“EU Taxonomy heralds cultural change” and “Warnings of
burden from sustainable finance” - these are just two examples of
headlines that have been gaining momentum in the media recently about
financing environmentally sustainable economic activities. One of the
key legislative activities here is the EU taxonomy. It defines what can
be classified as a sustainable economic activity and is a key instrument
in the EU’s action plan on financing sustainable growth. The taxonomy
applies to market participants who offer financial products as
environmentally sustainable investments. However, it also affects
companies and financial institutions that have to publish climate and
environmental data for non-financial reporting. In other words, it means
the banks will have their work cut out. But what does it mean for the
lending business?
The EU’s six environmental objectives
Let’s start with a look at the EU’s priorities. The taxonomy
classifies an economic activity as environmentally sustainable if it
contributes substantially to one of the following six EU objectives:
- climate protection,
- climate change adaptation,
- the sustainable use and protection of water and marine resources,
- the transition to a circular economy,
- pollution prevention and control and
- the protection and restoration of biodiversity and ecosystems.
It must also not significantly harm any of the other environmental
objectives above and be carried out in compliance with minimum
safeguards.
What we see as positive developments: that taxonomy is a flexible
instrument, taking into account technological changes, science and new
economic activities and data. It is not a strict list of investments and
so makes no conclusive statement about an investment’s risk. However,
the EU Commission is also considering expanding the taxonomy to cover
‘brown’ activities. At the Association of German Banks, we would rather
see sustainable finance incentivised and believe the idea of a ‘brown
taxonomy’ should not be pursued further.
Study by UNEP FI and EBF
Irrespective of its flexibility, applying the EU’s complex and
sometimes cumbersome taxonomy in practice will certainly represent a
challenge. And it will definitely need some further conceptual work to
tailor it to the needs of bank lending. However, initial implementation
projects have given us some pointers and revealed the opportunities and
challenges involved.
The recently published final report on a project implemented by the
United Nations Environment Programme Finance Initiative (UNEP FI) and
the European Banking Federation (EBF) is particularly interesting for
the financial sector. 25 European banks tested the application of the
taxonomy on more than 40 live or recently closed transactions in core
areas from January to August 2020.
According to the report, the main advantages of the taxonomy were that it
- provided good guidance for clients; the more successfully it did so, the greater the investor confidence,
- allowed a homogeneous evaluation of clients’ environmental
performance and provided clients with a transition pathway, simplifying
the switch to more climate-friendly economic activities,
- boosted the availability and quality of corporate data for sustainability,
- levelled the playing field in the banking industry
- and - last but not least - that it reduced, if not prevented, the notorious practice of ‘greenwashing’.
The project also identified a series of operative challenges and
recommendations for working with the taxonomy going forward. Phase 2 of
the project is about to begin. This phase looks at implementing
recommendations from the banking sector. Its focus is on highlighting
opportunities to collect methodical data for taxonomy-relevant
information and developing industry guidelines for implementing and
applying the EU taxonomy to core banking products. Besides the EBF and
the Association of German Banks, a number of other industry bodies are
also involved.
For example, in the real estate sector, the German Sustainable
Building Council is testing the taxonomy by applying it to existing
buildings. They are looking at how application of the taxonomy
influences the valuation process of financial institutions and investors
and what specific proof there is for compliance with the quantitative
and qualitative thresholds. The results of the study are expected in
February 2021.
Application issues in the lending business
The focus of the taxonomy is basically on investments and therefore
on the financial investment side, which is what it was designed for.
Applying the taxonomy is voluntary for the lending business.
Nevertheless, companies increasingly want to know how the taxonomy
influences the lending process. The EU taxonomy also has global reach,
more countries are adopting their own taxonomies. So, it makes sense to
develop some advisory expertise – in order to be prepared for questions
from clients and actively take part in the sustainable finance
discussion, instead of just watching from the sidelines.
Since the taxonomy was originally developed for the capital markets,
it cannot be readily transferred to the lending business. For example,
the link between some credit products and their financed activity can
often be hard to establish. Corporate loans, for instance, are not
commonly linked to a particular economic activity. A link only exists
for earmarked loans or project financing.
Furthermore, banks do not have the data from the real economy, such
as CO₂ emissions, that they would need as a basis for their own
assessments and activities. It is the larger companies that are already
measuring their emissions and making this information available. For
small companies, on the other hand, the data is more difficult to come
by. However, a project by the SME Initiative Energiewende and Climate
Protection shows that it is feasible for smaller companies to harvest
data on their CO₂ emissions.
In order to fill the gaps in data, it may help to develop methods
that allow the use of sector-specific estimates or proxy values. Users
of the taxonomy also need more clarity and support, for example with
more specific details about what is expected from due diligence on the
“do no significant harm” criteria, compliance with minimum social
standards and implementing the principle of proportionality.
Outlook
A number of new developments in sustainable finance are expected in
the coming months. The Association of German Banks supports the aim of
the European Commission to create and expand the taxonomy into a
classification system with standard terms for sustainable economic
activities.