Europe continues to shape the world of sustainable finance. Over the past three years the EU has been working on an ambitious initiative to mainstream environmental, social, and governance (ESG) factors into capital markets and reorient capital flows toward sustainable investment--articulated in the European Commission's Action Plan on Sustainable Finance. Most recently, the new president of the EC has pledged a new "Green Deal" as the centerpiece of the body's next five-year mandate, elevating sustainable investment as a key policy objective.

S&P Global Ratings sees the Action Plan on Sustainable Finance and specifically the development of an EU "taxonomy" of green activities as one of the most important developments in the sector in recent years. However, as with any major change, there are questions about implementation and implications for the capital markets. One of the main questions is whether the taxonomy can actually redirect capital flows toward a more sustainable economy.

In our view, a standardized, science- and evidence-based taxonomy could help dissipate widespread fears of greenwashing and, more importantly, may foster investments into a sustainable, low-carbon economy. However, while the proposed taxonomy is a well-shaped document, we believe its main focus now should be on reviewing what is considered eligible to gain more widespread market acceptance. The taxonomy should not be so strict that it becomes narrowly focused regulation for companies that are already green, without incentives for less green companies. Such an approach, in our view, may not allow the EU to meet its 2050 sustainability targets. Indeed, we believe what is considered "green" is worth reviewing regularly.

With the consultation period closing on Sept. 13, 2019, for the proposed green taxonomy by the EC's Technical Expert Group (TEG) on Sustainable Finance, S&P Global Ratings explores and attempts to answer the most frequently asked questions related to the proposal and what its implementation could mean for business and the capital markets.

Frequently Asked Questions

What is the Action Plan?

The EC's Action Plan, adopted in March 2018, intends to mainstream ESG considerations into capital markets and reorient capital flows toward sustainable investment. It contains 10 actions, some of which have already been translated into new legislation by political agreements between the European Parliament and the Council of the EU (see Appendix 1).

What economic activities are covered by the taxonomy?

The proposed taxonomy defines economic activities across multiple sectors that meet certain climate change mitigation and adaptation objectives of the EU, covering:

• Agriculture and forestry;
• Manufacturing;
• Electricity, gas, steam, and air-conditioning supply;
• Water, sewerage, remediation, and waste;
• Transport;
• Information and communication technologies; and
• Buildings.

The EU expects to add more activities in the future, including those that contribute significantly to the remaining four environmental objectives.

For climate change mitigation, the report presents a list of eligible economic activities. The taxonomy considers three kinds of activities that can make a substantial contribution to climate change mitigation:

• Activities that are already low carbon or are already compatible with a 2050 net-zero carbon economy (zero emissions transport, near-to-zero carbon electricity generation, and afforestation);
• Activities that contribute to a transition to a net-zero emissions economy in 2050 but are not currently operating at that level (building renovation, electricity generation <100g CO2/kWh); and
• Activities that enable those above (manufacture of wind turbines, installing efficient boilers in buildings).

The approach proposed for an adaptation taxonomy is different. It recognizes that adaptation is location- and context-specific. Therefore, it requires the use of a process-based approach to determine if an activity contributes to adaptation and climate resilience of a broader system. Hence, an adaptation taxonomy provides a set of guiding principles and screening criteria to assess the potential contribution of an economic activity to adapt to climate change and increase climate resilience, rather than a list of activities.

What are the proposed benefits of the taxonomy?

Sustainable-themed investments and financial tools are multiplying. Since 2007, $512 billion of green bonds have been issued globally, according to the Climate Bonds Initiative, and the figure is growing. The proposed EU taxonomy attempts to define which economic activities--for example, wind power generation--can be considered environmentally sustainable for the purposes of labeling economic activities (see sidebar). The aim of the taxonomy is to:

• Create a common language among sustainable finance professionals, companies, and investors;
• Articulate the importance of green economic activities to the market; and
• Help investors and companies to make informed investment decisions about environmentally friendly economic activities.

According to the High Level Expert Group on Sustainable Finance advising the EC, the taxonomy helps to overcome the accusations of "greenwashing" in the market by applying a harmonized standard for what can be marketed as environmentally sustainable or green. In fact, the EC has stated that a standardized taxonomy is a solution that can offer the market a homogenous approach, catalyze investment for green activities, and end discussions about gray areas in the sustainable finance market. Additionally, the taxonomy could boost research and development in new green technologies and direct capital toward activities that support improved environmental performance.

The taxonomy also attempts to align investments and close the financing gap to meet the 2015 Paris Agreement's climate commitments and the UN's Sustainable Development Goals (SDGs). The aim of the Paris Agreement is to keep the increase in the global average temperature to well below 2°C above pre-industrial levels and to pursue efforts to limit the temperature increase to 1.5°C above pre-industrial levels. The EU has set a target to cut greenhouse gas emissions (GHG) by 40% by 2030 and to adopt a net-zero emission goal for 2050 to meet its commitments under the Paris Agreement. However, achieving these targets will require substantial private investments in new low-carbon infrastructure and technologies--from greener buildings and industrial facilities to electric vehicle infrastructure and clean power generation capacity. According to the EC, the estimated annual investment gap to meet these targets is between €175 billion to €290 billion. The taxonomy attempts to support the market in redirecting private capital toward qualified low-carbon investments to meet the targets.

The SDGs are broader in scope and include a set of 17 global goals to address the world's biggest challenges, including those that are fit within the taxonomy, such as affordable and clean energy, climate action, clean water, and sanitation. The UN says achieving the SDGs will require between $5 trillion to $7 trillion, with an investment gap in developing countries of about $2.5 trillion.

Once implemented, the EC expects the taxonomy will help institutional and retail investors identify investment opportunities that meet a high standard of sustainability, construct portfolios, and monitor their impact. Furthermore, investors could use the taxonomy's criteria to screen investments or engage companies in their portfolios to understand their alignment with the taxonomy. Currently, the taxonomy is not binding, which allows investors to use their own methodologies if preferred.

Who could be affected by the taxonomy?

The taxonomy would apply to:

• EU member states and EU-level requirements for financial market participants in relation to financial products marketed as "environmentally sustainable" within the EU;
• Financial market participants who offer "environmentally sustainable" investments (or similar) in the EU; and
• Financial market participants who offer other products, unless they make clear that they are not pursuing sustainability objectives or impact.

Discussions are continuing about whether the legislation's scope would include banks and issuers.

Financial market participants that label or market themselves as sustainable would need to include information about whether their products or corporate bonds qualify as sustainable investments under the taxonomy in their disclosures. The taxonomy would enable them to determine the proportion of revenue from sustainable economic activities financed by the investment portfolio. The taxonomy would also support active ownership efforts: investors and companies may use the taxonomy to identify future growth opportunities.

What is excluded from the taxonomy?

As drafted, the taxonomy omits activities that either do not contribute toward or would be detrimental to climate change mitigation objectives. For example, while improving the efficiency of a coal-fueled power plant may provide short-term benefits in the form of reduced GHG emissions, this would not be considered consistent with taxonomy's long-term objective to support systemic decarbonization.

Additionally, the TEG (see Appendix 2) has recommended that nuclear energy not to be included in the taxonomy at this stage. Despite the potential of nuclear energy to contribute substantially to climate mitigation objectives, the prospective significant harm that the energy source could have to other environmental objectives (waste management, biodiversity, water systems, and pollution) appears to limit its potential for inclusion in the EU taxonomy.

What could be the obstacles in implementing the taxonomy?

The European Parliament and the EU Council member states still need to review and finalize the legislation governing the taxonomy. The TEG and the EC will also review the approach after the feedback period on the report concludes. As with any big change, there will be challenges in implementation. How these are addressed could shape the taxonomy and its use over time. Critics have so far mainly questioned how practical the taxonomy would be to implement, specifically:

Are the proposed thresholds too stringent?  The taxonomy specifies qualitative and quantitative thresholds to determine whether a technology is eligible to qualify as sustainable. In the current version, the thresholds for some activities are perceived as too strict and often misaligned with current market practices. Some financial market participants are concerned that if the thresholds of the taxonomy are too rigid or the scope is too narrow, it could potentially limit the sectors that are included and ultimately financed. This, in turn, could result in a reduction of the green investment universe to a small niche, which would undermine the taxonomy's goal to promote mainstream sustainability to consumers, investors, and issuers.

However, the threshold's stringency could be a double-edged sword. We would expect the taxonomy to be strict in order to elevate those activities that will enable the EU to contribute to the 2°C or lower targets of the Paris Agreement. On the other hand, this level of stringency may pose a risk for taxonomy development and acceptance by the market.

Transition activities: Could the criteria be too strict?  As a result of feedback from the market after the initial draft of the taxonomy was published in December, the TEG has broadened the scope of its taxonomy and included transitional activities that can temporarily be justified in order to help meet the EU's climate commitments. This was introduced to create a smooth transition period between the current state and a low-carbon or net-zero carbon economy and to foster such a transition, in the sectors that are not necessarily considered as green. This could be achieved by using currently available advanced technologies that are tending toward zero emissions.

Building renovation is an example of a transitional activity (see table 1). As not every building can have a carbon-neutral emissions profile, the TEG encourages energy-efficient renovations. Another example is that low-emission cars are eligible until 2025 with emissions <50g CO2/km, and only zero-emission cars and commercial vehicles will be eligible after that date. However, some transition activities in some sectors, such as the standards for the manufacture of cement and aluminum, could be considered to be too strict and too far from current market practices. This means only a limited number of companies would be able to meet the required criteria.

Table 1

The taxonomy's technical screening criteria for transitional activities will be subject to regular revision and will be phased out as the EU economy approaches a state of net zero emissions by 2050. TEG expects to tighten the criteria over time more so for sectors that do not align with a zero-net carbon economy. To remain relevant, the taxonomy should remain consistent with the Paris Agreement's goals and should not lock in emission-intensive activities in the long term.

The remaining questions are whether: 

• The EC is able to keep thresholds up to date in a fast-changing society,
• Heavy-emitting sectors are capable of catching up with the taxonomy criteria, or
• The thresholds should be lowered for the transitional period.

If the thresholds aren't lowered, there may be a risk of restricting the taxonomy to those sectors that are already green and discouraging sectors that have the potential to improve their environmental footprint.

Do market participants have enough resources to implement the taxonomy?

No taxonomy can be implemented overnight. In the case of the EU taxonomy, there will likely be a transition during which entities attempt to upgrade their reporting systems, while investors and other financial market participants decide whether to replace their existing classifications with the taxonomy. The EU taxonomy's implementation could be challenging and costly as it will require additional human resources, development of new methodologies for data collection and performance calculations, as well as modeling. It is possible that companies may require third-party involvement for certification audits at regular intervals. This may not be an obstacle to long-term use of the taxonomy. However, the EU should provide guidelines to different stakeholders to allow implementation of the taxonomy to be as fast and effective as possible.

Is there enough data for takeup of the taxonomy?

Data availability is probably the greatest obstacle to fast implementation of the taxonomy. For implementation to be feasible, we believe investors would need a specific data set about company or issuer performance. For example, some of the data points required include revenue or turnover breakdown by taxonomy-related activities or expenditure allocated to each taxonomy-related activity. However, barely any companies provide this level of detailed information today.

In light of this challenge, the TEG and the EC have developed climate-related disclosure guidelines that will serve as a supplement to the Non-Financial Reporting Directive. Updated guidelines encourage better corporate disclosure and specifically ask companies to provide their turnover broken down according to the taxonomy's classification. The guidelines also recommend that companies disclose their capital expenditure in activities compliant with the taxonomy. This forward-looking indicator could help investors to better assess companies' future performance and identify those that will have a competitive advantage in an environment of ever-stricter carbon regulations. However, guidelines that encourage disclosures are not the same as disclosure requirements. There is no guarantee that companies will take the new recommendations into account. If they don't, investors may find it difficult to obtain the necessary information for the taxonomy to function.

Appendix 1: 10 Actions To Promote Sustainable Finance

The Action Plan outlines 10 actions in three areas (see table 2).

Table 2

Appendix 2: About The TEG

The Technical Expert Group (TEG) on Sustainable Finance was established by the European Commission to assist in developing the Action Plan on Sustainable Finance. TEG has 35 members from civil society, academia, business, and the finance sector, as well as additional members and observers from the EU and international public bodies. TEG works both through formal plenaries and subgroup meetings for each work stream.

Related Research

S&P Global Ratings research

• Why Linking Loans To Sustainability Performance Is Taking Off, Sept 3, 2019
• How "Green" Are Telecom Green Bonds? Sept. 9, 2019
• Climate Change: Can Banks Weather The Effects? Sept. 9, 2019

Other research

• "A Union That Strives For More; My Agenda For Europe: Political Guidelines For The Next European Commission (2019-2024)," Ursula von der Leyen, European Commission, July 16, 2019
• "Transforming our world: the 2030 Agenda for Sustainable Development," UN, Oct. 21, 2015
• "Action Plan: Financing Sustainable Growth," EC, March 8, 2018
• "Taxonomy Technical Report," Technical Expert Group (TEG) on Sustainable Finance, EC, June 18, 2019
• "Financing Sustainable Growth," EC, 2019
• "Green bonds: The state of the market 2018," Climate Bonds Initiative, March 6, 2019
• "Impact investment to close the SDG funding gap," UNDP, July 13, 2017