Why the European Union’s green taxonomy is risky business

The European Commission’s so-called “taxonomy” for classifying green investments should address three important questions. Unfortunately, the Commission’s one-dimensional approach disregards two of the three, with potentially damaging consequences.

green banks
Cities are turning to ‘green banks’ to finance their initiatives towards a low carbon economy. Image: Pixabay

European Union member states and the European Parliament are soon expected to adopt a so-called “taxonomy” for classifying green investments, after reaching agreement last month on a list of “sustainable” economic activities.

Once the new system enters into force, most likely this year, the European Commission will use this list to determine which financial assets and products are sustainable.

This taxonomy is the backbone of the Commission’s regulatory package on sustainable finance, which has the ambitious goal of “reorient[ing] capital flows towards sustainable investment, in order to achieve sustainable and inclusive growth.”

The Commission hopes that the new labeling scheme will address the problem of market players “greenwashing” non-sustainable financial products and serve as the basis for policy incentives to promote sustainable investment.

To be fit for purpose, however, the taxonomy must address three important questions. Unfortunately, the EU’s one-dimensional approach disregards two of the three, with potentially damaging consequences.

The Commission’s focus on the question of which economic activities are sustainable entails defining and listing all activities that contribute to the energy transition, such as generating renewable power or producing electric cars. The main debates have centered on the potential inclusion of nuclear power or natural gas, and whether to define “shades of green” rather than adopt a binary system.

But the EU taxonomy also should address a second big question: Which green activities face a financing gap? After all, from an environmental perspective, the sole purpose of reorienting financial flows toward such activities is to bridge a funding shortfall. And not all sustainable activities listed in the proposed taxonomy are necessarily underfinanced.

In practice, the growth of certain green activities is capped by other factors, such as lack of consumer demand, an unfavorable tax environment, or technological obstacles. Indeed, a low level of financing may be a consequence of these difficulties rather than their cause.

Moreover, when a financing gap does exist, it does not necessarily apply to the entire spectrum of capital. Usually, the shortfall affects a specific phase, such as the so-called “valley of death” between venture capital and private equity.

In practice, the growth of certain green activities is capped by other factors, such as lack of consumer demand, an unfavorable tax environment, or technological obstacles.

In this context, channeling financing toward all activities defined as “sustainable,” including those that are not underfinanced, will not only dilute the effects of potential incentives (such as the “green supporting factor” envisioned by the Commission), but also risk creating an asset bubble. Yet, so far, the EU has simply ignored these potential problems.

Finally, the Commission has disregarded the evidence concerning the question of which financial instruments and products effectively influence the real economy.

One would expect European policymakers to encourage investments in instruments and products that help to scale up sustainable economic activities. For example, a recent review of academic research on the topic concluded that investors’ use of shareholder rights to support environmental resolutions is a “relatively reliable mechanism” for achieving such an outcome.

And this approach is gaining traction, as illustrated by BlackRock’s recent decision to join the Climate Action 100+ coalition of investors pushing such resolutions.

At the same time, however, the review noted that, “there is currently no empirical study that relates capital allocation decisions made by sustainable investors to corporate growth or to improvements in corporate practices.”

The Commission refers to this study, but has decided to act against the scientific evidence and base its sustainable-finance regulation on alternative facts. On one hand, the regulation identifies the exposure of portfolios to sustainable activities as the only way to deliver environmental outcomes.

Or, as the Commission says, “Greenness is derived from the uses to which [financial products or investments] are being put in underlying assets or activities.” On the other hand, the regulatory package overlooks shareholder engagement as a means of shifting investment toward sustainable activities.

The EU’s one-dimensional approach heightens the risk of three especially harmful consequences. First, it increases the likelihood of mis-selling. Soon, the 40 per cent of European retail investors who (according to our most recent survey, forthcoming in 2020) are concerned with the environmental impact of their savings could be systematically offered unsuitable products.

Moreover, the regulation could impede competition by creating entry barriers for genuine environmental impact-investing strategies. Finally, by spurning evidence-based approaches in finance, the EU’s regulation could slow down the sector’s transition — thus hindering global efforts to tackle climate change.

As a member of the High-Level Expert Group that recommended the sustainable-finance action plan, I have repeatedly called the Commission’s attention to these issues and still struggle to make sense of the decisions made. But when it comes to addressing complex, multi-dimensional social issues with a simple one-dimensional solution, there is an interesting precedent.

Not so long ago, the United States government, together with the finance industry, tried to address a challenge simpler than climate change: boosting home ownership among low-income households. They chose to focus on subprime mortgages, combined with the magic bullet of securitisation.

At some point, decision-makers thought that increasing market exposure to these subprime loans was a good proxy for helping low-income households to buy homes, and that no further assessment was necessary. We all know how that ended.

Stan Dupré, a former member of the European Commission High-Level Expert Group (HLEG) on Sustainable Finance, is CEO of the think tank 2° Investing Initiative.

Copyright: Project Syndicate, 2020.

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