Taxonomies exist across all industries. In simple terms, it is the act of naming, defining, and classifying a group of things. In financial markets, taxonomies are used to make sense of the myriad financial instruments, equities, and debt that make up the market. A green taxonomy relates to the classification of green assets, companies, and projects.
Adopting a taxonomic approach can create a common language for what can be considered green economic activity. For investors, it allows them to ascertain the percentage of their portfolios that are contributing to the low-carbon transition and understand the climate-related risks and opportunities within their portfolios. It also helps to facilitate the flow of capital into sustainable activities by making them easily identifiable.
For businesses, taxonomies help to translate global climate commitments (such as the Paris Agreement) and environmental objectives (such as climate change mitigation) into a clear criterion for business activity. Companies can then communicate to investors and stakeholders how their products and services are contributing to the low-carbon transition within a clear and recognised framework.
Adoption of taxonomies is spreading globally at pace. The EU and China have already established their own, whilst other countries such as the UK, Canada, Malaysia, Russia, and Singapore are at varying stages of development. Their development highlights the need for collaboration and consistency, to ensure green taxonomies remain decision-useful for investors and intermediaries whilst aiding cross-border capital flows.
Greenwashing is making its way up the sustainable finance agenda due to increased capital flows into green products. It is made possible by inconsistent standards for green economic activity that are open to interpretation, resulting in non-green activity being labelled as green. A prime motivator for wider adoption of green taxonomies is the role they can play in combatting greenwashing by establishing clear parameters for classification.
The EU Taxonomy
Published in 2018, the European Commission’s action plan on sustainable finance highlighted the need for a science-based classification system for sustainable activity. The EU Taxonomy was established primarily to encourage direct investment into sustainable projects and activities.
The legally binding Taxonomy Regulation sets out the basis for the EU Taxonomy by establishing six environmental objectives to which economic activity can be mapped:
- Climate change mitigation
- Climate change adaptation
- The sustainable use and protection of water and marine resources
- The transition to a circular economy
- Pollution prevention and control
- The protection and restoration of biodiversity and ecosystems
The development of the EU Taxonomy sets the tone for subsequent taxonomies both at national and corporate level.
The UK Taxonomy
The UK Government first announced it would implement a green taxonomy at the end of 2020, as part of wider plans to position the UK at the forefront of sustainable finance.
To develop the taxonomy, they appointed a Green Technical Advisory Group, chaired by the Green Finance Institute, which is made up of key financial markets stakeholders, including a representative from LSEG’s FTSE Russell. A key consideration for its creation was ensuring that it is usable and practicable for both financial and non-financial firms.
FTSE Russell’s Green Revenues Taxonomy
While the EU Taxonomy will set out a catalogue of green criteria, it leaves it to markets to assess individual companies against these criteria. FTSE Russell, a global leader in indexes, data, and analytics, developed a Green Revenues Classification System (GRCS) that covers 10 green sectors and 133 green micro-sectors and offers a solution to this challenge. In a mark of its credibility, the GRCS has been incrementally developed with the oversight of an independent global advisory committee for more than a decade.
The green micro-sectors within FTSE Russell’s GRCS are aligned with the environmental objectives set out by the EU Taxonomy, with the addition of ‘sustainable and efficient agriculture’. FTSE Russell uses the GRCS as the basis to produce a highly granular dataset, assessing more than 16,000 stocks globally on their exposure to green business activities.
In doing so, they are helping investors and financial markets to better identify companies with green products and services, track their performance and facilitate the construction of financial products that seek exposure to such companies.
Use case 1: Green Economy Mark
In an ecosystem where a growing number of companies are generating commercial revenues from green products whilst investors are increasingly seeking to deploy capital into legitimately green businesses, London Stock Exchange is dedicated to its role to act as a convener between these two mutually dependent groups.
Launched in 2019, its Green Economy Mark was established to help identify and champion issuers across all its markets which generate more than 50 percent of revenues from environmental solutions. Data from London Stock Exchange’s recent Green Economy report show that there are now 101 listed companies and funds with the Green Economy Mark, with a combined market capitalisation of £149billion (US$205.3 billion).
Comparative analysis found that the cohort was the fourth-largest sector for capital-raising in the last 24 months, outperforming the FTSE All-Share by 5 percent so far this year. Issuers with the Mark also showed resiliency during the global pandemic, outperforming global indexes.
Though there are different routes to qualification, the underlying methodology remains consistent. London Stock Exchange harnesses FTSE Russell’s Green Revenues 2.0 data model and GRCS to determine which companies and funds qualify for the accreditation. By using FTSE Russell’s taxonomy, it can take a broad, sector-agnostic view of green products and services. It can also establish the degree to which businesses are contributing to the environment via a tiering system to assess net ‘greenness’; the Mark is only credited to equity issuers that have a net-positive impact on the environment.
The benefits of an accreditation like this are twofold. Companies are offered exposure to investors looking to deploy capital into sustainable businesses as well as being able to demonstrate their suitability for ESG funds and indexes. Investors, on the other hand, can identify businesses with activity that is aligned to the EU taxonomy, accredited by a recognisable third party, and based on a robust methodology.
Use case 2: Sustainable Bond Market
London Stock Exchange’s Sustainable Bond Market (SBM) provides corporates, sovereigns, and investors access to a flexible and transparent market where they can issue debt and invest in debt instruments that demonstrably support the transition to a low-carbon economy. SBM includes dedicated platforms for green, social, sustainability, and sustainability-linked bonds. In 2020, it was expanded to include a world-first Transition Bond Segment, which enables a broader set of issuers to raise capital for climate transition purposes.
SBM’s Issuer-Level Classification enables businesses with activity aligned with the green economy to admit bonds for additional visibility. For an issuer to be eligible, they must meet the green revenue criteria, which is based on FTSE Russell’s GRCS. To admit via this route, issuers must meet the threshold of more than 90 percent green revenues. London-listed businesses with the Green Economy Mark may also use this segment. Applying the same taxonomy for debt issuance ensures that there is consistency across asset classes in the way green revenues and activity are defined.
With increased attention comes increased scrutiny for the green economy landscape, and for the corporates and funds that exist within it. The application of green taxonomies provides common language amongst the companies raising capital and the investors allocating it. A greener, more sustainable economy is powered by transparency and a sustainable flow of capital. London Stock Exchange is committed to harnessing those tools and supporting issuers in the pursuit of a financial ecosystem that supports our natural ecosystem.