Lost in transition: The regulatory challenge of sustainable finance taxonomies

When the European Union (EU) started to develop its taxonomy in 2018, the ambition was to create a common language for sustainable finance that investors can use to encourage investment  in projects and economic activities that have a substantial positive impact on the climate and the environment. Five years later, over 20 states and various international organisations, including the Association of Southeast Asian Nations (ASEAN) have adopted or are in the process of adopting sustainable finance taxonomies.

In essence, these taxonomies seek to establish a framework for ESG measurement in sustainable finance. Their underlying rationale is to address the problems of greenwashing, investor uncertainty and lack of trust in ESG products. Yet taxonomies come with their own set of challenges. One of them is how to translate high level sustainability objectives into concrete criteria. For instance, how to capture transition activities with standards that are flexible enough and easy to adapt. As the adoption of the EU Taxonomy has shown, regulators can be lost in transition.

Regulatory Race

Regulators worldwide are responding to the growing demand from companies and investors for greater consistency in measuring ESG factors after years of proliferation of competing ESG measurement methods. One of the main criticisms often made against ESG investing stems from the lack of a generally accepted understanding of the individual attributes of ‘environmental’, ‘social’ and ‘governance’. The absence of such an understanding has led to the formation of a subjective marketing-driven system, fraught with the risks of greenwashing, and ineffective allocation of resources. Sustainable finance taxonomies seek to address these shortcomings. They offer a classification system identifying activities or asset categories that deliver on key climate, green, social, or sustainable objectives with reference to clearly defined thresholds and targets. Taxonomies also distinguish between ESG as inputs into an investment process, and as outputs or goals to be maximized in the real economy. In general, taxonomies possess three fundamental elements. First, they define a set of objectives, such as climate change mitigation and adaption. Second, they provide a list of sector-specific economic activities with sustainability proprieties, and third, they set out detailed screening criteria in the form of performance indicators for each activity defining how an activity contributes to the pre-defined objectives.

Green by law

A business activity that fulfils the conditions of a taxonomy is considered as ‘sustainable’ or ‘green’. Taxonomies are standardisation tools, and as any other kind of standard-setting, they are not exactly neutral but bear distributive consequences. In the case of sustainable finance, the question of whether an asset is classified as ‘green’ or not may have implications on the availability and cost of financing. Therefore, the EU’s announcement in July 2022 that certain uses of fossil gas and nuclear energy were deemed environmentally ‘sustainable’ under the EU Taxonomy elicited strong reactions. The EU justified the amendment of the Taxonomy by pointing out the important transitional characteristics of natural gas and nuclear energy, such as the lack of viable low-carbon alternatives, their relatively low emission levels, and the fact that using them for a certain period of time would not hinder the transition to a net-zero future.

However, by labelling natural gas and nuclear energy as green, the EU went against the experts of the Sustainable Finance Platform, a body that was established by the EU to help elaborate a science-based taxonomy. According to the experts, natural gas generates huge emissions, and nuclear energy creates highly radioactive waste, for which it is still unclear how it could be safely handled and disposed. As a consequence, a number of NGOs, have taken legal action by filing a case in the Court of Justice of the European Union. Finding that the EU’s approach is inconsistent with the science-based approach, the principle of do no significant harm (DNSH), general EU Climate Law and the Paris Agreement. The case is currently pending.

For the claimants in this case, the EU is greenwashing. In light of energy security considerations in Europe, however, many (including green politicians) agree that these controversial energy sources will remain necessary in the next years. In my opinion, the case does not illustrate intentional greenwashing but rather that the regulatory approach taken by the EU is not nuanced enough to more adequately capture, albeit arguably necessary, transition activities.

Hereto it is important to note that the EU Taxonomy employs a binary classification system where activities are categorized as either sustainable or not, i.e., as taxonomy-aligned or not. This binary outcome model runs the risk of not including gradations in financing conditions as the taxonomy itself does not allow for gradations in the degree of sustainability of economic activities. The examples of natural gas and nuclear energy shows to what extent binary taxonomies are inflexible and easily susceptible to greenwashing. They place transition activities on the same level as uncontroversial sustainable economic activities, and might, in the opposite case, fall short in capturing relevant transition activities for the net zero pathway. A more nuanced approach favouring greater granularity has emerged in Asia. The taxonomies of ASEAN and Singapore, for instance, are designed with a ‘multi-colour’ screening system, which ranks an economic activity by assigning it a colour code: green (sustainable), amber (transition) or red (unsustainable). In other words, the traffic-light system allows a classification beyond mere identification of sustainable activities by also incorporating distinctions between transition activities and those that pose harm.

Way forward

Currently, there is a global regulatory race between different jurisdictions, and regulatory approaches differ. As I argue in a recent working paper, the efficiency of sustainable finance taxonomies hinges on international regulatory cooperation between states, government agencies and private experts. Non-concerted efforts would increasingly lead to a multiplication of different, and often divergent taxonomies and measurement approaches which would negate what taxonomies try to achieve, namely the establishment of consistency and clarity. The aim of regulatory cooperation initiatives is to achieve interoperability between different taxonomies. One design aspect for such interoperability is, for instance, the granularity of taxonomies, i.e., whether activities are subject to a binary or multi-colour classification. Regulatory cooperation can promote regulatory capacity and help establish best practices of ESG standardisation that is flexible enough to adapt to changing circumstances related to climate change and other sustainability challenges.

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By Stefanie Schacherer, Assistant Professor of Law at Singapore Management University

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