Following the Paris Agreement in 2015 and COP26, the UK government is preparing to publish its plans for the UK Green Taxonomy. But what is “taxonomy”, and what does it mean for businesses and investors?

Oliver Ingham and Chantelle Tang explore these issues and offer some thoughts on what we can expect.

What is green taxonomy?

Green taxonomy is a system for classifying whether an investment is sustainable. It seeks to assess and identify activities and assets that deliver on key climate, social, green or sustainable objectives using identified thresholds and/or targets as reference. Once those “green” and sustainable activities have been determined, this can be applied consistently to every company.

A common set of criteria will offer investors a tool by which they can screen potential investments and identify those that have been identified as “green” and sustainable.

Various governments and intra-state bodies have developed or are developing their own green taxonomy regime, including the EU, US, China, Bangladesh, Mongolia, Singapore, South Africa, Australia, Canada and Colombia. Each taxonomy is different in terms of the standards used and to which investments they apply. As a result, a “sustainable investment” in one part of the world may not be deemed so in another.

Why is it needed?

In recent years, as focus has shifted towards climate action, there has been a significant increase in the number of investment products sold as sustainable or labelled as “ESG”. However, concerns have been raised about the accuracy of these claims and whether “ESG” is no more than a marketing ploy. This may lead to investors being misled about the sustainability of investments (known as “greenwashing”).

To tackle this, the green taxonomy aims to create a shared benchmark to ensure the measurement is objective and consistent across the industry, thereby providing clarity for investors.

UK green finance

In October 2021, the UK Government published its Greening Finance: A Roadmap to Sustainable Finance (the “Roadmap”) as part of its plans to move towards a net-zero economy. While corporates are already reporting on sustainability, the Roadmap sets out the government’s plans to introduce further requirements to report on the sustainability of their actions and products. The overall aim is to transition in three phases towards a green financial system in the UK:

Phase 1: Informing investors and consumers – ensuring a flow of decision-useful information on environmental sustainability from corporates to financial market participants.

Phase 2: Acting on the information – ensuring that this information is mainstreamed into business and financial decisions, for example, in risk management and investor stewardship.

Phase 3: Shifting financial flows – ensuring financial flows across the economy shift to align with the UK’s net-zero commitment and wider environmental goals.

Steps toward this have already been introduced. For example, the Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2022 requires the largest UK-registered companies and financial institutions to disclose climate-related financial information on a mandatory basis in their strategic report from April 2022.

The Roadmap sets out plans for the introduction of Sustainability Disclosure Requirements (“SDRs”) and the UK Green Taxonomy. Both are currently being developed and will be introduced following industry consultations.

Sustainability Disclosure Requirements

The Roadmap outlines the SDRs as follows:

  • Corporate disclosure: new requirements for companies to make sustainability disclosures and reporting of environmental impact using the UK Green Taxonomy.
  • Asset manager/owner disclosure: new requirements for asset managers and asset owners that manage or administer assets on behalf of clients and consumers to disclose how they take sustainability into account. These will help consumers determine whether their assets are managed according to their sustainability preferences.
  • Investment product disclosure: new requirements for creators of investment products to report on the products’ sustainability impact and relevant financial risks and opportunities. This information will form the basis of a new sustainable investment labelling regime that will make it easier for consumers to navigate the range of investment products available.

The UK Green Taxonomy

The UK Green Taxonomy will act as a framework for the SDRs, setting out what activities or investments are “green”. The UK government will focus on net-zero in the UK context, building upon international taxonomies and taking the “scientific metrics in the EU taxonomy as its basis”.

The EU Taxonomy – what is it proposing?

As part of its European Green Deal, the EU Commission adopted the Taxonomy Regulation 2020/852 in June 2020. It sets six environmental objectives:

  1. Climate change mitigation.
  2. Climate change adaptation.
  3. The sustainable use and protection of water and marine resources.
  4. The transition to a circular economy.
  5. Pollution prevention and control.
  6. The protection and restoration of biodiversity and ecosystems.

In December 2021, an initial list of sustainable investments was approved, including renewables such as solar panels, hydroelectric dams, bioenergy and windfarms. However, concerns have been raised about the EU’s recent draft plans, which include gas and nuclear.

How will the UK taxonomy differ?

The UK government is yet to release its detailed plans, but the Roadmap indicates that the UK Green Taxonomy will adopt the EU’s six environmental objectives (see above). It will also have technical screening criteria, which will set out what activities are deemed “green”. Again, concerns have already been raised about the prospect of gas and nuclear being included (exacerbated by the war in Ukraine and the fuel crisis).

To be considered “taxonomy-aligned”, corporates or products will have to:

  1. Make a substantial contribution to one of six environmental objectives.
  2. Do no significant harm to the other objectives.
  3. Meet a set of minimum safeguards.

More detail will follow when the UK government releases its plans, which is expected shortly.

What does this mean for companies?

The introduction of the SDRs and UK Green Taxonomy will mean more regulation for large companies, asset managers and asset owners. Financial regulators such as the Financial Conduct Authority and Prudential Regulation Authority are working with the government to develop guidelines and regulations for implementation and enforcement.

This will mean more time and resources will need to be spent on compliance functions, which are already under mounting pressure due to the recent expansion of Russian sanctions.

What does this mean for investors?

The introduction of further disclosure requirements and an agreed framework will be a welcome development for investors. It will provide more reliable information on the impact of their investments on climate change and how climate change is impacting their investments.

It remains to be seen how the requirements will be enforced, but we already have seen action being taken in other jurisdictions. The new regulations are likely to open up further avenues via which regulators and investors will be able to hold corporates to account in respect of sustainability. For example, German authorities recently raided the offices of asset manager DWS and its owner Deutsche Bank as part of an investigation by German and US authorities into claims that it misled clients about its sustainable investments. In the US, the Securities and Exchange Commission has been taking a more proactive stance, having established an ESG and climate task force, which has brought three enforcement actions so far in 2022.

ESG-related shareholder litigation is also gaining traction in the UK. For example, Shell’s board of directors is facing a possible derivative claim from its shareholder, ClientEarth, on the basis of a breach of directors’ duties in respect of its climate policies. Further down the line, shareholders may be able to bring claims in the UK against a corporate for losses caused by misleading information in its reporting on sustainability under the new regulations.

Overall, more stringent regulation is a welcome development. While it will require extra compliance work for companies, it is worth getting it right. If they do not, corporates will face increased litigation risk from shareholders.

Conclusion

Partner Elaina Bailes says: “While the UK regulators have not taken equivalent actions to date, we expect to see enforcement action in the near future as the UK regulators tend to follow investigatory trends from the US and EU. Further, the Climate-related Financial Disclosures regulations start to bite for reporting of large companies from April 2022, which will give greater transparency on a business’s ESG strategy that investors will want to scrutinise.”