A ‘brown’ taxonomy could potentially have greater credit implications than the ‘green’ taxonomy as defined by the EU, a report said.
Background
The EU’s ‘green’ taxonomy is a classification system which defines thresholds for sustainable economic activities, and its final report was recently released.
The EU’s Green Bond Standard will be based on the green taxonomy, whereas the brown taxonomy is part of the EU’s consultation on a Renewed Sustainable Finance Strategy and may be set up in future.
Market participants as well as politicians and NGOs have been calling for the creation of a ‘brown’ taxonomy, which would list activities deemed to be environmentally harmful.
They have argued that, while a green taxonomy is aimed at incentivising investments in ‘green’ activities, a brown taxonomy could help to disincentivise so-called brown activities.
In its recently released report, titled ESG Credit Quarterly: 1Q20, Fitch Ratings suggested that defining a brown taxonomy may be harder than it was for the green version, but will potentially have greater credit implications by defining targets for disincentive policies such as higher prudential capital requirements.
This could support the argument that setting up a brown taxonomy is needed.
Green vs brown taxonomy
Referring to a previous report, Fitch Ratings said it does not expect that the green taxonomy will have “broad credit implications for issuers in the short term directly through the issuance of green and sustainable bonds”.
It also hasn’t seen much evidence so far “that these products provide significant financing advantages”.
A brown taxonomy, however, could become relevant to credit if asset managers and banks apply the taxonomy to their investment considerations, such as exclusion criteria.
The brown taxonomy “could inform how asset managers and banks screen for other fossil fuels or environmentally harmful activities in the future, beyond thermal coal which is already excluded by many in developed markets”.
But the report flags that financial institutions have applied different thresholds to screen out coal companies.
“A brown taxonomy could lead to greater standardisation in the approach of investors and banks in screening sectors deemed environmentally harmful, and could lead to significant shifts in financing conditions for affected sectors and entities,” the authors write.
“This could affect corporates’ ability to raise finance, particularly as asset managers increasingly apply exclusionary criteria across actively managed assets whether or not they are labelled as ESG,” the report writes.
ESG integration
A brown taxonomy could also affect how investors identify and assess environmentally harmful companies under ESG-integrated investment frameworks.
However, the authors expect that the impact of ESG integration on financing conditions will be broader but less significant.
“Entities with activities labelled as brown will likely come under greater scrutiny under ESG integration, but the consideration of other factors make it less likely to trigger mass sell-offs than hard-exclusion policies,” the report said.
But Fitch expects agreements on how to define a brown taxonomy will be considerably harder to reach due to stakeholder opposition.
Over 70% of global electricity produced from coal is generated in Asia Pacific, the report said.
General findings
The findings are part of Fitch Ratings’ analysis on changes identified in its environmental, social and governance (ESG) relevance scores (ESG.RS), evaluated from January 2019 to February 2020.
Its ESG.RS display both the relevance and materiality of individually identified ESG risk elements to rating decisions.
The rating agency has released more than 143,000 ESG.RS for over 10,200 issuers, transactions and programmes across corporates, financial institutions, sovereigns, public finances, infrastructure, structured finance and covered bonds, it said.
ESG factors have a medium or high impact (at least one ESG score of 4 or 5) for 23% of corporates and 18% of financial institutions as of end of February 2020, from 22% and 20% respectively at launch of the scores in January.
Other key findings of the report are:
- Governance scores for entities had the greatest frequency of increases, consistent with Fitch’s initial findings that governance factors most frequently affect credit ratings.
- Events such as operational disruptions, litigation and regulatory investigations have been frequent drivers of environmental and social relevance score changes.
- RS changes driven by extreme weather events have been rare despite the continued rise in the frequency of such events.
