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Setting the tone globally – The EU’s sustainable activities classification

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BNP Paribas Asset Management
 

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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.

What is a taxonomy?

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.

  • The Netherlands has had a legislative approach to green lending since 1995.
  • The People’s Bank of China issued a Green Bond Endorsed Project Catalogue, commonly referred to as the Chinese taxonomy, in 2015.
  • France created the GreenFin label for retail investment funds in 2015.
  • Japan’s Ministry of the Environment launched green bond guidelines in 2017.

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.

The objectives of the EU taxonomy

Its two main objectives are:

  1. To act as the official reference and common measurement tool against which the market will benchmark green financial products. China’s taxonomy is only for the issuance of green bonds, while in Europe, it applies to all financial products that are marketed as having an environmental objective or environmental characteristics. As such, it allows investors to make informed decisions. It helps prevent greenwashing. This is seen as a key barrier to boosting environment-related financial products and investments.
  2. To help raise investments in green, enabling and transitional activities needed to fund the transition to a climate-neutral, circular and more sustainable economy.

The uniqueness of the EU taxonomy

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

EU taxonomy exhibit 1

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

EU taxonomy exhibit 2

Source: https://insight.factset.com/eu-taxonomy-regulation

What features should all taxonomies have?

  1. The double-conditionality framework – environmental objectives are interdependent, e.g., climate change is a significant driver of biodiversity loss. So it is important to ensure that achieving one objective does not undermine other goals.
  2. The need to specify clear environmental goals and explain their alignment with international environmental agreements. For example, climate change mitigation goals should be consistent with the Paris Climate Agreement goal on capping global warming. Transparent environmental goals will help users of different taxonomies to calibrate the likely environmental performance of the economic activities covered.
  3. A clear sector and economic activity classification scheme must be the basis for a taxonomy. International translation between sector classification systems should be developed to facilitate their use by all parties.

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.

  1. While some environmental goals are specific to a location, others such as climate mitigation do not heed borders. To limit the rise in global temperature to 1.5 degrees above pre-industrial levels, global emissions should be halved by 2030 and net zero should be reached by 2050. As is the case for the EU, Japan, South Korea and the UK are aiming for climate neutrality by 2050.

6. Taxonomies need to specify whether disclosure is mandatory or voluntary, and whether there are rules for how exactly those disclosures should be made.

What are the international implications?

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.

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