There is an urgent need to mobilize global capital for climate action, particularly in emerging markets. Songwe, Stern, and Bhattacharya (2022) estimate that developing countries, excluding China, will need to spend approximately $1 trillion per year by 2025 and around $2.4 trillion per year by 2030 on sustainability and transition-related investments. To meet China’s carbon neutrality goal by 2060, the World Bank suggests that China needs an additional investment of $14-17 trillion for green infrastructure and technology in the power and transport sectors alone between 2021 to 2060.
At the same time, there has been a surge in demand from investors who are seeking to invest in green projects, which contribute to keeping global temperature rise below 2 degrees celsius. Membership to the UN Principles for Responsible Investing has continued to expand, and sustainability-themed investment grew by 80% in 2019 to $3.2 trillion.
A key obstacle to scaling up climate financing in emerging markets lies in investors’ concerns about greenwashing, whereby an entity either deliberately or unintentionally misstates the environmental benefits of an asset, activity, service, or product.
Regulators have responded to this challenge by developing classification systems that help to standardize definitions of what may be considered ‘green’. Such sustainable finance taxonomies are being adopted, or are in development, across various jurisdictions including the European Union, China, Singapore, ASEAN, Chile, Colombia, South Africa, and the UK. As of December 2022, there were 29 sustainable finance taxonomies with different levels of process maturity.
By providing financial markets with clearer definitions of what may be considered sustainable, regulators have helped to reduce information asymmetry and the transaction costs associated with investing in green bonds and other financial products. By labeling an economic activity/asset as green, governments send a signal to market participants that investments can receive certain benefits. However, this proliferation of taxonomies has inadvertently created a new challenge for international financial centers.
Each country has a unique responsibility regarding the current state of our planet’s climate. The United States and Europe have historically been the largest emitters of greenhouse gasses. However, in the 21st century, China’s contribution (and anticipated contribution) to global emissions vastly outweighs those of the other countries. The emissions trajectories of other countries, such as India, Brazil, Indonesia, and Russia will also have immense ramifications on humanity’s ability to keep global warming below 2 degrees.
Similarly, countries have their own energy generation mixes and other economic and geographical contexts which shape their unique pathways towards fulfilling their role in meeting the Paris Agreement objectives.
Thus, what some countries define as green may vary substantially from others. Moreover, there are inescapable political pressures and realities. For example, the Malaysian Taxonomy endorses the expansion of palm oil plantations – a direct contradiction to the European Union’s view that palm oil production often comes with immense biodiversity loss and deforestation. As more countries develop their own taxonomies, it may become increasingly difficult to find a common ground between what may be considered ‘green’.
There are certainly efforts to tackle this challenge. For example, the G20 Sustainable Finance Working Group (2021) has called for greater interoperability and comparability between taxonomies. Meanwhile, the European Union and People’s Republic of China (PRC) have identified common ground between their two taxonomies, and most recently, the Monetary Authority of Singapore and People’s Bank of China (PBOC) have announced efforts to do the same. Meanwhile, in Hong Kong, the Green and Sustainable Finance Cross-Agency Steering Group has been working towards proposing a local green classification framework that aligns with the Common Ground Taxonomy, an EU-China joint initiative launched through the International Platform on Sustainable Finance (IPSF).
In light of the policy context above, our recent paper studies how developed countries may effectively channel green finance to support emerging markets through coordination on taxonomies and the policies that support their adoption and use.
Coordination in taxonomy development is by no means an easy task. Each jurisdiction has its own development level and market maturity. These different local contexts lead to varying green finance taxonomy choices. To understand this context, our paper conducts an empirical analysis of existing green finance taxonomies, and identifies two ways in which different taxonomies may be misaligned.
First, we find that taxonomies may differ in design, for instance, by adopting different industrial classification systems for their economic activities, or by using different metrics to measure the environmental impact of an activity. For example, countries may reference their local building codes, standards, and labeling schemes when designing their own taxonomies. However, an investor subject to reporting requirements in one country, may have trouble understanding whether an investment in a building in a foreign market would comply with their domestic definition.
Second, we find that taxonomies may also differ in stringency, for instance, by setting different thresholds for climate contribution for the same economic activities. Two taxonomies may use the same metric for measuring the emissions intensity of an economic activity but may diverge in terms of what emissions intensity threshold must be met to be considered green; we call this stringency misalignment between two taxonomies
With a deeper understanding of the problem, we narrow down our focus to the potential problems caused by stringency misalignment, which we believe to be a more substantial problem when discussing taxonomy coordination between developed and emerging markets.
To investigate how stringency misalignment may impact cross-border capital flow, we construct a parsimonious microeconomic model to capture the economic and financial impacts of taxonomy coordination between developed and emerging markets. In particular, we study the market dynamics of two hypothetical jurisdictions A and B, which represent the developed and emerging markets respectively.
We focus on the illustrative case where the taxonomy of jurisdiction A is more stringent than that of jurisdiction B and analyze the optimal response of investors when regulators in jurisdiction A endorse the common ground of the two taxonomies.
We find that whether common ground endorsement leads to more or fewer green projects that are aligned with the taxonomy of jurisdiction A depends on four key factors:
- the price ratio between green bonds in the two markets;
- the supply elasticity of green bonds in the two markets;
- the misalignment ratio of their taxonomies;
- the preferential treatment that B gives to those domestic green bonds that are aligned with the more stringent taxonomy in A.
In other words, we have shown that reckless cross-border taxonomy recognition may be counter-productive to climate change mitigation. From here, we develop a series of recommendations for policymakers to prioritize cross-border taxonomy coordination, and to increase the fruitfulness of such coordination through improving the 4 key factors above. These serve to help international financial centers to help maximize the net benefit of cross-border taxonomy recognition.
Keith Jin Deng Chan is an Assistant Professor in Green Finance at the Hong Kong University of Science and Technology.
Lionel Wilson Mok is a PhD candidate in Environmental Science, Policy and Management at the Hong Kong University of Science and Technology.
Peter Chi Choi Lau is a final year BSc student in Environmental Management and Technology at the Hong Kong University of Science and Technology.
This post is adapted from their paper, “Leakage in the Common Ground: How Misalignment in Sustainable Finance Taxonomies Impacts Cross-Border Capital Flow,” available on SSRN.