Blog | Sustainable Finance Taxonomy: A Key Financial Regulatory Tool in the Reform of the Financial System

Our climate finance team discuss the COP27 outcomes and walk us through the global taxonomies landscape in Blog 2 of the Sustainable Finance Taxonomy series

Related: Blog 1: Sustainable Finance Taxonomy | Policy Brief: “Towards a Common Pathway Across Sustainable Finance Taxonomies"

Key Takeaways:

• The Sharm El-Sheikh Implementation Plan calls on investors and shareholders of multilateral development banks and financial institutions to define a new vision to address the global climate emergency.

• Recognizing the benefits and importance of clear definitions for sustainable activities, 26 jurisdictions have been in the process of designing, developing, or implementing sustainable finance taxonomies.

• More dialogues and knowledge-sharing among taxonomy users will play a key role in enhancing usability and compatibility of taxonomy and ultimately achieving the reform of the financial system.

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The Conference of the Parties (COP27) had interesting outcomes on climate finance, in spite of an imperceptible level of ambition in topics such as phasing out fossil fuel subsidies, adaptation finance, and the mobilization of $100 billion per year by 2020. New and upcoming topics of climate finance continue to emerge in the discussion to “complicate” or “resolve” the equation of aligning financial flows consistent with the goals of the Paris Agreement (Article 2.1c).

For the first time, parties recognized the need to create the awaited Loss and Damage (L&D) fund, bringing a new finance architecture and language that will need to coexist with ongoing finance mechanisms without losing momentum from any front. With the $100 billion annually coming up short, country Parties decided to set a New Collective Quantified Goal (NCQG) on climate finance by 2025—its relevance relies on the inclusion of non-party stakeholders like the private sector and civil society organizations (CSOs) to define this goal. This in turn opens the opportunity to operationalize and implement Article 2.1c to:

1. Enhance the transparency of public and private finance alignment to the Paris Agreement

2. Accelerate finance for adaptation and climate resilience

3. Signal financial market participants to shift from brown to green investments.

Last but not least, under the Sharm El Sheikh Implementation Plan, country Parties urged investors and shareholders of multilateral development banks (MDBs) and financial institutions to define a new vision to address the global climate emergency for the first time, which has been named the new reform of the financial system.

The New Reform of the Financial System for addressing climate emergency: What does it mean?

The experience of providing climate finance over the past two decades has made country Parties recognize the relevance of enabling environments such as fiscal policies and regulatory tools, in addition to the institutional arrangements. As stated in the Sharm El-Sheikh Implementation Plan, it is imperative to define channels and instruments that are fit for the purpose of adequately addressing climate change, including deploying a full suite of instruments, from grants to guarantees and non-debt instruments, taking into account debt burdens and to address risk appetite. In line with this mandate, new climate finance information architecture is being developed, including updated language, stakeholders, instruments, mechanisms, and rules of operation to transform the financial sector.

The International Monetary Fund (IMF) recognized that this new climate information architecture, along with the policy instruments, will send clear signals to the markets for mobilizing the global climate flows at the speed and volume needed. The transparency of the information architecture will bridge data and information gaps, establish clear guidelines, quantify climate risks in the financial sector, and align approaches and standards for climate finance, bringing clarity and transparency while overall improving interoperability across approaches and tools.

As such, CCAP has recognized the sustainable finance taxonomy as a tool for bringing coherence and a common understanding to the pursuit of system-wide alignment with the goals of the Paris Agreement, providing the opportunity to convey additional sustainable development agendas.

Sustainable Finance Taxonomy: A financial regulatory tool to signal the market

In the previous blog on Sustainable Finance Taxonomy (October 2022), CCAP showcased what a sustainable finance taxonomy is and its pivotal role in guiding public standards, regulations, fiscal policies, taxation, and subsidies, while promoting and signaling the market towards a national sustainable pathway.

Taxonomies take relevance to promote consistency, comparability, interoperability, and transparency of sustainable finance. It is important to recognize that sustainable finance taxonomies are advisory tools that will aid in the transparency for aligning financial flows. However, these tools do not work alone. Taxonomies need strong political commitment from country governments, specifically from financial regulators and supervisors together with a well-established governance structure.

The Global landscape of Sustainable Finance Taxonomies

Jurisdictions have made progress in the past three years in developing political and technical aspects for taxonomies, working towards a transparent information architecture for sustainable finance. Jurisdictions in Western and Eastern Europe, as well as the Asia-Pacific region, have made the most progress in developing taxonomies (and in some cases updating, such as of Bangladesh). This is the case for the first movers such as Mongolia, Bangladesh, European Union, China, Japan, and Malaysia, and second movers from the end of 2021 to date such as South Korea, Russia, Association of Southeast Nations (ASEAN), Indonesia, and Georgia. Jurisdictions such as South Africa and Colombia are becoming pioneers in developing taxonomies in their regions, setting a baseline for other jurisdictions in Africa and Latin America, respectively.

In addition, other taxonomies have been developed by financial actors, such as the Climate Bonds Initiative (CBI), the Multilateral Development Banks (MDBs), and the International Development Finance Club (IDFC) Common Principles. Another taxonomy that has been recently developed is the ISO 14030-3:2022 Green Debt Instruments, Part 3: Taxonomy. Each of these has the specific aim of supporting investors in classifying sustainable entities and assets across economic sectors.

Efforts have also been made to define standards for taxonomies. For instance, the ASEAN released the Taxonomy for Sustainable Development (November 2021), providing a framework for jurisdictions like Indonesia (November 2022) to develop their taxonomy. Some jurisdictions have also taken the EU taxonomy (June 2020) as a baseline for harmonizing technical aspects like South Korea (December 2021), South Africa (March 2022), and Colombia (March 2022).

The outlook for the third movers, which are developing or planning to develop taxonomies—such as the UK, Thailand, Singapore, Mexico, and Chile (See Figure 1)—would be to extrapolate best practices and lessons learned from other jurisdictions. They can achieve this by harmonizing technical aspects like the methodology for Technical Screening Criteria (TSC), while localizing specific features such as the metrics and verification process to their level of economic development, characteristics of their financial system, and the addition of relevant economic activities.

The evolving process of Sustainable Finance Taxonomies

The learning curve from first movers and second movers is critical to better understand which technical aspects should be considered in taxonomies. It also helps to understand the required political aspects such as governance mechanisms and stakeholder engagement for its success. As part of this learning experience, the methodology to develop taxonomies has evolved in terms of stakeholder engagement, governance, environmental objectives, eligibility approach, inclusion of transition or enabling activities, coverage, and level of granularity.

The CCAP policy brief, Towards a Common Pathway Across Sustainable Finance Taxonomies, has documented and analyzed the political and technical aspects that 13 jurisdictions took into consideration when developing sustainable finance taxonomies. Here, CCAP has found the following commonalities that could be used as a methodological baseline for jurisdictions that are starting their taxonomy process (See Figure 2).

Figure 2. Comparison of Sustainable Finance Taxonomies

Read the Full Policy Brief!

What’s next? A common pathway for sustainable finance taxonomies

Based on the findings, the evolving landscape where commonalities are envisioned could become a finance watershed to create a common language for the public and private actors when talking about sustainable finance. It seems jurisdictions are moving towards a more transparent market, by enhancing interoperability and comparability. In doing so, they are actively avoiding any information asymmetries that could potentially harm cross-border investments.

The G20 Sustainable Finance Report 2022 recommends that multilateral development banks (MDBs), international organizations, financial institutions, and country authorities improve the comparability and interoperability of sustainable investment alignment approaches to facilitate cross-border sustainable investment flows and avoid market fragmentation or greenwashing practices.

It specifically recommends identifying commonalities and differences in sustainable finance taxonomies, like the methodological exercise led by the International Platform on Sustainable Finance (IPSF) to develop the Common Ground Taxonomy (CGT) between EU and China’s green taxonomies, to facilitate a common understanding and use of sustainable finance by the market.

In line with this recommendation, the IPSF is starting to include taxonomies developed by the United Kingdom (UK) and Singapore to the Common Ground Taxonomy (CGT). During COP27, the IPSF called upon jurisdictions who would like to be included in this analysis. If this CGT is amplified and reflected in the numbers sampled around the globe, it could become an important tool to enhance the practical understanding of taxonomies’ technical aspects.

The IMF, WBG, OECD, and BIS are also working jointly to operationalize and design a common minimum guidance for the G20 high-level voluntary principles for sustainable finance alignment approaches, including taxonomies. The IMF has also recognized that in the information architecture needed to signal the market, it is required to offer theoretical information for enhancing taxonomy interoperability. As such, it is preparing the IMF Taxonomy Report which comprises taxonomies’ interoperability and asset-based approach, integration of biodiversity, and enumerates high-level principles to start a methodology for commonalities. In the case of this methodology, it could open the door for new analysis and new methods for promoting transparency among investors across different markets.

In the case of the Working Group on Sustainable Finance Taxonomies in Latin America and the Caribbean (GTT- LAC) a common framework of sustainable finance taxonomies is under development for the region, which will enable an easier understanding for LAC jurisdictions who are starting this process. This will also provide a baseline for aligning and mobilizing capital into the LAC region.

To date, there is no single recipe or solution for how to develop or implement taxonomies—nevertheless, jurisdictions are looking for an adequate standard to follow when creating their taxonomies. Within the picture of bursting new taxonomies, it is essential that these are evolving regulatory tools that must adapt to new commitments, regulations, technologies, and practices.

Some jurisdictions and institutions have a track record in developing and updating taxonomies. However, verification outcomes are still pending to determine their implementation success. Based on the results of implementation, a more standardized methodology could be available for jurisdictions that plan to develop taxonomies with the aim to provide a common understanding of the taxonomies’ objectives.

By sharing best practices and knowledge among experts, users institutions, and regions, sustainable finance taxonomy could be able to serve as a key instrument that could translate commitments into investment opportunities for achieving the goals of the Paris Agreement and additional sustainable agendas.