Is the European Union Forcing Investors to Go Green?
The European Union (EU) wants to be carbon-neutral by 2050, and knows it may need far more than the hodgepodge of policy pledges it made at the start of the year—the “European Green Deal”—to achieve a goal that the European Commission’s (EC) chief, Ursula Von der Leyen, has equated to “Europe's man-on-the-moon moment”. Its latest effort to pick up pace, a scheme to steer investment towards greener industries, could soon pique the interest of US progressives.
To be sure, EU environmental rules are already some of the world’s strictest, from the cap-and-trade system of Sen. Markey’s [D-MA] dreams to ambitious renewable energy mandates and fuel economy standards—and everything in between. The bloc’s Co2 emissions began a marked downward path after the 2008 slump—down to the lowest per-capita level of any advanced economy—owing majorly to a package passed the following year, which the European Green Deal aims to be a beefed-up redux of sorts.
Combined with the rise of Chinese and developing country C02 emissions, these trends have reduced the EU’s share of the world’s total to just under 10%. But consider this: for the EU to fulfill its pledge of net zero by 2050, its yearly pace of emissions abatement would need to be, on average, 1.7 times faster between 2018 and then than it was in the eight years prior. In other words, good isn’t good enough when you’re aiming for the stars.
Bending the emissions curve further downwards is the purpose of the European Green Deal, with commitments to tighten existing policies to yet unspecified levels—including the bloc’s emissions trading system and its arsenal of fuel taxes and subsidies. It is even considering giving energy transitioning industries a leg up against carbon-intensive imports through an “EU carbon border tax”. Just how ambitious these will turn out to be remains to be seen, but the long global record of equally zealous environmental plans overpromising and underdelivering suggests that falling short of carbon neutrality by 2050 is a very real prospect.
This fear of shortfall may help explain why the EU is widening its policy toolbox to match its greener ambitions. The world’s focus has so far largely been on a standard mix of rules, taxes and subsidies to both reduce carbon emissions at the margin and avail impacted industries of alternative energy sources to minimize their costs of transitioning. These policies seek to steer tomorrow’s economy towards lesser fossil fuel dependency by shaping the constraints facing today’s producers.
Besides tightening these, the EU is laying the groundwork for a faster pace of emissions abatement by turning to a channel less often associated with environmental policy that more directly shapes tomorrow’s economy: private investment. Once retrofitted buildings become a viable way to reduce power use, will real estate companies build them at sufficient rates? Will retail and transportation companies buy enough electric trucks once they enter the market? To be sure, mandating private capital to flow towards preferred industries would cause a level of market distortion that not even EU policymakers are willing to put their name on.
Meanwhile, the market is already playing a growing part, with investors upping their appetite for “sustainable finance” due to aforementioned regulatory changes they anticipate, genuinely placing sustainability over profit, or a combination of these (and other) motives. To meet this rising demand, money managers are marketing a widening array of so-called “green investments”. According to Morningstar, nearly $21 billion flowed to so-called ESG funds worldwide in 2019 alone—portfolios factoring in environmental, social and governance concerns—, four times the record set in 2018.
But much like fashionable clothing brands can meet the downsides of their own success in the form of widespread counterfeit, the worldwide hype over “green investments” has led to a whole lot of “greenwashing”—the practice of overselling a financial product’s benign impact on the environment. Hold stock in a restaurant chain doing away with plastic packaging? The carboard alternatives may turn out harder to recycle. A hotel chain is cutting power use faster than competitors? It may simply be cutting costs by asking guests to reuse towels.
It is fear of this “say-do” gap that has led the EU to work on a so-called “taxonomy”—a tool variously labeled as a “common language” or a “translation tool” aimed at those looking to channel their capital towards activities that can reliably be expected to reduce emissions. On Monday last week, a panel of over 200 experts entrusted by the bloc to design such a tool submitted a final report outlining about 140 activities known to help mitigate or adapt to climate change, with technical screening criteria to grade their contribution to each objective.
Their paper also contains guidance on how—when push comes to shove—the EU’s regulators could start requiring money managers to disclose their investments’ performance against the taxonomy’s criteria. Companies and funds already face EU disclosure requirements in a number of areas—labor standards, gender parity, detachment from dark money—and many are building ESG pedigree by voluntarily disclosing more than is statutorily required.
Granted, enforcing disclosure requirements in the way the report recommends is, stricto sensu, regulatory in nature—but a disclosure system of this sort ultimately serves as a nudge, not a rule. The EU isn’t (yet) mandating that you start turning your money towards greener options. It is simply making those options more visible to investors and stamping them with a scientifically backed proof that they do, indeed, reduce emissions.
To illustrate the voluntary action vs. rule vs. nudge distinction, think of health policies aimed at reducing diabetes. Food and beverage makers often voluntarily reduce their products’ sugar content (voluntary action). They’re often mandated to beef up these efforts (rules). But once these healthier products are on the market, governments can often advertise their benefits to consumers (nudge) or mandate that supermarkets more visibly display them (rule) so that you’re likelier to buy them (nudge).
The European Commission (EC) will soon begin the tedious work of turning the taxonomy criteria into legally binding disclosure requirements, with the first investor reports expected to be due by 2022 start. Meanwhile, expect the taxonomy to make global news. These requirements will apply not just to EU-based funds, but to any financial entity servicing EU-based clients. Due to the globalized scope of EU capital markets, this will likely spark a global compliance frenzy of the sort witnessed in 2018 after the EU rolled out its equally extra-jurisdictional data privacy rules known as GDPR.
More importantly, a growing share of the world’s capital markets could soon be covered by similar disclosure requirements if other countries take their cues from the EU and roll out their own. This doesn’t just raise the prospect of open-ended compliance costs for investors worldwide—it also forebodes thorny debates around what exactly makes for a green economic activity. Should the risks posed by nuclear plants’ hazardous waste override their contribution to lower emissions? How should lower emissions from burning natural gas be weighted relative to burning oil? The EU’s opaque policymaking process muted these important debates, but they should be faced head on by Congress if members propose a similar taxonomy.
The “European Green Deal” echoes Rep. Ocasio-Cortez [D-NY]’ more quixotic New Green Deal, but the EU’s new taxonomy signifies a step further in the tools employed towards the so-called energy transition. US investors should beware of Democrats following suit.
