Climate taxonomy, what is it and why does it matter to me?
If you are in the climate investment space, there’s a good chance you would have heard the term “climate taxonomy”. In the last two years, more than 10 countries have adopted a national taxonomy, and the rate at which they’re being released isn’t slowing down: more are due for draft release or full publication in the next 12 months.
So what is a climate taxonomy?
A taxonomy a tool for classification. If you have ever looked for a book in a library, you will have used the Dewey Decimal System. This ‘library taxonomy’ is used for classifying books, which makes it easier for users to find what they are searching for.
Similarly, a climate taxonomy helps investors by providing clarity on which products, activities and assets classify as ‘green’.
Terminology
The nomenclature of taxonomies is still in development, so it is useful to have an overview of the schema being used across various taxonomies. At the highest level, sustainable finance has two taxonomies: climate and social.
Under climate taxonomy, there are two sub-categories: green and transition. The term green taxonomy is often used interchangeably with climate taxonomy and refers to classification system for identifying activities or investments that will move a country toward meeting specific targets related to priority environmental objectives. Whereas a transition taxonomy, while also delivering climate outcomes, has a focus on transitioning to net zero.
A social taxonomy focusses social sustainability and management of investment risks relating to human rights, labour standards and other social risks.
There are a number of taxonomies under the banner of sustainable finance
One of the best examples of a climate taxonomy is found in the EU taxonomy. The EU taxonomy has been released to the public since 2019 and, under the EU’s Sustainable Financial Disclosure Regulation (SFDR), disclosures must be made on any financial product that claims to have ‘sustainable investment’ as an objective or environmental or social characteristics. As of 10 March 2021, disclosures are mandatory.
Why have a climate taxonomy?
As an investor looking at the reporting requirements and extra rigmarole of following a climate taxonomy, it wouldn’t be surprising if you were asking why a taxonomy is necessary.
In some cases, such as the EU example above, following the taxonomy will be mandatory. In other cases, the taxonomy may serve only as a guideline or best practice, but, it can still be useful.
By following a taxonomy, fund managers give investors a clear line of sign as to exactly what part of their investment is going to beneficial climate outcomes. As greater emphasis builds on demonstrating positive climate outcomes, we believe that increased transparency will be vital for the trust investors put in their managers.
For fund managers, there are some distinct advantages:
Increased confidence that investment is directly creating climate positive outcomes
Reduced likelihood of stranded assets resulting from high-emissions investments, and
Aligned performance metrics to demonstrate performance to investors and regulators
Investors will also see the advantages:
Reduced likelihood of “greenwashed” investment products, and
Simple comparison of investment climate performance
Are there any downsides?
Yes. It’s not all smooth sailing. Applying a taxonomy can be time consuming, increase costs and result in excluding new or unproven technologies from the scope of an investment vehicle.
This responsAbility case study highlights among its learnings in applying the EU taxonomy that fund managers should look to collaborate with co-investors to apply the taxonomy, thereby reducing the time and cost burden.
Alongside the additional time and cost of reporting, there are also some controversies within taxonomies. Controversial areas include:
Nuclear power
Gas
Forestry
Biofuels
Imported emissions
Building energy efficiency, and
Steel and aluminium production.
Even in countries or regions with a developed taxonomy, there are conflicting views about what should be included.
There is one further consideration. For investors who are particularly interested in new technology, such as VCs, consideration should also be given for technologies that are not-yet classified. Will the vehicle have the ability to make exceptions where technologies are emerging? If so, what proportion of the investable capital can be allocated to emerging technologies outside the taxonomy?
Do I need a taxonomy?
Whether you need to apply a climate taxonomy will depend on the jurisdiction of your fund and, potentially, the jurisdictions you’re working in. For in-country vehicles, the matter should be relatively simple: does the country have a mandatory taxonomy or not? Where the fund is working in multiple countries, assessment of whether a taxonomy applies should be made on a case-by-case basis.
Furthermore, some countries are making the application of the local taxonomy mandatory, while others are producing the taxonomy primarily as a guideline.
When deciding whether to apply a climate taxonomy, find out what your investors expect, local regulators require and what co-investors are doing. If you are working across geographies and the taxonomies conflict, you may also consider how to reconcile the conflicts.
Summary
A climate taxonomy is a classification tool to help identify ‘green’ investments. By applying a taxonomy, fund managers can reduce the risk of investing in greenwashed projects while reporting back to investors on their green performance. Right now, many climate taxonomies are in development and not all are mandatory, so application should be determined on a case-by-case basis.
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Additional links
Natixis sets out the development of various taxonomies globally
ADB presents an overview of sustainable finance governance
ADB develops the concept of social bonds in impact investment