Taxonomy astronomy: The global search to define sustainable finance

Arresting climate change will require trillions of investment, the vast majority of which must come from private investors. As issuers increasingly market their offerings to investors seeking green investments, how can they be sure they are putting their money to promote causes as intended?

The answer lies in what is known as a green or sustainable finance taxonomy. This is a classification system for identifying activities or investments that will move a country toward specific targets related to priority environmental or social objectives (ICMA 2021). They serve multiple purposes – providing a definition for what is ‘sustainable’ and thereby reducing ‘green-washing’, supporting ambitious sustainable development goals and building investor confidence of investors that they are contributing towards these outcomes and that their investments are not unintentionally doing harm to society or the environment.

Taxonomies began as simple lists of sectors and activities (with the Climate Bonds Initiative in 2012) and have increased in complexity over time. A new Toolkit  from Sustainable Banking and Finance Network (SBFN) shows that, as of April 2024, 47 sustainable finance taxonomies (ranging from formal regulatory tools to more simple lists of eligible activities such green bond frameworks) have been issued globally, While three-quarters of advanced economies are now covered by a national or regional sustainable finance taxonomy, just over 10 percent (~24) of emerging markets and developing economies are covered. This could slow their ability to attract capital looking for sustainable investment opportunities.

There is a great deal of variation across these instruments. For example, the SBFN Toolkit shows all countries with taxonomies include climate change mitigation, and most (26) identify multiple other “green” objectives, such as climate change adaptation, pollution prevention, circular economy, protection of water resources, and biodiversity. Meanwhile,  a small but growing number support social objectives, the blue economy, and the Sustainable Development Goals (SDGs). Taxonomies also range in complexity from high-level principles-based approaches and simple lists of eligible activities to comprehensive and detailed catalogues of activities with strict technical criteria, metrics, and environmental and social safeguards.

On the one hand, this diversity of approaches is beneficial, generating innovations that are suited to the local context of countries’ sustainable development. But there is also the risk of a proliferation of differing definitions, a fragmentation of approaches, and a consequent increase in transaction costs, especially for cross-border investments, can be significant. These risks are increasing as we reach a regulatory tipping point with taxonomies moving from being voluntary initiatives to increasingly integrated into national financial regulation.

Yet taxonomy ‘star gazers’ — such as ourselves – are beginning to detect common features across the galaxy of approaches – as we first pointed out in our Activating Alignment paper and as outlined in the  SBFN Taxonomy Toolkit. These include a common structure consisting of: clear framing of the driving principles, goals and environmental and/ or social objectives; setting technical criteria, with metrics and thresholds for performance; along with risk management elements such as ‘do no significant harm’ (DNSH) and minimum social safeguard features.

Transition is also a growing priority across jurisdictions. Different approaches are being tested, such as traffic light systems for aligned activities (“green”) versus those that aren’t fully green (such as hard-to abate activities such as steel and cement) but which meet transition criteria (“amber”) and the application of Transition Principles. Emerging markets are particularly interested in how to ensure inclusivity of taxonomies, such as by incorporating activities and criteria for Micro, Small and Medium Scale Enterprises (MSME’s), women-owned businesses, and vulnerable groups.

This emerging good practice is pointing the way towards the ‘interoperability’ between taxonomies which most countries – and investors - are seeking in order to confidently diversify their green investments. This is evolving on several levels, building on these common structural features and including governance frameworks for keeping taxonomies up to date, classifying activities by recognized systems such as ISIC, convergence on how to practically apply DNSH criteria, and increasingly standardized technical criteria for some sectors. We need to build on this common foundation as more work is needed to support harmonization and define rules for recognition of taxonomies across jurisdictions.

As taxonomies are becoming more widely used, evidence of their benefits is starting to come through. To give one example, China’s past 6 years of green credit data shows that green loans as defined by the national taxonomy had a 0.4% default rate versus approximately 2% average for the entire banking system. The EU is seeing multiple signals that taxonomy-aligned assets are more highly valued.

While taxonomies serve as a valuable foundation to guide complementary policies to promote sustainable finance, it is important to recognize that they are not a panacea. There are limitations to their applicability and effectiveness in addressing the complex challenges of sustainable finance, and they should be seen as part of a broader set of strategies and policies to accomplish climate and sustainability goals. That said, these taxonomies do have the potential to become not only a powerful ‘astronomical guidebook’ for policy makers and regulators but also a source of clarity and confidence for corporate and financial sector actors.  We look forward to collaboration with fellow taxonomy star gazers to better map the landscape and provide us all with a common path forward.