A lot has been written about the draft taxonomy since the European Commission’s Technical Expert Group (TEG) first published their report in June 2019, setting out their proposals on activities that should contribute to climate change mitigation and adaptation in relation to the development of an EU classification system for environmentally sustainable economic activities.
At Sustineri, we have undertaken an analysis of the range of commentaries that have emerged in relation to the Taxonomy Technical Report published by the TEG from a variety of stakeholders such as financial institutions and think-tanks. In this piece, we summarise what might be considered “good” about the proposals, where improvement may be needed, and what the future prospects may be. Anyone with an interest – investors, companies, international policymakers – in how this landmark policy initiative is developing should hopefully find this useful.
What is proposed?
The report on the EU Taxonomy provides a classification system to determine whether an economic activity is environmentally sustainable. Inclusion in the taxonomy is restricted to activities that contribute to at least one of the six environmental objectives – “Climate Change Mitigation, Climate Change Adaptation, Sustainable Use and Protection of Water and Marine Resources, Transition to a Circular Economy Waste Prevention and Recycling, Pollution Prevention and Control, and Protection of Healthy Ecosystems – and also on the basis that it does no significant harm to any of the other environmental objectives”.
In its current draft, the Taxonomy includes specifications for only two of the six environmental objectives. For Climate Change Mitigation, the report presents a list of eligible economic activities. Included are “activities that are already low carbon, activities that contribute to a transition to a net-zero emissions economy in 2050 but are not currently close to a net-zero carbon emissions level, and activities that enable low carbon performance or enable substantial emissions reductions”.
For Climate Change Adaptation, the draft recognises that adaptation is context – and location-specific. Hence, instead a list of activities, it provides a set of guiding principles and screening criteria to assess the potential contribution of an economic activity to adapt to climate change and increase climate resilience. An adaptation activity may be eligible if “all material physical climate risks identified for the economic activity are reduced to the extent possible and on a best effort basis; and/or it reduces material physical climate risk in other economic activities”.
The other four environmental objectives will be reviewed by the Platform on Sustainable Finance, which will permanently replace the TEG, starting from autumn 2019, and will also have the role of regularly updating the sustainability criteria.
The Taxonomy, according to the TEG, should be implemented in a five-step process:
- Identify the activities conducted by the investee that could be eligible.
- For each potentially eligible activity, verify whether the company or issuer meets the relevant screening criteria.
- Verify that the do no significant harm criteria are being met by the issuer.
- Ensure compliance of the investee with the social minimum safeguards specified in the Taxonomy.
- Calculate alignment of investments with the Taxonomy and prepare disclosures at the investment product level.
What are the benefits?
A substantial recognised benefit of the introduction of a taxonomy is that it would significantly reduce (perhaps even remove altogether) the risk of “green-washing”of financial products. At present, it is too convenient for financial institutions to launch a product on to the market which claims to support low-carbon investment when the reality is more dubious, e.g. the issuance of green bonds with question marks about the use of the proceeds.
Several of the commentaries on the TEG study have noted the importance of the green-washing issue, as they – including the UNEP FI– have identified the benefit that the taxonomy should bring in developing a common language around climate finance. The establishment of a common understanding and a definition about what should be classified as “green” is a primary objective of the taxonomy: this is presumably why TEG members have decided to go into such granular detail, to provide clarity and to avoid confusion.
Strengthened disclosure on climate risk by investors has been a European Commission target since they launched their sustainable finance initiative. Indeed, the draft InvestEU programme (which is essentially the investment plan for the EU financing institutions for the next decade) specifically requires sustainability-related financial products to disclose detailed information about how they will meet their sustainability objectives. Published commentaries are positive in their verdict that the advent of the taxonomy will enhance the quality of climate disclosure across the sector.
National policymakers and regulators, according to a couple of commentators, should also welcome the taxonomy because of what it will do to inform their own national policies and measures. These past two years have seen steady progress, certainly in Western Europe, by e.g. the British and Dutch central regulators (prime movers behind the Network for Greening the Financial System), to mainstream climate and sustainability for finance and investment. Once the EU taxonomy is in place, it should bolster, and perhaps embolden, the progressive national regulators and force climate on to the agenda of other regulators who still don’t believe they should pay attention to it.
Last on the benefits, we will note our view that the “do no significant harm” clause in respect of the broader environment has attracted less attention than the classification system of the taxonomy. However, its inclusion, with its emphasis on the need to safeguard key environmental areas, might be beneficial to the impact investing sector because of its straightforward read-across.
How might it be improved, now or in the future?
A number of the commentaries we analysed (including from the trade association EFAMA) were concerned that the taxonomy might simply impose – in the light of the complex and granular detail that it goes into – too much of a burden to make it usable for an investor. It wouldn’t be the first time that financial institutions have complained about “restrictive regulatory burdens”. But it’s certainly an issue the Commission will need to address in drawing up the legislation.
Linked to this, one or two commentators also complained that the taxonomy will not be made mandatory, and its impact will therefore be undermined by its non-binding nature. We heard the same about the TCFD when it was first introduced: making it mandatory would undoubtedly have accelerated its progress in some Western European jurisdictions. EU policymakers may wish to learn relevant lessons from the TCFD experience. There is also a related concern that, if the taxonomy is not mandatory, it risks being applied only by “greener” investors
The lack of available data at asset and activity level might also, it’s felt, hold back the take-up of the taxonomy, in that investors might not have the information to be able to undertake all five of the steps required under the taxonomy process. The reverse corollary of this, of course, is that the taxonomy might be a driver to make much more data available at the granular level.
The other consistent criticism aimed at the taxonomy (which academics and think-tanks have been particularly vocal about) has been circulating in European circles since the HLEG was established: that investors need a “brown” (i.e. carbon/fossil fuel-based) taxonomyas well as green, if they are able to make the most effective investment decisions that balance both opportunity and risk. The argument goes that, without sufficient knowledge of the brown exposure of an investment, there is a risk that an investor doesn’t have the full and necessary picture.
What does this mean specifically for investors?
The intended users of the EU Taxonomy are “Member States or the EU when adopting measures on market actors in respect to financial products or corporate bonds that are marketed as environmentally sustainable; and Financial market participants offering financial products as environmentally sustainable investments”. Furthermore, the EU believes that the Taxonomy could be used as the basis for labels, standards and definitions.
Apart from its significance for policymakers (which we address below in our conclusions), the taxonomy is therefore of particular importance, in our view, to institutional investors, banks and insurance companies. How financial institutions respond, will to a large extent depend on whether they see “first mover” competitive advantage to get ahead on green and sustainable investments.
Institutions will, of course, note that the TEG proposals are only a draft, but they should be under no illusion about the direction of travel and would be wise to work on the assumption that a taxonomy will pass into EU legislation by the middle of 2020.
Some of the major investment organisations have refrained from substantive comment on the TEG report, perhaps because the taxonomy is, at this stage, still some way from draft legislation status. However, in the light of the pros and cons listed above, it might still be helpful to underline what we have seen to be the principal investor concerns aired to date:
- the resources issue (highlighted above): some investors seem to be concerned that the detail required to apply the taxonomy to investments might be overly resource-intensive;
- lack of transparency and quality of data (see above) also seems to be a particular issue;
- one other factor considered is whether the taxonomy will promote more active investor engagement with companies which can enhance knowledge and insights into asset and activity-level data, thus, making investors better able to go through all five steps of the taxonomy convincingly.
Taking these concerns in the round does pose an overall question for investors: how much resource should they allocate to gain first mover advantage? Or would they be better advised to free-ride others and change gear in their approach as taxonomy-related practices and information becomes more widely used and available.
What next in Europe and internationally?
Most immediately for the EU, the TEG has asked for feedback on its report by 13 September. It will then analyse the responses and advise the Commission on next steps, with a view to the latter legislating. The Commission has promised to undertake a public consultationon its legislative proposal for the taxonomy before it becomes law. The expectation – although the EU law-making process will be subject to the inevitable hiatus as a new Commission, under new President Ursula von der Leyen, takes its place in autumn – is that it will pass into law, along with other parts of the Commission’s sustainable finance action plan, by the middle of next year.
The bigger issues surrounding the future prospects of the taxonomy are, in our view, threefold:
- whether the green wave of new MEPs, who as an early marker forced von der Leyen into more ambitious pledges on decarbonisation as a price for their support for her confirmation, will in tandem with the Commission in turn lobby for a more ambitious taxonomythat has a wider impact on member state legislation.
- looking beyond Europe, the Commission has been quite explicit about their hope that the taxonomy can set the bar around the world for others to follow suit. The EU has an active environment and green economy programme with China. In the light of the official policy guidance the Chinese Government has already issued on green investment guidelines, their activities on green bonds and disclosure, and also given the burgeoning clean energy sector there, the Chinese would seem to be following next in line after Europe. It’s also worth noting the interest that the EU has stimulated elsewhere: notably in Canada, where an expert panel on sustainable finance (along the lines of the Commission’s HLEG in 2017/18) issued a report in June with some practical recommendations to help push “sustainable finance into the mainstream”; and in Japan where a number of “green” bond issuances have taken place, where a high-level green finance network has been established, and the Economics Ministry is showing interest in what Europe is doing.
- last, within the global context, the next 16 months (in the run-up to and including COP 26) will be pivotal to unlocking a step change in international climate action. Campaigners will be hoping that the dynamic between Europe’s green taxonomy and the political backdrop can generate an exponential growth in green finance markets and frameworks globally– or at least one that can create the right environment for the next decade. Article 2.1.c of the Paris Agreement – “making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development” – will be pivotal to tackling the climate emergency.
For further information, please contact Shuen and Richard at Sustineri.
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