Few topics in the sustainable bond market are being discussed as hotly and controversially as the European Union’s sustainable finance taxonomy and the European green bond standard. Key actions in the European Commission’s 2018 action plan on financing sustainable growth, and part of the European Green Deal, the initiatives have been widely criticised by investors and issuers.
The EU taxonomy is a classification system that provides companies, investors and policy-makers with appropriate definitions for environmentally sustainable economic activities. The European green bond standard is a voluntary measure to help scale up the ambitions of green bonds. It has two main objectives: supporting the growth of the green bond segment and promoting its transparency and integrity.
The big challenge with the EU taxonomy is that it has to be both ambitious and implementable. The framework is meant to change over time, but many issuers and investors complain that the taxonomy could become too complex. While the technical screening criteria for climate change mitigation are quite straightforward (the focus is exclusively on carbon dioxide emissions), the criteria for the remaining four environmental goals are more complex as they cannot be reduced to a single indicator. Furthermore, it is limited in the economic activities covered.
Too much complexity could deter project owners from sustainable (re-)financing. Instead, they will most likely opt for traditional borrowing. This could lead to sustainability-orientated investors having fewer investment options to choose from.
Further criticisms include excessively demanding general criteria and too restrictive criteria concerning transition activities from hard to abate sectors that have a negative impact on competitiveness. Other critics have denounced a non-proportional administrative load, the lack of regional context and the need for consistent taxonomy alignment at entity and product level.
However, some critics accuse the taxonomy of being too lax. One complaint is that the discussion about what qualifies as green has shifted from a scientific to a political perspective. Many people regard the taxonomy’s inclusion of nuclear and natural gas as a setback. While natural gas can be seen as a bridging technology as it produces fewer emissions than coal, nuclear energy – a high-risk technology with a long transition period – is condemned by many as unsuitable for a sustainable future.
The success of the European green bond standard is closely linked to developments in the EU taxonomy, which will be crucial for building the standard’s acceptance among sustainability-orientated investors.
Many issuers assume that, due to the demanding thresholds for some 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.
The call of some market participants for lower alignment thresholds has gone unheard so far. For this reason, many issuers are still structuring their frameworks in accordance with the International Capital Market Association’s green bond principles. They acknowledge the need for the taxonomy and try to identify the positive contribution of the use of proceeds to environmental goals. There will be most likely be a co-existence between ICMA 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. Special attention should be paid to the latter, as we cannot implement the global sustainability agenda by painting already green activities one shade greener. Rather, we need to enable 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-orientated investors who have not invested in nuclear power so far will not do so in the future, regardless of whether the taxonomy allows it. Therefore, the taxonomy may be ‘political greenwashing’ in some places, but not from the perspective of investors.
In the interests of feasibility and acceptance, the EU should ensure that the taxonomy does not develop into a bureaucratic hurdle for financial market participants. Some guidance is necessary, but over-regulation would be detrimental to the goal 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 taxonomy alignment ratio in the future, they are likely to prefer European green bonds to 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 reality, no market participant should be able to escape it.
Marcus Pratsch is Head of Sustainable Bonds & Finance, DZ BANK AG.