'EU Ecolabels: muddy incentives for green investors'
The latest EU Ecolabel draft proposals for the funds industry present stark differences in the criteria for qualifying equity and bond funds. While the EU has relaxed the criteria on Ecolabels for equity funds, its focus on green bonds as a primary vehicle for fixed income products is too narrow, believes Rhys Petheram, fixed income fund manager at Jupiter Asset Management, and has the potential to create some unhealthy distortions when it comes to the allocation of capital that may in time undermine the goals of the initiative.
The Technical Expert Group (“TEG”) responsible for steering the Ecolabel credentials has proposed that bond funds will be required to invest at least 70% of assets in “labelled” green bonds to qualify for an Ecolabel. This means the “unlabelled” bonds of the rich seam of companies delivering sustainable solutions could be overlooked, even if the labelled green bonds are issued by some not-so-green companies or those raising capital against pre-existing or business-as-usual projects.
We worry that the sole focus on labelled green bonds under the current plans could crowd out vital investment in the wider pool of bonds issued by companies that by the nature of their products and services only have green projects. Under TEG’s current proposals, the bonds issued by many of these green-by-nature companies are already likely to miss out on potential benefits, including financial and pricing incentives.
As a point of clarity, green bonds typically do not directly result in new (or “additional”) green projects. Instead of providing additional project funding, these bonds finance companies which make promises to fund green projects in the future or, as is more often the case, have funded projects in the past. The fungibility of cash combined with a lack of commitment for incremental future spend leaves little distinction in the actual impact between their labelled and unlabelled bonds. We have long had concerns about the lack of additionality in the green bond market. As such we incorporate a number of extra layers in our green bond selection process to try and weed out bonds from issuers more focused on reputation management than the broader impact of their goods or services.
Ironically, the Ecolabel framework provides no guidelines for where the remaining 30% of a qualifying green bond fund should be invested. The exclusions list for equity funds is very clear. However, the reading for corporate bond exclusions is more ambiguous and in parts nonexistent. TEG appears to be attempting to sidestep the question as to how green bonds from companies with material activities on the exclusion list should be treated. Wording that encourages a sustainability bias for this tranche of the portfolio would give valuable reassurance to clients that their investments are aligned with their principles.
In contrast to those for Ecolabel bond funds, the proposed standards for equity funds are more appropriate for today’s investment practices and aspirations for the future. For these funds 60% of assets under management require revenues from green activities, comprising 20% with a minimum threshold of 50% of revenues and 40% with green revenues of between 20% and 49%.
In our view, this divergence between the proposed standards for equity and bond funds will lead to markedly different expectations about outcomes from each, with fixed income portfolios theoretically able to invest in some industries excluded from equity funds, and vice versa. At the stock level, for example, unlabelled bonds from issuers such as electric vehicle maker Tesla would be excluded from an ecolabelled bond fund but could appear in an equity fund. This problem becomes acute for sustainability-focused multi-asset funds, where the dispersion in criteria could encourage counterintuitive positioning along the capital structure.
A different path
To overcome these problems, we believe aligning the requirements for bond and equity funds would be a positive step by focusing on the corporate level activity. In addition, the Ecolabel for bonds could also include labelled green bonds, acknowledging their role in improving corporate engagement and the potential for more powerful additionality in the future. While we support the green bond market and believe it has a role to play in closing the financing gap, it is important to stress that corporations themselves are delivering outcomes, not their financial instruments. The aim of the EU’s Ecolabel framework therefore should be to encourage fund managers to invest in companies involved in sustainable economic activity and to be active stakeholders. For truly sustainable businesses, supporting their capital requirements regardless of the labelling exercise should be the focus.