11 July 2018

The anatomy of a taxonomy

The European Commission has a highly ambitious target – to develop a taxonomy to define what is green and act as a compass for sustainable finance. But there's a long and rocky road ahead for this controversial initiative, find Nick Roumpis and Peter Cripps

When European Commission Vice president Valdis Dombrovskis revealed the Sustainable Finance Action Plan in March, the creation of the taxonomy grabbed the headlines.

The taxonomy is important because it is expected to underpin subsequent work in numerous fields, including the development of a green bond standard, green labels for other financial products, and sustainability benchmarks.

In late May, the bare bones of this system emerged.

The Commission disclosed that the EU taxonomy, which is similar to the one suggested in the final report of the EU's High Level Expert Group on Sustainable Finance (HLEG), will have six environmental objectives: • climate change mitigation; • climate change adaptation; • sustainable use and protection of water and marine resources; • transition to a circular economy, waste prevention and recycling; • pollution prevention and control; and • protection of healthy ecosystems.

The next step was to assemble a technical expert group (TEG), announced in June, which is charged with drafting the taxonomy, which is expected to be adopted in the third quarter of 2019.

"There are different investors with different views, and that makes a market" Isabelle Laurent, EBRD

However, the concept of developing a taxonomy divides opinion.

The Commission hopes that it will add certainty for investors about what is sustainable, which will help to encourage greater investment in the sustainable, lowcarbon economy.

Jochen Krimphoff, deputy director, green finance at the World Wildlife Fund, who has been named as a member of the TEG, likens taxonomies to a pair of 3-dimensional glasses, which can help people see more clearly.

"Taxonomies can help you separate the two colours – green and red – and look from a different perspective," he said recently at a conference.

"To get out of this blurred view you need a translation device and that's what taxonomies are supposed to do."

He sees the latest iteration of the Green Bond Principles as significant because it separates objectives from activities, assets and projects, which he says is a "step in this direction".

"I am pleased to see the market has moved forward. The time is right for better standards. I would like to applaud the Commission for this bold move and the ambition to address the complexity of the problem for green bond standards.

"It won't be easy, it will be controversial, but that's the discomfort that you have to cope with because the ultimate goal will help the market grow."

Sean Kidney, CEO, Climate Bonds InitiativeSean Kidney, CEO of the Climate Bonds Initiative and another member of the TEG, is also enthused by the potential for the EU taxonomy.

"If we are going to achieve our Paris goals, we need a [green bond] market that is in the tens of trillions," he said.

"If we are going to do that, we have to follow some rules ... commoditisation requires rules. Bond markets, especially, thrive on rules.

"We have had a damn good first attempt with the Green Bond Principles, reporting principles and so on, but if we are to go beyond the huge fund managers of due diligence capability to all the smaller investors, towards retail, we are going to need some guidance about what is green, we will need people to understand what is in and what is out."

But others are less keen.

"Asking whether something is either sustainable or not, or if it is green or is not, I think that's getting us onto the wrong path," warns Alexander Barkawi, founder and director of the Zurich-based Council on Economic Policies.

"The name of the game is to become progressively greener or more sustainable. To do that we need a perspective of things that has a continuum.

"For example, with credit risk ratings, this is not a binary 1 or 0 analysis. This gives us a range from triple A to junk. This is exactly what we need in the sustainability world and, on top of this, we need [environmental analysis] to be integrated into mainstream credit risk assessments.

"If the taxonomy becomes the underlying definition for certain regulation, for instance if we give a tax incentive to certain bonds that fit within these boxes, that's fine. But if this becomes the underlying definition for anything that is happening in the ESG market, it will kill this market; people will just be box-ticking," said Barkawi, who was formerly the managing director of SAM Indexes where he was responsible for developing the Dow Jones Sustainability Indexes.

He said one example of where a taxonomy might be too restrictive would be for a product issued by an oil and gas company.

"How will I deal with it, if I can check three boxes on, for example, water, biodiversity and social issues? I need [freedom to make] judgement calls on this," he asked. "How do I deal with the fact that there will be funds out there that will say 'I will invest in anything but I will vote my share'? That doesn't fit into these boxes," he argued.

Isabelle Laurent, deputy Treasurer & head of funding, European Bank for Reconstruction and DevelopmentIsabelle Laurent, deputy Treasurer & head of funding, European Bank for Reconstruction and Development, said her personal view is to be sceptical with regard to taxonomies.

"I am a great believer in transparency of disclosure and impact reporting," she said. "There are different investors with different views, and that makes a market.

"To arrive at a standard will be very difficult and to change it or tweak it to take into account different factors may be hard.

"I don't think it's a lack of standards that is deterring corporates from issuing green bonds – it's the whole ability to be able to source assets and work out what is sufficiently green for many investors, and to impact report... This needs a whole organisational change and having people able to help finance their ability to do all those things is what will increase the market – not people saying 'this is green or green enough', and making it uniform."

But is there enough time for the Commission to be able to deliver a functional outcome? Lars Eibeholm, head of treasury at Nordic Investment Bank (NIB), said: "It's a tough timetable, but there should be enough time.

"They've narrowed the scope by focusing on the climate part at this stage."

At a later stage, the taxonomy is expected to address social and sustainability issues as well.

"It's good that they have limited the scope so much that it might be do-able."

Along with setting up the working group on the taxonomy, the Commission is also expected to launch a screening process for projects.

"This needs to be both qualitative and quantitative," Eibeholm said.

The first serious difficulty that is slated to emerge, is measuring the quantitative impact of the various projects.

Eibeholm added: "Setting the thresholds of the quantitative impact will be really challenging.

Will it be a country-specific threshold or will it be global, for example? These things will be extremely difficult to agree upon."

Orith Azoulay, Head of green and sustainable finance, NatixisOrith Azoulay, head of green and sustainable finance at Natixis, agreed that setting standards will be a protracted task.

"It will take quite some time to define it, and the devil will be in the detail," she said.

"Is a taxonomy supposed to define screening criteria – 'how green' on top of 'what is green'? I think there will be a need for that some time down the line, but it will take a lot of time."

She added that standards will help boost the green bond market in the US, a country she described as a lover of standards.

Others warn that keeping pace with the rapid developments in the market will prove impossible.

The proposed taxonomy "will potentially be a massive waste of time" because of the long time needed to create it, said Ashley Hamilton Claxton, head of responsible investments at Royal London Asset Management (RLAM), which has £113.4 billion ($153 billion) under management.

"My personal opinion is by the time they finish it, it will [need to] be updated," she said.

While labelling and a taxonomy could be helpful, Claxton still sees the fundamental need for asset owners to do their due diligence, citing the example of green bonds to demonstrate the danger of "impact washing" in environmental, social and governance (ESG) investments.

One asset manager, who asked not to be named, agreed: "The core of the problem is that this is a very fast moving and innovative world.

Every day we learn new things and new science and new products come in to place, which makes it very difficult to develop a taxonomy that is deep enough to use.

"The question for the Commission will be what processes we need to put in place to make it really dynamic."

It is not yet clear whether the resulting taxonomy would take the form of light-touch principles or a detailed system.

The Commission has encountered this problem even before announcing the first legislative proposals.

"It will take quite some time to define [the standards], and the devil will be in the detail" Orith Azoulay, Natixis

In its draft proposal, the Commission explained that views differed as to the level of detail an EU taxonomy should have, an issue widely discussed among investors and asset managers before and after the action plan was launched.

It said the financial industry generally favoured a non-prescriptive taxonomy, while private individuals and civil society preferred a more detailed classification system with clear definitions and measurable criteria.

However, the document gives no indication as to how prescriptive the resulting taxonomy will be.

The Regulatory Scrutiny Board, an independent advisory body to the Commission, raised concerns over the immediate use of the taxonomy and the risks associated with making such use mandatory for financial actors before the taxonomy is tried and tested.

To address this concern, the Commission suggests that the operational part of the resulting regulation will enter into force six months after the delegated, or non-legislative, acts, in order to give market participants time to prepare.

But even these delegated acts raise questions as to how exactly they will work.

"I think there are a lot of open questions in relation to these delegated acts," said Eibeholm. "It's somewhat of a black box still."

Delegated acts are normally adopted by the Commission after consultation with expert groups and contain an "explanatory memorandum" summarising the feedback received and how it was used.

The unnamed asset manager said the taxonomy runs the risk of creating false ambitions, just as biofuels did in the past.

"European public policies came in place to foster biofuels. A few years later, it became very clear that the first generation of biofuels could actually do more damage than we thought. Something similar could happen with the taxonomy," he warned.

Eibeholm cited forestry as a good example of how difficult it could be to introduce a taxonomy for some sectors. He said: "What is sustainable forestry? In general people think that trees absorb carbon dioxide, which is the positive part, and of course if you harvest the trees and use it for biomass you need to grow a new tree every time you harvest one. But is that really done? There are a lot of uncertainties around the forestry industry."

However, the CBI's Kidney warned that discussions over whether an EU taxonomy is a good idea are futile, because "that train has already left the station – we now have a firm commitment from the EU that there will be a taxonomy".

He said the main issues to focus on now are how to make the taxonomy simple and low cost in order to scale up the green bond market.