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April 26, 2022

A Future EU Social Taxonomy: addressing rising focus on social issues

Solene Chataigne and Jimmy Greer
Moody's ESG Solutions
VIEW REPORT

Summary

In recent years, the critical role that common definitions can play in facilitating social investment has become increasingly apparent. Myriad factors are propelling the need for greater standardization: from increased investor appetite for social bonds and combating social washing, to ensuring a “just transition” that minimizes negative consequences on affected workers, consumers and communities.

On 28 February 2022, the Platform on Sustainable Finance (PSF), an expert group advising the European Commission on the development of its sustainable finance agenda and the future of the EU Taxonomy, published its final recommendations on the development of a social taxonomy.  This report, along with the recommendations to extend the Environmental Taxonomy to significantly harmful, intermediate performance and low environmental impact activities published by the PSF on 29 March 2022, provide some ways forward for what the EU Taxonomy could look like in the coming years.

The PSF proposes a detailed framework centered around social objectives, building on the existing environmental taxonomy’s structure (known as the EU Taxonomy). The proposed framework is supported by a Do No Significant Harm (DNSH) principle and minimum environmental safeguards. Importantly, the PSF recognizes the complexity of operationalizing a social taxonomy and developing quantifiable criteria to determine the substantial contribution of an activity to a social objective, and social DNSH criteria, and underlines that more work is needed in these areas. In light of these complexities, and given the expectation that a social taxonomy likely will not be translated into legislative action in the near-term, the PSF encourages practitioners to move forward in developing market-led social taxonomies.

In our view, the proposed social taxonomy can have a positive impact on ESG investing and sustainable finance markets in Europe. It has the potential to further promote investment flows into social financing and strengthen market appreciation of the linkages between social and environmental factors.

PLANS FOR A SOCIAL TAXONOMY ARE AN IMPORTANT BUILD-OUT OF THE EU’S ECONOMY-WIDE CLASSIFICATION SYSTEM OF SUSTAINABLE ACTIVITIES

As part of its Renewed Sustainable Finance Strategy, the European Commission proposes to expand the scope of its existing EU Taxonomy to incorporate social factors. Plans for a social taxonomy are a logical, though challenging, next step in the development of the EU’s economy-wide classification system of sustainable activities.

The Covid-19 pandemic and recent cost of living issues have further highlighted the importance of social risk evaluation. Moody’s ESG Solutions’ Controversy Risk Assessment research found a 94% increase in social controversies in 2021 compared to 2020. Our data finds that the most common social controversies were linked to:

  • human rights; social & economic development;
  • health & safety;
  • product safety;
  • remuneration;
  • social dialogue;
  • non-discrimination & diversity;
  • societal impact of company's products and services;
  • and working hours.

By guiding companies and investors to reduce their negative social impact, respect human rights, and provide access to goods and services for communities, we expect the proposed social taxonomy to facilitate an increase in capital flows towards socially impactful assets, and to help investors appropriately price social risk factors into capital allocation decisions. Social financing is also on the rise. According to Moody’s ESG Solutions' research,  social bond issuance for 2021 reached $199 billion, up 19% from the $168 billion issued in 2020. While this surge was largely driven by the need to finance Covid-19-related responses, we expect social bond volumes to total $150 billion in 2022.

Finally, integrating minimum environmental safeguards into the proposed social taxonomy would reinforce the interconnectedness of social and environmental factors. This will be important to ensure that companies and investors support a fair and just transition as capital is mobilised to realise critical climate objectives over the next decade. Further coherence between the two domains is necessary. Moody’s ESG Solutions research into just transition-readiness of the most exposed sectors found a lack of preparedness for the coming social and workforce disruption caused by the transition to net zero. Additional guidance that connects social and environmental factors can support investors. As highlighted by the LSE Grantham Research Institute on Climate Change and the Environment, the ‘Just Transition’ provides a strategic way for investors to gain exposure to a large cross-section of Sustainable Development Goals (SDGs), including clean energy (SDG 7), and climate action (SDG 13), while simultaneously eliminating poverty (SDG 1), reducing inequalities (SDG 10), and delivering decent work (SDG 8).

HOW WOULD THE SOCIAL TAXONOMY WORK IN PRACTICE?

The PSF’s final recommendations compile their original proposal of ‘vertical’ and ‘horizontal’ social dimensions into three overarching social objectives, complemented by a list of detailed sub-objectives. The proposed three main social objectives are:

Importantly, the objectives outlined by the PSF are based on international norms and principles, aligning with current market best practice. Further harmonization with international conventions will strengthen efforts to reduce systemic social harm, including across supply and value chains. Such efforts are already underway. For example, Moody’s ESG Solutions analyzes and scores up to 30 distinct ESG criteria to generate our ESG scores, with half of these being social criteria. Each one comprises a defined set of ‘Principles of Actions’ derived from international standards such as the UN Guiding Principles on Business and Human Rights, the OECD Guidelines for Multinational Enterprises and the Fundamental Conventions of the International Labour Organization.

In addition, the PSF proposes three ways for an activity to ‘substantially contribute’ to the proposed social objectives and sub-objectives: By avoiding and addressing negative impacts on workers, consumers and communities; by enhancing the inherent social benefits it provides; and by enabling other activities to provide social benefits.

However, as the final recommendations stress, for such a proposed framework to become operational, more work needs to be done, notably on the development of specific criteria to evaluate the social contribution of goods and services, and on the DNSH criteria linked to social objectives.

CONCLUSION

While such work will likely prove challenging – as noted by the PSF – if successfully implemented, it would help filter harmful social practices out of commercial operations, as well as promoting goods and services generating positive social contributions.  

Moody’s ESG Solutions’ data stands ready to support market-led efforts to develop the social Taxonomies of the future. By promoting common standards and definitions for socially sustainable business behaviours, and empowering investors to better assess social risks, we will contribute to a more prosperous, just and sustainable post-pandemic world.

Moody’s ESG Solutions provides insights and analyses on ESG themes and multi-stakeholder performance, climate-related risks and opportunities and global sustainable finance trends.

Correction: this Comment was amended to indicate the correct name of the entity publishing the report: The Platform on Sustainable Finance (PSF).