negative and best-in-class screening in listed equities, to cover all core asset classes and focus on impact and outcomes.
The European Commission’s Sustainable Finance Action Plan push to codify sustainable investing and impact is a taste of what is to come across global capital markets. Here at Cardo AI, we already have seen some of the world’s largest pension and insurance investors applying the EU Taxonomy across private markets, including structured credit.
Why Structured Finance matters for Sustainability and Economic Resilience
The global structured credit market is worth trillions of dollars across different sub asset classes and is a vital tool for SMEs to access finance. SMEs are the backbone of economic growth, innovation, and employment around the world, including in OECD countries. Yet many of these smaller firms cannot access traditional bank lending needed to grow their business.
A lack of access to bank credit can limit the ability of growing SMEs to contribute to climate and sustainability goals. This is the role of private credit. This year, high inflation, volatile interest rates, and geopolitical uncertainty have dampened the market, but as small businesses start recovering, the structured credit market will continue to grow. Sustainability criteria and impact assessments will be at the heart of this new phase of growth.
Figure: approximate Global Structured Finance New Issue Volumes via S&P. European sustainable finance rules and demand from large asset owners are shifting market expectations on fund construction and reporting across this asset class.
3 questions all LPs need to ask their fund managers
Cardo AI recently worked with a European fund manager needing to report on the Taxonomy alignment of a number of their structured credit products to their LP, one of the world’s largest pension funds. To better understand the sustainability and impact profile of their investments in European SMEs, the pension investor requested that their manager report on the alignment of a new fund using the Taxonomy framework.
To address this challenge, Cardo AI had to develop a new approach for estimating Taxonomy alignment for non-reporting companies – mostly SMEs – overcoming data availability and quality gaps. Leveraging publicly available data and Natural Language Processing models, we were able to assess portfolios of thousands of companies against the six Taxonomy objectives, including Climate Change Mitigation, at a rate of 100 companies/minute.
From this work, we identified three questions that every LP can start asking their managers about Taxonomy aligned funds:
- How are you assessing the sustainability profile of the SMEs in your private equity or private debt portfolios through the fund lifecycle, from due diligence to exit?
- If you are investing in structured credit transactions, what is the Taxonomy profile of the underlying constituents of each transaction, and how does this affect the profile of the fund?
- If you do not already have a data-led approach to reporting on Taxonomy alignment and impact, what is your plan to put this in place for new fund launches?
EU’s taxonomy sets a global floor of expectations on sustainability reporting
The Taxonomy Regulation entered into force in 2020 with elements of the package still being updated. Article 9 of the Taxonomy Regulation sets out six climate and environmental objectives, relevant for investors who are seeking to label their funds as environmentally sustainable.
An economic activity is considered “aligned” with one of the six environmental objectives if it contributes substantially to the achievement of that objective; it does not harm any of the other five objectives described in the “Do No Significant Harm” criteria; and contains minimum safeguards, such as OECD and United Nations guidelines on human rights, are met.
For investors in SMEs and non-reporting companies, making these assessments consistently and efficiently is complex and requires a large set of data to provide consistent, comparable, and decision-useful information.
Cardo AI enables all types of investors to automate and scale their Taxonomy alignment analysis. We do this by bringing together intelligence, software, and machine learning tools that provide company and portfolio-level analytics at scale.
We then work with investors to build and understand detailed Taxonomy profiles for their portfolios that can inform client and regulatory reporting, new fund launches, and engagement strategies with companies to enhance sustainability impact over time.
Article 9 of the Taxonomy Regulation sets out six climate and environmental objectives that investors can use to report on portfolio-level sustainability impacts.
The Taxonomy’s fund classification complexity requires a data-led strategy
Under the EU’s sustainable financial disclosure regime, an investment strategy can be classified as Article 6, 8, or 9. But there is not yet an indication of the data gathering process required to make these distinctions consistently and comparably across investment products:
- Article 6 covers funds that do not integrate any sustainability criteria into the investment process. While these will be allowed to continue to be sold in the EU, provided they are clearly labeled as non-sustainable, they may face considerable marketing difficulties when matched against more sustainable funds.
- Article 8 fund labels can be applied “where a financial product promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices.”
- Article 9 refers to ‘products targeting sustainable investments’, and covers any products targeting bespoke sustainable investments. The Article 9 criteria apply “where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark.”
In a sign of the in-progress nature of the regulations, the European Commission has just launched two consultations to review what progress has been made with respect to the implementation of the SFDR since it entered into force in March 2021.
The consultation wants to identify how the SFDR framework could be improved to enhance legal certainty, useability, and its ability to tackle greenwashing.