Regulators

Financial firms are expected to be guided by a 'green taxonomy' developed by US regulators.

Published on: 9 December 2021 09:20 AM
by KnowESG
An aerial view shows a forest fire in the 30 km (19 miles) exclusion zone around the Chernobyl nuclear power plant, Ukraine, April 12, 2020.

A Brief Summary

A "green taxonomy" of U.S. financial firms' climate risk management is seen as an essential step toward providing firms with a clear understanding of what is expected from them. The development of such taxonomy would help financial participants understand what types of assets regulators view as green, a designation that would have multiple benefits across the industry. Coordination and collaboration among regulators are key, without which financial firms will be grappling with varying and possibly conflicting guidance. Look for the acting comptroller of the currency Michael Hsu to take coordinated action with other regulators on climate change, with a potential first step being the development of a joint taxonomy. Once developed, financial institutions could draw on these taxonomies to analyze the impact of their financing and investing activities.

Broad support for Taxonomies, Standard Developments in the EU's green taxonomy could be a possible guide to what might emerge in the United States, says S&P Global. "However, the regulation also places new taxonomy linked disclosure obligations on companies and on financial market participants." But at a basic level, the taxonomy's definitions and rules determine which economic activities are environmentally sustainable, and establish a standard to avert "greenwashing," or misleading claims of environmental responsibility. Regulators in the EU's Technical Expert Group (TEG) have defined a green taxonomy for the classification of key industrial sectors and economic activities with respect to climate change mitigation or adaptation. - Do no significant harm to any of the other objectives, while respecting basic human rights and labor standards. The U.S. Treasury's Financial Stability Oversight Council (FSOC) might be a forum to bring together various regulatory bodies in the development of a green taxonomy.

There are six environmental objectives of the taxonomy: climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, and biodiversity and ecosystems. This could be useful to financial industry participants in terms of their investment, lending, and disclosure requirements.

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Experts suggest that providing financial firms with a standard taxonomy and framework for managing their climate risk exposures is one of the first coordinated moves by US financial authorities, with the European Union's initiatives possibly acting as a precedent for future regulation.

Given the patchwork of responsibilities and laws of many agencies, speaking with one voice has long been a challenge for US regulators. Coordination among banking, securities, and derivatives authorities is considered as a critical step in providing firms with a clear knowledge of what is required of them, given climate risk regulation is still in the development phase.

Acting comptroller of the currency Michael Hsu was cited in a recent PwC report as a regulator who might take an active role in engaging with other agencies on a common climate taxonomy.

"In terms of his other goals, expect Hsu to take coordinated action on climate change with other regulators, with the formation of a joint taxonomy as a possible starting step," PwC said.

The creation of such a shared taxonomy , dubbed a "green taxonomy," would aid financial participants in understanding what types of assets regulators consider green, a distinction that would benefit the entire industry. For asset and investment managers, for example, a taxonomy like this would allow them to categorize assets based on an issuer's or borrower's commitment to mitigating or adapting to climate change consequences.

According to a report by Accenture, if created, financial institutions might use these taxonomies to monitor the impact of their financing and investment activities and match finance policies with them to meet climate impact targets.

However, without coordination and collaboration among authorities, financial firms will be forced to deal with diverse and possibly contradictory directions. Compliance with future rules would be substantially more difficult as a result.

"If it isn't done in a coordinated manner, financial institutions will wind up all over the place," PwC partner Adam Gilbert told. "As a result, there could be significant disparities in risk management practices and disclosures, and... it will be difficult for stakeholders responsible for evaluating or regulating the companies to make sense of it all."

STANDARDS AND BROAD SUPPORT FOR TAXONOMIES

The establishment of common taxonomies and standards was one of many recommendations made by a Commodity Futures Trading Commission sub-committee late last year, which deemed it vital for the management of climate change's physical and transition risks. The study's findings were as follows:

"Financial regulators should support the development of US-appropriate standardized and consistent classification systems or taxonomies for physical and transition risks, exposure, sensitivity, vulnerability, adaptation, and resilience, spanning asset classes and sectors, in order to define core terms supporting the comparison of climate risk data and related financial products and services, in collaboration with the private sector."

According to the report, such an effort "should incorporate international engagement to the extent practical in order to assure synchronization across global definitions."

A large percentage of respondents in a recent analysis of public comments to the Securities and Exchange Commission's future disclosure rules thought the SEC should draw on existing standards, such as those developed by the Task Force for Climate-Related Financial Disclosures (TCFD) or the Sustainability Accounting Standards Board (SASB), for reasons such as international harmonization.

IS THE EU A GUIDE FOR GREEN TAXONOMIES?

With US regulators becoming more engaged with European Union and UK regulators on climate change, the taxonomies and standards that have already been developed by nations who are leading the way could serve as a model for what might emerge in the US.

The Technical Expert Group (TEG) of the European Union has created a green taxonomy for the classification of key industrial sectors and economic activities in terms of climate change mitigation and adaptation. This taxonomy is also likely to serve as the groundwork for impending legal changes, such as the EU's Sustainable Finance Disclosures Regulation, according to experts (SFDR).

With almost 550 pages, the EU's taxonomy is intimidating. The taxonomy's definitions and regulations, on the other hand, specify which economic activities are environmentally sustainable and set a baseline to avoid "greenwashing," or false claims of environmental responsibility.

"The taxonomy was established as a classification system to address greenwashing by enabling market players to identify and invest in sustainable assets with greater confidence," S&P Global stated. "However, the regulation imposes on companies and financial market participants new taxonomy-related disclosure duties."

The definition of a sustainable economic activity lies at the heart of the EU's taxonomy legislation. This classification is based on two factors. An activity must include the following elements:

  • Contribute to at least one of the taxonomy's six environmental aims.

  • Do not jeopardize any of the other goals, while adhering to basic human rights and labor norms.

The taxonomy's six environmental goals are:

  1. Climate change mitigation,

  2. Climate change adaptation,

  3. Sustainable water and marine resource use and protection,

  4. Transition to a circular economy,

  5. Pollution prevention and control, and

  6. Biodiversity and ecosystem protection and restoration.

While the EU's taxonomy is largely a classification tool, it also mandates certain businesses to report on the degree to which their operations are aligned with the taxonomy. This is where financial industry participants can benefit from it in terms of investment, lending, and ultimately transparency obligations.

Experts disagree on how much the US authorities will use what the EU has established, but given the substantial amount of work that has already been done in this area, it is unlikely that they will want to start from scratch.

In terms of coordination, the Financial Stability Oversight Council (FSOC) of the US Treasury might serve as a venue for bringing together various regulatory organizations in the development of a green taxonomy.

PwC's Gilbert said, "It's a natural body to bring those regulators together." "While the FSOC's primary focus is on financial stability, it can also be used as a policy coordination instrument." said Henry Engler.

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