5 Green taxonomies

There have been significant efforts to ensure the proper classification of sustainable investment opportunities and in some cases to encourage investment in these opportunities. Similar to how investments at risk of becoming stranded are identified, unique security identification numbers and third-party data products can be employed to determine whether particular securities are in a sector that is traditionally viewed as sustainable, such as renewable energy or electric vehicle production. Numerical identifiers and third-party data products can also be used to determine the percentage of revenue that companies are generating from enterprises that are traditionally viewed as within sustainable sectors and the percentage of electricity that utilities are generating from sources that are traditionally viewed as within sustainable sectors. Together the numerical identifiers and third-party data products can be used to run an automated analysis across an investment portfolio to quickly identify the prevalence of investments that have traditionally been viewed as sustainable.

However, because of concerns raised with the manner in which securities have traditionally been labeled sustainable, governments and nonprofit organizations are instead developing more robust methodologies for identifying sustainable or green investments rather than relying on exclusively on existing numerical identifiers and third-party data productions. Through stakeholder engagement, government and nonprofit organizations have been developing their own classification systems for identifying sustainable investments, which are generally referred to as green taxonomies. These taxonomies have allowed for the inclusion of investments in a greater number of sectors than simply those traditionally viewed as within sustainable sectors and have taken into account additional considerations. These taxonomies are currently mapping to sector information, and third-party data product providers have been developing third-party data products that will further link green taxonomy classifications with security identification numbers. As these tools develop, numerical identifiers and new third-party data products can be used to run an automated analysis across an investment portfolio to quickly identify the prevalence of investments that are viewed as sustainable under green taxonomies.

Notable among efforts to classify green investments is the development and implementation of internationally recognized Green Bond Principles. There have also been efforts to harmonize green bond taxonomies currently in use, in particular between the Climate Bonds Initiative (CBI) and that of the Chinese government. A European Union Green Bond Standard is also being developed as part of its larger European Union sustainable finance strategy that includes a European Union taxonomy.

5.1 Chinese efforts

5.1.1 Guidance on Green Loans

The Chinese government has been the first government to aggressively push green investments. The Chinese government first encouraged green lending by developing green loan guidance. In 2013, the China Banking and Insurance Regulatory Commission established standards for green loans through its Guidance on Green Loans (CBIRC 2012; NGFS 2019, 34). After the publication of this Guidance, the China Banking and Insurance Regulatory Commission has required all large banks to report twice a year on the balance of and environmental benefits from a dozen categories of green loans. This Guidance has helped lead to a significant amount of green loan activity, with China’s banks now having over a trillion dollars or approximately ten percent of their loan balance in green investments (CBIRC 2012; NGFS 2019, 34).

5.1.2 Green Bond Endorsed Project Catalogue

The Chinese government followed up its green loan guidance by introducing the first national-level green bond taxonomy. In 2015, the People’s Bank of China’s Green Finance Committee of the China Society for Finance and Banking published the Green Bond Endorsed Project Catalogue (PBOC 2015; NGFS 2019, 34). The Catalogue detailed six main categories and thirty-one subcategories of projects eligible for green bond financing (PBOC 2015; NGFS 2019, 34). The six main project categories are listed in Table 5.1.

Although use of the Catalogue is not mandatory, essentially all Chinese issuers, investors, and verifiers use it. In only a few years, Chinese financial institutions have issued over one hundred billion dollars in green bonds, accounting for roughly a quarter of green bonds issued from 2016 to 2018. This has made China one of the world’s biggest green bond markets. Chinese regulators have also introduced rules and guidelines on green bond disclosures and verification (PBOC 2015; NGFS 2019, 15, 34).

Even with the onset of the COVID-19 pandemic, China is still focused on ensuring a transition to a low-carbon economy. Led by General Secretary and President Xi Jinping, the Politburo Standing Committee has dedicated over a trillion dollars to a range of low-carbon technologies (Worland 2020). It is not entirely clear how funding will be connected with China’s guidance on green loans and the Green Bond Endorsed Project Catalogue, but it is likely that capital will be directed to projects identified as green under these efforts.

5.2 Nonprofit efforts

5.2.1 Green Bond Principles

Outside of China, there have been a number of other efforts to label financial assets as environmentally sustainable or green, especially in private capital markets. This has helped direct investment to such assets, including green loans, green bonds, and green funds. With a number of organizations identifying assets as green and with little oversight as to what constituted green, there were growing concerns over organizations inappropriately labeling securities as sustainable or green, or “greenwashing.” To address these concerns, several international investment banks collaborated in 2014 to create voluntary best practice guidelines for the asset type with the most developed taxonomies and markets, green bonds (EU 2019b, 16). The voluntary best practice guidelines, called the Green Bond Principles, better ensure proper certification of bonds as green, with funds being directed appropriately to specific projects. The Green Bond Principles detail best practices that include guidance on the use of proceeds, project evaluation and selection, proceed management, and reporting (GBP and ICMA 2018; CBI 2020).

To begin with, the Green Bond Principles specifically recognize several broad categories of eligible green projects that are appropriate for proceeds, including the following: climate change mitigation, climate change adaption, natural resource conservation, biodiversity conservation, and pollution prevention and control (GBP and ICMA 2018, 4). These project categories are displayed in Table 5.2.

Next, the Green Bond Principles encourage transparency for project evaluation and selection. First, a green bond issuer should clearly explain the environmental sustainability objectives to investors. Second, a green bond issuer should explain to investors the process used to determine how a project fits within eligible green bond project categories. Third, a green bond issuer should identify any related eligibility criteria. The Green Bond Principles further recommend supplemental external review for these considerations (GBP and ICMA 2018, 5).

Further, the Green Bond Principles provide detailed guidance on the management of proceeds. This includes the issuer segregating net proceeds of a green bond to a subaccount, moving them to a subportfolio, and formally attesting to them. As long at the green bond is outstanding, the issuer should also periodically adjust the balance of the net proceeds to match allocations made to eligible green bond projects and update investors on the intended types of temporary placement for the balance of unallocated net proceeds. The Green Bond Principles also recommend that an auditor or other third party verify the internal tracking methodology and allocation of funds from the green bond proceeds (GBP and ICMA 2018, 5).

Finally, the Green Bond Principles discuss favored reporting processes. The Green Bond Principles support the use of annual reports showing a list of projects where green bond proceeds have been allocated, with a brief description of the projects, the amounts of proceeds allocated, and their expected impact. Until the full allocation of proceeds, the Green Bond Principles also dictate that an issuer should be able to readily provide current information on a timely basis in case of material developments. With respect to how information is categorized, the Green Bond Principles recommend the use of at least transparent qualitative performance criteria and transparent quantitative performance criteria where feasible. For certain project types, there are also voluntary guidelines aimed at facilitating more consistent reporting (GBP and ICMA 2018, 5).

The European Investment Bank, which is owned by the countries within the European Union, chairs the Steering Committee of the Green Bond Principles. The European Investment Bank is also the world’s largest issuer of green bonds (EIB and GFC 2017, 20). An independent secretariat hosted by the International Capital Market Association monitors and develops guidelines for the Green Bond Principles (EU 2019a, 16, 32–35).

5.2.2 Climate Bonds Initiative

Certification programs label debt instruments as green bonds when they are issued and proceeds are maintained in conformance with green bond practices, such as those described within the Green Bond Principles. One of the most prominent certification programs is the CBI certification program. The CBI certification program essentially takes the broad structure articulated in the Green Bond Principles and creates a workable classification system for labeling green bonds. The CBI certification program uses a “Climate Bonds Certified” label to identify debt instruments that can appropriately be labeled as green bonds under the Green Bond Principles and any additional requirements imposed by the CBI (CBI 2017, 3). This label provides investors with confidence that they are purchasing a green asset when buying such a debt instrument.

In order for a debt instrument to obtain a Climate Bonds Certified label, an issuer needs to have a third-party CBI approved verifier provide a verified statement that a bond meets the CBI standard (CBI 2017, 4–5). To meet the CBI standard, the proceeds from a debt instrument must fund a CBI eligible project. This includes a project that conforms with a CBI taxonomy that is essentially a detailed sector and subsector project listing that corresponds with requirements under the Green Bond Principles. This includes eight categories of projects: energy, transport, water, buildings, land use and marine resources, industry, waste, and information and communications technology. There are also subcategories to each of these with their own corresponding guidance (CBI 2017, 8, 15). In addition, to meet the CBI standard, use of proceeds, tracking, and reporting need to abide by CBI mandatory requirements that are modeled on the Green Bond Principles (CBI 2017, 3–13).

In a TCFD and French Energy Transition Law aligned report, AXA explained how the CBI label is used in practice. AXA has invested several billion dollars in green bonds making sure that these bonds are externally labeled by CBI and rating agencies that confirm that CBI taxonomy has been appropriately used and the proceeds are properly used. AXA also makes sure that bonds satisfy additional criteria that are tailored for specific project types (AXA 2020, 31).

The NGFS has explained ideals for green taxonomies. According to the NGFS, policymakers should ensure that a taxonomy is robust and detailed enough to allow for the certification of green assets and investments projects. A taxonomy should also prevent greenwashing (NGFS 2019).

Policymakers are working on harmonizing taxonomies in different jurisdictions. For instance, in 2017, the China Green Finance Committee and the European Investment Bank published a joint white paper entitled “The Need for a Common Language in Green Finance.” This was followed by a second edition in 2018. The white paper effort compares different green bond taxonomies and describes a potential strategy for harmonization of green bond taxonomies. This includes the work of the European Investment Bank to create translations for taxonomies so that categories of projects are comparable (EIB and GFC 2017).

5.3 European Union efforts

The European Commission has also been developing a sustainable investment strategy (EC 2018). This sustainable investment strategy is part of the European Commission’s long-term sustainability objective of achieving carbon neutrality by 2050. The European Commission believes that the European Union needs to fill an investment gap of nearly three hundred billion dollars per year in order to reach its long-term sustainability objective of achieving carbon neutrality, and the European Commission’s sustainable investment strategy is necessary to achieve this objective (EU 2019b, 85, 2020a, 8).

5.3.1 European Union taxonomy

The European Commission established a Technical Expert Group on sustainable finance to assist with developing legislative proposals for its sustainable finance strategy. This Technical Expert Group includes thirty-five members from fields such as academia and finance and observers from the European Commission and international bodies. The legislative proposals include a European Union taxonomy on when it is appropriate to classify financial activities as sustainable or green and a European Union green bond standard (EU 2019c, 16–18, 2020a, 10–12).

The European Union taxonomy has an overarching classification system for determining whether a financial activity can be identified as environmentally sustainable. For an economic activity to be identified as environmentally sustainable, it needs to (i) substantially contribute to at least one of six environmental objectives, (ii) do no significant harm to any of the other six environmental objectives, and (iii) comply with minimum safeguards (EU 2019c, 19, 2020a, 2). The six environmental objectives are climate change mitigation, climate change adaptation, 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 (EU 2019c, 19, 2020a, 2). To comply with minimum safeguards, financial activity must also abide by the UN Guiding Principles on Business and Human Rights and the OECD Guidelines for Multinational Enterprises, including the principles and rights set out in the eight fundamental conventions identified in the International Labor Organization’s declaration of Fundamental Rights and Principles at Work and the International Bill of Human Rights (EU 2019c, 19, 2020a, 2).

The plan for the European Union taxonomy and related technical screening criteria is what will act like a dictionary for sustainable activities (EU 2019c, 19, 2020a, 51–55). A user of the taxonomy can look up a particular sector or subsector and determine the criteria and thresholds necessary to meet in order to show meeting one of the six environmental objectives that has been identified by the European Commission as important for achieving its long-term sustainable objective. A user of the taxonomy can also look up a particular sector or subsector and determine the criteria to find guidance that can be used to help ensure that the other environmental objectives are not significantly harmed in meeting an environment objective. If an activity is not classified, it does not mean that it is brown or not sustainable, it just means that the activity has not currently been classified. For a fund, rather than a single activity, a user would be able to identify the percentage of the fund that fits the European Union taxonomy.

The European Union taxonomy and especially related technical screening criteria are dynamic. They will develop over time through consultation with stakeholders. They will require continuous updates to be kept current, taking into account new policy and technological innovations (EU 2019c, 22, 2020a, 54–55). A recently released Taxonomy Technical Report was several hundred pages in length, with the majority of pages dedicated to information on technical screening criteria for specific sectors and subsectors. This detailed how the taxonomy could be applied to sectors and subsectors and provided corresponding industry classifications (EU 2019c, 107–414, 2020b).

Financial institutions are not required to use the European Union taxonomy, but it must be used when marketing financial products as environmentally sustainable or green. Along these lines, European Union countries that are setting up policies for the marking of financial products as financially sustainable or green must also take into account the European Union taxonomy when doing so (EU 2019c, 57–59, 2020a, 26). In the future, investors may also put pressure on financial institutions to disclose their activities according to the European Union taxonomy.

5.3.2 European Union Green Bond Standard

As the centerpiece of the European Commission’s sustainable finance strategy, the European Union taxonomy sets up a classification system for another important part of the European Commission’s sustainable finance strategy, the European Union Green Bond Standard. In essence, the European Union has developed a European Union Green Bond Standard that allows for certification of green bonds in connection with the guidance of the European Union taxonomy. The Technical Expert Group recommends that this European Green Bond Standard should be a standard that most green bond issuers will be able to comply with for new issuances and which could even allow issuers the option of aligning their existing bonds (EU 2019a, 16–17, 2019b, 23–24, 2020c, 11).

As far as the structure of the green bond market itself, the Technical Expert Group has recognized that the European Union Green Bond Standard should be built on market best practices (EU 2019b, 23, 2020c, 11). Today, the green bond market consists of over six hundred billion dollars in capital, with major issuers based in Europe, North America, and Asia-Pacific (EU 2019b, 16, 2020c, 11). The creation of the Green Bond Principles and their adoption by the vast majority of issuers greatly facilitated standardization within the green bond market (EU 2019b, 16). The Technical Expert Group acknowledged that European and international green bond markets generally operate appropriately through best practices embodied within the Green Bond Principles. Therefore, while the structure for evaluating eligible projects differs, the Green Bond Principles are the starting point for the European Union Green Bond Standard with similar procedures for issuing, verifying, and reporting on green bonds (EU 2019b, 23–24, 57–61). Relying as much as possible on an existing green bond taxonomy and best practices in the green bond market allows for the European Union Green Bond Standard to be actionable and operational in the short term (EU 2019b, 23–24).

With respect to the classification system for eligible projects, green bond proceeds must be allocated only to green projects, which are defined as contributing substantially at least one of the European Union taxonomy’s six environmental objectives while not significantly harming any of the European Union’s other environmental objectives and complying with the minimum safeguards represented in the UN Guiding Principles on Business and Human Rights and the OECD Guidelines for Multinational Enterprises, including the principles and rights set out in the eight fundamental conventions identified in the International Labor Organization’s declaration of Fundamental Rights and Principles at Work and the International Bill of Human Rights (EU 2019b, 57–58, 2020c, 14). Eligible green projects are also expected to be aligned with technical criteria issued for the European Union taxonomy (EU 2019b, 58, 2020c, 14). Specifically, where technical screening criteria have been developed for specific sectors and subsectors, eligible green projects shall align with these criteria, except in exceptional circumstances where the criteria may not be directly applicable because of factors such as a project’s innovative nature, complexity, or location (EU 2019b, 58, 2020c, 14). It is further understood that subsequent changes to the European Union taxonomy will not apply to green bonds that have already been issued. Their status as green bonds will effectively be grandfathered (EU 2019b, 59, 2020c, 32). In Table 5.3 are the three primary steps for green bond classification that model the European Union taxonomy classification system.

A financial institution marketing a financial product as green or sustainable is responsible for ensuring that all three steps are met and that the financial product is not at odds with published European Union taxonomy technical screening criteria unless otherwise justified. Presumably, there will be areas of contention over whether certain steps are satisfied. Contentions are possibly likely to occur where there is a conflict between the first and second or third steps, especially where the European Union taxonomy technical screening criteria does not provide specific guidance. As time passes, however, it is likely that European Union taxonomy technical screening criteria will work to resolve some of these contentions. Moreover, third-party data product providers will develop tools linking security identification numbers with green classifications. For equity, this would likely consist of a percentage of greenness. For debt, this would likely consist of either a green classification or no green classification.

Issuing green bonds should occur in the following manner. An issuer of green bonds shall produce an issuing framework. The framework shall describe, for instance, how its issuing strategy aligns with the objectives of the European Union Green Bond Standard and the most current version of the European Union taxonomy, the green projects to be financed or refinanced with green bonds, and reporting detailing the methods for doing so and the frequency. The issuer should publish its framework before or when issuing green bonds and make the report available until the maturity of the green bonds (EU 2019b, 28–31, 2020c, 20–24).

Verifying green bonds should occur in the following manner. Issuers should appoint external reviewers to confirm alignment with the European Union Green Bond Standard and the most current version of the European Union taxonomy. This shall take place at the time green bonds are issued and after the allocation of green bond proceeds. Issuers shall make external reviewer reports publicly available. External reviewers will be subject to accreditation with regard to standardize procedures, minimum qualifications, and professional codes of conduct (EU 2019b, 31–42, 2020c, 26–28).

Reporting for green bonds should occur in the following manner. Issuers shall report at least annually until bond proceeds have been fully allocated to green projects and thereafter if there is a material change in the allocation of proceeds. The contents of a report shall include items such the following: a statement of compliance with the European Union Green Bond Standard, the amount allocated to each green project category, the geographic distribution of green projects, the actual or estimated environmental impact of green projects, what share of proceeds is for financing and for refinancing, and the total amount of green bonds outstanding divided by the total amount of debt outstanding at the end of a reporting period (EU 2019b, 28–31, 2020c, 24–26).

The Technical Expert Group has recommended that the European Union Green Bond Standard begin largely as a voluntary effort. To achieve this aim, the Technical Expert Group is advising that the European Union encourage the adoption of the European Union Green Bond Standard and require corresponding reporting. The European Union should specifically encourage institutional investors to adopt the European Union Green Bond Standard requirements when designing their green fixed-income investment plans and communicate their plans to green bond issuers and underwriters. The European Union itself should adopt a disclosure structure for institutional investors that requires institutional investors to periodically disclose green bond holdings. The European Union should also encourage underwriters to disclose what portion of underwritten bonds are green bonds (EU 2019b, 43–51, 2020c, 31, 44–46).

According to the Technical Expert Group, the European Union should also encourage efforts that would subsidize costs and otherwise stimulate market participation (EU 2019b, 43–51). The European Central Bank should consider prioritizing investment in green bonds certified under the European Union Green Bond Standard when making green bond purchases, so long as doing so does not prejudice the principle of market neutrality (EU 2019b, 45–46). The Technical Expert Group is advising that the European Union encourage all public-sector bond issuers in countries within the European Union, regardless of whether they have previously issued green bonds, to use the European Union Green Bond Standard for future green bond issuances (EU 2019b, 47–48). The European Commission could also consider credit enhancements for green bonds certified under the European Union Green Bond Standard, establish a grant program to pay the external verification costs for issuers, foster the growth of accredited verifiers, and promote the development of best practices within and outside the European Union (EU 2019a, 29–36, 2019b, 43–51).

The European Union taxonomy and European Union Green Bond Standard will likely have far-reaching impacts both within and outside the European Union. The European Union Green Bond Standard sets up a harmonized view across the countries of the European Union. Outside of the European Union, other green bond taxonomies are modeling to the European Union Green Bond Standard. For instance, the CBI has announced plans to harmonize its taxonomy with the European Green Bond Standard. Both efforts already have many similarities in their operation, as they are modeled on the Green Bond Principles, so presumably efforts at harmonizing will largely be centered on ensuring that the CBI taxonomy of eligible projects includes projects that are eligible under the European Union Green Bond Standard.

Even with the onset of the COVID-19 pandemic, the European Union is increasingly focused on ensuring a transition to a low-carbon economy. German Chancellor Angela Merkel emphasized, “We also have to encourage each other not to forget climate protection… . On the contrary, enhance it” (Worland 2020). Along these lines, Germany is evaluating major European companies again the European Union taxonomy to facilitate the develop of “sustainable, climate-friendly” recovery programs for a post–COVID-19 European Union (Azizuddin 2020; Federal Ministry for the Environment, Nature Conservation and Nuclear Safety 2020). The European Commission is dedicating over a trillion dollars to a European Green Deal that European Commission President Ursula von der Leyen has referred to as the European Union’s “motor for the recovery” (Worland 2020).

5.4 Comparing green classifications

Although not necessarily all projects would be eligible under each classification system, the three primary classification systems for evaluating green bonds have very similar overarching categories for evaluating eligible green projects. Table 5.4 compares categories of eligible green projects. The major difference with the classification systems is that the European Union Green Bond Standard has a couple of additional requirements. It does not allow for projects that harm another green objective, and projects must comply with minimum safeguards.

5.5 Emerging efforts

Other national and subnational governments have also been referencing green taxonomies used elsewhere in the world or are developing their own green taxonomies. The United House of Representatives introduced House Resolution 109 titled “Recognizing the duty of the Federal Government to create a Green New Deal.” The resolution acknowledged a need to keep temperatures below 1.5 degrees Celsius above preindustrialized levels in order to avoid the most severe climate impacts and contemplated efforts to make major reductions in greenhouse gas emissions. Although not specifically mentioning a green taxonomy, contemplated efforts for reducing greenhouse gas emissions include “directing investments to spur economic development” (Green New Deal 2019).

California also announced that it would investigate a framework for green investments. Governor Gavin Newsom directed the California Department of Finance to investigate potential green investments for CalPERS and CalSTRS (Newsom 2019). More details on how green investments will be categorized should become public over time.

Japan has been working on green bond guidelines and investing in green bonds. Japan’s Ministry of the Environment published original Green Bond Guidelines in 2017 (MoE 2017) and published updated Green Bond Guidelines in 2020 (MoE 2020). Japan’s 1.5 trillion-dollar pension fund announced that it is planning to make substantial green investments. The pension fund has been planning to create a strategy for making these investments (Mishima 2019). Additional details will be decided as these efforts develop.

The Monetary Authority of Singapore established a green investment program. The program appears to contemplate the development of environmental risk and management guidelines and the development of plans to involve external reviewers and rating agencies (MAS 2019). This program seeks to invest two billion dollars in green investments. Additional details will be decided as these efforts develop.

Moreover, while there has not been a lot of enforcement against those inappropriately asserting that their financial instruments are green, government agencies are starting to take steps to ensure that bond issuers are properly identifying debt as green. The Financial Conduct Authority recently explained that it would not tolerate greenwashing and will instead “take appropriate action to prevent consumers [from] being misled” (Binham and Hook 2019). Ben Caldecott, who directs Oxford University’s sustainable finance program, explained the significant of this described action: “This is a really big deal, because firms are making all sorts of claims. Consumers need to be protected. The [Financial Conduct Authority] needs to make sure these claims are justifiable and it is beginning to set out a framework for how it will do that” (Binham and Hook 2019).

Just as there are discussions about a brown penalizing factor, there are also discussions about a green supporting factor. However, while the Chinese government has set up requirements to make green investments, other bank supervisors and regulators have expressed reluctance to take such an approach. A recent publication by the Bank of International Settlements and Bank of France stated that “it is not obvious why being exposed to ‘green’ sectors would necessarily reduce non-climate-related financial risks, and thereby justify lower capital requirements” (Bolton et al. 2020, 52). Green investments are still subject to transition and physical risks (Bolton et al. 2020, 52).