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A framework identifying which business activities are sustainable, and by extension worth promoting and investing in, provides clarity to industry, policymakers and investors. The first draft of the EU’s classification system, known as the green taxonomy, was published a year ago[1] and can be considered a model for taxonomies elsewhere.
After setting out the basics and the uniqueness of the EU taxonomy, we will discuss the international aspects of the framework and the features we believe other taxonomies should have.
A taxonomy provides investors, companies and policymakers with a harmonised and uniform approach to identifying which economic activities are sustainable and under which circumstances.
Well-designed taxonomies can help policymakers to develop policies that help sustainable finance markets to support the achievement of environmental and other sustainable development goals.
Apart from the EU, other jurisdictions have addressed sustainable finance taxonomies and definitions.
Other countries expressing interest on sustainable finance taxonomies include Canada, Chile, Colombia, Kazakhstan and Indonesia. The ASEAN region is working on a taxonomy as well.
The majority of these have said they intend to take the EU taxonomy, seen as the most comprehensive and advanced classification system, as a starting point.
Its two main objectives are:
It is the first-ever common, comprehensive and science-based measurement tool for green investments. By measuring turnover and expenditure linked to sustainable economic activities, it assigns a degree of sustainability to companies’ operations, allowing investors to determine how environmentally sustainable an investment in a company would be.
It is based on a double conditionality framework. It is not sufficient for activities to contribute significantly to one of the EU’s six official environmental objectives (see Exhibit 1); they must also not significantly harm the other environmental objectives or undermine human and labour rights standards.
Exhibit 1: EU’s six official environmental objectives
Source: https://insight.factset.com/eu-taxonomy-regulation
It works with thresholds that determine whether economic activities contribute significantly to the EU’s targets. Some activities may not yet be fully sustainable, but contribute nonetheless to the transition towards a more sustainable economy.
For green funds and financial products, including those claiming to have environmental characteristics, it benchmarks the ‘greenness’ of the companies invested in. Marketers of these products must report the instruments’ percentage alignment with the taxonomy, ensuring consistency in reporting and allowing for comparability.
Reporting against the taxonomy is compulsory for funds as well as corporates – financial and non-financial – that under European regulation must disclose a non-financial statement.
Exhibit 2: Criteria for ‘environmental sustainability’ in the EU taxonomy
Source: https://insight.factset.com/eu-taxonomy-regulation
4. To assess whether the environmental performance of an activity is consistent with environmental goals, clear and common measurement metrics are needed. It is essential for these metrics to incorporate life-cycle impacts.
6. Taxonomies need to specify whether disclosure is mandatory or voluntary, and whether there are rules for how exactly those disclosures should be made.
Given that capital markets and economic supply chains are integrated around the world, the disclosure obligations on financial product issuers and companies in the EU create implications for international actors, even if the taxonomy is not intended to bind third countries on their own sustainability or sustainable finance activities.
To address these international or extra-EU considerations, the EU’s Technical Expert Group on Sustainable Finance (TEG) has proposed disclosure principles to help companies with operations outside the EU, and investors in those companies, to manage likely gaps in performance data and differences in expectations about environmental objectives and company performance.
The TEG has also identified certain criteria in the EU taxonomy as being of ‘international relevance’, meaning that users of the taxonomy could use them for economic activities located outside the EU.
Comparability of taxonomies is discussed in the International Platform on Sustainable Finance (IPSF), launched by the EU in 2019 to enhance international cooperation. Here, work is done on the harmonisation of all regional taxonomies in line with point 4 above.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
[1] The actual taxonomy is expected to be adopted formally by June 2021.
