Taxonomy limitations

The EU taxonomy was developed with environmental goals front of mind. It does not yet cover social principles in such detail, and the subjective nature of assessments in this area could cause difficulties down the road.

The ever-evolving sustainable finance market has most recently seen bond issuers seeking to use sustainability instruments to fund the fight against the impact of COVID-19.

International Finance Corporation was the first mover, with the pricing of a US$1 billion three-year social bond on 11 March. It also subsequently printed A$200 million (US$122.9 million) of Kangaroo social bonds with the same purpose. Other issuers of similar instruments include African Development Bank, Council of Europe Development Bank, European Investment Bank and World Bank.

These transactions all followed the International Capital Market Association (ICMA)’s social bond principles but fall outside the purview of the EU taxonomy. David Jenkins, head of sustainable finance at National Australia Bank, says the taxonomy is a hugely significant piece of work but is not yet ideally suited to innovative funding instruments and issues like those being faced with the COVID-19 pandemic.

Nicholas Pfaff, head of sustainability at ICMA and member of the EU technical expert group and green bond standards working group, agrees that virus prevention measures probably could not fall under the auspices of the taxonomy as currently construed. For the time being, issuers – as was the case with the recent spate of supranational COVID-19 related social bonds – fall back on the ICMA social bond principles.

When market participants highlight the taxonomy’s focus on climate change they do not intend it as a criticism. The depth of work done to establish performance thresholds for climate-related economic activity is widely acclaimed. In taking a vital next step towards codifying sustainable finance, in effect the EU had to start somewhere – and the environment was likely the best place to do so.

Subjective analysis

Nonetheless, there is still a need for judgement calls in some areas, which comes with potential pitfalls. In particular, the concept of “do no significant harm” ends up having to do a lot of heavy lifting in the taxonomy regime. In effect, it is a catch-all for any economic activity not directly accounted for in the thresholds.

“I suspect a lot of companies could find themselves slipping up when it comes to the do no significant harm and minimum safeguards tests,” warns Tania Smith, director, sustainable finance at ANZ. “They are very subjective – there are some quantitative definitions but there is still room for controversy with respect to social issues in particular. I suspect we will see a lot more work in this area.”

Pfaff refers to the do no significant harm requirement as a “failsafe”. He explains: “The idea is that project owners and investors should take a holistic view of technical criteria, the activity and its social safeguards to establish whether, overall, the project does not cause significant harm.”

As an example of this type of judgement, Pfaff cites a company that wants to roll out a series of energy-efficient new buildings. The taxonomy thresholds provide a tool for measuring things like emissions and energy usage, while do no significant harm asks the developer to ensure there is no significant biodiversity impact and monitor how workers on the building are being treated.