Sustainable Finance Taxonomies: the Challenges of Moving from Vision to Action

Sustainable finance taxonomies are rapidly emerging in many countries and jurisdictions. Existing frameworks are regularly updated in terms of their scope and the robustness of their requirements. However, taxonomies are lagging behind on one key aspect – their implementation. While other voluntary and semi-voluntary sustainability standards have seen varying phasing-in rates, taxonomies seem to demonstrate a disappointingly slow uptake. The EU should take the lead, make alignment mandatory and persuade its partners to follow suit.

Originating from the natural sciences, taxonomies could be broadly defined as systems for naming and organizing things into groups that share similar qualities. Today, they are widely employed to identify and classify financial assets, products, and services that can help combat environmental degradation or advance social progress. Sustainable finance taxonomies are one of the most rapidly developing areas of financial regulations.

In 2023–2024, in many countries taxonomies were developed (Australia, Kenya, Uzbekistan, Singapore, Mexico), updated (EU, ASEAN, Indonesia), proposed (Egypt), or commenced (New Zealand, Canada, Turkey, Rwanda, Tanzania). Several other countries and regions also demonstrate different phases of taxonomy development and implementation.

In July 2023, UNEP presented the Common Framework of Sustainable Finance Taxonomies for Latin America and the Caribbean, and there are calls for a common taxonomy for Africa. These regional taxonomies, both already in place and planned, can be potentially the most impactful ones, as they ensure international and cross-jurisdictional interoperability and, therefore, provide a more transparent and predictable space for global investors.

EU: new sectors, but a slow uptake

The EU Taxonomy, designed to meet the EU’s climate and energy targets and reach the objectives of the European Green Deal is, by far, the most advanced and most detailed. Since 2020, Technical Screening Criteria (TSC) for climate change adaption and mitigation were already defined. In June 2023 TSC were added to the Taxonomy for the remaining environmental objectives: sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control and protection and restoration of biodiversity and ecosystems.

The update made it operationally viable to apply the taxonomy to a far broader range of sectors and activities beyond climate change adaptation and mitigation. At the same time, for some of the objectives – notably, biodiversity, TSC only exist for a very limited number of activities: hotels, holiday-, camping grounds and similar accommodation, and conservation projects, including restoration of habitats, ecosystems, and species. The second category is not strictly speaking an economic activity. It is not often a part of regular business processes in the private sector. However, municipalities and national governments may make use of it as part of their sub-sovereign or sovereign bond issuances.

From January 1, 2024, under the Disclosures Delegated Act , financial institutions, including banks, are obliged to report on the taxonomy eligibility and alignment. That is, to disclose ‘to what extent their activities are covered by the EU Taxonomy (Taxonomy-eligibility) and comply with the criteria set in the Taxonomy delegated acts (Taxonomy-alignment).’ The reporting metric is called the Green Asset Ratio (GAR), which is calculated as a share of a credit institution’s Taxonomy-aligned balance sheet exposures over the total eligible exposures. The GAR helps stakeholders understand what is the FI’s contribution to European environmental and climate objectives.

Limited effects

However, GAR has been criticised by many major European banks and the European Banking Federation in its 2024 position paper . The key concern raised by the financial sector is that the calculation methodology for the ratio excludes from its numerator key activities that are included in the denominator, which is the bank’s total exposure. For example, GAR does not account for any exposure to small and medium enterprises and SPVs (special purpose vehicles) often used for financing renewable energy projects as neither is subject to the Non-financial Reporting Directive (NFRD). If a bank is financing entities outside the EU it also does not contribute to increasing the ratio. In addition, GAR does not take into account any social activities (as they are currently not part of the Taxonomy) like affordable housing or education, which form a significant part of banks’ exposure (via mortgages and education loans) and contribute to sustainability.

Because of these limitations, the 2024 reporting results on the Taxonomy of the EU’s major banks appear disappointingly low. According to recent ING research , which covered 33 major European banks from 13 jurisdictions, ‘the average eligibility rate lies at 35%, 5pp ahead of last year. However, while some estimated this year’s average GAR to be below 10%, in reality, the average reaches just over 3%.’

Overall, GAR reporting is an important step towards the actual enforcement of the EU taxonomy. However, because of the methodological limitations on the one hand, and as there is currently no legislation requiring financial institutions to set specific time-bound targets on the eligibility and alignment of their portfolios on the other, the effect remains limited. There is also no stimulus for banks to perform better, as they are neither rewarded for demonstrating a high GAR, nor sanctioned for showing low figures.

Other regional taxonomies

Outside of Europe, Asia appears to be the most fast-growing region in terms of taxonomy development. So far, the Association of Southeast Asian Nations (ASEAN) is the only regional economic block, except for the EU, which already has supra-national sustainable finance frameworks – the ASEAN Taxonomy. The taxonomy is a dynamic tool, and it is continuously reviewed and updated to better reflect market expectations, as well as the most recent scientific knowledge and technological advancements.

The ASEAN Taxonomy has already undergone two revisions, and Version 3 (released on the 24th of March, 2024) is currently open for stakeholder consultations. Version 2 , effective as of February 2024, elaborated the technical screening criteria for the Energy sector, while the latest version also introduces technical screening criteria for two more focus sectors: Transportation & Storage and Construction & Real Estate. Future versions will likely incorporate criteria for forestry, fishing, agriculture, waste management, and manufacturing as part of a phased rollout.

Lagging behind

Despite the seemingly universal boom in taxonomies, not all countries and regions are equally successful in this global race. Even in those regions that do succeed, like the EU and ASEAN, taxonomies still only cover certain sectors, while most of their economies remain outside of scope. As it has been demonstrated in a recent report developed by Profundo on behalf of Fair Finance Asia, in most cases, it is the climate and energy-related activities that receive the most attention, while other environmental objectives, including biodiversity, as well as the plethora of social issues, largely remain in the shadows. Another research , focusing on the ocean-based economic sectors in the South-West Indian Ocean (SWIO) seascape, has demonstrated that Africa is still largely lagging behind other regions, and Taxonomy proliferation is still low. African countries that do have taxonomies, like South Africa and Kenya, are lacking in scope, with many important sectors, including those related to the blue economy, still not included. The US, the largest economy in the World, is also among the laggers. Even though developing a national classification for sustainable activities was considered by the US Commodity Futures Trading Commission ‘crucial’ for managing climate risks, little has been done so far to develop an actual taxonomy.

Dilemmas and pathways

Taxonomies are springing up worldwide. They grow and improve in terms of their scope, the robustness of their criteria, and the contexts where they can be applied. Yet, they are lagging behind on one crucial aspect - implementation.

Currently, only reporting obligations on taxonomy eligibility and alignment apply to companies subject to the Corporate Sustainability Reporting Directive (CSRD). That is, they have to disclose how much their activities are covered by the Taxonomy and meet its criteria. The requirements apply to both financial and non-financial corporations. The key drawback is that the obligation concerns only the reporting, not the actual target-setting. Thus, there are no requirements for non-financial corporations to align a certain share of their operational expenses and investments with the Taxonomy, nor any such requirements for banks and asset managers to align their portfolios with it. To make the Taxonomy work, it is crucial to set such requirements for all economic sectors it covers or is planned to cover. The phasing-in of such mandatory targets does not have to be steep and drastic, but it has to be inevitable. The targets have to be ambitious, and at least in line with the 1.5 degrees pathway, as far as climate-related objectives are concerned.

Mandatory alignment targets

Setting mandatory alignment targets for the portfolios of the financial institutions could then be a second step. Like many other economic sectors before, the financial sector has been mainly relying on voluntary standards for integrating ESG considerations into its decision-making and business models. This strategy has been relatively successful and has borne certain fruits. Green and sustainable debt has been - and still is - on the rise for both credit and capital markets, including corporate, municipal, and sovereign issuances. New instruments emerged and flourished, including an array of sustainable trade finance tools and derivatives. A number of leading banks have adopted sector policies for financing climate- and deforestation-risk sectors; phasing out coal and limiting Arctic oil and gas exposure is becoming more common. However, the success achieved so far is also limited, as policies are often still not very robust and do not always lead to changes in portfolios fast enough.

But for taxonomies, things look far less bright. Even in the EU, where taxonomy reporting is obligatory, we see disappointingly low rates of both eligibility and alignment. On average, around 20% of companies ’ capital investments are aligned with the EU Taxonomy. It’s harder to assess how far taxonomies are actually applied in other jurisdictions, but some examples (notably, South Africa) show that even very well-designed best-in-class taxonomies are hardly applied.

Incentives

Across jurisdictions, Central Banks and financial regulators are facing a hard choice: whether to make taxonomy regulations obligatory - including requirements and commitments for banks and investors to align their portfolios - or to provide incentives to reach the same objective. These incentives could include, for example, subsidising interest rates on sustainable debt or automatically making green, social and sustainable bonds qualify for the Central Banks’ collateral frameworks, while simultaneously excluding brown bonds from the collateral frameworks. The first path means creating a regulatory burden for banks and investors and, as the financial sector lobbyists would say, affecting competitiveness. However, this does not necessarily have to be the case. On the contrary, excluding brown bonds from the collateral framework and giving preferential access to green bonds would support the competitiveness of banks that quickly align with the taxonomies.

Sticks and carrots

The second path adds pressure on the national budgets, as many incentives will have to be paid for by the taxpayers. Therefore, the most likely option would be to come up with a strategy based on a combination of sticks and carrots, including both more stringent legislation and a number of incentives. Such an approach may look the most likely – as it’s relatively convenient for both the regulators and the financial sector. However, it is definitely not the optimal one for the environment, and the society at large.

The narrative that strict regulations undermine Europe’s competitiveness is not fully justified, as numerous jurisdictions (with a notable and disappointing exception – the US) are also developing and (though less successfully) trying to enforce their taxonomies. If the EU takes the lead and persuades its key trading partners to follow suit, and if taxonomy-alignment targets are made obligatory across jurisdictions, a level playing field will be created, and the planet and our societies will benefit without jeopardizing economic prosperity.

Pavel Boev is researcher supply chains and finance at Profundo. For further information, please contact [email protected] .

(Photo: gaston-roulstone on Unsplash)