The UK has an opportunity to learn from Europe’s first-mover experience.
In terms of circuitous arguments, the current and pressing one over UK divergence from the European Union’s environmental taxonomy is a textbook example. As the UK government ponders its options for ‘on-shoring’ taxonomy regulations, some argue that Britain should remain more or less aligned to the EU framework, thus making it easier for financial services firms to offer green funds and other products on both sides of the Channel.
It is then riposted: what is the point in having left the EU if we are, in this case at least, going to stick to its rules? A third perspective asserts that ditching the Brussels rulebook – not because our proposed rules are likely to be any better but because Brexit makes it possible – is a classic case of the tail wagging the dog.
And so on.
As the UK government examines how and by what extent taxonomy rules should be repatriated, there are, fortunately, voices of moderation. One such is Will Martindale, Head of Sustainability at fiduciary manager and pension provider Cardano.
“EU is prescriptive”
“We should track the EU quite closely and keep significant divergence only for exceptional reasons,” he said. Energy may be one such, he added, in light of the EU’s inclusion of gas and nuclear energy under the ‘sustainable’ umbrella. “We are not as diverse an energy jurisdiction as the EU,” he said.
The EU is some years ahead of the UK in taxonomy development, which brings advantages and disadvantages. “The advantage is that we can learn from the EU approach, what has succeeded and what hasn’t, not least in terms of the gas and nuclear question,” noted Martindale.
“The disadvantage is that the UK regime will always be judged against that in the EU, which is better established.”
Anthony Kirby, Leader – ESG Regulation and Risk Management at EY, said: “Should we stick with the EU rules? Will the UK follow EU standards? There are different classifications round the world. A lot of entities, US corporations and banks, are asking that question. They want to do business in the EU.
“The biggest challenge firms are facing is that so much of the EU regime is prescriptive.”
Eliette Riera. Head of UK Policy at the Principles for Responsible Investment (PRI), said: “Ideally we would not diverge. But the UK has benefited from not being the first mover. Don’t replace something unless you come up with something better.”
Eyes are now on the UK government to see what it proposes to do, but any blueprint is taking time to arrive and ongoing political turmoil is only adding to the uncertainty. Riera said: “When will we see the proposals? No-one knows. We are hoping any time now.
“There is a 1 January legal obligation in the primary legislation. This could be amended. We would rather things were done properly than rushed out of the door.”
Kirby agreed on the need for rigour. “The consultation in the UK is on-going. It could take another year to finish. Best to take time. The UK government has not suggested a date.”
Not only has no date been put on the publication of proposals, said Martindale, but the scope of the consultation that will precede them has also yet to be decided. He added: “It is important that we understand the purpose of taxonomy. It is a disclosure tool allowing investors to judge the alignment of their portfolios with their goals.
“Taxonomy helps investors and the companies in their portfolios to understand what is green and what is not. For that reason, it needs a cut-off point beyond which something is not green. It is also a useful tool in terms of providing a starting point for judging what ‘good’ entails.”
Europe’s first-mover experience has highlighted other risks that fast followers will be keen to avoid. For example, the taxonomy is being pressed into the service of fiscal policy, being used to help allocate tax incentives for sustainable investing. “This moves taxonomy away from its core purpose of disclosure,” notes Martindale.
Britain faces a number of challenges in devising its own taxonomy regime, but that does not mean that the EU system has been trouble-free. Kirby said: “EU rules are very detailed and prescriptive. The problem is that vendors rely on corporations to file data correctly. The EU is also extra-territorial: it expects third countries to follow EU standards.
“But many won’t. There are more than 30 sets of standards around the world.”
Having provided the backdrop to the Paris agreement and been a key player in subsequent efforts to incorporate its objectives into policy, Europe has become used to its leadership position. But this is unlikely to last. “The EU will face the reality that it will have to work with other taxonomies,” said Kirby.
From a global perspective, the approaches of both China and, in particular, the US could have a growing influence on the development of sustainable finance frameworks internationally.
Market clarity essential
The European experience has also showed that putting a taxonomy in place is a complex affair, requiring supporting regulatory frameworks. In the EU, this includes the Corporate Sustainability Reporting Directive and the Sustainable Finance Disclosure Regulation, which require corporates and financial service providers respectively to report on their level of alignment with the taxonomy. Getting this pieces of the jigsaw in place, in the right order, has been an ongoing and imperfect process.
Jan Vandermosten, senior policy analyst EU at PRI, said: “We have engaged on the importance of EU taxonomy and held Interviews with about a dozen investors. They are seeing a few challenges in terms of the timing of disclosures and the challenge of investors interpreting the data.”
Expanding his point, he added: “The timing of reporting requirements has been a bit muddled in the EU. A lot of EU rules are hard for a company to use to see if it conforms to the criteria. The criteria should be made easier to understand and comply with.”
But, he added. “investors say the challenges are short term”.
Established in 2021, the independent Green Taxonomy Advisory Group (GTAG) earlier this month urged the UK government to offer clarity. “The UK needs to send a rapid market signal to financial market participants, their regulators and companies as to how their preparations for EU Taxonomy reporting will work in a future UK market context,” its advice read. ”A signal should be issued as soon as possible in order to ensure market certainty and a sense of continued relevance for the UK Green Taxonomy for market participants.”
GTAG said the benefits of divergence include Britain’s ability to ensure the integrity of the UK Green Taxonomy in terms of its coherence with other UK policies and to respond to changing scientific and market information. Divergence could also reflect the high ambition of the UK’s 2030 and 2035 targets and carbon budgets, and address some of the flaws of the EU system, such as its complexity to implement and lack of relevance outside of Europe.
But the risks of divergence, it said, include creating a fragmented regulatory landscape in which it is more difficult to achieve international norms and standards for net zero, and the potential loss of market influence in the event of competition between different jurisdictional standards.
“Given the importance of striking this balance correctly, it is important for the UK to decide which approach to take when it comes to ‘adopt versus revise’ and also set out principles that will be used for any revision process.”
“A healthy partnership”
Looking forward, Kirby said: “The UK is likely to be more about principles and guidelines than prescriptive rules. Britain is looking at pathways – how do you involve companies that may not be greener than green?
“The challenge will be for those doing some business in the UK and some in the EU.”
Martindale saw the risks of the UK taking too distinct a path. “Divergence raises costs. A firm may have to have two sets of disclosures. It changes the focus of the conversation so that instead of a common starting point, it is all about these difficulties.”
While acknowledging the UK has an opportunity to learn from issues that have arisen in an EU context, such as the gas and nuclear question, Kirby said it may need to decide much for itself. “What is green financing? How green is green? Should there be percentage thresholds? The EU demands a green asset ratio.
“We do need clarity.”
Riera agreed: “Clarity and consistency are what is needed for investors. The UK government should be sending a clear signal that investment should be going to sustainable objectives.”
Martindale is optimistic about the outcome of the discussions about ‘on-shoring’ the taxonomy system. “There’s a healthy government/stakeholder partnership here. It is an area of policymaking where we are bringing in expertise. Britain’s strong tradition of stewardship is invaluable here.”
In its advice paper, GTAG Chair Ingrid Holmes also struck an optimistic note: “A robust and science-based green taxonomy for the UK will also ensure that its globally focused financial sector, which has some of the deepest pools of internationally orientated capital, is well placed to take advantage of growth in the global green finance market.”