The Bank for International Settlements (BIS) published a paper that develops a framework to classify and compare existing taxonomies. The paper also identifies weaknesses that emerge from this classification and comparison and proposes five key principles for the design of effective taxonomies. The analysis in the paper concludes by setting out key policy recommendations, one of which is that authorities should aim to harmonize practices for calculating and reporting impact metrics. Furthermore, standardization of units and disclosure of computation methodologies should be encouraged and external auditing required.
The weaknesses identified by the analyses include the lack of use of relevant and measurable sustainability performance indicators, lack of granularity, and lack of verification of achieved sustainability benefits. The key principles for the design of effective taxonomies can be employed to develop a simple framework for transition taxonomies. While certain principles, both in traditional taxonomies and in the case of climate transition finance, are intended for application over medium to longer term horizons, the paper recommends some concrete near-term policy actions:
- Endeavor that specific taxonomies (or certification processes) correspond to specific sustainability objectives. A single taxonomy that categorizes activities or entities based on the achievement of multiple objectives, such as greenhouse gas emission reduction and social inclusion, runs the risk of increased greenwashing due to reduced market transparency resulting from complex weighting schemes to aggregate the objectives. Narrowly focused taxonomies benefit from less costly certification and verification processes.
- Encourage development of transition taxonomies to facilitate the channeling of funds to transition activities and increase the focus on Paris alignment. Practices and standards with respect to the reporting of climate transition plans, interim targets, and their level of alignment with Paris goals need to be harmonized further. Many institutional investors seeking to align portfolios with low-carbon transitions use environmental, social, and governance (ESG) ratings. Yet the metrics for the environmental pillar (the “E” of ESG) do not yet capture a forward-looking assessment on climate transition. In the absence of a globally accepted taxonomy, a wide range of transition terminologies and metrics exists, thus resulting in a low level of standardization across markets and jurisdictions.
- Monitor and supervise the evolution of certification and verification processes. To mitigate the risk of greenwashing, a high-quality and consistent verification process is critical. Supervisors and regulatory authorities should provide uniform standards of conduct for the providers of certification and verification services. Viable models for the supervision and regulation of providers of those services include those already in place for credit rating agencies in the United States and Euro area.
- Shift from current voluntary guidelines of post-issuance reporting to mandatory annual impact and use-of-proceeds reports. The success of outcome-based taxonomies will depend heavily on the availability of more data and analysis on the impact of the classified assets or activities. To the extent that taxonomies move toward incorporating outcome-based key performance indicators (Principle 3), impact reports are likely to be a key supplementary requirement of these taxonomy, with provisions of the report best made available on at least an annual or even a higher frequency basis. Estimation of the promised impact of the projects financed by green bonds as well as ex post tracking of their achievement is greatly facilitated by mandatory uniform annual impact and use-of-proceeds reports. Use of proceeds and impact should be reported project by project, specifying the environmental impact categories while the information should be aggregable at individual bond level and by category or sector.
Keywords: International, Banking, Sustainable Finance, ESG, Taxonomy, Paris Agreement, Green Bonds, Climate Change Risk, Transition Risk, Disclosures, Reporting, Impact Reports, BIS
Dr. Denton provides industry leadership in the quantification of sustainability issues, climate risk, trade credit and emerging lending risks. His deep foundations in market and credit risk provide critical perspectives on how climate/sustainability risks can be measured, communicated and used to drive commercial opportunities, policy, strategy, and compliance. He supports corporate clients and financial institutions in leveraging Moody’s tools and capabilities to improve decision-making and compliance capabilities, with particular focus on the energy, agriculture and physical commodities industries.
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