Sustainable Finance Taxonomy
A window of opportunity to create market clarity, integrity and transparency when aligning financial flows (public and private) consistent with the goals of the Paris Agreement
What is and isn’t sustainable? That’s a common question that many companies and investors raise during the decision-making process when allocating new capital in investment projects. The COVID-19 social and economic challenges, along with more frequent natural disasters such as heatwaves, hurricanes, flooding and wildfires are shaping the public's behavior, making individuals more aware of how companies invest in sustainable decisions.
When it comes to making investment decisions without truly knowing what is sustainable and what is not, there are lost opportunities for the market to make an investment decision that can have a real impact on the environment and people’s well-being.
A sustainable taxonomy is a classification of a list of economic activities that are considered environmentally sustainable for investment purposes. In general terms, it establishes a framework for enhancing market transparency, reducing uncertainty and incentivizing financing to a low-carbon and climate-resilient economy. The taxonomy helps commercial banks, financial institutions, asset managers, private equity funds, insurance companies, pension funds, corporations, angel investors, public trusts, national development banks, microfinance institutions and credit unions among others to identify truly sustainable finance opportunities and provide them with a transparent and credible list of prospective sustainable investments.
The usage of taxonomies could also help the public sector to guide public standards, regulations, fiscal policies, investments, subsidies, support and taxation to promote and achieve sustainable goals, while signaling the market towards a national sustainable pathway. It also has the potential to set climate finance disclosures, related to understanding how sustainability issues or climate change may affect public and private investment decisions in the long term.
According to the EU Technical Experts Group on Sustainable Finance (TEG), a sustainable taxonomy provides the perfect framework for tracking and measuring green economic recovery measures. It could also help to align investments towards achieving National Determined Contributions (NDC) for the Paris Agreement, reaching net-zero neutrality by 2050, while also achieving Sustainable Development Goals (SDGs).
Currently, six country governments and two regions (EU and ASEAN) have established a mandatory taxonomy for financial and green financial products, while another 12 country governments are in the process of developing a national sustainable finance taxonomy.
The process to establish a mandatory national sustainable finance taxonomy must follow consensus and dialogue among public and private stakeholders. Therefore, public actors such as Ministries of Finance, Ministries of Environment, Ministries of Economy, Ministries of Energy, the Superintendencies, financial regulators and Central Banks should all lead the discussion on what the country should catalog as sustainable. The participation from the private sector, including financial institutions, investors and sectorial experts, should lead the science-based technical discussion about the granularity of the information.
The taxonomies must be relevant and tied to the day-to-day country context, in terms of national sustainable goals and economic growth. It should also be flexible to adapt to different sustainable or green investments, new technologies and economic activities and be based on the latest scientific and industry experience at the national and international level.
Although there is no single recipe for establishing national taxonomies, the truth is that country governments should follow an overarching checklist for preparing, designing, developing, piloting, consulting and implementing a taxonomy. Using the lessons learned and best practices from around the world, the taxonomies should follow four key steps:
1. Establish specific environmental/sustainable goals, aligned with national goals and international pledges 2. Agree on the list of economic activities that are part of the most relevant productive sectors in the country. These are usually based on a pre-established classification system. 3. Develop metrics on environmental performance (or contributions). 4. Define the taxonomy governance and institutional framework for compliance.
As such, the process of taxonomies development is a process that must be built based on the country's economic context and sustainable goals. While it is true that roadmap processes around the globe have taken years to reach consensus and development, once a taxonomy is established, the benefits out-weigh the operating costs. Taxonomies could bring numerous benefits such as:
Making it possible to translate the commitments—national development plans, Paris Agreement goals, SDGs, biodiversity targets, decarbonization pathways, long-term strategies (LTS) and net-zero strategies—into actionable and easy to invest policies by identifying activities that can be considered sustainable.
Making it easier for public and private financial institutions to demonstrate whether they are working towards a low-carbon transition and strengthening their resilience to climate change.
Providing a common language for all stakeholders that take investment decisions.
The taxonomy will also ensure the financial flows and the injection of capital necessary to finance sustainable activities, whether it is not yet compulsory because it signals the market for years to come.
Towards COP27 in Egypt and the imminent challenges to converge the array of sustainable agendas—such as climate change, biodiversity, desertification, circular economy