EU Taxonomy – Room for Improvement

    Stockholm (NordSIP) – At a recent event organised by Schroders, NordSIP heard from Flemming Hedén, Senior Advisor at the Climate policy unit of Naturvårdsverket, Sweden’s environmental protection agency, about the EU’s sustainable investment taxonomy. The framework is an excellent first step, but investors and policy-makers should be aware of its trade-offs and keep a flexible and adaptable approach to it.

    The taxonomy is a classification system for sustainable activities devised by a technical expert group (TEG) to facilitate €175-290billion in annual investments necessary to achieve the 2015 Paris Agreement’s climate goals. The recommendations of the TEG were released in the middle of June and are the blueprint of legislation proposed by the European Commission.

    According to the Senior Advisor, the goal of the taxonomy is to facilitate investments compatible with the commitments made by the parties to the Paris Agreement. It echoes article 2.1c of the agreement: “Making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.” At its core, the purpose of the taxonomy is to create a classification of economic activities and assets that can help investors finance the transition to a net-zero carbon economy by 2050.

    However, the taxonomy is not perfect. There are pros and cons to the proposed legislation in Hedén’s personal opinion.

    Pros – A much needed, flexible benchmark

    Starting with the positive, Hedén emphasises just how important it is that the EU is taking the lead in defining sustainable investments. The taxonomy is a crucial first step that brings in policymakers to resolve a problem the market was unable to resolve. The classification system provides a homogenous, transparent and technical benchmark of what investors can call “green”. It creates a single standard for everyone, which clears confusions and facilitates cross border investment flows towards the green transition.

    At the same time, the framework is not the final word on the classification of sustainable investments. The proposed taxonomy was designed to be upgradeable and to remain flexible for investors to implement.  Under the current proposal, investors who market environmentally-sustainable funds will disclose how they use the taxonomy when determining if an investment is sustainable. Investors are also expected to divulge the share of their funds that they invest in taxonomy-eligible activities. Alternatively, investors can use the taxonomy as a benchmark in case they have an alternative methodology that they prefer.

    Cons – Adaptability, Uncertainty, Heterogeneity and NACE Costs

    However, the taxonomy involves trade-offs. The adaptability built into the framework matters because the classification system aims to be a tool meant to facilitate a transition to a zero net carbon emissions economy. Flexibility is essential to avoid sticky regulations and lock-in effects. According to the senior advisor, it is crucial to recognise that today’s rulebook will not necessarily be suitable for the future.

    What may initially qualify as a green investment will not necessarily stay so in the future. The need for flexibility is particularly important in terms of defining sustainable energy sources. Hedén noted that while all TEG contributors were very keen on wind power, support for natural gas was more problematic and might be phased away further down the line. The ability of the taxonomy to adjust in the future is desirable, but it may also create uncertainty and instability.

    The imposition of a single rulebook will also clash with different views across the Union. Using the example of energy again, Hedén noted that while France considered nuclear power to be sustainable, Germany did not endorse the same view.

    Methodologically, the taxonomy relies on the EU’s economic activity categorisation system (NACE), which differs from how investors usually define investment sectors and industry segments (GICS for examples is more widespread). Learning how to use NACE may be impractical and, ultimately, costly for the financial industry.

    The taxonomy will be a fundamental tool for investors seeking to understand what sustainability means. However, it is not the last word on the matter, and it won’t be cheap or easy. Sorting through noise and confusion seldom is.

    Image © NordSIP

    Filipe Albuquerque
    Filipe Albuquerque
    Filipe is an economist with 8 years of experience in macroeconomic and financial analysis for the Economist Intelligence Unit, the UN World Institute for Development Economic Research, the Stockholm School of Economics and the School of Oriental and African Studies. Filipe holds a MSc in European Political Economy from the LSE and a MSc in Economics from the University of London, where he currently is a PhD candidate.

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