Avoiding the Tower of Babel: building a common language for sustainable finance

Taxonomies have come a long way since the publication of the first taxonomy – by the Climate Bonds Initiative (CBI), in 2012. Originally designed to assist market participants to identify and evaluate green projects and assets, their objectives and scope have evolved. They shifted from climate to broader environmental objectives, and from pure green economic activities to hard-to­abate ones. There are currently 17 published taxonomies and another 18 under development. Taxonomies play a pivotal role in providing clear and precise definitions of what is sustainable. At the minimum, they enhance credibility and instil confidence in investors by addressing concerns related to greenwashing.

As more taxonomies emerge, it becomes imperative to establish a common language to avert the risk of multiple definitions and market fragmentation. These are real threats. Sustainable finance frameworks are shaping financial markets as they reorient capital flows, notably through labelled instruments such as green, social, sustainability and sustainability-linked (GSSS) bonds and loans.

The classification provided on eligible economic activities is essential for identifying which projects and assets can be included in GSSS transactions, and for evaluating their contributions to social and environmental objectives. By understanding taxonomy development, market participants can better grasp upcoming opportunities.

There is no single approach for developing a sustainable taxonomy. Taxonomies encompass structural elements such as objectives, scope and screening criteria, all guided by five overarching principles.

These have been proposed by market standard setters such as CBI, international organisations like the UN Environment Programme Finance Initiative and multilateral development banks to ensure harmonisation.

The fundamentals for a robust framework are interoperability, credibility, usability, prioritisation and adaptive factors. The majority of taxonomies, developed or under development – including Australia’s – are adopting these core principles.

A taxonomy’s objective sets out its ambition. The most used objectives revolve around climate mitigation and adaptation, but – influenced by the EU taxonomy – other environmental objectives are often incorporated. These include the sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection of biodiversity and ecosystems.

Once the objective is defined, the next step is to select economic sectors and activities that substantially cut down greenhouse gas emissions. Economic classification codes, such as the NACE in the EU and ISIC internationally, have been used to select relevant sectors and activities. The usual suspects are energy, construction and buildings, transport, water and waste management, and agriculture and forestry.

When it comes to taxonomy development, one of the most critical structural elements is the establishment of technical screening criteria. These dictate the eligibility of projects and assets. Three distinct approaches can be used to define screening criteria, either individually or in combination.

One is the whitelist-based approach that defines activities, projects and assets under each sector or subsector, including specific technologies. Second is the technical screening criteria-based approach that defines quantitative thresholds to measure a minimum performance level and environmental safeguards such as ‘do no significant harm’ (DNSH) for economic activities. Finally, the principles-based approach sets guiding principles without specifying economic activities or thresholds.

Another noteworthy feature is the need for contextualisation. This process captures local nuances and helps ensure that taxonomies meet local sustainable finance needs.

Their scope may vary from purely green to sustainable, transition or a combination of scopes. A green taxonomy covers green projects or assets that contribute to climate objectives. They still tend to be the most common type. A sustainable one covers green projects and assets contributing to climate and broader environmental objectives, including social themes.

Green taxonomies are occasionally perceived as binary or overly stringent as they aim to avoid confusion on what is green. But a more nuanced approach may be required. This is where transition taxonomies come to play. They provide criteria to assess credible transition pathways aligned to global heating caps of 1.5^oC or well below 2^oC.

Transition taxonomies, such as the one developed in Indonesia, are more dynamic and progress-centred as they employ a traffic light system to categorise activities as eligible, aligned, or excluded. This approach accommodates activities that are currently in the process of aligning with these pathways. Australia is considering this format.

Establishing the fundamentals is crucial, and it is time to see taxonomies in action. Issuers, such as corporates, E use taxonomies to identify eligible projects and assets, to communicate their climate, environmental and social attributes, and to report on alignment. Banks and financial institutions leverage taxonomies to originate and structure green and sustainable banking products such as bonds, loans and credit, to  meet issuers’ and investors’ needs.

Taxonomies can thus be crucial in issuing use-of-proceeds or performance-linked labelled instruments, as they confirm  substantial contributions to mitigation, adaptation, and broader environmental and social objectives. One of the observed uses so far is the mention of taxonomies within GSSS frameworks and their use for selecting KPIs.

An interesting example is Enel, which recently updated its sustainability-linked financing framework to reference the EU taxonomy and designed a dedicated KPI that will measure the proportion of capex aligned with it.

“The recent update of Enel’s sustainability-linked financing framework is a good illustration of how the forthcoming  Australian taxonomy might be leveraged in future by local issuers, to show to investors how their activities are transitioning and contributing to climate and environmental objectives,” says Frazer Ross, head of DCM, Australia at Natixis CIB in Sydney.

However, disclosing alignment to a taxonomy at product level and at scale is proving to be challenging. Further guidance from market authorities would be welcomed to harmonise the process.

Investors use taxonomies to identify opportunities that meet green or sustainability criteria, understand the exposure of their portfolios, design investment policies and disclose the exposure of their investment to sustainable projects and assets.

Taxonomy use in reporting is not as prominent in emerging and developing markets. Yet the global push for sustainability and climate-related disclosures could encourage the use of local taxonomies in corporate reporting.

In the EU, companies and investors must disclose their taxonomy alignment to demonstrate how they contribute to  climate and environmental objectives. Reporting comes with challenges, particularly in interpreting technical criteria and the level of granular data to demonstrate alignment.

Policymakers and regulators use taxonomies to introduce requirements and incentives. For policymakers, this means developing pipelines of green projects aligned to national priorities. Regulators use taxonomies to create disclosure requirements for corporations and investors, and to prevent greenwashing.

Central banks and financial supervisors have included taxonomies within the regulatory toolkit. Uses include credit operations, collateral and asset purchases. For instance, the European Central Bank referenced the local taxonomy to determine sustainability-linked bonds as collateral, and the People’s Bank of China used the local taxonomy – the Green Bond Endorsed Catalogue – to give aligned green bonds preferential status as collateral. The policy use of taxonomies is becoming more evident and shifting to a binding from a voluntary approach.

Taxonomies are in various stages of development and implementation. As inherently dynamic frameworks, their scope and uses continually evolve. There has been support for including social and other environmental themes such as biodiversity, resilience and hard-to-abate sectors.

As many taxonomies are in their implementation phase, the focus over the following years will inevitably shift to usability. This stands as a top priority on the agenda in the EU as regulatory requirements continue to emerge. Recurring challenges include the required data granularity and compliance with technical screening criteria.

Other jurisdictions are facing similar challenges. Directing efforts on piloting the taxonomy is crucial to test if it is fit for purpose and use. Colombia, for instance, conducted an implementation pilot for green credit lines in commercial and tier-two banks that provide financing to SMEs, which make up a significant part of the Colombian economy. Results demonstrated that the lack of data availability and capacity made compliance challenging, requiring a tiered approach based on the user type and project size.

Navigating through multiple taxonomies may be an arduous process for issuers and investors. Natixis CIB has worked on interpreting the many requirements of taxonomies worldwide, particularly in the EU.

The firm has integrated taxonomy eligibility criteria in GSSS bonds and loans issuance and, when assessing a potential deal, refers to the “green weighting factor” (GWF). The GWF has around 75 asset-based classifications and various uses, such as informing the credit process and lending decision-making, strategic dialogue with clients, product innovation and contribution to regulatory discussions.

“As daily users of ‘sustainability criteria’, taxonomies are instrumental to our activities. Our hands-on experience and willingness to feed policymakers with constructive feedback and counterproposals helped us build a franchise. This legitimacy leads us to be increasingly consulted in this space, with usability and robustness as key concerns,” says Cédric Merle, Paris-based head of the Centre of Expertise and Innovation at Natixis CIB’s Green and Sustainable Hub.

In the past five years, 35 jurisdictions in Europe, Asia, the Americas, Africa, and the Middle East have either published or begun their taxonomy development process (see map). This growth demonstrates that taxonomies are becoming a must-have, and this number will continue to rise.

The CBI and EU taxonomies have significantly influenced global development. CBI is involved in the design of at least 20 taxonomies to ensure these are credible, interoperable and usable – including in Australia. Various jurisdictions have used the EU taxonomy as a reference to develop their frameworks, considering its stringency and mandatory nature.

Further development of local frameworks is expected, particularly in emerging markets, as jurisdictions want to reflect national priorities and meet their most pressing climate, environmental and social objectives. Considering diverging economic and political circumstances, contextualisation becomes vital to reflect local specificities including technology use and viability.

While several taxonomies are leveraging the EU document, they include different sectors, adapt thresholds, and use DNSH and minimum safeguards to capture what applies to their national reality. For instance, Mexico and Colombia included agriculture in their taxonomies while Australia and Chile will include mining as these industries account for substantial portions of economic activity and greenhouse gas (GHG) emissions.

Each region has unique features when it comes to taxonomy development (see table 1). Though jurisdictions adopt common principles and structures, there is variation in their scope – for instance, the inclusion of social objectives in Latin America and transition categories in Asia Pacific, as well as in the selected economic activities. Comparing the main elements across specific regions allows for a more in-depth understanding of similarities and differences, facilitating interoperability for stakeholders with cross-jurisdictional operations.

Source: Natixis CIB Green and Sustainable Hub 2023

The Australian Sustainable Finance Initiative (ASFI), a not-for-profit body that aims to foster a sustainable and resilient financial system locally, first recommended the development of a taxonomy in its 2020 sustainable finance roadmap.

Over the past two years, ASFI has assessed the best outline for its taxonomy design. The scoping phase of the taxonomy kicked off in early 2022, followed by ASFI’s first publication on international taxonomies in October the same year. This comparative analysis describes taxonomy developments’ rationale, objectives and guiding principles, particularly interoperability and sectoral coverage.

Building on the findings of the taxonomy analysis report, in December 2022, ASFI published a framing paper for the design of the Australian taxonomy. This was in public consultation until mid-February 2023, with the final report launched in March.

The iteration process was positive, with feedback from diverse stakeholders in the finance sector, industry, civil society, third sector and real economy.

The proposed design elements were well received, emphasising credibility via the adoption of a science-based approach and inclusion of a transition category due to Australia’s economic and emissions profile. Natixis CIB has applied its taxonomy scorecard to the main elements of the proposal (see box).

The Australian taxonomy is in its early stages of development, with a projected completion date of January 2025. An essential part of this phase is the creation of a governance process and overarching taxonomy technical expert group (TTEG) composed of 25 senior leaders endorsed by the Australian Council of Financial Regulators’ climate working group.

The TTEG will provide strategic oversight, inputs, and endorsement of the taxonomy. Natixis CIB is part of this group. For the firm, this initiative is important to advancing sustainable finance globally as it is heavily committed to transitioning to a net zero future.

As is the case in other jurisdictions, Australia is leveraging the EU taxonomy as the EU is one of its primary sources of foreign direct investment (see table 2). Australia recognises the importance of meeting rising demand for climate-aligned products. While considering the taxonomies of jurisdictions like Japan, China, and Singapore, the Australian taxonomy clearly aligns with the EU taxonomy by adopting similar environmental objectives and technical screening criteria, including elements like DNSH and a minimum safeguard.

The overarching purpose of the two frameworks is similar. They aim to direct capital flows to ensure the transition to a low-carbon economy. The objectives also cover the same six environmental themes.

The most notable distinction, though not unexpected, is the inclusion of the mining and agriculture sectors in the Australian taxonomy. Mining is a relatively new topic within sustainable finance taxonomies, with significant emphasis on strategic minerals for a low-carbon transition. These include lithium, copper, nickel, cobalt and rare earth elements. However, a few taxonomies already include steel and aluminium manufacturing. Agriculture is also an emerging sector that, together with mining, is yet to be included in the EU’s taxonomy.

Source: Australian Sustainable Finance Institute, European Commission 2023

“By deliberately emphasising the main sources for GHGs for Australia and focusing on interoperability, the Australian taxonomy technical expert group will ensure immediate relevance of its proposed taxonomy and the continued flow of capital to support the country’s transition,” says Robert White, managing director, Green and Sustainable Hub at Natixis CIB in New York and a member of the TTEG.

He adds: “Being the first country to tackle the metals and mining sectors will not be straightforward. Metals and mining has not yet become a common asset class in sustainable finance, yet the sector has a pivotal role to play in ensuring the sustainable supply of critical resources vital to a successful energy transition. Without their critical outputs, we will not have the electricity grid or transportation network of the future.”

Ongoing efforts should focus on the socialisation and application of the taxonomy. As in other jurisdictions, corporations, financial institutions, institutional investors and government agencies will be the primary users of the taxonomy. With Australia also setting regulations on climate change disclosure and greenwashing, the taxonomy may also play an essential role in the regulatory landscape.

Taxonomy development has been prominent in the Asia-Pacific region. The progress made by Australia sends an important signal on its commitment to transforming its economy in a carbon-constrained world as well as attracting capital to enable such transformation.