Taxonomies are frameworks that seek to define and classify sustainable investments and activities based on common criteria and standards. They are intended to help investors, financial institutions and companies align their financial and investment decisions and practices with environmental and social goals. More specifically, taxonomies can steer companies in adapting their business strategies to meet Net Zero targets and help investment funds analyze sectors based on their environmental performance.

However, the global state of taxonomies is far from ideal. Many challenges have emerged, including fragmentation and an associated lack of comparability across regions and sectors. These challenges can undermine their credibility and effectiveness and create barriers to cross-border trade. None of this would matter if taxonomies played a bit-part in sustainability regimes. But they are increasingly at the center of regulatory frameworks, nowhere more so than when it comes to corporate disclosure and reporting.

We are now at a point of inflexion. The number of taxonomies is proliferating, and the range of financial products presenting themselves as “green” or otherwise “sustainable” is expanding rapidly.

In this context, what would a more effective and flexible taxonomy framework look like? What features would help bridge the current deficiencies and facilitate the verification of financial products that claim to be “green” or “sustainable”?

Market fragmentation

One of the main challenges of taxonomies is the lack of global consensus and coordination on the criteria, indicators and thresholds for defining and measuring sustainability.

Many countries across Asia Pacific and Latin America have introduced green or sustainable taxonomies, or published proposals to do so. According to the Green Technical Advisory Group, there are 47 taxonomies in effect or under development. Regional initiatives exist (such as the EU Taxonomy) or are underway (such as the ASEAN Taxonomy for Sustainable Finance). These frameworks vary in scope, methodology, prescriptiveness (some are voluntary), and level of detail, reflecting different policy objectives, legal frameworks, market conditions and the need for energy security.

For example, some taxonomies aligned with the Paris Agreement prioritize climate change mitigation and adaptation. Others address wider environmental objectives such as water management, pollution and biodiversity, as is the case in Colombia. As a result, the market is disparate among key economic blocs. The Platform on Sustainable Finance has, for example, found little convergence between the EU Taxonomy and China’s Green Industry Guiding Catalogue, with the two taxonomies differing in their objectives, scope, disclosure obligations and approaches to different activities.

Taxonomy arbitrage?

Such fragmentation undermines the credibility and effectiveness of the sustainability agenda, creating as it does confusion in the market, arbitrage and regulatory gaps. For example, an activity that is considered sustainable in one jurisdiction may not be recognized in another or may be subject to different levels of scrutiny and verification, although it’s not clear how far this drives investment towards “taxonomy-lite” jurisdictions. The reality will likely be that how a particular activity is classified under a taxonomy will be one of many considerations driving investment decisions.

Hindrance to cross-border trade

A degree of diversity and adaptation is desirable and indeed necessary to account for local contexts and requirements. The difficulty is that the proliferation of divergent and inconsistent taxonomies creates significant challenges for cross-border investors and businesses, which have to navigate multiple and potentially conflicting disclosure and reporting requirements at a time when they are increasingly looking to classify their investments as “taxonomy compliant”.

This lack of harmonization and coherence impedes efficient cross-border capital flows and creates confusion in the market, a challenge exacerbated by the uptick in tailored taxonomies that various financial institutions are creating for internal purposes.

Against this backdrop, it’s clear that the taxonomy model needs reappraising to avoid some of the emerging hindrances we are now seeing.

What a taxonomy should look like

Given the evolving market frameworks designed to drive capital towards more sustainable activities, the need for taxonomies seems unarguable. However, they should not be considered inevitable. A question remains around what the most impactful policy tools are for shifting capital in a way many policymakers want. For those jurisdictions that have chosen a regulation-lite path, there is a strong argument that no taxonomy is needed at all.

Where taxonomies are being deployed, there are some features that need to be carefully considered.

• Flexibility and adaptability to the different contexts and needs of a jurisdiction. Domestic and regional priorities will shape any given taxonomy, as well as its specific energy transition pathway. It would not be feasible or desirable for example to transpose a taxonomy from the EU on to jurisdictions in Asia Pacific or Latin America, where nations are at different stages of their economic development and energy transition pathways differ. For example, Colombia, one of the most nature-rich countries in the world, has focused on biodiversity in its taxonomy. More specifically, it has zeroed in on the management of soil and land by the forestry, agriculture, and livestock sectors. This reflects the fact that, when taken together, these sectors are responsible for 59% of Colombia’s greenhouse gas emissions. Ultimately, taxonomies must be suitable for each country or region. The question is how they can sit within a common framework.
• Openness to alignment with other taxonomies. Global taxonomies for sustainability should be consistent with, and facilitate the attainment of, the climate change mitigation and adaptation objectives established by the Paris Agreement. There may also be advantages in ensuring greater alignment in regional and national taxonomies between jurisdictions that conduct considerable cross-border trade. For instance, we expect there to be commonalities of language and base concepts between the UK’s green taxonomy, once finalized, and that of the EU. This is logical given the close trading ties between the two economies and should provide a blueprint for others to follow.
• Living and adaptable. A sustainable taxonomy should be a living document that accounts for and adapts to new scientific evidence, as well as policy and stakeholder feedback.
• Global coherence. Better international alignment around key concepts, principles and definitions would be of great benefit. We cannot expect all countries to reflect the same transition priorities in their taxonomies. We should, however, expect greater consistency between taxonomical frameworks in relation to sustainability reporting standards.

Sustainability taxonomies can play an important role in scaling up transition finance. While they cannot act as a safe harbor against greenwashing claims, the ability of financial institutions in particular to demonstrate that their use of investment labels is linked to a robust set of criteria and methodologies will be critical. Corporates will also increasingly need to report their activities as being taxonomy aligned. Given their role, much greater focus therefore needs to be given internationally to minimizing taxonomy fragmentation. We shouldn’t also assume that taxonomies are the right model for every economy. They are not an end in themselves and their fundamental purpose should be paramount – to reduce uncertainty around what are classified as sustainable activities, to provide greater confidence in the market, and to facilitate the Net Zero transition.