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September 22, 2022

Evolution of taxonomies treads line between fragmentation and generalisation

By Kit Gillet

With the increasing proliferation of green taxonomies, debate continues as to whether a global standard can be agreed, and how to reduce political inference in their criteria.

Green taxonomies – classifications used to clarify to companies, capital markets and policymakers which economic activities count as sustainable – are growing in popularity, as more money and attention is being dedicated to sustainability themed financial products like green bonds, funds and exchange traded funds.

Today, more than two dozen green taxonomies are in place or being established around the globe, covering single countries or whole regions. More are likely in the coming years, yet questions remain and contentious issues linger over an area that intersects national and international politics, business and the future of the planet.

In September, a group of non-governmental organisations involved in the writing of the EU’s green taxonomy announced they were leaving the platform that provides technical advice to the European Commission. The platform, the Platform on Sustainable Finance, had previously warned the commission against diluting the taxonomy. In their statement, the five NGOs said the commission had “interfered politically in the group and acted against evidence despite its legal obligation to follow science-based advice”. 

EU leading the way

The EU taxonomy for sustainable economic activities entered into force in 2020, with its arrival seen as an important landmark for the development of green taxonomies around the world.

At its most basic, the taxonomy requires eligible sustainable economic activity to contribute to at least one of six environmental objectives, while also not causing harm to any of the others. The six are: climate change mitigation; climate adaptation; sustainable use and protection of water and marine resources; pollution prevention; the transition to a circular economy; and protection and restoration of biodiversity and ecosystems.

A macroprudential bulletin published by the European Central Bank in 2021 found that just 1.3 per cent of the EU bond and equity markets’ activities were aligned with the green taxonomy, worth roughly €290bn. It found that another 15 per cent of the market financing activities could become classified as green, but were not yet there. 

Even so, the authors calculated that green loans and bonds could grow to around 10 per cent of total debt financing in the future. 

Science-based approach

The idea of establishing a green taxonomy in the EU was initially developed in 2012, as a way to guide the green bond market, but it would take years for it to start filtering through to government policies and agenda. For those involved in the process of establishing green taxonomies, however, the goal – and potential impact – has long been clear. 

“National climate change plans are creatures of political economy, not creatures of science. Our mantra has always been science-based definitions should guide this market,” says Sean Kidney, a member of the Platform on Sustainable Finance and the CEO of the Climate Bonds Initiative, an international NGO working to mobilise global capital for climate action.

“Financial markets, especially the trading desks, are commoditised markets. Clarity of definition makes all the difference to the successful trades and the growth of the market,” says Kidney. “If you’re a bond trader and you’re told to do green, you’ve got to know instantly if something qualifies or not. You’re not going to interrogate, so you need a simple binary label.”  

There is also a hope that established taxonomies will reduce greenwashing, with specific criteria established regarding what is and isn’t green investing. Work is under way on a potential European Green Bond Standard regulation, which is expected to use the green taxonomy as the benchmark for eligibility.

Inclusions and exclusions

As they proliferate, green investment taxonomies are likely to play an important role in developing equity and debt-based financial products that adhere to sustainability principles. However, usability will be key. “If you’re a bank loan officer trying to identify a green loan, if you can’t get a data point, what’s the point? It’s a waste of time,” says Kidney.

At the same time, while the ultimate goal of green taxonomies is to scale up sustainable investment in order to better meet climate change goals, it’s been impossible to divorce politics from the development of taxonomies. Many are raising red flags over some of the decisions being made when taxonomies are created, with what is and isn’t being included in different taxonomies becoming highly controversial.

The Colombian taxonomy, for example, has a full section on agriculture but the EU taxonomy lacks a similar section, as EU member states are unable to agree on recommendations by the technical expert.

Environmental NGO Greenpeace recently said it is taking legal action against the EU’s decision to include gas and nuclear energy in its list of climate-friendly investments earlier this year; the EU Commission proposed that gas-fuelled power plants be deemed green if they emit no more than 270 grams of CO₂ equivalent per kilowatt hour, and if they commit to switching to low-carbon gases by 2035.

On the path from coal to renewable energy “we need to move with all the means at our disposal,” EU finance commissioner Mairead McGuiness said when announcing the decision. “That may mean accepting imperfect solutions.”

South Korea has also included gas in its green investments classification system, despite pushback from environmentalists and other groups.

A strong starting point

Those working on their own taxonomies see the value of the EU taxonomy as a benchmark, but also strong differences in what they intend to include (or not). Alexander Stafford, a UK member of parliament and chair of the All-Party Parliamentary Group on ESG, says: “From an international perspective, I have watched with interest as the EU has been developing their taxonomy and, while I think the EU has made a valiant effort, Britain can and must do better: a well-trodden example being the EU’s taxonomy including natural gas as a transitional fuel.” 

The UK is currently working on its own taxonomy, with the Green Technical Advisory Group completing its screening of climate change mitigation and adaptation ahead of legislation scheduled for the end of the year.

At the same time, Stafford stresses that not only do taxonomies need to be science-based and robust but they also need to be not too internationally divergent. “Too many different and conflicting international taxonomies will only serve to increase the compliance burden on companies and reduce ESG considerations to a box-ticking exercise,” he says.

Work required

Many on the investor side see the value of having these established criteria for sustainable investing, but also the challenges ahead. Marie Freier, global co-head of sustainable and impact investment banking at Barclays, says: “Green taxonomies are an important tool for increased clarity, transparency and comparability for ESG investors looking to better understand how environmentally sustainable their investee companies’ business activities are.”  

Freier says investors are now undertaking substantial work to better understand the alignment of their portfolios with this taxonomy, in view of the existing and growing requirements under the EU’s Sustainable Finance Disclosure Regulation.

“Initially there was a lot of uncertainty around what levels of alignment would be seen as credible – and hence commercial – by the market, though more recently, some consensus around likely typical levels of taxonomy alignment for different investment products is emerging,” she adds. “Observers less familiar with the details or in the weeds of these mapping exercises and the taxonomy may be surprised by the relatively low percentage numbers.”

Market fragmentation risk

China is another leader in the drive to establish green investing criteria. The country has created its own classification system, the Green Bond Endorsed Project Catalogue, which has been in place since 2021 with the goal of identifying assets and projects that are eligible to be financed using green bonds. Other countries that now have taxonomies in place include Malaysia, Russia and Mongolia. 

Earlier this year, Colombia became the first country in Latin America to launch its green taxonomy. According to Mariana Escobar Uribe, an advisor to the Financial Superintendent of Colombia who is responsible for its Green Finance and Climate Risk strategy: “We saw the taxonomy as a tool to help market development. Colombian issuers have been saying being an issuer in Colombia is expensive, our capital market is very small. The biggest benefit is investor-base diversification – international investors that have [a sustainability] mandate.”

As more green taxonomies appear, there is a risk of market fragmentation, however, with inconsistency in green definitions potentially adding layers of confusion to businesses and investors that are involved in cross-border activities.

“At CDP, we strongly believe taxonomies can drive capital allocation towards sustainable activities, reduce greenwashing and enable comparison between investment opportunities,” Pietro Bertazzi, global director for policy at environmental not-for-profit CDP, wrote in a recent opinion piece for Sustainable Views

However, Bertazzi added that with at least 28 initiatives developed globally, “the explosion of different taxonomies presents major risks that, over time, could make their use redundant. A wide variety of criteria – often opposing or incompatible – will increase uncertainty, ultimately undermining the core purpose of taxonomies”.

Left behind

Countries that don’t currently have established frameworks are also increasingly feeling the need to establish their own green taxonomies.

“If you don’t have a taxonomy, you’re going to be subject to the taxonomy of your funders, because there’s this absence. That taxonomy won’t fit with your individual specific circumstances,” says Eugene Wong, CEO of Sustainable Finance Institute Asia in Singapore and an advisor to the Association of Southeast Asian Nations central banks on taxonomy.

Wong points out that Southeast Asia has 10 countries, and many of them are devising their own taxonomies in addition to the regional Asean green taxonomy that was released in its initial form last November. “The idea of a taxonomy is to reduce fragmentation, not increase it,” he says. “But we also recognise that each country may come up with a taxonomy that’s slightly different, to meet its national agenda. That’s not helping the overall Asean ambition, nor is it helping the intra-Asean capital flow or the international flow of capital into Asean.”

Despite this, Wong says establishing a global green finance taxonomy seems unlikely. “It’s really difficult to implement a global taxonomy and we don’t think we’re ever going to get to a global taxonomy, because every country is having a very different starting point.” 

Hope for the future

Even with these teething issues, there is hope for the impact of green taxonomies going forward, and their role in funnelling money into greener projects and businesses. As of January 2023, sustainable funds in the EU will need to disclose whether their economic activities are aligned with the bloc’s taxonomy. 

However, the often complex and broad alignment criteria leaves many businesses or projects struggling or unwilling to jump the necessary hurdles, even if their products would likely pass the test. 

Climate Bonds Initiative’s Kidney says while following taxonomy labels is entirely voluntary at this stage, having them in place can still have a strong impact just by bringing greater clarity. “That’s the key point of what we’re trying to do. Clarity around what to do. When you’ve got clarity around what to do, you can mobilise capital,” he says.

“You will see announcements coming through now about taxonomies in Vietnam, Thailand, Chile. Mexico will start soon,” he adds. “Russia passed a taxonomy in parliament last September, which mirrors the substantial contribution provisions of the European taxonomy.”

Barclays’ Freier says: “Awareness among companies of these green taxonomies and how their businesses map onto them will grow with increasing focus of investors.”

At the same time, there is acceptance that green taxonomies need to be constantly evolving documents that will require authorities to monitor and adapt them continually. “We are going to develop a governance structure to update it,” says Escobar Uribe, of Colombia. “How to update it, how often, how to engage with experts in the private sector. This is probably going to come in during the next couple of months.”

 



A service from the Financial Times