Climate change is one the defining issues of our generation. New studies show that global warming needs to be limited to 1.5°C (rather than 2°C) compared to pre-industrial levels, to avoid the worst effects of climate change. Achieving that objective requires trillions of dollars of investments, funded mostly from private enterprise.
While governments could catalyse green investments in a variety of ways, coming up with a comprehensive list of “green activities” is a great place to start. As sustainable investments have grown over the last decade, the number of definitions put forth by non-profits, commercial data providers, and regulators have proliferated. Given the lack of standardization there is a temptation for asset managers to market green funds based on misleading claims, a phenomenon called greenwashing.
EU taxonomy for green activities
Earlier this year, the European Union (EU) concluded an agreement and passed into law, a framework for classifying green activities, or the EU taxonomy. EU taxonomy for green activities has three broad objectives – to provide an unambiguous definition to companies for disclosures, and asset managers for marketing investment products; to protect consumers from dubious claims of greenwashing; and to provide EU member states a basis for further policy action such as financing or incentivising green investments, or for central bank to calibrate prudential measures (such as risk weights or priority lending limits) based on a consistent framework.
According to the EU taxonomy, green activities should satisfy three criteria. First, it should make a “significant contribution”, based on technical thresholds, to at least one of 6 environmental objectives – climate change mitigation, adaptation, water use, waste prevention and recycling, pollution control, and protection of ecosystems. For example, cars with tailpipe emissions of less than 50 g CO2/ Km, including zero emission vehicles, contributes significantly to climate mitigation.
Second, it should do no significant harm to other 5 objectives; nuclear energy may contribute significantly to climate mitigation, but may not meet the recycling objective, and hence not included.
Lastly, the activity should comply with minimum social safeguards: a company’s hydropower plant might contribute to climate mitigation, but not at the expense of violent displacement of local communities.
While other national governments have been working on similar measures - China’s Green Industry Guiding Catalogue is a recent example – EU taxonomy regulation is a landmark event. EU is a global powerhouse when it comes to rule-making.
Its size, it’s long and consultative process to rule-making, and the cut-and-thrust of negotiating a common legislation for 27 member states with competing interests, usually produces outcomes which not only works for its member states, but also serves as a model elsewhere, as the popularity of EU’s data privacy rules (GDPR) or rules for cross-border funds (UCITS) attests. The impact of the regulation will be felt in India.
Indian attempts at defining green activities
India has made good strides in meeting its commitments negotiated in the Paris agreement, in particular its focus on shifting its energy mix towards renewables. ESG funds and green bonds have been gaining in popularity, with SBI raising $100 mn through green bonds recently at competitive rates in volatile market conditions.
Indian regulators and non-profits have attempted to provide clarity for environmentally sustainable activities. SEBI’s 2017 green bonds circular defined “green” as falling broadly under one of eight categories, including renewable energy, green transportation, and biodiversity conservation.
The RBI has considered issuing green finance guidelines before, and fielded requests from the government to remove project size limits for classifying renewable projects as priority sector. But in its 2019 Report on Trend and Progress of Banking in India, it suggested the lack of a standard terminology as a bottleneck in the development of green finance market.
Among non-profits, Shakti Foundation’s 2019 report was the first attempt at defining a green taxonomy for India, in the context of India’s Nationally Defined Contributions (NDCs) and economic goals. However, the resources mobilised for this initial step pale in comparison with the intensive efforts that went into creating the EU taxonomy, with 35 members representing 32 organizations having worked over the course of 2 years, and work on full technical criteria and sub-legislations is expected to continue till the end of 2022.
The way forward
While countries are free to frame its own rules, India will feel the influence of the taxonomy in two ways: indirectly via the globally integrated capital markets and supply chains; and directly through its participation in international groupings.
India, along with EU, China, and a few other countries, co-founded the International Platform on Sustainable Finance (IPSF) in October 2019, with an objective to scale up the mobilisation of private capital towards environmentally sustainable investments. It will encourage dialogue, and where appropriate, co-ordination on development of its taxonomy.
However, India’s taxonomy is unlikely to be identical with the EU taxonomy. For one, EU taxonomy excludes any reference to solid fossil fuels, including the so-called “clean coal” from its definitions.
Coal accounted for 56% of India’s energy mix in 2017. India’s recent budget proposed closing old thermal coal plants that do not meet emission norms, but its budgetary allocation to coal was still twice the allocation to renewable energy, indicating a place for cleaner production of coal in its taxonomy in the near-term, like that of China.
Even if India paves its own path, it could take heed from the general design considerations made in the EU taxonomy report. First, the taxonomy should be aligned with India’s own international climate goals – 40% renewables in energy mix by 2022, 33% forest cover, and a 35% reduction from 2005 CO2 levels by 2030.
Second, there needs to be a clear sector classification as the basis of the taxonomy; EU taxonomy is based on NACE, its industry classification system. Lastly, it should have performance thresholds, quantitative or qualitative, aligned with the climate goals.
India requires at least $2.5 trillion in capital to meet its ambitious climate actions between 2015 and 2030, according to government estimates. Given the fiscal constraints, a substantial portion of it needs to come from private investors and international agencies. A standard taxonomy of green finance based on best principles, with an eventual path towards global convergence, would catalyse investments that are desperately needed.
Sivananth Ramachandran, CFA, Director, Capital Markets Policy, India at CFA Institute and Sandeep Bhattacharya, India Project Manager, Climate Bonds Initiative