Floods, droughts and food shortages are just some of the effects of climate change, while exploitation and corruption drive social injustice around the world. Governments tackling these issues are realizing that to solve them, they need first to define and measure them. Some are turning to so-called taxonomies that establish which economic practices and products are harmful to the planet and which aren’t. The idea is that the price of goods and services must reflect the human and environmental cost of both production and disposal, which in turn would spur much needed change. But designing a code is fiendishly difficult. For instance, in August 2022, it was reported that a taxonomy focused on social questions had been shelved indefinitely by the European Commission, the executive arm of the European Union.
1. What are taxonomies?
They’re essentially systems for organizing information, and form the basis of codes for sustainable corporate conduct and investing. Those that already exist focus mostly on environmental risks, and are based on research by scientists backed by the United Nations. When the 2015 Paris climate accord was struck, its roughly 200 signatories acknowledged that action must be taken. The average global temperature is already 1.1 degree Celsius (2 degrees Fahrenheit) higher than it was before the industrial revolution. Scientists say the limit is 1.5 degrees Celsius, beyond which lies climate catastrophe. Taxonomies provide a detailed guide for which activities jeopardize climate goals and which support them.
2. Which jurisdictions have taxonomies?
The EU has set a global benchmark with its taxonomy, on which a technical group began work back in 2018. The EU has since been followed by Colombia, China, Japan and members of the Association of Southeast Asian Nations. The UK is also working on its own version of one. Based on work by the EU and China, the International Platform on Sustainable Finance is focusing on establishing some uniformity through a “Common Ground Taxonomy,” which covers areas such as agriculture and manufacturing. If definitions diverge too much, that could hamper efforts to channel funding to sustainable businesses and meet climate goals.
3. What does the EU’s taxonomy cover?
Right now, it addresses climate change mitigation and adaptation. It covers 170 different economic activities that combined represent around 40% of the EU’s listed companies operating in industries responsible for almost 80% of direct greenhouse gas emissions. There are four more environmental objectives to go, including biodiversity, and also a social taxonomy in the works. But the difficulties in reaching agreement on the environmental taxonomy -- in many ways the simplest of the set -- appears to be putting at least some of these plans on hold.
4. What was the conflict?
For several years, there had been arguments over whether some natural gas and nuclear plants should be labeled green. The European Parliament’s vote in July to allow that at least for a while to help relieve tight energy supplies -- a situation worsened by the war in Ukraine -- was criticized by some investors and climate activists.
5. What about the other taxonomies?
Although the “E” usually gets most attention in debates around ESG taxonomies, there were plans to also include social and governance criteria in the definition of sustainable economic activities. To an extent, social and governance-related minimum safeguards have already been made part of the EU’s environmental taxonomy, which includes some fundamental conventions on human rights and good corporate governance. But to establish a standalone social taxonomy, the EU would need to define economic activities that are inherently socially beneficial, contribute to social objectives or are socially harmful under any circumstances. Social objectives include decent work for direct employees as well as workers in a company’s value change along with the well-being of consumers and contributions to inclusive societies.
6. What’s happened with this?
The task to define socially beneficial economic activities has proven even more politically contentious than establishing an environmental taxonomy. Social issues are less quantifiable than environmental goals, and they include questions on which there’s much less consensus on a need for urgent action, compared with climate change. A first European Commission report outlining the main features of a social taxonomy was supposed to be published by the end of 2021, but never came to fruition. Then in August 2022 came word that in light of the bruising fights over nuclear power and natural gas the social issues were being put on hold.
7. Who would be covered by the environmental taxonomy?
Which companies or business activities will be included and by what deadline is currently under review. Larger listed corporates are first in line in the EU, where companies including those in the financial industry will be required to identify how much of their business corresponds to the lists, so investors can direct their money to those with the highest degree of alignment. But requiring disclosure from all companies irrespective of size is at present unrealistic; it’s too complex and costly, with lack of data a constant obstacle.
8. How do you know which companies are aligned?
Calculating how much of sales, operating profit and capital expenditures are eligible to be aligned with the EU’s taxonomy is difficult. Data is tough to obtain and financial institutions, for example, can’t use estimates. To help both investors and companies, the EU is developing a central database of information, and the IPSF has created a tool to map sales that are eligible, though it warns this isn’t an indicator of environmental performance.
9. Will it work?
A recent survey by the Network of Central Banks and Supervisors for Greening the Financial System found that, of two dozen financial regulators, 20% are using taxonomies and another 60% plan to use, or are considering using, one. Some trade organizations have warned regulations are so complex that there’s a risk investors will steer clear of companies, even low emitters, depriving them of financing to clean up. But organizations like the UN’s Intergovernmental Panel on Climate Change warn failure isn’t an option.
10. How do taxonomies work elsewhere?
There are more than 20 under development around the world, according to the IPSF, and they’re starting to diverge. The EU for example has established minimum social safeguards and criteria reflecting the principle of ‘do no significant harm,’ but these aren’t universally used.
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