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Taxonomy in trouble

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The sustainable finance market clamoured for a Taxonomy to tell it what was green. Now it’s here, many are finding the answers constraining or simplistic. Alarmingly, the Taxonomy is also perpetuating the very thing it was supposed to root out — greenwashing.

The idea of a Taxonomy of Sustainable Economic Activities — as the European Union has now created — was always a problematic one. It is like asking a conference full of people with clashing views to condense the internet into a telephone directory.

Over the four years or so of its gestation, GlobalCapital has held back from criticising the Taxonomy because there is a chance that, for all its drawbacks, it could do good.

Indeed, virtually all in the sustainable finance market are convinced of this, and support the idea wholeheartedly, and we have respect for their knowledge and opinions.

But the closer the Taxonomy gets to becoming a reality, the more difficulties market participants are finding with it.

Only the best will do

Players in the financial institution segment of the green bond market are dismayed that the European Commission has decided to classify housing as sustainable only if it earns an A grade on its Energy Performance Certificate.

This would include only 1% of properties in the EU. So far, the green bond market has used the top 15% of properties in any country as a rule of thumb for what is sustainable.

Most green bank bonds based on mortgages, including covered bonds, will therefore not be Taxonomy-compliant.

In this case, the Taxonomy, as currently drafted, is too strict for some market participants’ liking.

Industry capture

Much more seriously, in other areas, the Taxonomy is far too lenient. Take biofuels. Virtually all of these will be classed by the Taxonomy as helping to reduce climate change. In reality, most of them make global warming worse.

Wood, vegetable oil and ethanol are hydrocarbons, just like coal, oil and gas. Burning them makes carbon dioxide and other pollutants.

Claiming that these do not matter is based on false counting. In nearly all cases, biofuel cultivation does not significantly increase the total amount of plants growing in the world. The land where fuel crops are grown was similarly vegetated before. So the biofuel industry raises emissions, but not carbon sequestration.

Time is short

Those who object to such blunders have little chance to change the Taxonomy in the near term.

Put under pressure to get the Taxonomy finished by the end of 2020, the European Commission — which has the power to write all the detailed rules — has given market participants just four weeks to comment on the drafts of the first two chapters.

These cover climate change mitigation and climate change adaptation.

More worrying still, the EC will give itself only a few weeks — over Christmas — to digest the feedback and produce the final texts. The chances of changing the Commission’s mind on any substantial point look slim.

The property and biofuel problems are only two examples. Very experienced issuers have found it extremely difficult mapping the assets in their green bond programmes to the Taxonomy. They are used to categorising their green work by project, not, as the Taxonomy requires, by activity.

A single project — building a new factory, for example — will involve many activities, each of which needs to be assessed against the Taxonomy.

Here, again, users are finding the Taxonomy constraining.

Let nation speak green unto nation

When considering any gripes, it is important to ask whether the complainers are using the Taxonomy in the right way.

It is meant to be a disclosure standard — a tool to help market participants of all kinds describe their activities in a standardised way.

In its purest and original form — most clearly articulated by Aldo Romani of the European Investment Bank — the Taxonomy was a “Rosetta Stone”, a translation tool, to enable users to compare different standards of greenness.

Investors trying to compare the claims to greenness of two products or organisations are often bewildered, because the claims are expressed differently. If everyone used a common language, the claims could be compared with ease, Romani and his collaborators thought.

To do this, environmental worth should be divided into objectives — such as mitigating climate change — and economic life into activities, like making cars.

Mapping activities against objectives would form a grid. Each square would be the contribution a certain activity makes to an objective — for example, how making cars can contribute to mitigating climate change.

To make the Taxonomy useful, market participants need to agree on criteria to put in each square — what metrics to use, to compare one car with another, such as carbon dioxide and nitrous oxide emissions.

Each market actor can then declare where it is, using those scales, and everyone can understand each other.

Guide becomes a catechism

This idea was turned into policy during 2017 by the High Level Expert Group on Sustainable Finance, appointed to advise it by the European Commission.

By the time the Taxonomy emerged from the HLEG, it was a blunter instrument — perhaps inevitably. As Sean Kidney, CEO of the Climate Bonds Initiative and a member of the HLEG, memorably said in 2017: “Every man and his dog is saying ‘just tell me what’s green’.” 

Taking the HLEG’s advice, the Commission proposed in March 2018 a Taxonomy organised by objectives and activities, but that would not just define the criteria for comparison. It would lay down the EU’s minimum standard for each criterion, for an activity to be considered sustainable.

Rather than the Taxonomy being an encyclopaedia in which you could look everything up and find its description, it became an anthology. Things would be either “in” the Taxonomy or “out”, depending on how they measured up to the criteria for the squares they belonged in.

Description, not instruction

Even so, the Taxonomy is still meant as a descriptive tool. No one is obliged to do things just because they are in the Taxonomy, or avoid them because they are out.

But investors are required to describe their activities, using the Taxonomy — stating how much of their portfolios comply with it. Firms offering sustainable investment products must describe them with reference to the Taxonomy. If they include assets not considered sustainable by the Taxonomy, they must declare this and explain why.

Attached to the Taxonomy will be an EU Green Bond Standard. Again, this is voluntary. No one is forbidden to issue a green bond without using the standard. But if they want to apply for this kitemark, the bond proceeds have to go to activities in the Taxonomy.

Participants in the sustainable finance market, however, are no rebels. They all want to be teacher’s pet. So when gold stars are being handed out, everyone wants one.

The fact that €80bn of green bank bonds linked to property have been issued and bought by happy investors should give participants in that market confidence that they are doing something that works.

Instead, they are all at sea because few of those bonds will be classed as sustainable under the Taxonomy. The tail is wagging the dog. The description, intended to create understanding in the market, is being treated as it if were an edict from the master.

Black and white

This over-reaction can, with luck, be cured by reminding people what the Taxonomy is for and how to use it.

But the phenomenon is problematic, all the same. It shows that the Taxonomy will create regulatory cliffs.

Such arbitrary distinctions can be useful, even if they are sometimes harsh. Investment grade credit ratings are a category it hurts to fall out of — but the market finds it useful all the same.

But environmental issues — not to mention social, promised later this decade in Taxonomy II — are far more complicated than financial ones.

Ultimately, finance just comes down to how much money an organisation can bring in, and how much it can pay its debt and equity investors.

How many birds can a wind turbine kill? How much hazardous nuclear waste can we store? Should hydroelectric dams be allowed to block rivers? How much antibiotic use is safe? Finance is linear — the environment is three dimensional.

Answering any of these questions is difficult — there may be no one right answer. The best course of action may differ from case to case.

The Taxonomy, however, tries to give a single answer to all these questions. The attempt was heroic. It might also be called naïve.

Reinventing the wheel

Odder still is that the EU already has environmental standards for many areas of life. Every industry with substantial environmental impacts has had these regulated, at least to some extent, for decades. Many have also developed self-regulatory codes, such as the Breeam standards for buildings.

Environmental protection in each industry — chemicals, for example — is a whole discipline and science in itself.

Thirty years after all this began, people in the capital markets noticed environmental issues mattered, and wanted to be told what was green. But they had short attention spans, so needed one book to cover the whole lot.

They have been granted their wish — the Taxonomy gives them their answers.

Although the rules are complex, the answers are childishly simple — things are either in the Taxonomy or not. Companies’ reporting obligation is a single number: they merely have to say what percentage of their activities is sustainable.

In providing these answers, the Taxonomy is bound to displease some people — such as the green bank bond issuers.

Much worse is misleading people. This is the danger with the biofuel standard. The already disastrous global regulation of this issue is now being enshrined in EU financial laws.

Who governs?

That such wrong turns can happen makes the governance of the Taxonomy all-important.

It is highly unusual. The Taxonomy’s oversight is a weird mixture of politics, civil service and the private sector.

The EU has empowered its civil service, the European Commission, to write the detailed Taxonomy rules. The EC outsourced the job of drafting them to a Technical Expert Group, drawn from the public, private and voluntary sectors.

Mirroring the odd nature of the Taxonomy itself — an encyclopaedia of everything, to replace a library — the TEG was not a professional body. Its members all had day jobs.

It comprised many worthy people, with expertise in their fields. But most, broadly speaking, were sustainable finance practitioners — not experts in chemicals regulation or agricultural emissions. Such experts — some 200 in all — did advise the TEG. But it remained essentially a college of amateurs.

That may be no bad thing. Translating detailed industrial regulations into language financial markets can understand is a worthwhile job. Experts are not always right, either. The self-regulatory standards in the biofuel industry completely mask the harm it does.

But it’s a strange process to use for forming such an important document.

Commission in the driving seat

The Commission, of course, has the final say. In the main, it has followed the TEG’s recommendations. In several places, including on biofuels and hydroelectric power, it has ignored them, in favour of more environmentally damaging options.

The Taxonomy Regulation decrees that in forging the rules, the Commission should base its conclusions on science and evidence.

Environmental NGOs fought for this when the law was being negotiated — their main fear was that the Taxonomy would be distorted by political forces. They wanted it to be a neutral, scientific authority.

But distancing the Taxonomy from politicians has not removed their influence — vested interests still shape how the Commission acts.

The TEG has now finished its work and been replaced by a permanent successor, the Platform on Sustainable Finance, chaired by Nathan Fabian of the UN Principles for Responsible Investment.

The Taxonomy will live its early life like a child with three warring parents — the scientific pole, represented by the Platform; the civil service; and the brawling world of politics, industry lobby groups and NGOs.

In this triumvirate, the Commission is the arbiter.

Unfortunately, in writing the first version of the Taxonomy that is published in January, it is likely to make mistakes, some of them very serious.

Society and the market want to ask the Commission and the Platform two things. When will you put them right? And what is the process for us to persuade you?