Tuesday, July 23, 2024
 
 

The EU’s risky green taxonomy

- Advertisement -

The European Union and the European Parliament are soon expected to adopt a so-called “taxonomy” for classifying green investments, after reaching agreement last month on a list of “sustainable” economic activities. Once the new system enters into force, most likely this year, the European Commission will use this list to determine which financial assets and products are sustainable.

This taxonomy is the backbone of the Commission’s regulatory package on sustainable finance, which has the ambitious goal of “reorient(ing) capital flows towards sustainable investment, in order to achieve sustainable and inclusive growth.” The Commission hopes that the new labeling scheme will address the problem of market players “greenwashing” non-sustainable financial products and serve as the basis for policy incentives to promote sustainable investment.

To be fit for purpose, however, the taxonomy must address three important questions. Unfortunately, the EU’s one-dimensional approach disregards two of the three, with potentially damaging consequences.

The Commission’s focus on the question of which economic activities are sustainable entails defining and listing all activities that contribute to the energy transition, such as generating renewable power or producing electric cars. The main debates have centered on the potential inclusion of nuclear power or natural gas, and whether to define “shades of green” rather than adopt a binary system.

But the EU taxonomy also should address a second big question: Which green activities face a financing gap? After all, from an environmental perspective, the sole purpose of reorienting financial flows toward such activities is to bridge a funding shortfall. And not all sustainable activities listed in the proposed taxonomy are necessarily underfinanced. In practice, the growth of certain green activities is capped by other factors, such as lack of consumer demand, an unfavorable tax environment, or technological obstacles. Indeed, a low level of financing may be a consequence of these difficulties rather than their cause.

Moreover, when a financing gap does exist, it does not necessarily apply to the entire spectrum of capital. Usually, the shortfall affects a specific phase, such as the so-called “valley of death” between venture capital and private equity.

In this context, channeling financing toward all activities defined as “sustainable,” including those that are not underfinanced, will not only dilute the effects of potential incentives (such as the “green supporting factor” envisioned by the Commission), but also risk creating an asset bubble. Yet, so far, the EU has simply ignored these potential problems.

Finally, the Commission has disregarded the evidence concerning the question of which financial instruments and products effectively influence the real economy.

One would expect European policymakers to encourage investments in instruments and products that help to scale up sustainable economic activities. For example, a recent review of academic research on the topic concluded that investors’ use of shareholder rights to support environmental resolutions is a “relatively reliable mechanism” for achieving such an outcome. And this approach is gaining traction, as illustrated by BlackRock’s recent decision to join the Climate Action 100+ coalition of investors pushing such resolutions. At the same time, however, the review noted that, “there is currently no empirical study that relates capital allocation decisions made by sustainable investors to corporate growth or to improvements in corporate practices.”

The Commission refers to this study, but has decided to act against the scientific evidence and base its sustainable-finance regulation on alternative facts. On one hand, the regulation identifies the exposure of portfolios to sustainable activities as the only way to deliver environmental outcomes. Or, as the Commission says, “Greenness is derived from the uses to which (financial products or investments) are being put in underlying assets or activities.” On the other hand, the regulatory package overlooks shareholder engagement as a means of shifting investment toward sustainable activities.

The EU’s one-dimensional approach heightens the risk of three especially harmful consequences. First, it increases the likelihood of mis-selling. Soon, the 40% of European retail investors who (according to our most recent survey, forthcoming in 2020) are concerned with the environmental impact of their savings could be systematically offered unsuitable products. Moreover, the regulation could impede competition by creating entry barriers for genuine environmental impact-investing strategies. Finally, by spurning evidence-based approaches in finance, the EU’s regulation could slow down the sector’s transition – thus hindering global efforts to tackle climate change.

As a member of the High-Level Expert Group that recommended the sustainable-finance action plan, I have repeatedly called the Commission’s attention to these issues and still struggle to make sense of the decisions made. But when it comes to addressing complex, multi-dimensional social issues with a simple one-dimensional solution, there is an interesting precedent.

Not so long ago, the United States government, together with the finance industry, tried to address a challenge simpler than climate change: boosting home ownership among low-income households. They chose to focus on subprime mortgages, combined with the magic bullet of securitisation. At some point, decision-makers thought that increasing market exposure to these subprime loans was a good proxy for helping low-income households to buy homes, and that no further assessment was necessary. We all know how that ended.

- Advertisement -

Subscribe to our newsletter

Latest

Americans deserve far more than a coronation

After the NATO Summit in Washington on July 9-11,...

EU Parliament begins its 10th mandate

The European Parliament was officially constituted on July 16,...

Policies on Deforestation Show Europe’s Internal Splits

Former U.S. Secretary of State Henry Kissinger once famously...

NATO Summit: “Trump-proofing” Ukraine support while Biden appearances under a microscope

The July 9-11 NATO Summit was originally envisioned as...

Don't miss

Americans deserve far more than a coronation

After the NATO Summit in Washington on July 9-11,...

EU Parliament begins its 10th mandate

The European Parliament was officially constituted on July 16,...

Policies on Deforestation Show Europe’s Internal Splits

Former U.S. Secretary of State Henry Kissinger once famously...

NATO Summit: “Trump-proofing” Ukraine support while Biden appearances under a microscope

The July 9-11 NATO Summit was originally envisioned as...

Russia failing to replace lucrative European gas deliveries with sales to China

Russia’s attempts to build the Power of Siberia 2...

Policies on Deforestation Show Europe’s Internal Splits

Former U.S. Secretary of State Henry Kissinger once famously asked the question “Who do I call if I want to call Europe?” to highlight...

Uzbekistan: A Key Player in the (Central Asian) Great Game

Uzbekistan has had considerable success in attracting billions of dollars of aid, concessional debt, and co-investment, which has helped transform the economy since 2017....

Jeffrey Sachs: three times a traitor

An economist with an international reputation, Professor Jeffrey Sachs has increasingly raised his profile in the world media. A U.S. citizen, he accuses his...

The UK Economy – Another Twist in The Tale

Around the world most nations have been trying to recover their financial strength and where possible find some growth. Above all, they have been...

Genocide Rears its Ugly Head in Sudan’s Brutal War

The UN Security Council has called for a halt to the siege of the city of el-Fasher in the Darfur region, where 1.5 million...

Azerbaijan, Kazakhstan, Uzbekistan open path for integrating energy systems with the EU

On May 1, during the Tashkent International Investment Forum in Tashkent, Azerbaijan, Uzbekistan and Kazakhstan signed a memorandum of cooperation on merging the energy...

Good news – the UK is not in recession; Bad news – it doesn’t feel like it

One of the greatest problems that both economists and politicians face is the key element of communication. Yes, they may indeed be trying to...

A Green 5+1, regional water issues in Central Asia and previewing next year’s Astana International Forum

Kazakhstan’s Astana International Forum (AIF) has been postponed to 2025, as Astana is diverting financial resources to assist the relief efforts after massive flooding hit several regions....