EU Taxonomy alignment poses challenges for equity and fixed income investors

As a green classification system that translates the EU’s climate and environmental objectives into criteria for specific economic activities for investment purposes, the EU Taxonomy is meant to provide transparency and clarity for investors and companies in determining which activities are considered environmentally sustainable. As such, it is supposed to help scale up investments in green projects that are necessary to implement the transition to a low-carbon economy.

However, investors looking to support these efforts by increasing the Taxonomy alignment of their portfolios currently still face considerable challenges, according to Bernhard Langer, Chief Investment Officer, Invesco Quantitative Strategies (photo), and Elizabeth Gillam, Head of EU Government Relations and Public Policy at Invesco. Foremost among these is a substantial increase in active risk, or tracking error, versus broader market benchmarks. “This highlights the need for a robust construction of portfolios that require a minimum share to be aligned with the EU Taxonomy,” Langer stresses.

Invesco’s investment experts have undertaken in-depth analyses of the process and results of Taxonomy integration into equity and fixed income portfolios to gain better insights into the specific challenges facing investors, and potential ways to address these, for example, with screenings of a custom universe from a Taxonomy perspective, or through factor investing.

Aside from limited data availability requiring substantial estimates of companies’ alignment levels, their research shows that the narrow scope of the current implementation stage of the EU Taxonomy means that only a small section of the market currently reports significant Taxonomy alignment.

In their example of a European equity portfolio, an increase in Taxonomy alignment reduces the number of holdings notably. From a broad-based portfolio of close to 300 stocks without Taxonomy alignment, the number of assets falls linearly to around 75 for a portfolio with a 30% Taxonomy share. “This is expected as only a small subset of the universe – mostly clean energy firms – has a significant Taxonomy alignment all,” Langer explains.

Noticeable deviations from a market capitalisation weighting scheme are required to increase the focus on companies active in climate change mitigation and adaptation – which, in turn, leads to a higher tracking error versus the benchmark. While a European equity portfolio with no Taxonomy alignment is found to have a minimal tracking error of 0,17% against the MSCI Europe, bumping up the Taxonomy-aligned share in the portfolio to up to 30% almost linearly increases the tracking error to a level of more than 6%.

As Gillam points out, increasing Taxonomy alignment in equity portfolios therefore requires leeway in terms of deviations from the market and a relaxation of constraints on unwanted risk factors such as active industry and sector deviations from an index, with similar tests using a global, US and emerging markets universe generally showing very similar trends to Europe. Notably, the Invesco analyses showed the highest increase in tracking error in the US context as the market is fairly concentrated, with the largest firms – e.g., Apple, Microsoft and Amazon – having minimal Taxonomy alignments.

Invesco’s investment experts observed similar results when trying to increase the Taxonomy alignment of a corporate bond portfolio. The Bloomberg EUR Aggregate Corporate Index that was used as a starting point for this analysis is only about 1.1% aligned with the EU Taxonomy. Maximum Taxonomy alignment that can be achieved while keeping maximum issuer concentration of 2% was found to be 9.4%. Increasing Taxonomy alignment beyond that was shown to require relaxing the issuer constraint to 3% for a maximum alignment of 14.0% and to 4% for a maximum alignment of 18.7%.

As the Invesco analysis shows, increasing the Taxonomy alignment of a corporate bond portfolio leads to a slightly higher duration of the portfolio. Furthermore, an increase in Taxonomy alignment of approximately 4% goes along with a spread widening of an average 6 basis points. From a credit quality perspective, a higher Taxonomy alignment would require a reallocation to lower rated bonds.

“Trying to bring a portfolio to be aligned with the EU Taxonomy would materially impact its risk-return characteristics compared to the market,” Gillam notes. “A careful assessment and consideration of the possible impacts would need to be observed in the portfolio construction.”

In light of ever more complex regulatory requirements in combination with significantly increased ESG data availability, Invesco’s investment experts are convinced that a systematic investment approach is best positioned to deliver a complete portfolio with ESG consideration. “Only a systematic approach that can handle multiple data sets and various constraints is able to deliver an optimal solution that both controls unrewarded risks and at the same time ensures financial objectives are met,” Langer concludes.

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