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Supplements » ESG Report October 2022

Social taxonomy: Is the shelving of the EU’s social taxonomy all gloom for the financial sector?

TaxonomyA promised social taxonomy has not appeared, but investors wanting to make a social impact hope the EU will pursue other policy initiatives. Benjamin David explains.

ESG commitments across Europe are no strangers to controversy. Earlier this year, gas and nuclear were included in the EU’s green taxonomy, causing a considerable political wrangle across the continent - and while that argument still rages, Europe’s goal of becoming a benchmark for other regulatory regimes on ESG has been shelved.

The European Commission originally promised a report by the end of 2021 to detail how it would create a social taxonomy. That process is unfinished, meaning no guidelines have been put forward by the EU’s executive branch.

In February, the EU’s Platform on Sustainable Finance, which advises the Commission, published a set of proposals for the social taxonomy. It provides details on guidelines for gender equality and humane supply chains, among other issues. Yet, the proposals did nothing to expedite the process.

One reason cited for shelving the social taxonomy is infighting; another is the Commission’s exhaustion following the green taxonomy row. Either way, the lack of progress has disappointed investors and led to questions about the standards for social lending and investing.

What is the social taxonomy?
The social taxonomy is the planned classification of economic activities that contribute to the EU’s social goals and provide guidelines for investors, businesses and regulators concerning what is and is not sustainable from a social perspective.

The social taxonomy would represent, in many ways, a change in the priorities of sustainable finance. The European Commission set up a technical expert group (TEG) on sustainable finance in 2018 to assist it in developing an EU classification system – the “EU Taxonomy” – to determine the environmental sustainability of economic activity. TEG presented the first draft of the social taxonomy in July 2021, with the final report released in February 2022, aiming to encourage sustainable investment in Europe.

“In contrast to environmental objectives, which are often based on science, progress on social impact is often qualitative and harder to quantify.”

Traditional social welfare financing options, including government spending and stable social security systems, are seen as fundamental by the TEG. Policymakers recognise that private investment has a vital role to play, too, provided it doesn’t cause social harm. The TEG report stresses that “companies implement a system to ensure human rights are respected”. Moreover, investors must improve the provision of basic goods and services, particularly those involving vulnerable people and groups.

The report cites a prediction in the World Bank’s ‘Poverty and Shared Prosperity Report 2020’ that 88-115 million people worldwide will be pushed into extreme poverty (living on less than $1.90 per day) in 2022 as a result of Covid-19. In Europe, issuing social bonds to finance measures to mitigate the Covid crisis has proved an indispensable tool for upholding employment, incomes, skills and competitiveness.

Between $3.3-4.5 trillion a year is required to achieve the objectives laid out in the ‘2030 Agenda for Sustainable Development’ – a UN initiative to end world poverty. Today’s public and private investment levels in relevant areas to achieve this mean that developing countries face an average annual funding gap of $2.5 trillion.

Positive externalities
TEG notes that from 2009 to 2017, Europe’s compound annual growth rate of capital investment that uses using a ‘best-in-class’ ESG approach “rose 20% from $130 billion to $580 billion”. TEG says growing interest in sustainable investment goes hand in hand with interest in social investments. The number of social bonds issued in 2020 increased to ten times what it was before the pandemic, and the figure continues to surge.

While proceeds from social bonds exclusively finance social projects, since 2010, a new instrument has emerged: social-impact bonds.

The OECD defines social-impact bonds as “an innovative financing mechanism in which governments or commissioners enter into agreements with social service providers, such as social enterprises or non-profit organisations, and investors, to pay for the delivery of pre-defined social outcomes”. In short, they are bonds that link financial returns to social outcomes.

According to the Brooking report ‘What is the size and scope of the impact bonds market?’, the number of these bonds has increased in recent years, doubling in 2017 to 45 and rising again in 2018 to a peak of 48.

BiodiversityThis comes as no surprise to Stephanie Niven, portfolio manager, global sustainable equities at Ninety One, who sees a growing consideration of social elements as an essential component of sustainable investing.

Niven points to “an increasingly urgent requirement to consider not just shareholders in corporate decision-making, but broader stakeholders”. Additionally, she explains that businesses that are socially conscious will see the positive externalities of their actions being priced in over time.

There is also a financial benefit from such investments. Bloomberg reported in 2021 that proceeds from the sale of social bonds mushroomed from about $20 billion in 2019 to $147.7 billion the following year.

“We see additional value creation coming from those positive externalities as they likely lead to improving operating performance as customers make choices in favour of those socially conscious businesses,” says Niven.

Kristina Church, head of responsible strategy at BNY Mellon Investment Management, points to the Covid-19 pandemic and current inflationary environment as “clearly exposing and amplifying deep-seated inequalities in society and heightening investor focus on key social issues”.

Key hurdle
Given the need for social investments, there are many questions about why the social taxonomy was shelved and the subsequent impact across the continent. An oft-cited problem by experts concerns definition.

Church points out that the absence of international standards to measure social impact makes it complicated to agree on definitions of social investment globally. She also cites the availability of data on social issues as a key hurdle.

“In contrast to environmental objectives, which are often based on science, progress on social impact is often qualitative and harder to quantify,” she says.

“However, the EU’s Corporate Sustainability Reporting Directive (CSRD) should start to drive an improvement in corporate sustainability data availability over time. Alignment to the objectives of the UN Sustainable Development Goals can also drive social investment opportunities.

“Relying solely on data risks missing the wood for the trees.”

Likewise, Niven highlights social capital data points and metrics as challenging. Investors need to be brave and “embrace both quantitative and qualitative approaches to considering social components”, she says.

Niven specifies that the industry needs to have “grown-up conversations” about the challenges of data across all elements – and to be “wary” of valuing “only what can be measured”.

The difficulties of the social taxonomy seemingly speak to these challenges of measurement, according to Niven, and the funds industry needs to be “courageous” and build out analytical frameworks to capture socially conscious elements in investment cases. In short, “relying solely on data risks missing the wood for the trees”.

Notwithstanding, it perhaps isn’t all gloom for social investments. Despite shortcomings, Church explains that investment can still be directed towards greater social impact.

Likewise, Sergio Carvalho, head of impact at investment house Planet First Partners, stresses that the Sustainable Finance Disclosure Regulation (SFDR) and the subsequent work done by the Platform on Sustainable Finance have provided some tools and a legal definition to drive a sense of “substantial” into the heart of this discussion.

“In the absence of an externally defined and minimum consensual reference – as we have for the environmental taxonomy – the challenge lies in demonstrating preferences and ambition levels of target groups or geographies for specific issues and then building a thesis to be stress tested for how economic activities will substantially contribute to these issues,” he explains.

“In the absence of an externally defined and minimum consensual reference, the challenge lies in demonstrating preferences and ambition levels of target groups or geographies for specific issues.”

Experts appear to agree that even though a codified framework won’t back capital allocations, there is every hope that the bloc will pursue other policy initiatives to guide investors. For example, the EU’s Corporate Sustainability Reporting Directive (adoption scheduled for October 2022) is a law that will improve data availability on companies’ sustainability information.

Meanwhile, the EU’s Social Economy Action Plan, launched in December 2021, aims to promote a more coordinated approach to currently irregular and varied financial support for the social economy across the bloc.

Whether it’s due to infighting or the challenges around data, the financial industry in Europe appears unanimous in its desire for the social taxonomy, and the bloc will be keeping a watchful eye on the EU over the coming months.

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