For corporate executives looking to shift their companies on to a sustainable footing, the EU Sustainable Finance Taxonomy might appear to be a somewhat esoteric exercise. Released in its latest draft on 21 April, the taxonomy requires disclosure but does not dictate investment. It defines what economic activities are aligned with EU sustainability objectives but does not require that companies pursue them.
“When I talk to my clients in the finance sector about the taxonomy, there is a bit of eye-rolling as to whether this is really going to matter [in terms of lending] if a company is financially viable,” says Jon Williams, a UK-based partner in Pwc’s sustainability and climate change practice. “Nothing I see today would stop somebody lending at scale to a large non-green project.”
However, while the immediate impact of the taxonomy is likely to be muted, it is expected to inform a range of incentives, standards, regulations and investment flows that, over time, will profoundly influence corporate behaviour, experts say.
“With the taxonomy, the [European] Commission is trying to build the foundations of the house,” says Andrew Hedges, climate change and clean energy partner at law firm Norton Rose Fulbright. “Once it is accepted in one context, you can see how it starts to bite in the real economy, whether through the financing products offered to companies, or as the lens investors use when they gauge the transition plans of industrial companies.”
The taxonomy has generated considerable controversy and furious lobbying by interest groups and member states. The Commission received more than 45,000 comments to a draft of the taxonomy released last year and, on the publication of the delegated act that will enshrine the taxonomy criteria in EU law, five representatives from environmental groups temporarily suspended their involvement in the process.
“We can’t support the final act,” says Sebastian Godinot, senior economist at WWF. “The criteria covering forestry and bioenergy are not science-based, as required by the law, but are based on lobbying.”
Pending: gas, nuclear and agriculture
That lobbying has led to the Commission deferring decisions on three controversial areas — the use of natural gas, nuclear power and agriculture. Meanwhile, pressure from Sweden and Finland has led to loopholes on forestry and bioenergy, NGOs say. These include exemptions for smaller estates and a 30-year window to demonstrate a climate benefit – a mark on the horizon that is already beyond the EU’s 2050 net-zero deadline, they point out.
“Rather than being a gold standard to prevent greenwashing, it has become a tool for greenwashing in these two sectors,” says Godinot.
The Commission describes the taxonomy as a “robust, science-based transparency tool”, designed to create a common language around economic activities that can be deemed sustainable. It has two objectives: to prevent greenwashing by providers of sustainable investment products and to encourage investment in activities that are aligned with EU sustainability goals.
The technical screening criteria set out in the act released in April tackle climate mitigation and adaptation. They cover the economic activities of 40% of listed companies in the EU, in sectors responsible for almost 80% of greenhouse gas emissions. Later acts will address water and marine resources, the circular economy, pollution prevention and biodiversity protection.
The Commission describes the taxonomy as “a living document” that will evolve in the light of scientific, technological and economic developments. Its underlying criteria will be subject to regular review.
The taxonomy does not proscribe or penalise unsustainable activities. Rather it seeks to build consensus on definitions of ‘sustainable’.
“This is extraordinarily important: there is now a common language for sustainability, and one that is science-based,” says Sean Kidney, chief executive of the Climate Bonds Initiative.
“If you are the new CEO of a company with a large environmental footprint, and you want to do the green thing, this shows where you set detailed targets, define your capital investment programme and define your financing relationships,” says James Vaccaro, head of the Climate Safe Lending Network, and a veteran of sustainable finance specialist Triodos Bank.
The capital risk weighting is the biggest driver of bank strategy. If you don’t price capital in a different way, you should expect to see continued flows into fossil fuels and deforestation. James Vaccaro, Climate Safe Lending Network
The clearest immediate impact of the taxonomy is that it will require providers of sustainable investment products to disclose the degree to which underlying investments are aligned with the taxonomy. This is designed to prevent greenwashing and encourage capital to flow towards these activities. Eventually, this should make it harder for unsustainable companies to raise finance.
As Victor van Hoorn, executive director of the European Sustainable Investment Forum, has argued, so far there is no evidence it will make it harder for such companies to fund themselves – but that may change.
Williams at PwC underlines the speed at which sales of sustainable investment products are accelerating. He points to recent data finding that inflows into sustainable exchange-traded funds in Europe in the first quarter of 2021 outpaced non-sustainable funds for the first time. A preference for green assets, which a growing number of investors see as more resilient, will increasingly help the Commission in its objective of moving capital towards sustainability objectives, he believes.
“But if you want to accelerate this, you are going to need some sort of regulatory incentive,” he adds.
The clearest such incentive is a price on carbon, but there is also a growing discussion around using the taxonomy as the basis for what is known as a ‘green supporting factor’ – including a consultation by the European Banking Authority. This instrument would allow banks to hold less of a capital buffer against lending to taxonomy-aligned activities, and/or more capital against non-taxonomy-aligned lending, enabling them able to offer cheaper financing to the former.
There are risks in such an approach, Williams says. The danger is that it distorts lending, encouraging banks to pile into high-risk green projects and companies, inflating a “green bubble” that subsequently bursts. For this reason, “members of the European Central Bank are nowhere near aligned” on the proposal.
Others disagree. “The capital risk weighting is the biggest driver of bank strategy,” says Vaccaro. “If you don’t price capital in a different way, you should expect to see continued flows into fossil fuels and deforestation.”
While the debate around bank regulation continues, there are other levers that could use the taxonomy to drive real-economy investment decisions. One is the EU’s planned Green Bond Standard, which will define the requirements to be met by entities looking to certify that their bond issues are green. Another is the proposal from the Commission that the taxonomy guides investments made by the EU’s Recovery and Resilience facility, the €672.5bn ($813.6) package of loans and grants to help member states recover from the Covid pandemic.
It is proposals such as these that have prompted furious lobbying by sectors that were set to lose out, argues Vaccaro. “This is real money. Suddenly, everybody woke up,” he says.
Choking on gas
Natural gas has proved one of the thornier issues. The original draft of the technical criteria set a threshold for permissible emissions from natural gas that would have excluded its use without carbon capture and storage. A draft leaked in March 2021 raised that threshold to the extent that around half of existing EU capacity would be taxonomy-aligned. The Commission then punted the decision, alongside those relating to nuclear and agriculture, for further consideration in a future delegated act.
While some member states continue to argue in favour of natural gas, the Commission has been “consistent” in its strict consideration of the fossil fuel in earlier iterations of the taxonomy, says Kidney. He also highlights that the EU’s development finance institution, the European Investment Bank, has ruled it will end its financing of unabated natural gas. “Gas is over,” its president, Werner Hoyer, said in January 2021.
The Commission’s decision to remove natural gas from the delegated act, alongside what environmentalists like WWF’s Godinot see as the watering down of the criteria relating to forestry and bioenergy, reflect that agreeing the taxonomy is ultimately a political process.
“The Commission has to look at the science-based principles approach, which we also support,” says Carolina Inga, policy adviser at industry lobby group BusinessEurope. “But they also need to look at the usability perspective and its political acceptability. This is a democratic process.”
For all its controversy in the EU, the taxonomy is being closely watched further afield. “This is causing a ripple effect around the world” as other jurisdictions look to harmonise with EU rules, says Kidney at the Climate Bonds Initiative. He cites the publication by the Peoples Bank of China of an updated version of its green bond taxonomy on the same day, with provisions that bring it closer to the EU in a number of regards.
“While we are having necessary arguments about the detail, there is a message of collaboration and cooperation on ambition, which has not been the case in the past,” he says.
“The EU is a first mover in this area, and there is strong scope for it being exported internationally,” says Daniel Nevzat, government relations manager at Norton Rose Fulbright in London. “Given that capital flows are often global, there is the potential for companies operating in other jurisdictions seeking financing from EU lenders and investors to look to make their business models compliant with the taxonomy.”