Anatomy of a taxonomy

In March, Europe’s technical expert group on sustainable finance (TEG) delivered the final report on the EU’s taxonomy for climate change mitigation and adaptation. The taxonomy – and the green bond standard (GBS) that is expected to follow it – will have global ramifications for sustainable finance including opportunities and challenges for Australasian market participants.

Laurence Davison Head of Content and Editor KANGANEWS

The taxonomy is the product of a big goal, and one which has come to dominate the high-level thinking behind sustainable finance markets. Following the Paris Agreement in December 2015, European governments, financial institutions, investors and companies had a tangible concept of the task in front of them but no obvious roadmap to guide the reallocation of capital that would be needed to achieve it.

Nathan Fabian, chief responsible investment officer at the UN-supported Principles for Responsible Investment in London and a member of the TEG, explains that the EU reached the point where it had very well defined goals for the next 10 years of sustainable finance. These included a requirement for roughly an additional €175-290 billion [US$194-321.4 billion] a year to fund climate goals alone – most of which would have to come from the private sector.

“The EU realised it had to align its policy settings with these goals, and that it would have a really big problem if no-one could agree which investments contributed and which didn’t,” he tells KangaNews.

The EU elected to follow a path of trying to help the sustainable finance market flourish, including by promoting lower transaction costs over time. In this context, it recognised that the benefit of a common language and benchmarks is high once market participants have adopted them. The guiding principle of what followed is that it should be an investment in a more efficient market.

The TEG was created by the European Commission with this in mind. It started work, in July 2018, with the task of developing the EU taxonomy, an EU GBS using the taxonomy as the basis for measuring project impact, methodologies for climate benchmarks and related disclosures, and guidance on improved corporate disclosure.

The TEG published its final report on the GBS in June last year. The taxonomy establishes a classification system for environmentally sustainable economic activities, under which an economic activity must “substantially contribute” to one of six environmental objectives, “do no significant harm” to any of the other objectives, meet minimum regulatory safeguards and comply with technical screening criteria.

This is an extraordinarily ambitious project. It seeks to weave detailed environmental performance thresholds that go down to the level of individual economic activities into a legislative and regulatory regime governing a rigorous sustainable finance market – and to do so in a way that does not create excessive barriers to entry or other cost.

“This is much more than just a technical classification of sustainable economic activities. It is a very practical effort to provide guidance including on actual metrics for environmental thresholds.”

The taxonomy explicitly incorporates environmental goals by creating performance thresholds at the economic-activity level. This is a new way of thinking about environmental, social and governance (ESG) integration, Fabian tells KangaNews.

“Most ESG scoring to date has been based on process and has been risk-based – asking whether an entity is taking factors into account and making informed judgements about them based on the potential implications,” he explains. “The new layer is comparing the decisions entities are making – as a result of their processes – with alignment with specific environmental goals. It’s complementary, but it adds an extra layer of data in order to provide clarity on an activity’s environmental performance.”

Nicholas Pfaff is the London-based managing director, market practice and regulatory policy, and head of sustainability at the International Capital Market Association (ICMA) as well as a member of both the TEG and the EU GBS working group. He adds: “This is much more than just a technical classification of sustainable economic activities. It is a very practical effort to provide guidance including on actual metrics for environmental thresholds for manufacturing.”

Updates in the final taxonomy report include expanding the explanation of climate adaptation activities and giving practical guidance on how large European companies will be able to report on their taxonomy-aligned activities. It also attempts to give more detail on the all-important requirement that activities do no significant harm, which plays a major role in governing outcomes that currently lie beyond the scope of the taxonomy.

Broad deployment

The risk with a piece of work as detailed as the EU taxonomy is that it could become unnecessarily – if inadvertently – restrictive. It was a work in progress for more than a year and the sustainable finance market continued to evolve rapidly throughout. In particular, sustainable debt is waking up to the potential of holistic sustainability scoring as a supplement to or step beyond use-of-proceeds instruments like green, social and sustainability (GSS) bonds.

Fabian acknowledges that basing environmental thresholds on economic activities, as the EU taxonomy does, may at face value be much closer to a use-of-proceeds approach. But, he insists, there is no reason why it cannot also be used as the basis for entity-level scoring.

If a bond was offered on a broader basis, for instance around environmental governance or performance methodology, an additional component could be analysis of what proportion of the issuer’s activity meets environmental objectives today. It would be relatively simple, Fabian says, to have standards about improving the proportion of an issuer’s activities that must meet the thresholds over time.

The same would apply to debt instruments that explicitly measure an issuer’s environmental transition. Fabian continues: “A typical understanding of transition is that an entity is not meeting standards now but has a commitment to doing so in future. The thresholds in the taxonomy should help with understanding of the performance of underlying assets in a much more precise and comparable way.”

“Classical green bonds are still largely about capex, but not all issuers have significant capex needs. Borrowers that do not can use the taxonomy in a different manner, for example to set a target of improving the taxonomy-aligned share of revenue.”

This type of flexibility was always in the TEG’s thinking. Eila Kreivi, director and head of capital markets at European Investment Bank (EIB) in Luxembourg and member of the TEG and EU GBS working group, explains that the taxonomy is asset-class blind: it can be used for equity, funds, fixed income, loans and more.

Kreivi adds that during the development phase the TEG explored a test case of a corporate that analysed all its business areas to see whether or not they were taxonomy-aligned. She says the company concluded that it was feasible, though execution took some time the first time around.

“As the taxonomy is updated with other environmental areas, it will be increasingly possible to analyse a company and its activities in a holistic manner,” Kreivi insists.

The fact that the taxonomy will be incorporated into the EU GBS to some extent masks the fact that the TEG was always aware that wider deployment would be key to achieving the overarching goal of building a bigger sustainable finance market.

“Classical green bonds are still largely about capex, but not all issuers have significant capex needs,” Kreivi points out. “Borrowers that do not can use the taxonomy in a different manner, for example to set a target of improving the taxonomy-aligned share of revenue or other indicator. This can be used as a rigorous and verifiable KPI.”

There may be some limitations to the taxonomy’s scope, even so – and in many cases these also relate to the pace of development of the sustainable finance market as well as the taxonomy’s tight focus on environmental activities (see box).

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.

International implications

At face value, the taxonomy does not have a direct impact on companies outside the EU, including bond issuers. Reporting against the economic activity thresholds will be compulsory for EU-domiciled companies but of course this jurisdiction does not extend globally. The GBS will not be mandatory, even for issuance of instruments by EU companies or within EU borders.

Optional or not, market participants expect widespread and enthusiastic adoption of the taxonomy and GBS in Europe. Companies seeking to engage with European capital markets will not be able to sidestep the regime even if they do not fall directly under its purview.

Tania Smith, Melbourne-based director, sustainable finance at ANZ, says Australian companies with investors in Europe will likely be asked about their potential alignment with the taxonomy, while any firm that wants to be able to demonstrate global best practice will also have to take note. Smith compares the taxonomy to the UN Sustainable Development Goals (SDGs), in the sense that she anticipates companies will incorporate it into their strategies and reporting of their own accord as well as because of investor expectations.

ANZ’s Sydney-based head of sustainable finance, Katharine Tapley, confirms that enquiry from European investors was in evidence even before the taxonomy was finalised in March this year. She reveals ANZ prepared itself for questions from investors about alignment with the taxonomy when it issued its euro SDG bond in 2019, for instance.

Tessa Dann, director, sustainable finance at ANZ in Sydney, adds: “Given the future legislative requirements for EU asset managers to disclose alignment with the taxonomy, it will be in the interests of any issuer going to Europe to provide the information necessary to demonstrate alignment with the taxonomy where possible – even if it is not looking to issue a green bond.”

The impact of the taxonomy will be more than just another reporting requirement for issuers seeking access to European investors. Europe is the acknowledged global leader in sustainable finance and market participants within the union and beyond universally agree that a development of the taxonomy’s scope will have a worldwide impact.

“This is a significant body of work done by the EU and the TEG – nothing of this magnitude and detail has been done before,” says Dann. “It will undoubtedly have a global impact, including in the form of other jurisdictions looking to leverage the European work and apply it to regional markets.”

To some extent, global relevance is simply the product of the universality of the issues and activities the taxonomy tackles. For Fabian, international uptake of the taxonomy’s principles rests on whether environmental performance thresholds is an idea with sticking power.

He tells KangaNews: “If it is, investors across all markets will inevitably incorporate it in some way in future. I think it is here to stay, because we are well behind where we need to be on environmental goals – on climate, but also on biodiversity, the circular economy, a range of pollutants and many more environmental factors. To catch up, we need to be very specific in how we compare the environmental performance of economic activities with our goals.”

“We have to work out the shortest distance between two points, by which I mean whether other jurisdictions simply adopt something akin to what the EU has done or invest in a more nuanced and different local version.”

The good news for Australian and New Zealand issuers is that they have a good chance of not falling foul of changing standards in Europe.

This may not be the case for all existing GSS bond issuers. National Australia Bank’s Sydney-based head of sustainable finance, David Jenkins, says there has been commentary from second-party opinion providers to the effect that some GSS bonds already in the market may no longer pass muster when the taxonomy is applied to the EU GBS.

There will be a fundamental change to the requirements in the EU a green-bond framework, including more granularity than the existing green-bond principles (GBPs). Under the new standards, use of proceeds must be aligned with the taxonomy. There will also be a more granular definition of reporting that features templates covering the environmental thresholds.

Fortunately, Australasian issuers have tended to align their GSS bond issuance with standards that Jenkins says should hold up even under the scrutiny of taxonomy and GBS equivalence.

“The CBI [Climate Bonds Initiative] standards essentially align with what the EU has done, by starting with the ICMA GBPs and adding minimum thresholds,” Jenkins comments. “The vast majority of issuers in Australia and New Zealand have gone down the CBI route and this will make it much easier for them to align with the GBS.”

Local equivalents

Perhaps the biggest question for Australia and New Zealand is whether seeking to develop local equivalents for the EU taxonomy is a worthwhile goal. In general terms, Pfaff argues, there is a lot of value in referencing the taxonomy.

“It makes a lot of sense for issuers in Asia to look at what the EU says is a technical threshold for sustainability in their economic activity,” he says. “They may then wish to take the view that it does not work in their jurisdiction or industry, but they should know that there is a very informed, expert view on what constitutes an appropriate threshold with respect to climate-change mitigation and the Paris Agreement targets in particular.”

“Nothing of this magnitude and detail has been done before. It will undoubtedly have a global impact, including in the form of other jurisdictions looking to leverage the European work and apply it to regional markets.”

According to Mushtaq Kapasi, ICMA’s Hong Kong-based chief representative, Asia Pacific, the most likely approach individual jurisdictions will take is using the EU’s work as a basis for – but not the entirety of – local regimes.

He explains: “I think the EU efforts – the taxonomy and the GBS – will be influential in Asia to some extent but not in their entirety. At the very least, they will be used as a reference point and I think all Asian jurisdictions will evaluate the benefits of the taxonomy and GBS.”

This seems to be the way market leaders in Australia and New Zealand are thinking. For one thing, it makes little sense to start from scratch given the scale of the task the EU and the TEG have just completed. Dann thinks any Australian or New Zealand taxonomy equivalent would almost inevitably leverage significantly off the EU’s work.

Australasian challenges

Jenkins reveals the idea of taxonomies is “very much front of mind” for the Australian Sustainable Finance Initiative (ASFI) and the New Zealand Sustainable Finance Forum (NZSFF). Some foundations that would help build a taxonomy on a similar basis to the EU project are already in place.

The EU taxonomy looks at economic activities with reference to the accounting concepts contained in the European NACE – nomenclature statistique des activités économiques dans la Communauté Européenne or statistical classification of economic activities in the European Community – code. This is an extremely granular system. It goes, for instance, into the specific means of energy production and the details of types of suppliers in manufacturing sectors.

NACE has been used for many years to measure economic activity in areas including the loan market. Pfaff reveals: “No-one in the TEG could think of a system that would be clearly superior in approach as the basis for the classifications underpinning the taxonomy.”

Lack of suitable national standards has been a problem at times in the Australian sustainable finance market. Local development of green mortgages and thus green residential mortgage-backed securities issuance has been hindered by the underdeveloped nature of local building standards and the lack of readily accessible data covering housing emissions and energy efficiency.

There is an Australasian equivalent to NACE, however. Jenkins explains the majority of Australasian bank lending is categorised by Australian and New Zealand Standard Industrial Classification code, known as ANZSIC. It was introduced in 1993 and had its last full update in 2006, though there have been a number of minor updates since.

There would still be challenges, however, even if Australia and New Zealand were content simply to tweak the EU work for local needs. Jenkins says: “Australasian taxonomies are achievable and worthwhile. But the devil is in the detail, in particular whether local versions are supported by regulation and policy as the EU taxonomy will be. This is ‘the stick’ – and without it the pace of change will be slow.”

“Australia will still have the same challenges to arrive at science-based threshold criteria as was the case for the EU taxonomy. Even more so as Australia and New Zealand are looking to develop broader sustainable taxonomies.”

Social factors

It also seems likely that Australia and New Zealand will seek to broaden the scope of local taxonomies beyond an environmental focus even in their first iterations. Tapley argues that doing so recognises both the way the two countries’ sustainable finance markets have developed and the latest developments in the sector globally.

“Social finance is a really important point,” she tells KangaNews. “ASFI and NZSFF have a broad approach to sustainability and – as COVID-19 is making very clear – the level of interconnectedness between the different aspects of sustainability is high. We have to use what has been done in Europe as the basis for our own strategy while reflecting the nature of our own regional social and environmental issues.”

Tapley believes there will be a version of what the EU has done in Australia and New Zealand, but it will be tailored to suit the local context. The challenges will be around social finance, where targets are often harder to measure. One hope for progress is the SDGs, which Tapley says include targets and indicators that lend themselves quite well to social-impact measurement.

Jenkins adds: “Australia will still have the same challenges to arrive at science-based threshold criteria as was the case for the EU taxonomy. Even more so as Australia and New Zealand are looking to develop broader sustainable taxonomies which address environmental and social categories, not just green ones like in the EU.”

Incorporating the social dimension from day one will pose a whole new level of challenge. Participants across the sustainable finance market universally agree that measurement is inevitably a more complex task in the social space. Further, some market leaders are yet to be convinced of the value of jurisdictions attempting to step into territory beyond that explored by the EU.

Fabian cautions: “We have to work out the shortest distance between two points, by which I mean whether other jurisdictions simply adopt something akin to what the EU has done or invest in a more nuanced and different local version. It’s hard for smaller markets to differentiate themselves when capital is global.”

He continues: “It doesn’t seem to make sense for individual countries all to develop their own version of what good environmental performance is and then propagate it in a global capital market. Investors would certainly prefer some level of standardisation, simplicity and efficiency.”

Fabian’s main concern is the potential for differing jurisdictional definitions of green rather than the development of regimes with wider scope. For instance, China’s original plan to develop a green-bond endorsed-project catalogue included clean coal among the eligible projects – a decision that would have been anathema to global markets.

The warning is clear, however: jurisdictions outside the EU should be wary of developing standards that do not readily align with the European baseline or that cause disquiet in the European market. Whether this causes problems for Australasian taxonomy efforts remains to be seen, but Tapley notes that “what is green in Australia might not be green in Germany”.