Defining green investments is not an exact science.

A lack of clarity around what should be classed as a climate-friendly investment has long been an obstacle preventing funding from flowing to green projects.

The EU has been keen to change this by introducing a classification system, known as the ‘Green Taxonomy’, as part of its wider efforts to become the first continent in the world to be carbon neutral by 2050.

The Taxonomy became law last summer and provides a framework to determine whether a company’s economic activity is deemed sustainable.

While this initial classification has provided a helpful starting point towards providing better definitions to boost green investment while avoiding greenwashing, there are still a number of grey areas which need further clarity to ensure sustainable finance can flourish and the EU’s Taxonomy becomes a leading standard of sustainable finance.

For example, the Taxonomy currently lacks the desired flexibility in how it recognises green investments, particularly with respect to companies already taking intermediary steps on the path towards being more sustainable.

Companies need a framework that recognises overall improvements in the environmental performance of their activities, as opposed to the current binary system which defines low carbon "green" economic activities and neglects other types of activities.

The problem with a framework that doesn’t sufficiently recognise activities that contribute to an improvement in the company’s environmental performance is that it leads to lower capital inflows and curtails activities which are on their way to being considered green.

Going forward, the Taxonomy needs to include both activities and companies that are already low carbon, but also be forward-looking and include companies that demonstrate the commitment and potential for transition.

A further limitation relates to the Taxonomy’s coverage of sectors of the economy, which restricts the use of taxonomy-based labelling schemes such as the EU Green Bond Standard and the EU Ecolabel. The EU has recognised these limitations in its recent Renewed Sustainable Finance Strategy, which is a positive step towards achieving its net-zero carbon emission objectives.

Finally, more clarity is needed around how the Taxonomy should be applied – for example, at the moment it only applies to a company’s economic activities, but it should really be applied more broadly to companies as a whole.

As it stands, companies can only finance specific projects linked to eligible green activities. This is generally done by issuing bonds, because the company will use the proceeds from issuing the bond on green projects and, in turn, the bond may qualify as green under the EU Green Bond Standard.

But as the screening is only possible for activities, it is difficult to use the Taxonomy to identify green or transitioning companies who issue equity, for example.

If it was possible to use the Taxonomy to screen companies, banks would be able to provide more general-purpose sustainability-linked funding to green companies or companies on a credible transition path. This entity-level approach would mobilise a wider range of supporting financial instruments such as such as loans, bonds, equity, derivatives and structured products.

It is no easy feat to define a new and rapidly growing area of sustainable investment opportunities which span multiple sectors and regions. Such differences mean pathways to transition will be different across jurisdictions and industries. For this reason, a single global taxonomy is a near-impossible task.

Therefore, what will be important is for regulators to cooperate to ensure taxonomies work together.

There are signs this is already happening, particularly with the International Platform on Sustainable Finance, which includes members from 17 jurisdictions, representing 55% of both global greenhouse gas emissions and GDP, with the goal of developing mutually compatible taxonomies and sustainability reporting standards.

At the global level, it will be vital for policymakers to agree on a minimum set of global guiding principles and definitions to underpin taxonomies across regions. This was also recommended by the Global Financial Markets Association and Boston Consulting Group in a recent report ‘Global Guiding Principles for Developing Climate Finance Taxonomies – A Key Enabler for transition Finance’. 

Although there will continue to be grey areas to resolve around the evolution of such taxonomies, they remain vital for determining whether investments in certain activities are aligned with climate goals.

Going forward, the main challenge will be to ensure taxonomies are flexible enough to broaden the set of eligible sources of financing to unlock as much funding as possible for a greener economy.

This article was originally published in Thomson Reuters Foundation 09/08/2021