A green taxonomy is a classification system for defining the concept of environmental sustainability, which, in turn, provides clarity for investors on the economic activities and investments various jurisdictions consider sustainable or not.
Prior to the existence of green taxonomies, the definition of environmental sustainability varied widely, and the impetus for the inception of the first green taxonomy came after the EU Commission discovered that Europe would require investments of more than €700 billion (US$761 billion) per annum to meet its energy transition goals to combat the climate crisis.
The EU taxonomy is a part of the EU’s broader efforts to transition towards a more sustainable and low-carbon economy. It was proposed as a part of the EU Action Plan on Sustainable Finance, which was introduced in 2018, and officially adopted in July 2020, requiring companies and financial institutions to disclose the proportion of their activities that are taxonomy-eligible or taxonomy-aligned. The overall goal of the EU Action Plan is to redirect financial flows towards sustainable investments and to integrate ESG considerations into the financial sector.
The EU taxonomy established criteria for determining whether an economic activity is environmentally sustainable within six environmental objectives: climate mitigation, climate adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems.
Each objective has specific criteria that an economic activity must meet to be considered environmentally sustainable. For instance, an economic activity should make a substantial contribution to one or more of the objectives, do no significant harm to others, and comply with minimum social and governance safeguards.
In practice, companies and financial institutions can use the EU taxonomy to assess the sustainability of their activities and investments. It can also guide them in disclosing relevant information to investors, allowing the latter to make more informed decisions. The EU taxonomy plays a role in the EU’s Sustainable Finance Disclosure Regulation (SFDR), which requires financial market participants to disclose how they integrate ESG factors into their investment decisions and advisory processes.
Not all taxonomies have the same objectives or priorities. Looking at the role of a green taxonomy from the perspective of Singapore or China, for example, the focus shifts more toward financial products, particularly debt instruments like loans and bonds with the aim to classify these instruments and capital pathways as green or sustainable using a taxonomy-like framework.
Many countries have implemented green taxonomies or are in the process of doing so, helping investors, businesses, and financial institutions in identifying and supporting environmentally friendly investments. In the original context of the EU, its taxonomy was constructed around the prominent, heavy-emitting sectors that contributed significantly to the bloc’s carbon profile.
While investors welcome the development of green taxonomies around the world, an overabundance of divergent approaches risks rendering these tools impractical if there is a lack of interoperability. Though it is important for green taxonomies to consider the unique characteristics of the underlying economy if jurisdictions diverge too much it may lead to a situation where a company’s economic activity is considered green by one country’s taxonomy but not by another, creating confusion for investors and posing barriers to sustainable investment.
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