By Pavel Boev

In recent years, many sustainable finance taxonomies have sprung up at both national and regional levels, and many more are still to come. How is this emerging universe going to develop? What trends are already visible, and how can they help to make green and social financial products more accessible for a wider range of companies, and even entirely new sectors, and ultimately help with the environmental and social transformation of our societies?

In the financial sector, “taxonomy” is the new buzz-word. It is interesting to realize that this term originates from the life sciences, centuries ago. Describing and classifying the world around us has laid the foundation of modern science as we know it. In biology, from the time of the Swedish botanist Carl Linnaeus who invented binomial nomenclature in the 1750s, and well into the age of genetics, systematics helped to shape our perception and understanding of the living world.

At the beginning of the 19^th century, another botanist, Augustin de Candolle, first proposed the term ‘taxonomy’. In its strict meaning, as defined by the Cambridge dictionary, taxonomy is “a system for naming and organizing things, especially plants and animals, into groups that share similar qualities.”

Designed to better systematize the world of plants, taxonomy as a concept has enriched far wider areas of scientific knowledge, from geology to linguistics and from geography to mathematics. In the 21^st century, it was taken up by the financial world and is now widely employed to identify and classify financial assets, products, and services that can help to combat environmental degradation or advance social progress.

Sustainable finance taxonomies

To be included in a sustainable finance taxonomy, financial products, and assets must fall into an eligible ‘green’ or social category (for example, renewable energy or affordable housing), and often also meet one or more technical criteria. But it is important to note that these categories and criteria vary considerably among the vast array of national and supranational taxonomies that already exist or are now being developed. Some taxonomies also contain a list of ‘brown’ activities (sometimes called exclusion lists) covering the sectors and projects that are considered unsustainable and are thus a no-go zone for those seeking to benefit from green or social finance.

Qualifying under the eligible categories and criteria brings on benefits for the borrowers both on the loan and on the capital markets. For green and social loans, a better rate may be negotiated with a bank. For sustainability-linked loans a margin-adjustment mechanism is often included, making the rate tied to the achievement of sustainability KPIs, and resulting in either a bonus or a malus depending on the borrower’s sustainability performance. On the capital markets, bonds may be placed at more favourable conditions because of a high demand fuelled by ESG (Environmental, Social, and Governance) – sensitive investors and regulatory incentives, for example, automatic inclusion of such bonds in central bank’s collateral frameworks in some jurisdictions.

Today, over a dozen taxonomies have been designed: in the EU and ASEAN at the regional level, and in China, South Korea, Malaysia, Indonesia, Mongolia, Russia, Kazakhstan, Japan, Bangladesh, South Africa, and Colombia, at the national level. Mexico, Nepal, and a number of other countries and jurisdictions are also currently at different stages of taxonomy-building. These taxonomies may cover a part of the ESG agenda (either green or social), and may also include transition activities. The European Commission defines them as activities “for which there are no technologically and economically feasible low-carbon alternatives, but that support the transition to a climate-neutral economy in a manner that is consistent with a pathway to limit the temperature increase to 1.5 degrees Celsius above pre-industrial levels.”

Though countries and jurisdictions enjoy considerable freedom while designing and putting into practice their taxonomies, several international frameworks and guidelines have been developed to inform and mainstream national efforts. The two most comprehensive include Developing a National Green Taxonomy: a World Bank Guide, and A Taxonomy of Sustainable Finance Taxonomies developed by the Bank of International Settlements. These documents provide a common ground for national taxonomies and can help to harmonize them. This is particularly important for international banks operating across jurisdictions, and also for asset managers whose portfolios include investments in many countries and jurisdictions, as it helps to add clarity on what is expected of them.

Universal taxonomies

It is of course tempting to suggest that further harmonization is welcome and that at some point we may arrive at universal taxonomy accepted and put into practice at the global level. On the one hand, this will indeed help the global banks and investors to better align their loan and asset portfolios with these universal criteria (instead of doing cross-checks if what’s considered green in the multiple jurisdictions where they operate is also ‘green enough’ for the jurisdiction where they are headquartered).

On the other hand, such an overarching taxonomy will inevitably seem too weak for countries with stronger sustainability aspirations, and too strong, often unattainable, for the less advanced or less ESG-sensitive jurisdictions. An effective way to deal with this problem may be designing overarching principles for taxonomies (as has been done, for example, by the International Capital Market Association and the Loan Market Association for the bonds and loans, respectively) while allowing considerable variation in the choice of eligible sectors, thresholds, and technical criteria.

So what would be the potential trends, and how will the recently emerged universe of sustainable taxonomies evolve? One trend already visible is the emergence of new national and regional taxonomies in increasingly more countries and jurisdictions. Another likely trend is that taxonomies will become more comprehensive, covering green, social, and transition activities under an umbrella framework.

Transition

In terms of implementation, a stricter approach to claiming, measuring, and reporting positive environment or social impact may be expected. Originally put forward for the capital market products – green, social, transition, sustainability, and sustainability-linked bonds – impact measurement, disclosure, and independent third-party verification are already becoming a norm for loans, and may soon spill over to non-credit products, including leasing, guarantees, and other trade finance products. Not yet a trend, but a very much desired development would be seeing increasingly more taxonomies covering transition activities -  and also understanding transition in a broader sense – not just as a shift from fossil fuels to renewables, but also from less harmful practices to more sustainable ones.

Sustainable finance, especially on the green segment of the spectrum, is often seen as a reward for those companies that are already very advanced in their ESG agenda. To qualify for green finance products they must comply with a number of increasingly strict requirements, both in respect of the green project they need funds for and in terms of their overall sustainability performance.

Spillover

This approach is justified, as it helps to limit the risk of greenwashing, but at the same time, it limits considerably the number of entities, and entire sectors, that could benefit from green finance. Making these tools available only for those few who are already high up the ESG ladder only increases the gap between them and the rest of the economy. To meet the Paris goals and stop the biodiversity collapse we need to make sustainable finance more accessible, not less, and only a major spillover of sustainable finance tools to a broad range of sectors and companies can result in a quantitative shift.

Transition targets may include time-bound emission commitments (understood in a broader sense than just GHG, but also including other emissions and discharges), which decrease over time. It is important to avoid greenwashing in such instances, but it’s equally important to recognize that transitioning towards new practices and technologies requires time - and money. And that is why transition activities should be part of any taxonomy.

Another critically important development would be to include technical screening criteria in all taxonomies, as currently only about half have incorporated them. This measure will simplify qualification and help avoid greenwashing.

Last but not least, developing a sustainable finance taxonomy for the US, one of the largest and most developed capital markets globally, will likely help to raise the bar for many US and international banks and asset managers. Some efforts seem to be taking place since mid-2021, however, but as of February 2023, no draft has been released.

Sustainable finance taxonomies are an important tool to combat environmental degradation and advance societal progress. At the same time, they must be combined with other regulatory measures and market developments. Sustainable financial tools should be incentivized by central banks (for example, by decreasing capital requirements and subsidizing the rates for loans, and including bonds in their collateral frameworks). And they should be also better supported by asset managers who should promote ESG funds among their clients as an alternative to classical investment strategies.

This Expert View is written by Pavel Boev, researcher supply chains and finance at Profundo. Please contact him at p.boev@profundo.nl

(Photo: Alamy on Climate Visuals)