Multiple classifications and interpretations of what is ‘green’ co-exist today in the public and private spheres. It is not uncommon for a financial institution to have as many variations of taxonomy as it does business units developing ‘green’ financial products. Some might include conventional gas as a transition energy source, or flaring systems that reduce emissions to the environment. Others would include neither in an environmentally sustainable fund.
The lack of reliability and standardisation is the reason why many, particularly in the retail market, remain sceptical about what lies beneath financial products marketed as ‘green’.
The taxonomy: Part of the EC’s 10-point Action Plan on sustainable finance
Source: Europa 2018
The idea is simple. For an activity to be eligible, it needs to demonstrate that it makes a substantial contribution to one of the EU’s six environmental objectives without having a detrimental impact on any of the other five. The goals are
- climate change mitigation
- climate change adaptation
- water and marine resources
- circular economy
- waste prevention and recycling
- pollution and healthy ecosystems.
Thresholds of eligibility based on best available science
The European Commission’s Technical Expert Group on Sustainable Finance (TEG), takes guidance from existing EU legislation, policies and goals. It bases the development of the taxonomy on the NACE codes, the industry classification system. The TEG defines thresholds for the eligibility of activities according to metrics such as carbon intensity (gCO2/kWh) based on the best science available, with reference to existing recognised standards, balancing this against practical needs.
By developing a taxonomy, the European Commission aims to develop a ‘universal understanding’ of what is environmentally sustainable shared by scientists, governments, industrialists and individuals. It will, like the metric system did in its time, foster science, innovation and industrial growth.
Benefits of a ‘universal measure’ not an easy sell
In the 17th century, the use of innumerable measurement systems divided Europe, with each country using its own units. Often, multiple systems would co-exist within the same country. John Wilkins, a natural philosopher, understood the benefits that a shared ‘universal measure’ could bring to science and industry. He developed a single, rational standard based on the best science of the time, but it was not until over a century later that French scientists re-evaluated it and implemented a practical version.
The new metric system was not warmly welcomed at the time a people concentrated on the short-term pains of adopting it rather than on its long-term benefits. But by the end of the 19th century, its usefulness was widely recognised and it became the official measurement system across almost all of continental Europe. Not much later it was recognised as the international standard.
In the same vein, the development of the ‘green’ taxonomy has spurred more than a few criticisms. Detractors argue that it will translate into higher costs, inefficiencies and a possible obstacle for industry and finance as it will impose restrictions. Easy access to a breakdown of a company’s turnover by activity according to the taxonomy is fundamental.
Data availability remains greatest hurdle
In the case of green projects or use of proceeds, the same information should be disclosed to all investors. At this point, most companies do not provide detailed information, so data availability is probably the greatest hurdle to the rapid implementation of the taxonomy.
With this in mind, the TEG’s climate-related disclosures guidelines will upgrade the Non-Financial Reporting Directive (NFRD) on the social and environmental impacts of company activities. They specifically encourage companies to provide turnover data broken down according to the taxonomy’s classification.
But encouraging it is not the same as making it mandatory. This is why we, as an investor committed to aligning our portfolios with the Paris Agreement, are calling for the upgraded guidelines to be made compulsory. We will draw on our power as a responsible investor to encourage the companies we invest in to disclose the necessary information.
The guidelines also recommend that companies disclose their capital investments in activities compliant with the taxonomy. This forward-looking indicator will help investors to better assess companies’ future performance and identify those that will have a competitive advantage in an environment of ever-stricter carbon regulation.
Taxonomy needs to be updated constantly
The adoption of the measures will involve a transition period. The taxonomy will be implemented gradually. Companies will need to upgrade their reporting systems, and investors and other financial market participants will have to progressively replace their current classifications.
Another precondition for the success of the taxonomy is to ensure that it is dynamic, integrating all advancements in green technologies. As with the Paris Agreement, almost more important than the first version of the taxonomy is the process put in place to “ratchet it up” and update it constantly.
To ensure its evolution, the Commission has proposed setting up a Platform on Sustainable Finance to promote the taxonomy within and beyond European borders and be responsible for overseeing, updating and assessing the taxonomy and its impact on the economy and the environment.
A clear direction of travel
Once implemented, the taxonomy will reassure institutional and retail investors while saving them time and resources in the medium and long term. Like the metric system at the time, it will provide a clear direction of travel to companies, encouraging research and development in truly green technologies and rewarding those that make efforts to green their activities.
It will enable the measurement of private and public, national and international capital flows to environmental activities within and beyond Europe. A standardised, science and evidence-based taxonomy will dissipate widespread fears of greenwashing and, more importantly, foster investments where they are most needed.
Source: the EC’s 10-point Action Plan on sustainable finance
 The legislative proposal is currently being negotiated. While the European Parliament agreed on 28 March, the European Council has not. Most analysts assert that the final text will not be approved until this autumn in light of coming elections, although an agreement cannot be discounted.