The European Union says that the region needs an additional €175-290 billion in private investment a year (pdf) to become a “climate-neutral” economy by 2050. (That’s $199-330 billion.) That may sound like a lot, but it barely puts a dent in the $5-7 trillion that the UN thinks is needed every year to achieve its Sustainable Development Goals by 2030, which target the environment in addition to a host of other issues.
To plug the gap, “sustainable investing” is spreading from a niche area of the financial sector into the mainstream. Investing along environmental, social, and governance (ESG) criteria is one of the fastest-growing strategies in finance. ESG is not quite as intensive as “impact investing” (investments that must produce a specific and measurable environmental or social impact) but it’s more than just negative screening (cutting out tobacco or firearms stocks from portfolios). Within ESG, it’s the “E” that’s gaining the most traction as global protests and severe weather events push climate policy higher in the public’s consciousness.
But the rapid growth of the field—by some measures, assets committed to sustainable investment strategies represents half of all professionally managed assets in Europe—is raising concerns about “greenwashing.” The industry has grown organically, with organizations deciding for themselves what counts as an environmentally sustainable, or “green,” investment.
Now, the EU has sought to settle the matter.
Last week, the European Commission published a classification system, known as a taxonomy, that details what economic activities are green, and therefore what really counts as an environmentally sustainable investment. The 400-page report by the Technical Expert Group on sustainable finance identifies activities with “the potential to contribute substantially to climate change mitigation.”
What counts as sustainable?
According to the taxonomy (pdf), there are three kinds of activities that make a “real contribution” to climate change mitigation and adaption: first, activities that are already low carbon and therefore compatible with plans for a net-zero carbon economy by 2050, zero-emissions transport; second, activities that are clearly contributing to a net-zero carbon economy, such as low-emissions cars; and third, activities that enable the previous two, such as the manufacturing of wind turbines.
To be considered environmentally sustainable, the activity has to actively contribute to one of six objectives:
- Climate change mitigation
- Climate change adaption
- Sustainable use of water and marine resources
- Transition to a circular economy, and waste prevention and recycling
- Pollution prevention control
- Protection of healthy ecosystems
Even if the activity is designed to achieve climate change mitigation or adaption—the first two objectives—it still has to avoid “significant harm” to the four other objectives to be considered environmentally sustainable under the taxonomy.
On the same day it published the taxonomy, the EU also published guidelines for companies on how to report non-financial, or ESG, information in line with the classification system.
How does the taxonomy work?
The taxonomy immediately excludes any activities that are believed to undermine long-term efforts towards a carbon-neutral economy, such as anything to do with coal-powered electricity generation. “Improving the efficiency of these activities may provide short-term benefits, but they are not considered consistent with the aims of the taxonomy,” the report says.
The classification system covers 67 activities across eight different sectors—agriculture, forestry, manufacturing, energy, transportation, water and waste, information technology, and buildings—that the EU believes will make substantial contributions to climate change mitigation. For each activity, there is a technical screening about why the activity will help achieve a carbon-neutral economy, what metrics will be used to assess the environmental performance of the activity, and where the threshold will be set for those measures to be considered environmentally sustainable.
For example, afforestation is covered by the taxonomy and so is the renovation of existing buildings. All investments in electricity storage are also eligible to be considered green. (The full list of activities can be found on pages 22-25 of this pdf.)
Manufacturing is the one of the largest contributors of greenhouse gas emissions in the EU, but it is also vital to building low-carbon products and technology. So, the taxonomy splits manufacturing into activities that need to be greened, called “greening of” activities, such as the manufacturing of iron and steel, cement, and chemicals. And then there are “greening by” activities, such as the making of products needed for renewable technologies, low-carbon vehicles, and equipment that boosts the energy efficiency of buildings.
Here’s how the classification works for a significant “greening of” activity: the manufacture of steel and iron. For investments in this sector, the metric is greenhouse gas emissions and the taxonomy sets thresholds for emissions at the average of the 10% most greenhouse gas-efficient installations. It also notes that steel production from a minimum 90% scrap is eligible to be classified as a sustainable investment. It then lays out the “do no significant harm” assessment: the key potential damages to avoid include drawing water from sources already under stress, the impact on local biodiversity, and the generation of waste and other byproducts.
The EU taxonomy hasn’t been officially adopted yet. It will go through six more months of refinement and public feedback.
For many in the field of sustainable investing, one of the biggest bugbears has been a lack of standardization. It’s this excessive flexibility that invites greenwashing and foments fears that investments marketed as satisfying ESG standards could blow up and tarnish the entire sector. Still, not everyone thinks the EU’s classification system gets it right.
Ben Caldecott, director of the Sustainable Finance Programme at Oxford University, says the taxonomy “encourages laziness and disincentives ambition.” In an article for Responsible Investor just before its publication, Caldecott lays out a range of concerns. He argues that sustainability has “shades of green” that depend on local and national contexts, with definitions changing over time. The EU’s binary assessment of what is and isn’t green “does not reflect reality or the science,” he says. What’s more, the process of setting thresholds could be vulnerable to lobbying and political influence.
The European Commission is pushing ahead: last week it also issued a report for an EU Green Bond Standard (pdf), detailing how the taxonomy would be used to cement the development of another fast-growing asset class, in addition to a report on disclosure requirements for climate and ESG benchmarks (pdf).
How forceful the taxonomy, classifications, and other standards will be within EU legislation is uncertain. Last week, EU leaders met to set the agenda for the new five-year European Parliament. The meeting included a proposal to strengthen the EU’s climate goals to reduce net carbon emissions to zero by 2050, which could boost the sustainable investing sector (and was assumed as a goal in the taxonomy). But delegates from Poland and other eastern European countries, which still heavily rely on coal, objected. Instead, the meeting ended with a compromise resolution to make the EU climate neutral, but with no stated target date.