What is a green taxonomy?
- A green taxonomy is a common framework that sets the bar for investments that can be defined as environmentally sustainable. The taxonomy aims to allow investors and consumers to better understand whether an activity is sustainable by providing an objective threshold.
In June 2021, the UK government announced the creation of the Green Technical Advisory Group (GTAG) made up of representatives of finance and business, data and taxonomy experts and subject matter experts. The GTAG, chaired by the Green Finance Institute, will provide independent and non-binding advice on developing and implementing a UK green taxonomy.
While the task ahead may seem daunting, the UK isn’t starting from scratch. The GTAG and the UK government have the opportunity to learn from a similar process in the EU, where the development of the EU Taxonomy has been underway for three years. The European Commission has so far adopted technical screening criteria for two out of six of its environmental objectives, with the rest expected in the coming months.
The UK will use the established screening criteria of the EU as the foundation for the UK Taxonomy, with a review process to ensure the metrics are right for the UK market. This approach will enable the UK to diverge from the EU where differing perspectives are held – and the energy sector may well be one example – while leveraging the extensive work that has already gone into defining thresholds for a range of economic activities.
Aside from the technical screening criteria, the UK has the opportunity to learn from some of the challenges that have arisen during the EU’s development process. Here we outline five key lessons the UK can learn from the EU:
1. It is crucial that the taxonomy is perceived to be science based.
The EU has faced fierce and often highly controversial debate over the inclusion of particular economic activities. Some member states lobbied for additional activities (such as natural gas) to be included or thresholds to be lowered (in particular, for forestry and bioenergy). In April 2021, when it seemed that the EU may give way to the pressure, members of the EU’s expert group – the Platform on Sustainable Finance – threatened to quit, forcing the EU to carve out certain controversial activities from the first delegated act in order to keep the legislative process moving.
While the UK will not have to deal with the challenge of negotiating between 27 member states, there are still a range of interests at stake. Industry groups may well lobby for the inclusion of particular activities in the taxonomy given the potential implications for access to capital. It is important that the screening criteria of the taxonomy are determined based on scientific, not political, reasoning in order to ensure its credibility and support the UK in achieving its net zero commitments.
2. The taxonomy must be part of a coherent UK sustainability reporting regime.
The parallel development of the EU taxonomy and the Sustainable Finance Disclosures Regulation (SFDR) created inconsistencies which may pose implementation challenges if not resolved. Beyond the design of the reporting requirements themselves, financial institutions face particular challenges in the EU as they are required to aggregate data from companies that will not be required to disclose in advance of financial reporting deadlines, if at all.
The UK can intentionally design a framework that integrates the taxonomy with the announced UK Sustainability Disclosure Requirements (SDR) and the mandatory reporting requirements in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) which are being rolled out across the UK economy by 2025. Sequencing should also be a key consideration to ensure that company disclosures precede financial institutions’ disclosures.
3. The UK should explicitly recognise the extent of the transition that needs to take place in order to achieve its environmental goals, and the role that investors have to play in this.
For the first, three years after publishing its initial sustainable finance action plan, the EU predominantly focused on identifying existing ‘green’ activities, and until its July 2021 Renewed Sustainable Finance Strategy did not give particular attention to the role of investor stewardship. While ultimately all activities will need to be meet high standards of environmental sustainability, the majority of the economy is not there yet. Investors have a crucial role to play in driving and supporting companies to move further and faster. The UK already has a strong concept of stewardship through the UK Stewardship Code, and can build on this to ensure that the government’s approach – whether in the taxonomy or the wider disclosure framework – acknowledges the need for investors to support the transition, not just invest in what is already sustainable.
4. Communication and transparency are key to obtaining buy-in.
Investors have faced challenges in implementing EU regulation due to shifting timelines, with detailed SFDR disclosures already delayed twice. The UK government should be transparent on the process that will be followed and communicate any changes to this clearly. Likewise, when the taxonomy and accompanying regulations are published, clear guidance will be needed on implementation. Questions raised by industry around the implementation of the EU Taxonomy can provide a useful indication of the kind of questions industry participants may need answered. Industry input throughout the process will help to ensure that the end solution is workable.
5. There is a need and an opportunity for global cohesion.
Since the EU first announced its intention to create a green taxonomy, several other jurisdictions have followed suit. The UK will therefore need to give greater consideration to how its taxonomy aligns with others, with any divergence carefully justified. Although this does pose a challenge, working through fora such as the International Platform on Sustainable Finance on the development of closely aligned taxonomies in other jurisdictions offers an opportunity to improve the data that feeds into UK financial institutions’ own disclosures, given the global nature of their investments.
The UK is in a strong position to leverage the significant effort that has gone into creating the EU Taxonomy, whilst adapting the framework to suit the UK market where necessary. This will enable the UK to move quickly in creating a coherent sustainability reporting framework that helps investors play their role in the economy-wide transition to meet the UK’s environmental goals.