The EU Taxonomy is a classification system that defines a list of environmentally sustainable economic activities. If your activity is on the list you should see green finance flow your way. Hence the heated debate over what is “green”. It’s of vital interest to sectors like gas and nuclear (it’s green compared to the coal it replaces) as it will have a major effect on the cost of capital and therefore the future of the sector. Indeed, any significant activity that has emissions and environmental impacts – think steel, cement, buildings, etc. – will be affected. Ian Simm at Impax Asset Management warns of the unintended consequences of a taxonomy that does not properly account for all the challenges involved. They include future innovations, trade-offs over environmental outcomes, definitions, data gathering, too much rigidity, and more. Simm presents and explains five principles for effective taxonomies: simplicity within a science-based framework; periodic reviews that reflect innovations and change; standardisation; more than one shade of green to prevent a “cliff edge” effect; non-political governance. The ultimate goal should be to develop simple, flexible and transparent frameworks that succeed in directing capital into the best climate solutions.
As politicians unveil new environmental policies and business leaders seek recognition for their latest low-carbon commitments, others are wrestling with what “green” actually means. Green taxonomies have a key role to play in answering this question. However, unless they’re appropriately defined and operated, there’s a major risk of unintended consequences.
A history of Green Taxonomies
In 1999, shortly after I founded Impax Asset Management, Bruce Jenkyn-Jones and I were asked by a Danish bank to design an environmental fund, so we established a “classification” of environmental markets. This produced one of the world’s first green taxonomies, which in 2007 was adopted by FTSE Russell as the foundation for what they now call their Green Revenues Classification, which has an independent, expert, advisory committee. Since then Impax has supported FTSE Russell in a biannual review of this taxonomy, advising on adjustments and updates to help ensure it remains dynamic.
By 2016, investors could choose from taxonomies supplied by nimble private-sector providers (such as MSCI and HSBC as well as FTSE Russell), each of which had an incentive to innovate and seek endorsement for their approaches.
That year the European Commission launched the programme that led to the creation of its own green taxonomy, which was the first major attempt by a country or bloc to define “green”. Its initial purpose was to drive better corporate disclosure and is now being used to underpin a raft of legislation, for example the Sustainable Finance Reporting Directive and the Next Generation stimulus package.
Two unintended consequences
Although this move has dramatically raised the profile of green investing, it has had two unintended consequences. First, the Commission has found implementation to be difficult, and has for example recently asked advisors to rework the rules after receiving 45,000 written comments, as well as pushback from ten Member States.
And second, other countries and blocs have decided to establish their own green taxonomies, leading to a situation where users will soon have competing alternative classification systems provided by the public sector rather than choosing between private sector providers. This isn’t ideal!
What are we trying to achieve & why is it difficult? Five challenges
Green taxonomies are attractive to investors seeking to navigate environmental risk and/or increase their exposure to rapidly expanding environmental markets.
However, from our experience, green taxonomies face five challenges.
First, complexity: the origins of environmental markets lie mainly in science, technology and engineering, where debates about topics such as definitions, vulnerability, causality and tipping points often produce uncertainty; furthermore, there are typically trade-offs over environmental outcomes, for example the debate two decades ago on whether petrol engines (more CO2; fewer particulates) were more polluting than diesel engines, or whether nuclear power is (overall) environmentally beneficial.
Second, rapid evolution: the transportation debate has moved on and today we discuss the relative environmental merits of electric and fuel-cell powered vehicles when viewed on a life-cycle basis. Similarly, after a false start twenty years ago, a sharp fall in the cost of electrolysers has reawakened the idea that the “hydrogen economy” may become viable.
Third, data: collecting standardised data is often challenging and expensive for companies, who may baulk at dissimilar requests from alternative taxonomy providers.
Fourth, threshold levels and “do no harm” definitions: a company may provide some green products, but how much of its revenue should this represent if it’s to be labelled “green”? And if it’s engaged in certain “non-green” activities or operations that could be deemed harmful or risky e.g. employment practices, should that disqualify it from a green taxonomy?
Finally, perverse incentives: if run by the public sector, green taxonomies are exposed to lobbying from corporates seeking to move the boundaries in their favour, with the risk that standards are lowered for all. Also, a rigid definition of “green” lowers the cost of capital for more attractive activities while raising it for those companies who currently have “non-green” activities but are determined to transition.
So, what’s to be done? In a world in which green taxonomies are sponsored by multiple public-sector providers, we recommend those working to develop this area adopt five principles.
First, appropriate simplicity within a science-based framework: taxonomy users are seeking guidance and up-to-date information, so taxonomies should be based on principles and higher-level frameworks, providing detail only where required to avoid ambiguity.
Second, responsive oversight: to be effective, green taxonomies should reflect changes in technology and environmental science, for example with annual (or even biannual) reviews.
Fourth, tiering: to mitigate the “cliff effect” of a single definition of “green”, it makes sense to define more than one “shade”; for example, FTSE Russell’s Green Revenues Classification refers to three shades.
What governments can do
Is it too late to call for the public sector to stop trying to define green taxonomies? For over fifty years governments have done a creditable job in legislating to protect the environment, e.g. putting a price on pollution through taxation, cap-and-trade schemes and product standards. There’s an awful lot more to do to ensure these “guard-rails” delineate a truly sustainable economy, for example around power markets, water abstraction and circularity. The model in which governments set ambitious green goals supported by tough laws, regulations and well-targeted incentives should remain society’s main response to the challenges of sustainable development.
Around the edges, green taxonomies can help investors to swiftly assess risk and opportunity. As governments seem intent on developing proprietary definitions of green business activity to stimulate investor action, they must ensure that this does not result in confusion, unnecessary costs and unintended consequences for the quality of the environment. The best way to do that is by applying the principles set out above to develop simple, flexible and transparent frameworks that help redirect capital into climate solutions.
Ian Simm is the Founder and Chief Executive of Impax Asset Management Group plc
This article is published with permission