Demystifying Sustainable Finance Taxonomies

More than 50 countries and regions around the world have developed sustainable finance taxonomies or are in the process of doing so. The concept first emerged over ten years ago with the Climate Bonds Initiative releasing a simple taxonomy, but it gained significant traction following the release of the EU taxonomy in 2020. Australia is next in line, with an official launch date set for June 17.

These taxonomies promise to reduce greenwashing and direct capital to where it's needed to mitigate climate change. While emissions reduction is currently the primary focus, taxonomies are gradually expanding to include other social and environmental objectives as well.

Put simply, a sustainable finance taxonomy is a complicated set of rules that answers a straightforward question: "Can we call this economic activity green?" Although the term 'economic activity' may sound broad, each taxonomy typically specifies a detailed list of eligible activities, such as the Manufacture of Renewable Energy Technologies, Conservation of Natural Ecosystems, and Lithium Ore Mining.

Taxonomies operate at the activity level, allowing companies to quantify how green they are by calculating the percentage of their operations involved in green activities. This is usually expressed as a proportion of revenue, operating expenditure, or capital expenditure related to green activities. Similarly, taxonomies enable assessments of investment portfolios or even capital flows within jurisdictions.

Many taxonomies also feature a runner-up category, such as Transition or Amber labels, for activities that aren't strictly green but are still crucial for the transition. Some, like the ASEAN taxonomy, even explicitly identify harmful activities, although most jurisdictions decide the political cost of such a category outweighs the benefit.

Because determining what qualifies as "green" is surprisingly difficult. Solar electricity generation is obviously green, but should it be allowed to use that label if there are human rights violations in its supply chain? Wind turbines require steel—does that make iron ore green? What about metallurgical coal? A sustainable finance taxonomy aims to provide definitive answers to these challenging questions.

This complexity also explains why so many countries are developing their own taxonomies rather converging on a global standard. Each of the above questions is inherently political, and countries naturally arrive at different answers depending on their unique circumstances and political contexts. The classification of gas is a prime example, with each taxonomy coming up with its own way of making both sides of that particular debate unhappy.

Individual country taxonomies are also intended to align closely with national policy objectives, directing capital towards activities essential for meeting national emissions reduction targets without undermining other social or environmental goals.

While each taxonomy varies, it is common to require activities to clear three hurdles to be classified as sustainable:

Technical Screening Criteria are specific to each economic activity, such as Copper Ore Mining or Cement Manufacturing. These criteria usually include conditions like emissions intensity thresholds or requirements for using zero or low-carbon energy sources. Some TSC explicitly exclude subsets of activities based on their potential to support or hinder sustainability, such as transmission lines that may connect renewable energy sources or coal-fired power stations.

A critical implication of activity-specific criteria is that if an activity lacks defined criteria, it cannot be classified as green—not necessarily indicating it's harmful, just not captured. For instance, the EU taxonomy does not currently cover mining, whereas Australia's taxonomy will include it, recognising certain minerals' importance for the transition.

DNSH criteria include a checklist to ensure that various environmental objectives, such as biodiversity protection and pollution prevention, are supported or, at a minimum, not undermined by the activity. DNSH criteria can be generic, applying broadly to all activities, or specific to certain activities.

MSS criteria generally apply uniformly across activities, covering extensive governance requirements, human rights protections, and—in Australia—First Nations considerations.

DNSH and MSS criteria often generate the most controversy. Their existence is justified—companies shouldn't claim they're green if they significantly harm people or the environment—but DNSH and MSS can be extremely challenging to verify. Consequently, some taxonomies allow an initial focus on Technical Screening Criteria, progressing toward fulfilling DNSH and MSS criteria over time.

I hope this overview has provided clarity on sustainable finance taxonomies. Over the next few weeks, I'll explore practical uses of the taxonomy and discuss why companies and investors may find it beneficial to adopt voluntarily.