What is the EU’s ‘taxonomy’ for sustainable finance, and will states agree on it?

Taxonomy is a dry, technical word for a classification system but, when used by the EU as part of its efforts to achieve net zero emissions by 2050, the term sparked heated debate. In short, the EU taxonomy defines and classifies the economic activities that can be qualified as “green” to benefit from EU funding. Since its first proposal in March 2019, the debate over what to include in the taxonomy has quickly become a debate over the national interests of EU member states.

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The main sticking point concerns fossil gas and nuclear energy. Pragmatists concerned about energy security argued for their inclusion, while environmental campaigners objected that it would contradict the EU’s net zero emissions strategy. As the end-of-year deadline for a decision approached last month, fears that the European Commission would allow their inclusion were such that environmental activists gathered in Brussels to stage a mock funeral for that. Their fears proved to be well-founded since on New Year’s Eve, the commission published draft proposals allowing the inclusion of gas and nuclear, under certain conditions.

So what is it? The EU taxonomy, according to a European Commission document, is “a tool to help investors, companies, issuers and project developers navigate the transition to a low-carbon, resilient and sustainable economy. resource-efficient”. The aim is to “protect private investors from greenwashing, help businesses become more climate friendly, alleviate market fragmentation and help move investments to where they are most needed”. As such, it is central to the EU’s wider goal of achieving net zero emissions by 2050.

Environmental objectives

The EU taxonomy strategy sets six environmental objectives: to mitigate climate change (mainly through decarbonisation); adaptation to climate change (physical risk management); protect water and marine resources; transition to a circular economy; prevent and control pollution; and protect and restore biodiversity and ecosystems. Each of these objectives covers a range of economic activities. The climate change mitigation section alone covers 90, each with ‘technical screening criteria’ for determining whether income or capital expenditure from the activity can be considered green.

The system is designed to be flexible, to incentivize companies to adopt its rules. In addition to activities that are more obviously green, such as the manufacture of solar panels and wind turbines, the EU taxonomy also sets criteria for ‘transition’ activities; in other words, for companies striving to meet the green definition. For example, cement manufacturing has always been a carbon-intensive industry, but if the CO2 emitted in the process can be reduced below a certain threshold set by the EU taxonomy, then it can be considered like green. This would be important for a cement manufacturer because, with these green references, he can then access Green Deal funds at attractive prices to finance his activity.

So, by simply defining which activities are green and setting the standards to be met, the EU taxonomy effectively decides which sectors and companies receive green funding, incentivizing them to stay on the path to net zero. The EU itself, as well as other governments and agencies, will also use the taxonomy criteria in financial markets for their risk assessments and for their green bond program. Asset managers managing pension funds and other investment funds will also seek to follow the taxonomy when deciding which companies to invest in. comes from investments in green businesses.

Another element of flexibility in the system comes with the taxonomy review process, as the criteria must be reviewed every three years, after which they can be adjusted if necessary. For conservationists, however, the EU taxonomy has already seen far too much flexibility – to the point, they say, that it could potentially undermine its entire purpose. As WWF said in a statement issued to coincide with the mock funeral held in Brussels last month: “Billions of euros are at risk of being diverted into fossil fuels, nuclear power and factory farming, aggravating the climatic and natural crises. This is because the EU taxonomy is probably about to be whitewashed.

A politicized debate

The EU taxonomy, in addition to being an environmental measure, has become an extremely political issue for EU member state governments, now under pressure from their constituents in the face of soaring energy prices , the rising cost of living and fears of power outages. In early 2021, the French government provided support for new nuclear projects. But since they wanted nuclear included in the taxonomy, France had to strike a deal with Germany, which instead wanted gas included, having decided to decommission all its nuclear reactors after the Fukushima disaster.

As Energy Monitor put it, “it now appears that a nuclear vs. gas compromise may be the only way to get the taxonomy through a vote in the EU Council.” If that were to happen, the WWF said, “it would be a fatal blow to taxonomy. The consequences for the EU Green Deal, EU leadership in sustainable finance and the climate and natural crises would be disastrous.

Climate change think tank E3G says such a move would contradict EU regulatory process and principles, lead to reputational damage and loss of trust, ceding its current role of regulatory leadership on issues. climate in China.

European taxonomy lagging behind

Developments in the EU taxonomy debate are closely watched by regulators and investors around the world. China’s own taxonomy is known as the Green Bond Endorsed Project Catalogue. It excludes gas, liquefied natural gas and coal, and thus sets the highest standards for financing green energy. This taxonomy is mainly used by financial institutions and corporations for issuing green bonds in China’s onshore markets, with different disclosure requirements for different types of green bonds.

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China and the EU conducted a thorough comparison of their respective systems, which resulted in the Common Ground Taxonomy. This could eventually form the basis of an eventual global standard for sustainable finance, usable by other countries wishing to develop their own green taxonomies.

The Russian taxonomy also limits investment in new gas projects, closely mirroring initial EU proposals. South Korea, meanwhile – sensing the EU taxonomy is in trouble – appears to be backtracking on its own standards. According to E3G, Korea’s Ministry of Environment explained that continued debate on this issue in Europe influenced its decision not to relentlessly exclude gas power from its “green” list, although nuclear power is always excluded.

Japan is struggling to keep its commitments made at COP26 in Glasgow last November, so great is its concern about energy supply. According to Bloomberg, the Japanese Prime Minister, Fumio Kishida, approved on October 22, before the COP, a strategic energy plan which stipulates: “no compromise is acceptable to ensure energy security, and it is the obligation to a nation to continue to secure the necessary resources.” The United States and the United Kingdom have already announced that they will draft their own taxonomies in due course.

The taxonomy cannot prohibit investments in polluting activities. This is a transparency tool.

Tsvetelina Kuzmanova, Sustainable Finance Policy Advisor at E3G’s Brussels office

Back in Europe, the reality is that the taxonomy debate has been skewed by serious misconceptions and a lack of understanding, focusing on national interests rather than long-term goals or vision, says Tsvetelina Kuzmanova, policy advisor on sustainable finance in Brussels at E3G Bureau.

As she told China Dialogue, “Taxonomy can’t tell you what to invest in. It cannot prohibit investments in polluting activities. It doesn’t even apply to Member States’ spending or budget – it’s for private finance disclosure requirements as a tool for transparency. If someone is willing to invest in unsustainable activities, that is their decision. Corn [the taxonomy] should not justify greenwashing and thereby undermine legitimacy and trust in the broader framework.

Policy analysts from Principles for Responsible Investment, a UN-backed international network of investors, draw a line between the EU taxonomy’s treatment of gas and nuclear and the role they could play in the transition energy. As the taxonomy’s goal is to define which economic activities can be considered green, rather than excluding non-green activities from playing a role in this transition, analysts say it should be possible for lawmakers to develop a separate framework that gives gas and nuclear a role in the transition that does not compromise the integrity of the taxonomy.

The European Commission has already indicated that it is considering making its rules less binary in their effects. Currently in the legislative process, an initiative to support the financing of certain activities not covered by the EU taxonomy can help reduce the amount of carbon dioxide produced by the economy over the next decade. And in October, European Commissioner Mairead McGuinness mentioned to the Financial Times the possibility of an “orange” category for activities not eligible for the green label but which could nevertheless have a role to play in the energy transition.

The debate is much more nuanced than it first appears. One thing is certain: the European taxonomy does not prohibit anything; it is simply a tool to promote green economic activities. This technical point has, not for the first time, been lost in the heat of political action.

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