How the EU taxonomy can be the tool for dynamic climate transition

The EU’s “sustainable Taxonomy” has been sometimes portrayed as a binary tool defining which economic activities are sustainable and which ones are not. In fact, it can benefit a wide cross-section of Europe’s economy, writes Nathan Fabian.

Nathan Fabian is Chief Responsible Investment Officer at PRI, a United Nations-supported international network of investors promoting sustainable investment. He is also chairperson of the European Commission’s Platform on Sustainable Finance, an EU advisory body.

The climate crisis is one of the most fundamental challenges the global economy faces.

Europe has shown political leadership to address this challenge: taking steps towards a net-zero greenhouse gas (GHG) commitment by 2050; and a more ambitious 2030 target.

This crisis, however, also presents an opportunity. We already have many of the technologies and practices needed for a sustainable economy. And there is no shortage of capital looking for returns.

It is for this reason that the EU is moving forward with a “sustainable Taxonomy” – a tool to make clear which investments in Europe are aligned to these goals, and which are not. The aim is to make it easier for investors and companies – indeed for all of us – to know what the sustainable investments are that we need.

Behind this seemingly binary approach is a sophisticated set of ideas which can benefit a wide cross-section of Europe’s economy, while accelerating the transition to a net-zero economy. Companies seeking to benefit from the Taxonomy have multiple routes to explore.

These ‘ways to green’ are often misunderstood but they provide a dynamic way to use the Taxonomy right away.

Ways to green

The Taxonomy defines “green” economic activities. Very few companies will be in 100% alignment already, but companies can demonstrate their commitment to transition by increasing their share of green activities over time.

Crucially, the Taxonomy does not just recognise those activities and companies that are already green, but allows companies making improvements towards the Taxonomy standards to claim capital expenditure as Taxonomy-aligned.

This means they would be eligible to raise green financing from the markets, including through use of the proposed EU Green Bond Standard or by getting a Green Loan from a bank.

The Taxonomy is not a substitute for an individual company or investor’s judgement. Companies will continue to make and communicate their own plans to transition to net-zero and build climate-resilience.

But by creating a shared understanding of green activities, and by increasing the demand for investments with these attributes, the Taxonomy can help companies to access a wider pool of potential investment.

The Taxonomy recognises that not every sector or industry is ready to be zero carbon. In certain industries, the necessary technologies simply aren’t yet ready at scale. The Taxonomy addresses this in two ways.

Firstly, by recognising the best available level of performance for these industries. These are referred to in the Taxonomy Regulation as “transitional” criteria, and while there are robust legal safeguards in place, they represent an interim step between typical performance for an industry and a net-zero future.

As an example, highly efficient steel production would count as Taxonomy-aligned.

Secondly, Taxonomy recognises the need for investment in innovation. Research, development and innovation financing, where it contributes to meeting or exceeding the criteria, can be counted as Taxonomy-aligned. This allows companies to get recognition for investing in the low-carbon solutions their industries need.

While much of the Taxonomy is focused on high emitting sectors, it also recognises decarbonisation efforts across the economy. A good example is buildings. With the exception of buildings dedicated to fossil fuel storage, any new buildings and any energy efficiency building renovation meeting the criteria in any sector can count as Taxonomy-aligned.

Certain activities can enable another activity to meet its Taxonomy criteria, such as manufacture of energy efficiency equipment or micro-renewables. Beyond this, the draft Taxonomy also includes a general principle that any innovative technology helping another sector achieve the Taxonomy criteria can count, as long as it meets certain safeguards.

Next steps for a more inclusive Taxonomy

The Taxonomy framework provides important opportunities for companies and public entities, but our work isn’t complete. The EU Platform on Sustainable Finance, the technical group tasked with further developing the Taxonomy criteria, is exploring several promising ideas to further support the climate transition.

First, the draft Taxonomy criteria recognise that some actions are so clearly beneficial that they can count as Taxonomy-aligned in any situation if the overall activity doesn’t significantly harm the environment. Examples include energy efficiency measures such as thermally efficient windows.

Expanding the list of these cross-cutting “measures” in the Taxonomy presents an important opportunity for companies, particularly those currently out of scope for the Taxonomy to gain credit for energy and resource efficiency measures.

Secondly, perhaps the best kept secret about the Taxonomy arises from the fact that large parts of Europe’s economy have a small emissions footprint.

Health services and education, for example, may not be able to reduce direct emissions in the economy in the same way that the energy sector can – but neither do they do significant environmental harm, as long as they are following good environmental management practices and addressing the energy efficiency of their building stock.

Allowing companies and investors to get credit for low environmental impact with appropriate safeguards in place – could create a taxonomy where many more sectors and companies can find their place.

Finally, the Platform is also considering how to recognise improvements made by the heaviest emitting activities – those that are currently considered as doing “significant harm” under the Taxonomy.

These activities may be able to cut emissions significantly. Examples include existing unabated gas fired energy generation or manufacture of gas-guzzling trucks.

Improving the performance of the heaviest-emitting sectors to the point that they are no longer causing significant harm is an important step. The Platform is considering how to recognise these ‘harm reducing’ transitions.

Of course, this does not make them low carbon, and given the strictness of the EU’s own targets, this means at best such activities will continue only for a period, before the last few gigatons of our rapidly reducing emissions budget are used up.

Reducing harm now may allow them to continue long enough to provide the cash flows needed to transition the workforce into high quality, more sustainable jobs.

The last chances to achieve our shared climate goals are fast approaching, and many in the market still underestimate the scale and pace of the transition that is needed.

The Taxonomy defines what is “green”. It does not say that everything else is bad for the environment, or that it has to be shut out of the transition to a more sustainable economy. In fact, a Taxonomy implemented in the ways described above says the opposite, showing the pathway for economic transition in an inclusive way.

Many paths to a green economy are needed, and fast. The Taxonomy gives us guidance and confidence in what we need to do. The EU Platform on Sustainable Finance is working hard to develop the Taxonomy further, and to unlock its full potential as the tool we need for a dynamic climate transition.

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