The flow of capital required for emerging markets and developing economies’ energy transition is insufficient. This global misallocation of funds is grounded in various factors, such as inherent biases against EMDEs in environmental, social and governance screenings, greenwashing fears and inadequate ESG data. This means that countries most vulnerable to climate change face increasing barriers in cost and access to capital necessary for their net-zero transitions.

As EMDEs account for around two-thirds of global greenhouse gas emissions, this misallocation is a missed opportunity to advance significant environmental and social imperatives that are internationally recognised in the Paris Agreement and the United Nations' sustainable development goals. A differentiated approach to sustainable finance is needed to accelerate the transition for developing economies.

Such an approach would acknowledge the differing needs of developed and developing markets. The former requires a cleaner energy mix and the latter requires increasing amounts of clean, affordable and accessible energy. Beyond these considerations, this approach would better reflect the current measurement problem negatively affecting EMDEs’ transition credibility assessments.

However, difficulties arise when the emissions for goods consumed in developed markets – such as extracting key transition materials – are ‘exported’ to the EMDEs where they are produced. Less prosperous countries (as measured by Human Development Index) have lower levels of economic and climate resilience, meaning that EMDEs with lower income per capita levels are less able to fund their net-zero transition. To add, Oxfam estimates that people in poorer countries are, on average, five times more likely than people in richer countries to be displaced by extreme weather events. Where the needs of developed and developing markets vary, so does the impact.

While EMDEs require greater energy usage for mitigation and adaptation purposes, their infrastructure is carbon-intensive and young in terms of asset life. This reflects a stronger trade-off between growth and decarbonisation aims in EMDEs relative to developed markets.

The Global Commission on Adaptation estimates that every dollar invested in climate resilience could result in between $2 to $10 in net economic benefits – not taking into account the spillover impact. To mobilise environmentally concerned investors, regional and country taxonomies have sought to classify the sustainability of investment opportunities and improve market clarity. But for taxonomies to improve cross-border capital flows and address the wider transition-related challenges of EMDEs, they must clearly and consistently distinguish between sustainable, green and transition finance.

To address this, the European Union taxonomy regulation treats transition finance as a subset of sustainable finance and defines sustainability solely in environmental terms (see articles 1(1) and 10(2)). On the other hand, the Association of Southeast Asian Nations taxonomy for sustainable finance conceptualises sustainable finance more broadly. It prohibits harmful interference with ‘social aspects’, including the prevention of forced labour and the management of investment-related impacts on people in at-risk areas. While the European Commission embarked on a taxonomy to classify socially sustainable activities, this project was indefinitely halted last year.

Another key difference is the classification of coal phase-out activities, which are prohibited under the EU taxonomy, yet permitted – under different circumstances – in both the Asean and Climate Bonds Initiative taxonomies.

Differing definitions

What constitutes ‘green’, ‘transition’ or ‘sustainable’ finance appears to be inconsistent, resulting in market fragmentation and impeding energy transition financing. Therefore, we must question whether sustainable finance taxonomies should treat all regions the same, given their needs and priorities markedly differ.

As a regulatory trailblazer, the European Commission may have opted for relatively strict classifications to avoid triggering a ‘race to the bottom’ that permits the financing of high-emitting activities. Simultaneously, the transition for EMDEs requires a wider range of economic activities where, unlike developed markets, building renewable energy is not always the highest priority. Economic activities like affordable housing and education are likely to improve per capita income and boost climate resilience levels in EMDEs. However, it would be confusing to think of such activities as ‘environmentally sustainable’.

Figure 1. Emissions reductions for net zero by 2050 relative to the Stated Policies Scenario

Source: International Energy Agency

A broader definition of transition finance would centre around decarbonisation while encompassing activities that move EMDEs towards both the Paris Agreement targets and the UN’s sustainable development goals in a timebound manner. This would mean understanding transition finance as activities that support emissions reductions in all regions (see Figure 1), not solely the ‘build low emissions’ region, which interpretations of the EU taxonomy have focused on.

If defined in this context, transition finance can channel capital to the most high-impact areas, including high-emitting sectors that fall outside the scope of other sustainability financing instruments. Taxonomic consistency may lie in a deliberately differentiated approach to sustainable finance that targets the various development challenges faced by EMDEs.