Incorporating taxonomy in corporate strategy
In recent years, EU governments have made ambitious commitments to engage the industrial transition towards a more sustainable, climate neutral model – such as the Paris Agreement and the EU Green Deal. The current linear model of industrialisation based on extraction of nature’s resources and waste is no longer sustainable, because of the limited quantity of non-renewable natural resources such as fossil fuels in the biosphere; climate change and its collateral effects such as global warming; and human impacts on the environment including pollution. In the long run, it leads to a zero-sum game whereby industrial progress is neutralised by climate and environmental degradation and exhausted resources or raw materials. It also contributes to geopolitical stress, unfair competition and inequality.
These commitments will not be easy, not from a financial, public governance or corporate strategy perspective. According to recent estimates, around €180 billion of annual additional investments are required to meet the 2030 targets, and a multiple of this sum to meet the 2050 targets in the EU alone. This comes on top of the money spent to support the economy during the COVID pandemic.
Governments and international institutions will have to manage complex policy and regulatory changes. In the EU like in the UK, billions of euros are spent every year on environmentally harmful subsidies, in contradiction with energy and climate commitments. These subsidies play an important role in steering economic and consumer behaviour away from the transition.
Governments and monetary authorities also need to address the impacts of climate change on the stability of the financial system, and how to enable the re-allocation of existing financial flows towards more sustainable investment targets. Such is the case of the EU Action Plan on sustainable finance and the central banks’ Network for Greening the Financial System.
Many industry sectors have started to lay out adaptation strategies to upgrade their business models towards ‘greener’, more responsible manufacturing processes and technologies. Yet, it is not obvious how the whole-scale transformation of large, particularly energy intensive industries with significant investments in fixed assets can be managed within the current regulatory frameworks. Some of them resort to greenwashing, but most make substantial efforts, leading to the discovery of never imagined management issues.
Both in government and in corporations, the key challenge lies not in individual issues, which can be analysed and solved, but in the interdependence of all these aspects of the transition. They have to deal with complex adaptive systems, and this requires innovative steering methods, a far cry from the traditional hierarchical and bureaucratic ways still favoured by large institutions, public or private.
The first step though is to achieve accurate information about sustainable industrial practices. Several countries have developed classification systems to identify environmentally sustainable economic activities, commonly referred to as ‘taxonomies’. Three types of systems are emerging.
Two of the three largest economies, the EU and China, are setting up fully-fledged and advanced classification systems, with a focus on concrete economic activities and sectors. These are sometimes associated with specific technical or performance criteria, based on a binary classification (green/not green), mandatory for specific purposes such as green bond issuance or disclosures, and sometimes directly linked to green bond issuance (China). India seems to follow this approach.
Japan is moving towards specific support schemes, labels and guidelines, somewhat comparable to a taxonomy, yet with a simpler design and a more restrictive purpose, for example guidelines with sectorial priorities for issuance of specific green financial products, loans or investments, sometimes completed by technical or performance criteria. Those instruments are more sophisticated than simple labels, yet less comprehensive than fully-fledged taxonomies. Other countries, such as Canada, are considering a multi-shade classification system of activities.
The diversity of existing and future classification systems shows the variety of uses for which they are conceived. It can also lead to extra burden on industry and to shifts in capital markets. Very often, taxonomies are developed to define criteria for green or sustainable financial products, securities, or bank loans. However, the purpose of the most advanced taxonomies goes beyond that and seeks to ensure certainty to investors on the inherent climate-related financial risks that they will avoid. Big re-insurers already simply no longer provide insurance for certain types of investments.
Taxonomies apply to a specific territory, however, they can have cross-border effects on global value-chains and on trade. Around 80% of the ‘do no significant harm’ (DNSH) criteria in EU taxonomy corresponds to existing regulatory obligations of environmental protection, circular economy, or biodiversity preservation. Eligibility to the EU taxonomy will therefore contribute to promoting EU standards and practices abroad, but could also lead to conflicting priorities with other jurisdictions. The fact that the EU and China move largely in parallel in developing their systems makes this all the more likely and is one of the reasons for the new US administration to try to catch up in order to avoid becoming ultimately a sort of rule-taker, however much Congress may like to camouflage this.
The tripartite High Level Group on Financing Sustainability Transition therefore pleads in the EU for further regulatory convergence, which would help cross-border green financial flows, the scaling up of green finance and facilitating trade. Coherence could be facilitated in the framework of the International Platform on Sustainable Finance (IPSF), which foresees a Common Ground Taxonomy as a “unique common reference point” for the identification of eligible investments. To date, European capital markets offer only limited investment options that comply with the EU taxonomy.
There are still serious problems to be solved. The binary approach of the EU taxonomy excludes many potentially relevant activities, which fail to fit into the transition activity category despite their effective contribution to climate change mitigation. It also insufficiently reflects complex life cycle and supply chain issues, even more in the case of cross-border intra-industry trade, when it is increasingly challenging to measure and validate all eligibility criteria for investment projects.
Read the previous article in this series: Brexit or the march of folly?