Dissecting the EU taxonomy
On 18 June, the EU technical expert group (TEG) subgroup on taxonomy published the Taxonomy Technical Report. The taxonomy is expected to become the world’s foremost roadmap for sustainable investment, with a key definitional role in the green-bond market.
Europe is the acknowledged world leader in sustainable finance and there is a widespread expectation that the EU taxonomy will provide the foundations for similar projects elsewhere. The taxonomy itself provides recommendations for technical screening criteria for economic activities that can make a substantial contribution to climate-change mitigation or adaptation, while avoiding significant harm to other environmental objectives.
KangaNews spoke to Nathan Fabian, London-based chief investment officer at Principles for Responsible Investment and rapporteur for the EU TEG subgroup on taxonomy, about the role of the taxonomy and the complexities involved in its delivery.
At root, Fabian says the central idea of the taxonomy is to connect market practice to political goals like the Paris Agreement targets and environment-related UN Sustainable Development Goals (SDGs).
Fabian explains: “Political goals are well and good but investors can’t invest in them. They need to know what types of assets, economic activities, products and services contribute to the goals. To do this, we need to build environmental or social performance into a tool for assessment of these assets.”
The taxonomy translates political goals into economic or investment terms, from which investors can make judgements on how they allocate capital and whether they are making a contribution to climate-change objectives.
Initially, the taxonomy focuses on environmental issues by mapping to seven of the 17 SDGs. Fabian reveals that it can be extended to other SDGs and the plan is to do so in future, but development time dictates that the rollout is done in stages. “The climate-change piece was seen as the most urgent so this is where the process started,” he notes.
The taxonomy itself is a list of activities deemed to meet criteria relating to environmental performance. For example, says Fabian, the energy sector includes sections for factors like energy generation and transmission lines. The transport sector covers issues like urban transport systems, while the water and waste section focuses on water distribution. Fabian emphasises that it is a “very practical” list of classifications.
Having identified 67 activities across eight sectors that are especially relevant to the task of climate-change mitigation and adaptation, the taxonomy then suggests thresholds for the level of performance that, for instance, a water or transport system would need in order to make a contribution from a mitigation and adaptation perspective.
“The question is then about what the taxonomy might be used for and what the benefits might be,” Fabian comments. “One of the expected benefits is that it will act as a comparative tool which a seller and buyer can both use for communication and disclosure if, for example, a company is trying to communicate environmental performance to an investment fund.”
The idea, he continues, is to reduce transaction costs for all market participants by standardisation. “Investors won’t need to relitigate environmental performance every time they buy a financial product.”
Market applicability has been ingrained in the process from the start, Fabian insists. The problem the TEG subgroup on taxonomy was aiming to solve is that market actors tend to underestimate the level of performance needed to meet environmental goals.
On the other hand, Fabian adds: “We still need markets to make choices. We all believe in open capital markets and there is no intention to change this as far as we can tell. We are trying to put in place a framework that allows markets to respond to evidence and information and to use both in their decision making.”
Private-sector entities should view the taxonomy as an opportunity to act appropriately on climate change without the need for excessive state intervention.
“If governments are committed to the goals and markets don’t start to shift, governments will need to harden their intervention,” Fabian warns. “We want to avoid this. The taxonomy tools should be used on a voluntary basis, allowing capital markets to operate in the way they should while also working towards environmental goals.”
Fabian argues that market participants should not be afraid of the taxonomy as it was created by market participants, not bureaucrats. The recommendation that it should be created came from the EU high-level expert group (HLEG), which was made up entirely of individuals from the financial sector. Of the roughly 25 original participants, 11 were PRI signatories.
“Their message was that we need a taxonomy because the sustainable-finance market was growing but not a lot of attention was being paid to the details of what was really going on,” Fabian continues. “The number one recommendation from the HLEG report was that a taxonomy is needed, and this was essentially an investor recommendation.”
Moving on to the development phase, the composition of the TEG subgroup on taxonomy is also mostly from the financial sector – banks and investors – complemented by small component of industry and NGOs. There are 35 people in the group, with 160 extra industry, environmental and scientific experts appointed to provide additional technical input.
Fabian tells KangaNews: “It is an independent group, and there were points where we disagreed with the European Commission [EC] because what we recommended was right for the market. For example, we argued there was a role for biofuels in long-distance freight because there aren’t any easy electric options. This did not align with the commission’s regulatory approach.”
He acknowledges, however, that implementation will ultimately be at the discretion of the EC when the taxonomy passes into law. The TEG hopes its document will prove to be an acceptable compromise between market and legislative preferences.
There has been some market consternation about the taxonomy principle of doing “no significant harm” in otherwise beneficial activities. Fabian downplays this concern, emphasising the word “significant”. He explains: “A wind farm that might kill a few birds is not ‘significant harm’. We need to be sensible about what the level of performance is.”
“Why would a large investor have one way to deal with environmental risks or impacts in Europe and use an entirely different approach – which describes exactly the same process and ideas – elsewhere?”
This will be a game changer. Fabian explains: “The rubber will finally be hitting the road in what it means to pursue an environmental objective. It is no longer sufficient for an issuer or investor to just say ‘I care’. These tools will transform the way market users actually demonstrate the impact they are having – which will help with greenwashing concerns in a very substantial way.
As the taxonomy works its way into law, Fabian believes it will cast bright light on which entities are doing their bit and which are shirking the load or even claiming unearned credit. “If you want to sell a financial product which claims to be environmental you need to explain how it is so,” he says.
Product issuers will not be required to comply with the taxonomy but they are required by the proposed regulation if they sell financial products that have a claim of being environmental to explain how that is. One way to do so will be to use the taxonomy. Fabian suggests the regulatory regime will be similar to a “comply-and-explain” setup, which Australian market participants will be familiar with because it is similar to the approach taken by the Australian Securities Exchange.
“The proposed regulation is not formally a comply-and-explain regime but it is close in practice,” Fabian tells KangaNews. “If you make a claim you need to say something, and if you want you can use the taxonomy to explain it. If you do not, you need to explain the alternative approach you are using.”
One of the biggest issues in sustainable finance today is how to widen the application of sustainability beyond use of proceeds and into environmental transition and mitigation. Directing capital towards entities that need to fund a move away from fossil-fuel usage, for instance, can have as much impact as direct funding of renewable energy.
When it came to including transition in the taxonomy, the TEG taxonomy subgroup acknowledged in December last year that it had to work out a framework for transition. But the complexities of the issue made it delay a determination until the latest report.
The subgroup spent the last six months working out what activities would make a substantial contribution to transition and mitigation objectives, Fabian reveals. It has worked on a methodology which focuses on the sectors of the economy with the highest emissions, as this is the heart of the economy where transition needs to take place.
This is across the energy, transport, agriculture, buildings, water, utilities and other infrastructure sectors. “There is lots of economic activity here that is not anywhere near zero carbon, but we still wanted to set criteria which would allow them to make a substantial contribution,” Fabian tells KangaNews.
He adds: “We went through these sectors and identified the level of performance they should have if they are to be considered to be making a substantial contribution. In effect, in these high-emission parts of the economy we are roughly identifying the top 10 per cent of performers.”
In terms of how the taxonomy is used to further optimal capital allocation objectives, Fabian stresses that the purpose of the taxonomy is to set up a framework for the market to use rather than to be prescriptive. For example, it may be impossible for a large, cross-economy investment fund only to hold assets that are performing at optimal level right now. But it could use the taxonomy to interrogate companies’ strategies to engage over time – which would be a legitimate deployment of the principles.
“These investors could launch funds which could be labelled as something like ‘future green leaders’. This might only be small at the moment but it would hold companies that have demonstrated they can improve their environmental performance,” Fabian says.
He adds: “How the investor uses the taxonomy is really its own decision to make: it is really just a comparative tool. A lot of work has gone into the criteria to ensure they are robust, but they can be used by market participants however they see fit.”
Another key part of the taxonomy relates to providing tools to assess adaptation and resilience of assets to the changing climate.
The example he gives is an Australian one. Investors in Brisbane Airport took forecasts indicating that sea-level rise and storm surge risks in the bay around the airport would increase over the period to 2100, Fabian says. Therefore, the airport elevated its planned runway extension by 1.5 meters to mitigate against the amount of airport closure days due to water inundation.
“It is about adapting assets to be resilient to what may come with climate change,” Fabian confirms. “The taxonomy says what companies should do to work out what the risks may be. This is a lot more contextual, because if an airport has an inland runway it will be more worried about heat stress than sea-level rise.”
The taxonomy report provides maps of climate hazards which can be used to assess climate risks of different assets. “We then talk through how to plan resilience and how to communicate this to the market,” says Fabian.
“Where market users want to use the taxonomy they can and where they want the assurance of the green-bond standard – which is a very high standard with accreditation and verification – they can do this and still be consistent.”
The EU is leading on sustainable-finance taxonomy but it is not alone. China already has a taxonomy and a harmonisation process is underway with the EU with the aim of avoiding a kind of regulatory arbitrage, says Fabian.
A recent Canadian high-level expert group report indicated a desire to be involved in the conversation on taxonomies as well. Fabian says Canada has started its national standard-setting authority on the path of understanding what this means in a local context.
He also reveals that the Japanese government is interested in the taxonomy concept and has engaged with the TEG, while even the United Arab Emirates announced in late June it will be working on a harmonised taxonomy and certification measures supporting the issuance of a broad range of sustainable-finance products.
“However, not too many institutions around the world can keep these things up to date and bring together the firepower needed to get them done,” Fabian warns. “I think it is more likely that if some big countries agree on a framework most other countries will follow and use it.
The EU’s effort, Fabian insists, is “the most comprehensive project of its kind to date”. He believes a very large proportion of the EU’s effort will prove relevant elsewhere and should therefore form the basis of local work.
A good comparison is for global deployment is the markets in financial instruments directive (MiFID), Fabian suggests. When the EU changed the laws for research broking under MiFID, he says the American funds that provide research in Europe began just applying the same rules globally because it was not worth having two different business models.
“This could be the same,” Fabian argues. “Why would a large investor have one way to deal with environmental risks or impacts in Europe and use an entirely different approach – which describes exactly the same process and ideas – elsewhere?”
The goal is that the EU taxonomy could become an overarching set of principles that guides and facilitates other market initiatives. For instance, Fabian says market participants are being encouraged to use standards such as the International Capital Market Association’s green-bond principles as an accompaniment to the EU green bond standards.
“The taxonomy does not cover everything and will never be complete, so there will still need to be mechanisms that describe what people do on a voluntary basis,” Fabian tells KangaNews. “They are complementary, though. Where market users want to use the taxonomy they can and where they want the assurance of the green-bond standard – which is a very high standard with accreditation and verification – they can do this and still be consistent.”