The EU taxonomy is a part of the EU’s broader efforts to transition towards a more sustainable and low-carbon economy. It was proposed as a part of the EU Action Plan on Sustainable Finance, which was introduced in 2018, and officially adopted in July 2020, requiring companies and financial institutions to disclose the proportion of their activities that are taxonomy-eligible or taxonomy-aligned. The overall goal of the EU Action Plan is to redirect financial flows towards sustainable investments and to integrate ESG considerations into the financial sector.
“The question was how to direct this capital appropriately,” says Humphreys, who also is an observer on the Platform on Sustainable Finance (PSF), a permanent expert group of the Commission that was established to assist the development of sustainable finance policies, including the EU taxonomy.
“The solution was to identify the highest emitting sectors that could significantly contribute to this goal and establish a set of criteria for determining environmental sustainability – this marked the beginning of the taxonomy’s development.”
Theory and practice
The EU taxonomy established criteria for determining whether an economic activity is environmentally sustainable within six environmental objectives: climate mitigation, climate adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems.
Each objective has specific criteria that an economic activity must meet to be considered environmentally sustainable. For instance, an economic activity should make a substantial contribution to one or more of these objectives, do no significant harm to the others, and comply with minimum social and governance safeguards.
In practice, companies and financial institutions can use the EU taxonomy to assess the sustainability of their activities and investments. It can also guide them in disclosing relevant information to investors, allowing the latter to make more informed decisions. The EU taxonomy plays a role in the EU’s Sustainable Finance Disclosure Regulation (SFDR), which requires financial market participants to disclose how they integrate ESG factors into their investment decisions and advisory processes.
However, certain criticisms have been raised against Europe’s taxonomy, explains Humphreys, due to it not encompassing the entire economy, potentially leading to an incomplete representation of a financial product’s sustainability. Additionally, the taxonomy currently does not address social objectives, leaving such determinations up to investors.
When examining other green taxonomies, such as the UK’s, says Humphreys, who also is a member of the Green Technical Advisory Group (GTAG), advising the UK government on its taxonomy approach, it possesses a similar remit to its EU counterpart.
“The UK, being the first major economy to pass net zero emissions into law, requires tools to track progress toward its commitments,” she tells ESG Investor, adding that the UK taxonomy serves this purpose and may be used as a performance measurement tool for financial products that pursue environmental outcomes under the UK’s Sustainability Disclosure Requirements (SDR).
Not all taxonomies have the same objectives or priorities. Looking at the role of a green taxonomy from the perspective of Singapore or China, for example, the focus shifts more toward financial products, particularly debt instruments like loans and bonds, she says, with the aim to classify these instruments and capital pathways as green or sustainable using a taxonomy-like framework.
“This approach provides a means of aligning financial activities with environmental objectives.”
Unique characteristics
Many countries have implemented green taxonomies or are in the progress of doing so, helping investors, businesses and financial institutions in identifying and supporting environmentally friendly investments. However, the profile of national taxonomies deviates somewhat dependent on the underlining characteristics of a given economy.
In the original context of the EU, its taxonomy was constructed around the prominent, heavy emitting sectors that contributed significantly to the bloc’s carbon profile, says Humphreys, with this approach aimed at addressing the emissions the EU sought to reduce.
According to Humphreys, while the energy sector will play a dominant role in all governments’ taxonomies, the original technical guidance from the EU did not focus on particular sectors. Instead, the emphasis was on achieving a specific target, applying an overarching technology-agnostic intensity of 100g CO2 equivalent per kilowatt hour of energy produced.
But as this guidance evolved into EU legislation, distinctions began to emerge based on specific activity types, she says, with some activities incorporated into the taxonomy, while others were excluded.
Over time, the criteria for inclusion also expanded. Additionally, the concept of merely achieving the carbon target evolved as it became evident that environmental harm had to be taken into account as well, she says.
“For instance, in cases involving nuclear energy, considerations extended beyond carbon emissions to include aspects like waste management practices or water use within the facility,” says Humphreys, adding that harm criteria were established across all environmental objectives, not only in relation to the primary climate mitigation goal of achieving low-carbon emissions.
For economies like Australia or South Africa, taxonomies may take on unique dynamics, she says, given that mining accounts for a significant portion of both countries’ economic activity.
“This differs from the EU, where mining contributes relatively less to the GDP and, consequently, wasn’t prioritised in the original scope of the taxonomy,” she says. “However, for these economies, mining becomes a crucial sector that they might need to consider in their sustainability efforts.”
In August, the Australian Sustainable Finance Institute (ASFI) started the development phase of the Australian sustainable finance taxonomy with the appointment of its Taxonomy Technical Expert Group (TTEG). Humphreys was appointed a member of the TTEG by the ASFI, which will offer strategic direction over input into, and endorsement of, an Australian sustainable finance taxonomy that will be evaluated by the country’s government.
Australia’s green taxonomy is a joint government-industry initiative that aims to provide a common standard for green and transition finance that will assist in accelerating the allocation of capital towards sustainable activities to achieve Australia’s net zero goals.
Ensuring compatibility
While investors welcome the development of green taxonomies around the world, an overabundance of divergent approaches risks rendering these tools impractical if there is a lack of interoperability.
Though it is important for green taxonomies to consider the unique characteristics of the underlying economy, if jurisdictions diverge too much it may lead to a situation where a company’s economic activity is considered green by one country’s taxonomy but not by another, creating confusion for investors and posing barriers to sustainable investment.
The International Platform for Sustainable Finance (IPSF) plays a significant role in unlocking the potential of interoperable taxonomies and the moving the world towards a standardised approach.
“Representatives from participating countries, often including their respective treasury departments, convene within this central forum to discuss matters concerning taxonomy development, alignment strategies, and potential deviations,” says Humphreys.
“Within this framework, the concept of equivalence comes into play. This refers to the idea that if a company reports under a domestic taxonomy, it could potentially be recognised as equivalent to a corresponding framework, such as the EU’s, especially for financial market purposes.”
For instance, if a UK company adheres to the UK taxonomy, it might be exempt from reporting obligations under the EU taxonomy, she says, noting that currently, no law addresses this notion, with there being no universally accepted principles-based framework in place that would automatically grant equivalence.
“The imminent challenge for IPSF is to establish a principles-based framework that facilitates the assessment of equivalence among various jurisdictions that are in the process of building their own taxonomies,” she says, adding that the advantage of technical expert groups lies in their ability to include individuals experienced in other taxonomy development processes, thereby aligning decision-making efforts closely with other taxonomies.
“These groups consider potential deviations and aim to strike a balance between alignment and distinctiveness,” she says.
Nevertheless, at the current juncture, there isn’t a stable foundation that ensures automatic equivalence recognition between taxonomies.
Hence, while IPSF and technical expert groups contribute to harmonisation and alignment, the crucial task ahead involves developing a well-defined principles-based framework that governs the assessment of equivalence between different taxonomies across jurisdictions.
This article was written by Aaran Fronda and is reproduced from ESG Investor.
Bloomberg
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