Private funds: how to tackle the EU Taxonomy

From data-gathering requirements and dealing with delays to interpreting complex rules, the EU Taxonomy Regulation presents a steep learning curve for private equity.

This was the view of Carmela Mondino Borromeo, head of ESG and sustainability at Partners Group, who took part in our recent #PrivateFundsIndustryREPLAY event.

She and I were joined by Peter Dunbar, head of private equity at PRI. Together, we discussed how the initiative works, how private equity firms are adapting, and what managers should do to comply with the latest regulatory changes.

The EU Taxonomy explained

The main purpose of the EU Taxonomy Regulation, which came into force in July 2020, is to classify sustainable economic activities. This will help the European Commission meet its net-zero targets by scaling up green investments, thereby encouraging managers to divert capital into more sustainable activities. The European Green Deal aims to reduce carbon emissions by 55% by 2030 and make the EU carbon-neutral by 2050.

Previously, there was no agreed definition of what makes an economic activity sustainable; the EU Taxonomy uses a science-based “dictionary” to classify economic activities as sustainable. There are six objectives: climate-change mitigation, climate-change adaptation, circular economy, pollution prevention, water and marine resources and biodiversity.

In a nutshell, an activity is classified as sustainable if:

• It contributes substantially to one or more of these environmental objectives
• It does not significantly harm any of the environmental objectives
• It is carried out in compliance with minimum social safeguards (i.e. the UN Guiding Principles on Business and Human Rights)
• It complies with the technical screening criteria specified by the European Commission

What’s the impact of EU Taxonomy on private equity?

In addition to establishing this classification system, the EU Taxonomy amends the disclosure requirements under the Sustainable Finance Disclosure Regulation (SFDR) and the Non-Financial Reporting Directive (NFRD); the latter will soon be replaced by the Corporate Sustainability Reporting Directive (CSRD).

The NFRD currently only applies to the 12,000 or so large listed companies in Europe; but the CSRD will increase that scope to about 50,000 companies, meaning more companies will need to report their taxonomy alignment.

Meanwhile, the SFDR’s Article 8 and Article 9 funds will have to report the taxonomy alignment of their investments periodically as part of level 2 SFDR implementation, which goes live on 1 January 2023.

This is creating a significant volume of data that will have to be managed, which is particularly challenging for funds that invest in private companies.

PRI’s Dunbar called the rollout of the EU Taxonomy Regulation “suboptimal”. He pointed to delays – the regulatory technical standards have been delayed twice – and confusion regarding Article 8 funds: “Do certain Article 8 funds need to report through the taxonomy, or can they simply report 0%? There’s been a lot of confusion.”

Mondino Borromeo agreed that SFDR’s article 8 was causing problems. “You can speak to as many advisers as you like, and everyone has a different interpretation of what the requirements are,” she said.

She added that many companies – especially in the mid-market – had found it a really steep learning curve to both gather the data and present it in a way that satisfied the EU Taxonomy requirements.

What are the challenges with the EU Taxonomy rules?

The inclusion of investments associated with natural gas and nuclear power in the EU Taxonomy criteria has been a politically contentious issue. While Peter admitted that the two power sources can play a role in energy transition, he said PRI believes they should not be labelled as sustainable.

He believes the EU Taxonomy is still a little way off creating a common language of classification, due to a potential taxonomy rule for social impact and the fact other countries such as China may create their own rules.

“I believe there’s still a lot of work to be done to create a global standard for the collection of ESG data,” he said, “but regulators and industry associations are moving in the right direction.”

How should private equity adapt to the EU Taxonomy?

For Partners Group’s Mondino Borromeo, data and education are top priorities. “Most of the time when we buy a private company, they haven’t done much on sustainability,” she said. “You need to teach them how to collect all the data.”

ESG has moved from a “nice to have” to something that all private firms must address if they want an exit or to get listed, she added.

Together, we outlined key steps to help private fund managers comply with the rules:

• Set time aside to educate and coach private firms about the data required.
• Encourage a culture in which the private firm understands how important the data is and that they should own the data. It’s relevant not only for the investment company buying the private firm, but their lenders and the next owner.
• Get the chief financial officer involved, because they will need to help with CSRD requirements.
• Invest in tech. In Intertrust Group’s latest survey of 300+ private capital CFOs, the majority said technology would be a key enabler in meeting regulatory requirements. Many are implementing solutions to gather, consolidate and report data from portfolio companies.
• Ensure your solution is flexible to adapt to any regulatory changes.
• Keep an eye out for the next set of technical screening criteria, which should be published for the remaining four objectives later this year. (Climate-change mitigation and adaptation have already been published).
• Be cautious. Don’t make assumptions regarding the taxonomy that could lead to accusations of greenwashing.
• Don’t be afraid to seek expert help; these are technical rules that can be difficult to understand.

Why Intertrust Group?

• We offer a comprehensive and bespoke ESG solution that can be adapted to suit client processes and software solutions. We provide managers with the necessary knowledge and support to meet taxonomy reporting requirements.
• Our presence in more than 30 jurisdictions means we have excellent insight into regulatory demands.
• Intertrust Group is a publicly listed company with 70 years’ experience in providing world-class trust and corporate services to clients around the world.