“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.
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.