What Is The Taxonomy?
On Tuesday June 18th, a group of experts appointed by the European Commission released the EU Taxonomy, a classification tool to help investors and companies analyze the sustainability of potential investments and engage in two-way dialogue between investors and investees, known as strategic engagement, on sustainability.
The taxonomy has six environmental goals: climate change mitigation; climate change adaptation; sustainable use and protection of water; transition to a circular economy and waste prevention and recycling; pollution reduction; and biodiversity. The taxonomy consists of economic activities that contribute substantially to one of these six environmental goals, do no significant harm to the other five, and meet minimum social safeguards.
How Would Investors Use The Taxonomy?
Under the proposed taxonomy regulation, institutional investors marketing environmentally sustainable investment products would be required to explain whether, and how, they used the taxonomy criteria. Alternatively, investors could disclose their own preferred approach to determine that their investment is environmentally sustainable. These proposed rules would apply to a range of products, from European mutual funds (UCITS funds) to alternative investment funds and from securitization funds to index funds.
The taxonomy would bridge the gap between commitments to the Paris Agreement and SDGs and investment practice, reduce the costs of analyzing the sustainability of an investment and eliminate the reputational risk of having to define sustainability for themselves for the purposes of strategic engagement.
How Was the Taxonomy Developed?
As part of its commitment to the Paris Climate Agreement and the Sustainable Development Goals (SDGs), the European Commission developed its Action Plan on Sustainable Finance, which seeks to incorporate environmental and social considerations into the European financial system through regulation. Specifically, the European Commission appointed a High-Level Expert Group on Sustainable Finance, which recommended a taxonomy. The European Commission convened experts from academia, finance, industry and civil society, called the Technical Expert Group, to establish the taxonomy. Almost 200 selected experts in turn supported the Technical Expert Group. The report that they produced is impressive in quality and breadth.
What Is The Road Ahead?
The European Commission is also hosting a stakeholder dialogue on Monday June 24th to discuss the taxonomy, as well as the Technical Expert Group’s work on an EU green bond standard, benchmarks for low-carbon investment strategies and new guidelines on corporate disclosure of climate-related information.
So far, the Technical Expert Group has identified activities that can make a substantial contribution to climate change mitigation in agriculture, energy, water, transport, information and communication technologies and building sectors. Other sectors will follow. The taxonomy also includes an advanced climate change adaptation framework. Taxonomies still need to be developed for water, circular economy, pollution and biodiversity—the four other environmental objectives.
The Technical Expert Group will continue to work with the European Commission until the end of 2019 to prepare the taxonomy for the political process. This will include refining the taxonomy, soliciting feedback on criteria that have not yet been subject to public consultation and further developing guidance on implementation and use of the taxonomy.
So What?
It will take time for investors to digest the 414-page taxonomy and integrate it into their investment processes. Investors may also disagree with thresholds and categorizations. Until the taxonomy passes the political process and becomes law, there will be an opportunity for investors to provide feedback.
Setting the global standard. According to Curtis Ravenel, Global Head of Sustainable Business & Finance at Bloomberg and member of the Technical Expert Group, “It is important that Europe, the most active jurisdiction in sustainable finance, responds to the growing need for clarification on what is sustainable economic activity. The key next step will be to work across the large financial markets to harmonize the different approaches.”
Taxonomies are challenging to create and adapt to changing markets. The EU taxonomy was 414 pages long and required substantial input. China already has its Green Industry Guidance Catalogue, which attempts to provide consistent nationwide guidelines for green industries and projects. Discussions are underway to harmonize the EU and Chinese guidelines, and China’s removal of clean coal from qualifying for green bonds represents progress toward harmonization. Indeed, major institutions like the European Commission and the People’s Bank of China are necessary give taxonomies credibility and keep them updated. It is therefore likely that a number of economies will follow Europe’s and China’s lead, rather than developing their own taxonomies from scratch.
Canada’s Expert Panel on Sustainable Finance—the Canadian equivalent of the EU’s High-Level Expert Group—released its framework for sustainable finance last week. Japan is expected to announce its approach to transparency in emissions soon. Global momentum is strong, international harmonization has benefits, and as Curtis Ravenel explains, “the European Commission hopes that the taxonomy will be adopted by Europe and beyond.”
More than just hot air. Europe needs at least EUR 175 billion of incremental investment per year to respond to the climate mitigation challenge alone. The stringent thresholds for making a substantial contribution to climate change mitigation in multiple sectors should reduce the greenwashing that makes achieving these goals more difficult. For example, the taxonomy’s threshold for making a substantial contribution to climate change mitigation in electricity generation is <100g CO2/kWh. Nathan Fabian, Technical Expert Group member and Chief Responsible Investment Officer at Principles for Responsible Investment, explains that “gas needs carbon capture and storage to reach this threshold. Investors wanting to account for the risk of emissions in their investments or the environmental impacts of gas should take note.”
Similarly, the taxonomy’s threshold for cars is <50g CO2/km until 2025 and <0 CO2/km thereafter. This implies that car companies claiming to be sustainable will need to transition to electric or hydrogen fuel to be compatible with the taxonomy. Both of these thresholds could drive paradigm shifts in major industries.
In summary, the taxonomy as a whole should catalyze existing companies to improve their environmental performance and encourage the founding of new more environmentally friendly ones. Investors, other business leaders, and policymakers globally will be watching.
