A response to Ben Caldecott: While not without flaws, investors should welcome the EU taxonomy

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This is the sixth in RI’s ‘The EU Action Plan: What Matters To Me’ series, providing insights from market experts on the implications of the EU Action Plan on Sustainable Finance. Today, FTSE Russell’s Jaakko Kooroshy argues that taxonomies are never perfect, but they can be vital for setting expectations and pushing corporate disclosure.

On Tuesday, the EU Commission published a draft report on the new EU classification system for environmentally sustainable economic activities (‘the Taxonomy’). It has already generated polarised responses, not only from carbon-intensive industries and business-as-usual investors, but also among sustainable finance experts. Concerns, as recently elaborated by Ben Caldecott from Oxford University have focused on issues such as a lack of granularity on different ‘shades of green’, and the challenge of keeping the taxonomy up to date with rapidly evolving green technologies.

Answers may indeed be hard to find in the 400-page plus Technical Report of the TEG, but it certainly asks the right question and provides a starting point – it is now up to the finance community to deliberate

The Taxonomy drafted by the EU-appointed Technical Expert Group (TEG) in less than a year appears far from perfect. However, labelling the taxonomy as counterproductive and calls for a return to the drawing board seem misguided.
Whether it evolves into a broadly accepted standard for investors remains to be seen, but the Taxonomy should be welcomed as it could help stimulate the development of a key missing piece of sustainable finance infrastructure. At the minimum, it should help to bring more clarity to investors about the financial flows towards the myriad green solutions that will accelerate the transition to a more sustainable global economy and meeting global climate goals.

Taxonomies make the world go around

Those familiar with the intricacies of the classification systems that underpin everything from finance to trade to macroeconomics, will know that we live in a world of imperfect taxonomies. The complexity of a fast-paced global economy is inherently difficult to capture perfectly in neat, binary boxes – whether green or otherwise.
Broader, general industry classifications systems used by investors, like ICB or GICS, are a case in point. They are regularly updated and are subject to robust governance, but healthy debate will continue e.g. on the best way to fit the big tech platforms like Facebook or Google into them. The Harmonized System (HS) that underpins global trade is another good example; any international trade lawyer will happily attest that labelling it as ‘harmonised’ might be a stretch. Alternatively, ask an economist how they feel about the treatment of ride-hailing drivers and franchisees in the International Classification of Status in Employment (ICSE-93), which underpins global employment statistics.
Despite these limitations, such taxonomies are critically important to financial markets. By creating a shared, clear language and allowing for systematic data collection they act as critical enablers for the flow of information and capital across the global economy.h6. A practitioner’s perspective

At FTSE Russell we regularly contend with the task of maintaining and evolving taxonomies to keep them up to date. We oversee the Industry Classification Benchmark (ICB) but we have also spent many years developing a more specialised, granular Green Revenues classification system now covering 133 micro-sectors – from advanced irrigation systems all the way to ride-hailing services.
Many of the TEG debates have felt familiar – our external advisory board representing global investors and industry experts has discussed issues such as pragmatic definitions for carbon-efficient aluminium or sustainable aquaculture for many years. From this vantage point, some of the choices the TEG has made, like allowing for ‘transition activities’, appear sensible. Others are more open to further deliberation – is more efficiently farmed beef really a ‘green product’ in its own right?

Three reasons we should welcome the EU taxonomy

While the draft taxonomy may oversimplify the dynamic and disruptive phenomenon that is the green economy, and scrutiny of its exact scope and structure is needed, investors should still welcome the new Taxonomy for three key reasons:

1) It encourages corporate disclosure. The key challenge in making any green taxonomy useful to investors is a shortage of granular data. Among the over 14,000 listed companies we collect data on globally, more than 3,000 provide some green goods or services. But a majority of corporate disclosures are not granular enough to determine revenues from green industries. The EU taxonomy could be a major incentive for companies to provide investors with more meaningful data on this.

2) Markets need clear (green) lines. One of the charges that has been levelled against the taxonomy is that it “encourages laziness”. To put this another way, it simplifies and provides more standardised signals to investors. By generating a clear if imperfect language and dataset, the taxonomy will allow green finance to integrate more effectively into mainstream finance – something that is necessary if green industries are to scale rapidly.

3) A common yardstick for progress. By creating common definitions, investors and society at large will be able to keep track of investments in the green economy more effectively. Using our data, we estimate the size of the global green economy at 5.8% of global market capitalisation, or roughly the same size as the oil & gas sector. However, if effective, the EU taxonomy should enable us to develop a more precise calculation.

The anthropologist Claude Lévi-Strauss, who pioneered the scientific study of why humans use taxonomies, once quipped that “the scientist is not a person who gives the right answers, he is one who asks the right questions”. Answers may indeed be hard to find in the 400-page plus Technical Report of the TEG, but it certainly asks the right questions and provides a starting point – it is now up to the finance community to deliberate.

Jaakko Kooroshy is Head of Innovation & Standards for Sustainable Investment at FTSE Russell.