‘Encourages laziness and disincentives ambition’: Ben Caldecott shares his thoughts on the EU’s green taxonomy

Responsible Investor’s latest instalment of The EU Action Plan: What Matters To Me

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This is the second in RI’s ‘The EU Action Plan: What Matters To Me’ series, providing insights from market experts on the implications of the current EU Action Plan on Sustainable Finance. Today, Oxford University’s Dr Ben Caldecott gives ten reasons why the current proposals for a green taxonomy are a bad idea.

The European Commission set up a Technical Expert Group (TEG) on sustainable finance to assist it in developing a new EU taxonomy of economic activities that are environmentally sustainable. The TEG commenced its work in July 2018 and its final taxonomy proposals will be published next week, though details of them have already been widely shared by the TEG itself.

I have been extremely reluctant to ‘go negative’ on the taxonomy given the overall strength of the EU Sustainable Finance Action Plan, as well as the hard work of the TEG and its various working groups.

However, the concerns I have (and share with many others) are a compelling case against the proposals. Some of the arguments against are as follows:

1. A binary ‘green’/’not green’ assessment does not reflect reality or the science
There are ‘shades of green’ and this depends on local and national contexts, as well as when an assessment is made. ‘Green’ in Germany in 2020 will be very different from ‘green’ in 2030, and what could reasonably be considered green in Germany will be different from what could be considered green in a developing country, or even in another G7 country.

2. Thresholds set administratively and the lobbying that will result
The thresholds for these binary green/not green assessments will be set administratively. That process will be open to lobbying and political influence. Further, this process is unlikely to be very dynamic and could be slow moving relative to changes in the science and evolving client preferences. For example, less than two years ago ‘net zero’ was considered a fringe view in the climate discourse and now is becoming the reasonable middle ground (on Wednesday, the UK legislated for a net zero target by 2050, becoming the first major economy to do so). Plastics has only recently emerged as a major topic of concern. Any administrative process for setting thresholds, even if we generously assume it will be entirely science-based and run effectively, might not have kept pace. We should not want administrative processes to set the pace of market innovation.

3. Reinforces a view that green is niche not mainstream
Consumer labels highlight that something is special; that it is better than the ‘normal’ equivalent on offer. We should want to make green entirely mainstream. It is hard to see how bucketing green as a niche special product supports that endeavour. A very high ambition green label that identifies truly exceptional green activities might help to raise the bar over time, but the taxonomy is quite explicit that a resolute focus on excellence and the ‘best of the best’ is not its intention. A ‘brown’ taxonomy would also be much better for focusing minds on reducing unsustainable activities in portfolios and making brown niche over time.

4. Disingenuous claims that the taxonomy won’t become a standard or mandatory
Of course it will be! Any student or follower of policy and politics, especially in Europe, will know that a taxonomy of this kind will likely become a mandatory standard. The TEG says that the taxonomy, “is not a mandatory list to invest in, nor a standard, nor an exclusion list. It does not harmonise the existing market practices and strategies with regards to sustainable finance.” But the taxonomy is being created explicitly to harmonise, through the creation of new EU labels for green financial products, a new category of EU climate benchmarks, and new corporate disclosure guidance. It will be very easy for politicians and/or the European Commission to include reference to the taxonomy in future statutory and regulatory changes. And it even if they do not, which seems very unlikely, it will become a default standard as financial institutions will need to use it to report. The proposed regulation at least admits as much: “The aim is to embed the future EU taxonomy in EU law and provide the basis for using that classification system in different areas (e.g. standards, labels, sustainability benchmarks).”

5. Encourages laziness and disincentives ambition
Labels encourage institutions to just buy the label and not look at the underlying economic activities and cash flows. Forcing market participants to gain familiarity with the underlying activities means that once that expertise is developed, there are strong institutional (and individual) incentives to repeat similar transactions. The taxonomy discourages this kind of dynamic. Further, it disincentivises being more ambitious than the administratively set arbitrary thresholds. A 30% green portfolio where green is ‘deep green’ is seen and treated the same as a 30% green portfolio where green is ‘light green’. This is entirely the wrong dynamic for the market.

6. Misses the point
Taxonomies (or classification systems) are incredibly powerful, especially for enabling transparency and comparability. The main issue that the taxonomy process should have focused on is on enabling a comparison of what different institutions (or funds) think is green. For example, what does Blackrock view as green and how does that differ from Amundi, or HSBC vs BNP Paribas, or the Spanish Government vs the Chinese Government. That requires a resolute focus on defining economic activities and sub-activities and identifying robust measures of greenness. The thresholds for green of Blackrock in ‘X’ activity can then be compared with the threshold that Amundi has. This would unleash the right competitive dynamic we want to see in the market: competing to be green and being rewarded for doing so through client demand.

7. Inflating an asset bubble
Over time the taxonomy could unintentionally overinflate the value of assets labelled green, which could backfire as that could make it more likely that green underperforms relative to ‘normal’ or ‘average’ in any market correction.

8. Potential free riding
Any direct or indirect incentive would benefit owners of green assets already created, as well as new assets. We should focus incentives on creating new green assets, not subsidising assets that were already economic at the time of investment.

9. Scientific competence
The TEG have worked tirelessly, but there is a genuine question about whether its “35 members from civil society, academia, business and the finance sector” has sufficient scientific expertise or independence to really adjudicate on whether economic activities are sustainable or not. These are incredibly challenging questions (see point 1 above), which is one of the reasons why we should let entities set their own thresholds but in a way that is comparable (see point 6 above).

10. Green vs Sustainable
The work and terms of reference focus on sustainability, and the market (and clients) are clearly embracing a broader scope of green that embraces the Sustainable Development Goals. This begs the question why just ‘green’ and is that the right framing for the development of the market?

How did this happen?

The need for a taxonomy is linked with a proposal to introduce a Green Supporting Factor (GSF) that would incentivise banks to lend to ‘green’ activities under capital requirement frameworks by reducing the capital charge for green assets.

This is a bad idea, as it takes capital requirement frameworks away from their risk-based origins. But if you are going to subsidise things that are ‘green’, whether through fiscal policy or indirectly via a GSF, you need to taxonomise what you subsidise and what you don’t.

The taxonomy work therefore stems from three forces coming together: a policy focus on subsidy allocation and the GSF; industry quite liking the idea of receiving subsidy for green assets they already held; and then well-meaning NGOs seeing this as another victory for green that they should support whatever the actual detail.

Where next?

This taxonomy and the associated rules and standards that will inevitably follow could easily become another example of well-intentioned financial regulation actually being very counter-productive. Policymakers have form in this regard, as readers very well know.

Things can be retrieved, but only by narrowing down the scope and lowering ambitions for mandation. The main focus for the Platform for Sustainable Finance (that is intended to replace the TEG) should be on updating classification systems, so they are sufficiently detailed to allow us to do ‘shades of green’ measurement for each type of economic activity or sub-activity (see point 6 above). The Platform could coordinate this work and commission analysis that needs to do be done.

More generally policymakers and regulators should focus on creating a dynamic where market participants are rewarded for being as green as possible and that what is considered ‘green’ is improving all the time.

Given the stage of market development, I strongly encourage policymakers and regulators to instead focus on a) transparency and comparability (to empower consumers and clients), b) conduct (enforcement to prevent false claims of greenness and skills/knowledge among practitioners), and c) risk management, in particular implementing and introducing regulations similar to the Bank of England’s excellent new Supervisory Statement on Climate Change.

Dr Ben Caldecott is founding Director of the Oxford Sustainable Finance Programme and an Associate Professor at the University of Oxford, as well as Co-Chair of the Global Research Alliance for Sustainable Finance and Investment.