U.S. regulators seen developing ‘green taxonomy’ to provide guidance to financial firms

2021-07-14 22:04:41 GMT+00:00 - By Henry Engler

NEW YORK(Thomson Reuters Regulatory Intelligence) - Giving financial firms a common taxonomy and framework for managing their climate risk exposures is seen as one of the first coordinated actions by U.S. financial regulators, say experts, with efforts by the European Union possibly serving as a model to future regulation.

Speaking with one voice has long been a challenge for U.S. regulators given the patchwork of responsibilities and rules of multiple agencies. With climate risk regulation still in the development phase, coordination among banking, securities and derivatives regulators is seen as an essential step toward providing firms with a clear understanding of what is expected from them.

In a recent analysis by PwC, the consultancy, acting comptroller of the currency Michael Hsu, was cited as a regulator who might take an active role in collaborating with other agencies on a joint climate taxonomy.

“Regarding his other priorities, look for Hsu to take coordinated action with other regulators on climate change, with a potential first step being the development of a joint taxonomy,” PwC said.

The development of such a joint taxonomy, often referred to as a “green taxonomy,” would help financial participants understand what types of assets regulators view as green, a designation that would have multiple benefits across the industry. For asset and investment managers, for example, such a taxonomy would allow them to classify assets with respect to an issuer’s or borrower’s contribution to mitigating or adapting to the impacts of climate change.

Once developed, financial institutions could draw on these taxonomies to analyze the impact of their financing and investing activities and align financing policies with them to achieve climate impact goals, according to a report by Accenture.

However, coordination and collaboration among regulators is key, without which financial firms will be grappling with varying and possibly conflicting guidance. That would make compliance with future rules much more difficult.

“If it’s not done in a coordinated fashion, then financial institutions will end up being all over the place,” Adam Gilbert, partner at PwC, told Regulatory Intelligence. “As a result, you could get very big differences in risk management approaches, big differences in disclosures, and ... it will be hard for stakeholders who are responsible for evaluating the companies or regulating them to make sense of it all.”

BROAD SUPPORT FOR TAXONOMIES, STANDARDS

The development of common taxonomies and standards was among numerous recommendations made by a subcommittee of the Commodity Futures Trading Commission late last year, deeming it critical for the management of the physical and transition risks of climate change. Specifically, the study said:

“Financial regulators, in coordination with the private sector, should support the development of U.S.-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 associated financial products and services.”

The study also noted that such an “effort should include international engagement in order to ensure coordination across global definitions to the extent practicable.”

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

GREEN TAXONOMIES: IS THE EU A GUIDE?

With U.S. regulators increasingly engaged with their fellow European Union and UK regulators on climate change, the taxonomies and standards have already been created by countries taking the lead could be a possible guide to what might emerge in the United States.

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. According to experts, this taxonomy is also expected to serve as the framework for upcoming regulatory changes, such as the EU’s Sustainable Finance Disclosures Regulation (SFDR).

The EU’s taxonomy is daunting at over 550 pages. 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.

“As a classification system, the taxonomy was created to address greenwashing by enabling market participants to identify and invest in sustainable assets with more confidence,” said S&P Global. “However, the regulation also places new taxonomy linked disclosure obligations on companies and on financial market participants.”

At the core of the EU’s taxonomy regulation is the definition of a sustainable economic activity. This definition is based on two criteria. An activity must:

- Contribute to at least one of six environmental objectives listed in the taxonomy.

- Do no significant harm to any of the other objectives, while respecting basic human rights and labor standards.

The six environmental objectives of the taxonomy are: (1) climate change mitigation, (2) climate change adaptation, (3) sustainable use and protection of water and marine resources, (4) transition to a circular economy, (5) pollution prevention and control, and (6) protection and restoration of biodiversity and ecosystems.

While the EU’s taxonomy is primarily a classification tool, it also requires certain entities to disclose information concerning the degree of alignment of their activities with the taxonomy. This is where it can be useful to financial industry participants in terms of their investment, lending and ultimately disclosure requirements.

How much U.S. regulators will leverage from what the EU has developed is open to debate, say experts, but given the considerable 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, there is also the possibility that 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.

"It is a natural body to bring those regulators together," said Gilbert of PwC. "While FSOC's focus typically is financial stability . . . it can also serve as a policy coordinating tool."

(Henry Engler, Regulatory Intelligence)

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