To make investments climate-resilient, the EU needs to expand its sustainable finance taxonomy

To make investments climate-resilient, the EU needs to expand its sustainable finance taxonomy

Today, the UN office for Disaster Risk Reduction in collaboration with E3G, launched a report showing the development of an EU sustainable finance taxonomy is a unique opportunity to support a major reduction in disaster risk and scale up climate change adaptation and resilience.

An assessment of the EU’s Action Plan on Financing Sustainable Growth recommends expanding the EU’s sustainable finance taxonomy to define “unsustainable” economic activities as a necessary step to ensure investments that are not physically resilient to climate change and natural disasters are avoided. This recommendation echoes the newly released first comprehensive report from the Network of Central Banks and Supervisors for Greening the Financial System (NGFS). It is also aligned with the proposal to expand the framework in the recently adopted position on the EU’s taxonomy by the European Parliament.

The Action Plan’s first recommendation was to establish a unified classification system (‘taxonomy’) in order to define what can be considered an environmentally sustainable economic activity and create a common language for all actors in the financial system. The NGFS encourages policymakers to develop a sustainable finance taxonomy that provides transparency on which economic activities are more exposed to climate and environment-related risks as well as those contributing toward the transition to a green and low-carbon economy. Meanwhile, the European Parliament adopted its position on the EU’s taxonomy at the end of March, proposing to expand the framework for defining sustainable investments to include criteria for when and how an economic activity has a significant negative impact on sustainability. It also proposed if the taxonomy is to lead to transformative change, then it should be used by all investors, not only those already offering ‘green’ financial products.

There are two main reasons why defining “unsustainable” economic activities in the EU’s taxonomy will enable financial markets to more effectively deliver the transition to a sustainable economy. Firstly, it will support the reallocation of capital flows toward a more sustainable economy, rather than solely supporting additional allocations to sustainable investments which on its own won’t be enough to reach a net-zero and climate-resilient economy. Secondly, it will facilitate financial institutions’ identification, assessment and management of climate and environment-related risks (both physical and transition), which will increase Europe’s financial resilience and stability.

The original rationale for establishing the EU’s taxonomy was to shift financial flows. The current focus on sustainable activities however, is likely to limit its ability to reallocate capital from ‘unsustainable’ to ‘sustainable’ assets and won’t fulfil the NGFS calls for a taxonomy that identifies economic activities most exposed to climate and environment-related risks. Identification of ‘unsustainable’ activities will support capital reallocation by incentivising better investment decisions as well as the necessary improvements to assets. The Technical Expert Group on sustainable finance has already begun looking beyond activities with an environmental purpose to the “greening of” polluting sectors. Defining “unsustainable” economic activities is a logical next step in the development of a comprehensive and usable taxonomy framework.

Considering opportunity and risk alongside one another is important to ensure finance flows meet Europe’s needs. Integrating climate-related financial risk into the financial system, in isolation and without a political vision for sustainable investment, has the potential to reduce access to finance for those who need it most – sectors, communities or even entire geographies – with a high social and political cost. Equally, incentivising sustainable investment will not on its own address the risks we face. A sound sustainable finance policy framework must do both.

Expanding the taxonomy to define “unsustainable” economic activities would also better enable policy makers to use the taxonomy as the lynchpin in the transition to a sustainable economy. It would create links with the broader financial and economic policy framework both to reallocate capital to sustainable investments and to mitigate risks. This could happen through links to public finance interventions, private financial reforms (such as disclosure of sustainability risks by investors, developing benchmarks and green bonds), infrastructure planning, financial supervision, corporate disclosure and structural policies such as competition or taxation.

In the case of public finance, an expanded taxonomy will be more effective in ensuring investments are fully supportive of the transition to a sustainable economy, leveraging private finance for investment in high-quality infrastructure which is physically resilient to climate change. Investment through the InvestEU Fund, the future successor of the European Fund for Strategic Investments, will be subject to sustainability proofing in accordance with guidance which reflects the EU’s taxonomy. This guidance, accompanied by an expanded taxonomy, can inform which investments should be avoided.

Member State and EU level public bodies will require oversight and advice, for example for integrating resilience into infrastructure planning and fine‐tuning public policy and public finance interventions to close climate change adaptation‐related investment gaps. The Platform on Sustainable Finance, established to support the taxonomy as well as the wider sustainable finance agenda, has the potential to fulfil this role through its planned observatory and advisory functions. The Platform should monitor Europe’s sustainable investment needs and progress in the shift of capital flows away from activities with a negative impact on environmental sustainability, and towards sustainable investment. This will require annual Member State reporting to allow European policymakers to understand where capital is flowing, where more attention is needed and when to develop/update initiatives to close investment gaps, re-orient capital and mitigate risks.

The Platform should be tasked with expanding the taxonomy to include “unsustainable” economic activities. After its establishment, this should be completed as soon as possible, building on next month’s TEG report on sustainable climate mitigation and adaptation. This would respond directly to renewed calls for stress testing all investments and support decision making to create opportunities in the transition to the sustainable economy and address the growing risks posed by climate change and natural hazards.

Tough decisions will need to be made in the transition to a net-zero greenhouse gas economy. The urgency of the transition means these must be made soon. Current efforts to produce a taxonomy, which covers “greening of” and greening by” activities is a good first step, but must be quickly followed by efforts to include “unsustainable” activities. This will be the only way to answer increasing calls for ‘stress testing” investments and ensure Europe is truly climate resilient and meets its 2050 climate neutrality goals.

This article also appears on E!sharp.


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