Understanding green taxonomies: impacts for sustainable finance

Sustainable finance taxonomies are essential frameworks that classify economic activities based on their sustainability credentials. As the world grapples with climate change and environmental issues, these taxonomies play a crucial role in mobilizing capital towards projects aligned with sustainability goals. This article explores the definition, historical context, regulatory landscape, implications for the financial sector, and the latest developments in sustainable finance taxonomies, including a particular focus on the EU Taxonomy.

What Are Sustainable Finance Taxonomies?

Sustainable finance taxonomies are classification systems that identify capex, opex, and revenue that align with broader sustainability objectives. They provide clarity on what constitutes a sustainable activity thereby helping to reduce the risk of ‘greenwashing’, where products or processes are misrepresented as environmentally friendly (World Bank, 2021). Typically, taxonomies can be categorized into:

1. Regulatory frameworks established by governments or regulatory bodies; and 
2. Market-based approaches that vary in complexity and criteria and are often developed by industry groups or private organizations.

By defining sustainable activities, green taxonomies support capital providers to make more informed decisions, thereby building greater confidence in sustainable finance markets.

Historical Development of Taxonomies

The concept of taxonomies gained traction in the early 2010s, with the Climate Bonds Initiative introducing a simple list of sectors eligible for green bonds in 2012 (Climate Bonds Initiative, 2012). This marked the beginning of a more structured approach to sustainable finance.

Over time, taxonomies have evolved into complex frameworks that encompass various environmental objectives. A significant milestone was reached in 2020 with the introduction of the EU Taxonomy, which established a comprehensive classification system to guide investments into more sustainable activities (European Commission, 2020). This regulation not only defined what constitutes a sustainable economic activity but set out a framework for reporting and compliance.

The EU Taxonomy: A Game Changer

The EU Taxonomy is a cornerstone of the European Union’s sustainable finance framework and the most progressive taxonomy globally. It provides a standardised classification system for identifying environmentally sustainable economic activities, to help speed up the transition to a low-carbon, resource-efficient economy across Europe (European Commission, 2020).

Objectives of the EU Taxonomy

The EU Taxonomy is designed to support the EU’s 2030 climate and energy targets and the broader goals of the European Green Deal. It establishes six key environmental objectives (although currently only mitigation has been fully detailed by the EU:

1. Climate change mitigation
2. Climate change adaptation
3. The sustainable use and protection of water and marine resources
4. The transition to a circular economy
5. Pollution prevention and control
6. The protection and restoration of biodiversity and ecosystems

To qualify as environmentally sustainable, an economic activity must substantially contribute to one or more of these objectives while not significantly harming any of the others (European Commission, 2020).

Regulatory Framework

The Taxonomy Regulation entered into force on July 12, 2020, and laid the groundwork for the EU Taxonomy. It required the European Commission to define technical screening criteria for each environmental objective through delegated and implementing acts. This means that specific criteria must be met for an activity to be classified as sustainable. This includes being ‘eligible’ if an activity meets the minimum sustainability criteria, and being ‘aligned’ when it not only is eligible but also contributes positively to overarching sustainability goals (European Commission, 2020).

The regulation also mandated that financial market participants and large companies disclose their alignment with the Taxonomy, enhancing transparency in sustainable investment decisions. From January 2024, companies have been required to report on their eligibility for all six environmental objectives, expanding the scope of disclosures beyond the initial climate-focused criteria (European Commission, 2020).

Why it is Important for Investors and Companies

The EU Taxonomy plays a vital role in directing capital towards sustainable projects. It does this by:

• Creating a common language: It establishes a clear definition of what constitutes a sustainable economic activity, reducing ambiguity and enhancing investor confidence (World Bank, 2021).
• Mitigating greenwashing: By providing a standardized framework, the Taxonomy helps protect investors from misleading claims about sustainability.
• Facilitating compliance: Companies can use the Taxonomy to align their operations with sustainability goals, making it easier to attract investment and comply with regulatory requirements.

Implications for the Financial Services Sector

The rise of taxonomies has profound implications for the financial services sector. Financial institutions are increasingly required to align their investment strategies with taxonomy definitions, influencing asset valuations and risk assessments.

Key implications include:

• Pressure on financial institutions to adapt their portfolios to comply with taxonomy criteria, leading to a shift in investment strategies towards more sustainable assets. This is more pertinent for institutions that seek to be aligned with Article 9 of the Sustainable Finance Disclosure Regulation (SFDR) (Zhang, 2019).
• While compliance with taxonomies presents challenges, such as the need for data collection and reporting, it also offers opportunities for innovation in financial products and services that meet sustainability criteria.
• Aligning with taxonomies can help institutions to better assess environmental risks, leading to more resilient investment strategies.

Latest Industry Developments and Innovations

Recent trends indicate a growing interest in transition taxonomies. These support activities that contribute to the transition towards a low-carbon economy. These taxonomies recognize that not all sustainable activities are fully green from the start, allowing for a more inclusive approach to sustainability (ICMA, 2021).

Innovations in reporting practices are also emerging, with the development of standardized metrics and disclosure requirements. For example, the Task Force on Climate-related Financial Disclosures (TCFD), has now integrated into the ISSB, and has been instrumental in promoting transparency in reporting on climate-related financial risks (TCFD, 2020).

It is estimated that the EU Taxonomy alone will help mobilize the €1 trillion needed by 2027 to facilitate the transition to a low-carbon economy (European Commission, 2020). Additionally, the Taxonomy is expected to channel investments into low-carbon technologies and activities responsible for up to 80% of EU greenhouse gas emissions, demonstrating its critical role in shaping investment decisions and promoting sustainability across various sectors (Tandfonline, 2021). Therefore, successful implementations of taxonomies, such as the one in the EU, which is now rolling out to other markets including China, provide valuable insights for other regions seeking to enhance their sustainable finance agendas.

Conclusion

Taxonomies, like EU Taxonomy, are pivotal in steering investments towards sustainable development. As regulatory frameworks evolve and the financial sector adapts, the importance and impact of these taxonomies will only increase. By providing clarity and reducing ambiguity in sustainable investments, taxonomies will play a critical role in delivering global sustainability goals.

As we move forward, the integration of taxonomies into financial decision-making processes will be essential in ensuring that capital flows towards projects that genuinely contribute to a sustainable future. The continued evolution of these frameworks, alongside innovations in reporting and compliance, will help build a more resilient and sustainable financial system.

References

• Bank for International Settlements (BIS). (2021). Sustainable Finance: Taxonomies and the Role of Central Banks. Retrieved from BIS.
• Climate Bonds Initiative. (2012). The Green Bond Market. Retrieved from Climate Bonds Initiative.
• European Commission. (2020). EU Taxonomy for Sustainable Activities. Retrieved from European Commission.
• Hessenius, M., Henn, S., & Müller, J. (2021). The EU sustainable finance taxonomy and its contribution to climate change mitigation. Sustainability Accounting, Management and Policy Journal, 12(1), 1-23.
• ICMA. (2021). Green Bond Principles. Retrieved from ICMA.
• UNDP. (2021). Common Framework of Sustainable Finance Taxonomies. Retrieved from UNDP.
• World Bank. (2021). Sustainable Finance Taxonomies: A Global Overview. Retrieved from World Bank.

Zhang, Y. (2019). China’s Green Credit Policy: Progress and Challenges. Retrieved from China Development Bank.