Countries are increasingly adopting green taxonomies to foster a sustainable finance market to attract international investors
This article is part of the series—Raisina Edit 2024
Since the publication of China's first national green finance taxonomy in 2015, we have seen a boom in the development of such documents. The Climate Bonds Initiative estimates that more than 40 such documents have been or are being developed globally, and this number is only set to grow. The taxonomy is perceived mainly as a convenient tool used to improve local financial market transparency and attract the attention of international investors, but with few exceptions. It is rarely a domestic policy tool that can significantly improve the structure of the economy. This does not mean that banks and ministries developing taxonomies in different countries exclude themselves from using taxonomies to change the structure of the economy. On the contrary, this is explicitly stated, for example, in the preamble to the Singaporean or the Mexican taxonomies.
However, there is a significant difference between labelling various potential uses of the taxonomy and actually restructuring national policy. In fact, the European Union (EU) is one of two regions where taxonomy has been fully integrated into the political process and has become a core of many additional policies. Since the publication of the EU Action Plan on Financing Sustainable Growth in 2018, the EU has created many different documents and functions that depend on the application of the taxonomy.
The taxonomy is perceived mainly as a convenient tool used to improve local financial market transparency and attract the attention of international investors, but with few exceptions.
Not only have disclosure rules, a green bond standard, and rules for investment managers been developed but taxonomy-compliant projects have also been connected to funds and funds-backed policies, such as the European Green Deal Investment Plan or InvestEU programmes. In fact, in recent years, all major European economic support programmes have had to contribute to decarbonisation to the greatest extent possible, following the taxonomy.
China is another example of a country where the government is following a similar path, although it does not tie all policies to a taxonomy and does not make a definitive commitment to decarbonising the economy, continuing to develop both climate-positive and climate-harmful sectors in parallel. Chinese ministries and agencies have nevertheless incorporated taxonomy into a number of areas in recent years. In particular, taxonomy-based mandatory guidelines for the banking and insurance sectors, disclosure guidelines, and incentive mechanisms have been developed at the central bank and China Banking and Insurance Regulatory Commission (CBIRC) levels. Local governments have launched pilot economic zones with preferential conditions for taxonomy-compliant projects.
These two taxonomies are among the earliest, but in the last two years, the world has seen a boom in the development of these kinds of documents. They have appeared in South Africa, Colombia, South Korea, Thailand, Singapore, and Mexico, amongst other countries.. Many countries , including India, are in the process of developing their own taxonomy. Once developed, these documents remain voluntary standards for the market and do not have the necessary additional body of regulation needed to realise the full potential of this type of document.
The accumulated experience allows us to identify a number of additional measures that will help turn taxonomy from a tool for the financial market into an instrument of public policy.
It is not a question of making the taxonomy mandatory, as is done in the EU (and pretty much nowhere else). For many countries in the Global South, this would create unnecessary obstacles to the functioning of the local market. But even in the format of a voluntary taxonomy, states and their institutions can do enough to support the taxonomy and turn it into a tool for economic modernisation. The accumulated experience allows us to identify a number of additional measures that will help turn taxonomy from a tool for the financial market into an instrument of public policy. Some of them are taken from the practices of individual countries and regions and some are from comprehensive studies on the issue, like “101 Sustainable Finance Policies” prepared by the Climate Bonds Initiative.
The first and most important step is to supplement the taxonomy with additional supporting documents that open access to it for different market players. This set of documents may include standards for green bonds and loans; rules for application to the insurance industry; taxonomy compliance disclosure rules for financial and non-financial companies; rules for assigning taxonomy compliance labels for financial and non-financial products; guidelines for investment managers, and more.
The taxonomy itself most often does not provide guidance on how it can be used in these areas; it simply indicates which economic activities meet a country's climate policy objectives. The development of procedures for applying the taxonomy in all of these areas (at least in the form of voluntary recommendations) can be done by both government and non-government entities, but it is very instrumental for realisation of the potential of the taxonomy.
The first and most important step is to supplement the taxonomy with additional supporting documents that open access to it for different market players.
Another effective means of supporting the taxonomy could be the introduction of incentives at the level of the Central Bank and government agencies. In a “carrot and stick” incentive scheme for decarbonisation, this element acts as a carrot.
A first step in this direction could be the integration of definitions from the taxonomy into strategic documents. If the achievement of a state’s climate objectives is expressed in terms and definitions specified in the taxonomy, this will automatically lead all state agencies to work towards expanding its application. For example, if the transport roadmap mentions a target share of low-carbon transport, it should be mentioned that the definition of this type of transport can be found in the taxonomy. At this level, it is also possible to change the collection of information and evaluation of budget expenditures by introducing a mechanism of green budgeting according to the categories defined by the taxonomy, as well as to adjust the policy of granting state subsidies, excluding activities incompatible with the taxonomy (high-emission energy or cars with internal combustion engines).
To support commercial banks financing green projects, central banks can adjust the risk weights for capital and reserve requirements to account for climate risk, assigning higher credit quality status to the project aligned with the taxonomy. Risk weights are usually based on historical data, so central banks can add a reserve factor, green reserve factor (based on a taxonomy), or brown penalisation factor to account for future climate risks. Central banks can also conduct climate stress testing, taking into account investments by different entities in companies whose activities are compatible or incompatible with the taxonomy. This would identify the entities with the highest climate risk and allow decisions to be made accordingly.
Central banks can also conduct climate stress testing, taking into account investments by different entities in companies whose activities are compatible or incompatible with the taxonomy.
Potentially, the most effective means is to integrate the taxonomy into the mandates and policies of sovereign wealth funds and national development institutions. With substantial resources, these institutions can significantly accelerate the transition to a green economy if their annual Key Performance Indicators include investing at least a certain percentage of funds in taxonomy-compliant projects. They can also set up public advisory structures that can help applicants to structure their green projects correctly and make them bankable. Banks and development institutions, as operators of different types of subsidies, are in a unique position to set preferential lending terms for all types of enterprises, including agricultural co-operatives, Small and Medium Enterprises, and national champions.
We do not yet have reliable statistics on how the implementation of such measures helps to restructure the economy. Firstly, too little time has passed since the introduction and operationalisation of the first taxonomies; and secondly, it is difficult to identify the isolated effect of certain measures. Nevertheless, we can say with confidence that the two regions with the most taxonomy support measures, namely China and the EU, have achieved the greatest success in building a green economy. This is especially noticeable in the example of China, which has made industrial development in accordance with the priorities of the taxonomy one of the main focuses of economic policy. Those countries that are just developing or have just adopted a taxonomy have many opportunities to enhance its effectiveness based on this experience and this opportunity is worth taking advantage of.
Mikhail Korostikov is a Senior Analyst at the Climate Bonds Initiative
The views expressed above belong to the author(s). ORF research and analyses now available on Telegram! Click here to access our curated content — blogs, longforms and interviews.
Mikhail Korostikov is a Senior Analyst at the Climate Bonds Initiative ...
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