Green Financing and the EU taxonomy – A Dismal Swamp of Bureaucracy or a Business Opportunity?

Green financing, seen from a European perspective, has its roots in the EU’s Sustainable Finance Framework that aims to promote sustainable investment and the Union’s overarching climate goals of becoming the world’s first climate neutral bloc by 2050.

In essence, green financing is a financial product or service that ensures, or strives towards ensuring, a better environmental outcome. The term is broad and encompasses a wide range of loans and debt instruments, most commonly Green Bonds and Green Loans, the proceeds of which are used to finance green projects or lessen the environmental impact of regular projects.

The benefits of green financing are both company and investor driven; green projects appeal to a rapidly growing group of green investors looking to generate environmental and social returns on their capital and  firm environmental targets are increasingly becoming strategic goals for a growing number of companies. Additional driving force behind the expansion of the green financing market is the image and goodwill benefits that “being green” provides in the modern marketplace.

Since its inception the green finance industry has been self-regulated by several standards, principles, and handbooks, chiefly by the International Capital Market Association’s Green Bond Principles, which in addition to bonds also serve as the underlying principles for most green loan frameworks.

The Green Bond Principles requires issuers of Green Bonds to comply with four core components;

  1. Use of Proceeds: the cornerstone of Green Bonds (and green financing in general) – the proceeds of the bonds are used for green (i.e., environmentally friendly, or beneficial) projects.
  2. Process for Project Evaluation and Selection: Sustainability objectives, the method of determination used to classify the project as a particular category of green project, potential negative environmental effects of the project as well as other applicable eligibility criteria is to be clearly communicated to investors.
  3. Management of Proceeds: The net proceeds of the Green Bonds must be tracked and managed by the issuer to assure that the proceeds are used for green projects.
  4. Reporting: Issuers are to make, and keep available, up to date information on the use of proceeds for investors, including a description of proceed allocation and expected environmental impact.

To further expediate the processes of assuring compliance with the core components, many actors opt to develop their own Green Finance Framework, which can then, with adequate modification, be used any time the actor wants to issue Green Bonds or take out Green Loans.

The Green Finance Frameworks are often developed in cooperation with industry experts such as financial institutions or law firms, many of whom today have specialized green finance teams, whereafter the framework is reviewed and given a second opinion by a neutral third party and published on the issuers or lenders homepage together with the second opinion. A company looking to develop their own Green Finance Framework should ideally reserve at least four to six weeks for the processes of drafting the framework and obtaining the second opinion.

It is important to note that, while the Green Bond Principles contains examples of categories of projects that would generally be considered green, the list it not exhaustive, and even projects that may not be seen as conventionally environmentally beneficial can be eligible for green financing.

New developments – the EU taxonomy

The European Commission recently presented its draft of the EU Taxonomy Climate Delegated Act (the “Taxonomy”, set to enter into force January 1st, 2022) that sets out definitions and criteria that economic activities must meet to qualify as green within the EU, ultimately leading to a more objective and science-based approach to green financing.

At its core, the taxonomy’s classification system builds upon the EU’s climate and environmental objectives:

  1. Climate change mitigation
  2. Climate change adaptation
  3. Sustainable use and protection of water and marine resources
  4. Transition to a circular economy
  5. Pollution prevention and control
  6. Protection and restoration of biodiversity

For an economic activity to be considered green, it must;

a) contribute substantially to at least one of the above-mentioned objectives,

b) do no significant harm to any other objectives,

c) comply with minimum social safeguards is required (e.g., the UN Guiding Principles on Business and Human Rights), and

d) comply with technical screening criteria.

The technical screening criteria (d above, the “TSC”) are made up of objective and science-based criteria used as detailed conditions for determining substantial contributions and significant harm in the context of economic activity. For instance, the TSC’s sets out CO2 emission limits for the manufacture of passenger cars, where the manufacture of cars that surpass the limit is not considered to substantially contribute to climate change mitigation. Similarly, the TSC’s contain criteria for when a certain economic activity does significant harm to any of the other climate and environmental objectives, often in the form of references to compliance with applicable EU legislation (e.g., in relation to objective 3 above, compliance with EU water legislation).

Practical effects of the Taxonomy on green financing

The main effects of the Taxonomy, starting January 1st 2022, will come in the form of taxonomy disclosure requirements for all companies that offer financial products in the EU and fall under the Non-Financial Reporting Directive (these companies will be required to disclose how and to what extent their activities are aligned with the Taxonomy). This means, in essence, that financial institutions seeking to increase their sustainability presence will see financing of Taxonomy compliant economic activities as more attractive.

While the Taxonomy does not directly affect the eligibility criteria for Green Bonds or Green Loans, plans are, however, in motion to finalize the EU Green Bond Standard, which aims to make use of the Taxonomy when defining what bonds may be marketed as “EU Green Bonds”. The European Commission intends to make the EU Green Bond Standard voluntary for issuers, meaning that issuers will still be allowed to issue Green Bonds (albeit marketed without the “EU” prefix) compliant with the Green Bond Principles without compliance with the EU Green Bond standard.

Whether and to what extent the Taxonomy and/or the EU Green Bond Standard will change the currently utilized green finance framework will remain to be seen, but it is generally acknowledged that the Taxonomy will, albeit indirectly, affect how project eligibility under the Green Bond Principle are determined today, at least for Green Bonds issued and marketed within the EU.