Few topics in the sustainable bond market are discussed as heatedly and contentiously as the European Union’s Sustainable Finance Taxonomy and the European Green Bond Standard. Key actions from the European Commission’s 2018 Action Plan on Financing Sustainable Growth and part of the European Green Deal, the initiatives have been widely criticized by investors and issuers.
The EU Taxonomy is a classification system that provides businesses, investors and policy makers with appropriate definitions for environmentally sustainable economic activities. The European Green Bond Standard is a voluntary measure to help increase the ambition of green bonds. It has two main objectives: to support the growth of the green bond segment and to promote its transparency and integrity.
The big challenge for the EU taxonomy is that it must be both ambitious and achievable. The framework is meant to change over time, but many issuers and investors complain that the taxonomy could become too complex. While the technical selection criteria for climate change mitigation are quite straightforward (the focus is exclusively on carbon dioxide emissions), the criteria for the remaining four environmental objectives are more complex as they cannot be reduced to a single indicator. Moreover, it is limited in the economic activities covered.
Too much complexity could dissuade project promoters from (re)financing sustainably. Instead, they will most likely opt for traditional borrowing. This could lead to sustainability-focused investors having fewer investment options to choose from.
Other criticisms relate to overly demanding general criteria and overly restrictive criteria concerning the transition activities of hard-to-reduce sectors which have a negative impact on competitiveness. Other critics have denounced disproportionate administrative burden, lack of regional context, and the need for consistent taxonomic alignment at the entity and product level.
However, some critics accuse the taxonomy of being too lax. One complaint is that the discussion of what is considered green has shifted from a scientific perspective to a political one. Many people see the inclusion of nuclear and natural gas in the taxonomy as a setback. While natural gas can be considered a transition technology because it produces fewer emissions than coal, nuclear power – a high-risk technology with a long transition period – is condemned by many as unsuitable for a future. sustainable.
The success of the European Green Bond Standard is closely linked to the evolution of the EU taxonomy, which will be crucial in gaining acceptance of the standard by sustainability-focused investors.
Many issuers assume that due to demanding thresholds for certain activities, few issuers will initially be able to demonstrate 100% alignment with the European Green Bond Standard. This is especially true for past activities and assets.
Calls by some market players to lower the alignment thresholds have so far gone unheeded. For this reason, many issuers still structure their frameworks in accordance with the International Capital Market Association’s Green Bond Principles. They recognize the need for taxonomy and attempt to identify the positive contribution of revenue use to environmental goals. There will most likely be coexistence between ICMA’s GBP-aligned green bonds and European green bonds for some time to come.
Acceptance of the EU taxonomy will involve carrying out genuine sustainable activities or initiating transitional activities. Particular attention must be given to the latter, as we cannot implement the global sustainability agenda by painting already green activities a greener hue. Rather, we must allow brown activities to transition to light brown or light green. This has been evident in the market for some time, as more and more asset managers are living the new credo: “transform instead of divest”.
Many investors will take a pragmatic approach to critical activities. For example, sustainability-focused investors who have not yet invested in nuclear energy will not do so in the future, whether the taxonomy allows it or not. Therefore, the taxonomy may be “political greenwashing” in some places, but not from an investor perspective.
In the interest of feasibility and acceptance, the EU should ensure that the taxonomy does not become a bureaucratic hurdle for financial market participants. Some guidance is needed, but excessive regulation would be detrimental to the objective of growing the sustainable finance market.
European sovereigns, sub-sovereigns, supranationals and agencies are likely to align with the European Green Bond Standard as a result of political pressure. Since investors will also be benchmarked by the taxonomic alignment ratio in the future, they are likely to prefer European green bonds over non-European green bonds. Moreover, if the European Central Bank’s recommendation that the EU should make its green bond standard mandatory within five years becomes a reality, no market player should be able to escape it.
Marcus Pratsch is Head of Sustainability Bonds and Finance, DZ BANK AG.
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