Essential ESG: Episode 14 – Macro trends in sustainable finance

Alison Morris, Special Counsel, Banking and Finance

Emmanuel Georgouras, Associate, Banking and Finance

Emmanuel: Welcome to another instalment of the Corrs Essential ESG Podcast. My name is Emmanuel Georgouras and I’m an Associate in the Banking and Finance team and a member of the Sustainable Finance Working Group. Today I’ll be speaking with Alison Morris, a Special Counsel in our team. Before I commence, I would just like to say that this podcast is being recorded on the lands of the Gadigal People of the Eora Nation and I pay my respects to their Elders past, present and emerging.

Emmanuel: Welcome Alison.

Alison: Thanks Emmanuel.

Emmanuel: So, today we are going to be talking about sustainable finance. So, macro trends in regulation specifically taxonomies and what regulatory classifications and challenges that we can expect to see in the Australian market. So this is the second podcast in the Essential ESG miniseries covering Sustainable Finance Trends and we recommend listening to our intro into sustainable finance podcasts we’ve previously recorded before listening to this version. Our final podcast in this miniseries will be considering how investors are increasingly taking account of human rights factors in their investment decisions. So, to kick-off Alison, if you don’t mind, could you just tell us exactly what is taxonomy?

Alison: Great question Emmanuel. A taxonomy is a classification system. And what does that mean for sustainable finance? Well in our context it’s a set of definitions or activities or assets that are considered sustainable and which can be used to define sustainable investments credibly and transparently. The criteria are generally science or normative based and they apply to financing, lending, investments and underwriting activities across the entire financial sector. So, what’s an example? Well, the EU has implemented a taxonomy for environmentally sustainable activities. For activities to be considered ‘green’ they need to contribute substantially to, and not significantly harm, the environmental objectives of the taxonomy and that includes climate change mitigation and adaptation, sustainable use and protection of water and marine resources, the transition to a circular economy, pollution prevention and control and the protection and restoration of biodiversity and ecosystems.

Emmanuel: That’s really interesting Alison. So, what’s actually driving the need for the development of a taxonomy?

Alison: Taxonomy development is being driven by the need to provide clear and transparent definitions of what sustainable economic activities are and to promote consistency and comparability facilitating the just transition to a net zero economy and also to facilitate and encourage capital flows into sustainable activities. It also helps reduce the likelihood of greenwashing, as company’s activities will be assessed against objective criteria and that improves accountability via reporting and disclosures.

Emmanuel: It’s interesting to see, so from there Alison maybe we can talk about the trends that are being witnessed internationally on the taxonomy development and also its implementation.

Alison: Sure, so the Australian Sustainable Finance Institute (ASFI), they’ve got a taxonomy project which is underway at the moment. They released a paper in October 2022 which scoped International Taxonomies used across 13 different jurisdictions. The ASFI paper found that 12 taxonomies were in place, 15 were under development and collectively, this accounted for over 55% of global GDP. So, what are some general observations across the International Taxonomies? Well taxonomies are predominantly being developed to address environmental objectives, as these objectives can be more readily measured and tracked via science-based criteria. The EU and China are also developing social taxonomies which categorise economic activities achieving social objectives including promoting health, human rights, equality or socioeconomic conditions. Taxonomies are not yet being developed to classify and assess economic activities against governance objectives and those would include anti-bribery and corruption, responsible lobbying and political engagement outcomes. It has found that jurisdictions in which taxonomies are being developed are also seeing higher rates of greenwashing enforcement actions against companies operating within the financial sector. For example, the US, EU and the UK also have a high-profile enforcement actions lead by regulators and stakeholders against companies found to be making misleading ESG claims regarding financial products and services they were offering.

Emmanuel: So, are there any relevant regulatory developments that are supporting taxonomies globally that you could talk us through Alison?

Alison: Taxonomies are being supported by regulatory developments in the relevant jurisdictions such as the EU Sustainable Finance Disclosure Regulations. These regulations require that funds disclose their sustainability risks meaning an ESG event or condition that could cause a negative material impact on the value of the relevant financing investment product. The regulations also require that financial actors disclose how any possible negative impacts are prevented and/or mitigated and the level of sustainability integration within their investment decision making. In terms of other trends, the applicability of taxonomies within various jurisdictions have prioritised economic activities carried out by sectors based on their contribution to taxonomy objectives or the National or Regional economy. ASFI has also found that the classification of economic activities often employs a ‘traffic light’ approach, where green activities are those which are fully aligned with taxonomy objectives, yellow are those facilitating the transition to achieve taxonomy objectives and red are unsustainable economic activities which may harm those objectives.

Emmanuel: So, has there been any industry feedback or commentary on the EU taxonomy at all?

Alison: More recently there has been some criticism of the EU taxonomy because of its inclusion of nuclear energy and natural gas. With other jurisdictions currently developing taxonomies being urged to avoid politicisation of activities to be included in the taxonomy. In terms of lobby groups, Greenpeace and a coalition including Client Earth and the World Wild Life Fund have lodged separate legal challenges in April 2023 with the EU’s General Court, respectively arguing that the EU executive has acted unlawfully in designating gas and nuclear energy as bridge technologies to meet the EU’s goal of carbon neutrality by 2050 and breaking the EU climate laws setting the binding target of net zero by 2050.

Emmanuel: Are there other bodies that are active in this space?

Alison: It is not just ASFI who are active in this space. ASEAN has also released the second version of its Sustainable Finance Taxonomy in March 2023, which introduced technical screening criteria for its first focus sector, which is the energy sector. Interestingly for classification under ASEAN’s ‘foundational framework’ or ‘plus standard’, a company must show that its activities contribute to at least environmental objectives while fulfilling all three essential criteria. These criteria are do no significant harm, provide remedial measures to transition and address social aspects including human rights and community aspects.

Emmanuel: It's interesting Alison because now it’s not just happening in the EU and the ASEAN areas I guess if we drill down specifically into Australia there is actually government stakeholder support for developing a sustainable finance taxonomy on our shores so before we talk about how the Australian Sustainable Finance Institute have published an updated Taxonomy paper which is recommending key design elements for an Australian Sustainable Finance Taxonomy, but also a timeline for immediate development so late March 2023 they incorporated input from stakeholders and the Australian Taxonomy is framed as enabling financial institutions to identify economic activities that address key environmental and social objectives. So, some of these include the Paris Agreement goal of less than 1.5 degrees global warming and Australia’s commitment to achieve net zero by 2050 and a 43% emission reduction target by 2030. We also have the United Nations Sustainable Development goals or SDGs. We have reporting and disclosures under the Federal Modern Slavery Act. We have the Protection of Cultural Heritage and FPIC (Free Prior and Informed Consent) for First Nations Peoples. We also have risks and opportunities associated with the taskforce on the nature related financial disclosures, including compliance with environmental and biodiversity laws of course and also commitments to reduce waste and transition to a circular economy. So, ASFI is taking a holistic approach to developing and implementing an Australian taxonomy across the ESG spectrum so the development is supported by the Australian government. Treasurer Dr. Jim Chalmers announced on 12 December last year that the Australian Government would work to accelerate its Sustainable Finance strategy endorsing the development of a Sustainable Finance Taxonomy to assist in approving transparency to ensure the market has more credible and verifiable data to make investment decisions. The Australian Government announced in April this year that it will co-fund the development of a national sustainable finance taxonomy with ASFI. And phase 2 of the Taxonomy Project actually commenced on 1 July 2023, and this will be overseen by the Australian Council of Financial Regulators Climate Working Group. So, this phase will convene a Technical Expert Group to oversee the development of screening criteria and other products with input from taxonomy and sustainability specialists. So, this working group will then work with Treasury to review the outputs and provide feedback on taxonomy development to align with the Government’s sustainable finance strategy. Now, the two key policy objectives of this strategy are: developing a framework to assist financial markets fund the transition to net zero and also integrating the taxonomy into a stronger greenwashing regime. So, Treasury is motivated by recognition that the financial sector has a significant role to play in funding the net zero transmission and addressing sustainability issues in investment decisions, noting that Australia has fallen behind in keeping pace with international taxonomy and regulatory developments. So, it’s important for Australia to keep up to avoid having standards imposed that aren’t suited to the Australian economy. And the Federal Government has also announced the creation of a National Reconstruction Fund Corporation which will provide $15 billion for financing projects that actually support Australia’s transformation to a low carbon economy. Australia’s Net Zero Economy Agency will be supporting workers to transition from emissions intensive sectors, coordinating programs to help regions and communities take advantage of new clean energy industries, and also help investors and companies engage with net zero transformation opportunities. So, I guess now we can probably shift to talking about, Alison, some of the unique barriers and challenges in actually developing a sustainable finance taxonomy and obviously this goal of achieving a net zero economy in Australia? Maybe you want to speak on the emission or the carbon-intensive industries and their resources.

Alison: Yes. Thanks Emmanuel. Australia’s economy is reliant on emission and carbon-intensive industries and resources. I think there’s no getting away from that!

Emmanuel: Yep! Hahaha.

Alison: Australia’s import market is also reliant on carbon-intensive industries, including airline travel, refined petroleum, motor vehicles, freight services and crude petroleum. The journey of distance. Australia’s export market is predominately emissions-heavy resources, with iron ore and concentrates, coal and natural gas being the top three exports for 2019-20. But despite this, over 80% of Australia’s two-way trade is with countries with net zero GHG emissions commitments in place. And 9 out of 10 major foreign investment partners are committed to reaching net zero by 2050. So, Australia will need to fundamentally transition to a sustainable economy to meet its own targets, as well as to prevent being excluded from opportunities with its key trading partners. The ASFI report scoping international taxonomies noted that Australia’s carbon-intensive economy will need to evolve to meet the rising global demands for net zero aligned products and services. Delaying action will only exacerbate the environmental, social, economic, and financial systems implications in Australia. This context provides Australia with the unique opportunity to develop a taxonomy that is specifically adapted to its economy. Now, Emmanuel, do you want to talk to us about what ASFI’s recommendations are for the design of that taxonomy?

Emmanuel: I think it’s a good transition actually Alison. So, where we’ve ended up…

Alison: Pardon the pun.

Emmanuel: Yes! I think we’ve got a few recommendations that have come out of ASFI’s design of taxonomy actual recommendations. So, the 15 are quite in depth and we’ll run through a few of them now. So, basically, the guiding principles for developing a taxonomy should be credibility, interoperability across global financial markets and also with key trading partners, the prioritisation of sectors who actually lead Australia’s economic transition, so according to contribution to the sustainability objectives and also the contribution to the economy by GDP (being gross domestic product) and the potential growth and competitiveness opportunities and impact. So, although the taxonomy should cover key sustainability objectives of environmental management, resource resilience, the transition to a circular economy and social objectives, the criteria for climate mitigation should be prioritised. The ASFI recommendations: one is the recommendation of the adoption of a traffic-light coding framework. So, as you can think: green activities would be aligned to the taxonomy objectives; yellow would be the transition activities, so they’re on a pathway to aligning with the taxonomy objectives; and then red is an excluded activity, so those that are unsustainable or excluded that might cause significant harm and they do not align with the taxonomy objectives. So, another recommendation suggested the incorporation of an additional qualifying criteria if the ‘do no harm’, similar to the UK framework, will be adapted to the Australian context. So, standards for recommending Indigenous rights and heritage and also supporting workers and communities in relation to an equitable and a just transition. The final recommendation by ASFI is designed to address greenwashing by suggesting that reporting on taxonomy alignment should be mandatory where users are seeking to make claims around how their activities, financial instruments, products, or even the development of sustainability labels and standards address the taxonomy sustainability objectives.

Alison: Thanks, Emmanuel. So, that’s interesting. What were some of the responses from stakeholders to the taxonomy recommendations by ASFI?

Emmanuel: It’s interesting Alison because, in line with ASFI’s membership, there was actually 38% of respondents who were investors; and the next largest group represented, which was civil society and NGOs, or non-governmental organisations, was 18%. So, according to ASFI’s public consultation with stakeholders, responses broadly validate the recommendations made by ASFI. ASFI further noted that a majority of respondents agreed to each of the recommendations, with a further percentage partially agreeing and providing additional detail around how the recommendations should be applied. So the traffic light system I just spoke about and the ‘do no significant harm’ recommendations, they were the main focus of stakeholder responses. So, Alison, there is actually still some hesitancy from stakeholders regarding the incorporation of additional qualifying criteria for activities. So, these are – so examples can be minimum social safeguards, although stakeholders were more open to including the ‘do no significant harm’ criteria, actually at 67% of support. Now, although 84% of respondents explicitly supported the inclusion of a ‘transition’ category, there was limited consensus on the appropriate methodology for how the transition category could actually be integrated into the taxonomy.

Alison: That percentage of respondents is interesting, Emmanuel. What have we seen from the recently released research paper by ASFI?

Emmanuel: So, ASFI recently released a research paper which outlines ten key considerations which will form the building blocks for the development of a transition category within the taxonomy. So, some of the key considerations include purpose and principles. So, one is design the methodology for integrating transition activities into the Australian Taxonomy which should be guided by core principles. So, as you are aware, credibility, usability, interoperability, prioritisation, and impact, which were all mentioned earlier. The transition category should be principally designed to encourage the allocation of capital towards decarbonising hard-to-abate and high-emitting sectors. So, there should not be a transition category for other sectors. Speaking of eligible transition sectors and activities, the transition categorisation methodology should be designed to encourage the allocation of a capital toward activities that decarbonise sectors with material scope 1 and 2 emissions where economic activity will likely remain stable or grow in a low carbon economy, for example steel manufacturing, accelerate the decarbonisation and phasing out of sectors with material scope 3 emissions that will face decreasing demand in a low-carbon economy. So, one example of this is natural gas. Or have an increasing demand-side opportunity in a low-carbon economy, which includes sectors that could help facilitate the transition of other sectors. So, two examples of this could be renewable energy or afforestation. National level determinations should be made to identify economic activities and sectors such as green or transition-eligible, whilst users of the Australian taxonomy should be responsible for assessing the alignment of eligible activities or entities based on considerations 7 to 10, which I will get to in a moment. To avoid carbon lock-in, the transition category should only be eligible for existing projects. New projects must meet a more stringent green category technical screening criteria. All solid fossil fuel, so hard coal, brown coal, and coal products for example – these projects should be excluded for consideration under the Australian taxonomy’s transition category.

Alison: So, Emmanuel, how does this tie in with the general entity level requirements?

Emmanuel: In regard to what I mentioned earlier about considerations 7 to 10, these are general entity-level requirements. So, for activities and entities to be categorised as green or transition under the Australian Taxonomy, they must meet the following general entity-level requirements – so one is set credible long-term and interim science-based targets for 2050 aligned with a 1.5 degree pathway under the Paris Agreement. Another is develop and disclose a credible transition plan aligned with leading international standards and disclosure recommendations. Another is to regularly update the transition plan and report on progress annually. And another one is to align climate disclosures with Australia’s upcoming mandatory climate-related disclosure requirements.

Alison: What about technical screening criteria?

Emmanuel: In regard to technical screening criteria, the criteria should be aligned with national sectoral pathways that have been adapted from credible international, science-based scenarios, aligned with achieving the Paris Agreement’s goal that I spoke about earlier which is limiting global warming to 1.5 degrees. The transition category should be timebound, so basically sunset dates for example for each sector or sub-sector, which also aligns to the Paris Agreement’s five yearly interim targets. And the final point, entities and activities being on trajectory to align with the 1.5 degree pathway by the sector’s transition sunset date – these should actually be considered eligible to be labelled transition-aligned under the Australian taxonomy, but only as long as there is sufficient ambition and also a credible transition plan which outlines the strategy to achieve future emissions intensity performance thresholds. Alison, have you seen much about governmental support about the Australian taxonomy besides everything we’ve just spoken about?

Alison: Emmanuel, yes, there is government support for the development of an Australian taxonomy. Government has stated that it is working in parallel and that its taxonomy recommendations and proposed sustainable finance roadmap are broadly aligned to ASFI’s recommendations. In terms of policy considerations for government development of taxonomy, that the system is fit for purpose to assist business and investors to make decisions consistent with the transition to net zero, as well as how to take more vigorous action against greenwashing. There’s that greenwashing again!

Emmanuel: Yes, hahaha!

Alison: Governance needs to address how ambition translates to outcomes.

Emmanuel: That’s interesting, Alison. So, I guess probably now that we’re talking about the consequences, maybe you can just talk a little bit about what they would be on taxonomies, on financial services and their products.

Alison: So, the development and implementation of taxonomies in Australia, as well as globally, mean that companies making sustainability commitments and seeking to undertake related activities will face increased stakeholder scrutiny and companies engaged in greenwashing will be exposed for their failure to act consistently with sustainability objectives. Transparency and accountability should increase significantly. It’s currently piecemeal, overlapping or non-existent standards and criteria for sustainable economic activities, as we mentioned in our first podcast. And this limits the ability to assess corporate activities and to hold companies accountable for failing to meet their stated objectives. Introducing consistent, uniform and transparent criteria, and methodologies for assessing activities against these criteria, will make it easier for regulators and stakeholders to hold companies accountable for their stated sustainability commitments. There is some uncertainty regarding classification of ‘transition’ activities and how high-emitting industries can be assessed against the taxonomy criteria. As Emmanuel noted, ASFI has said to ‘watch this space’. We do know that ASFI has stated that its proposed taxonomy will not be designed to exclude carbon-intensive materials or products which are required to support carbon-reduction projects and activities in Australia. The development of an Australian taxonomy must consider how to deal with the large number of high-emitting companies with diversified activities, such as mining and minerals companies who are looking to develop renewable energy sources or contribute to waste reduction activities, to avoid excluding them from capital flows necessary to support their role in transitioning the Australian economy to net zero.

Emmanuel: Alison, what would be the priority sectors for this do you think?

Alison: Electricity, mining, manufacturing and agriculture will likely be the priority sectors for the Australian taxonomy, Emmanuel.

Emmanuel: Interesting. So, I guess now that we’re on this tangent to talk about consequences, it might be good to just do a little deep dive into some of the other regulatory trends that we are seeing. So, I’ll just start off by talking about the Australian Government’s consultation paper that has been released on key considerations for the ‘design and implementation of the Government’s commitment to standardised, internationally aligned requirement for the disclosure of climate-related financial risks and opportunities in Australia.’ And then, I guess, from what we’re seeing, this follows the global trends of implementing the ‘Taskforce on Climate-related Financial Disclosures’ voluntary framework. I guess against this is which many corporates already report – large corporates that is – into a mandatory domestic reporting requirement. So, the quotation comes from the Government saying that “Our initial view is that mandatory reporting requirements should be phased in over time, both in terms of entities covered and the reporting that is required”.

Alison: What about regulatory trends in the EU, for example?

Emmanuel: In regard to the EU, so the EU was also poised to introduce key parts of its European Green Deal, after the European Parliament approved legislation on 25 April this year that revises the EU’s Emissions Trading System, introduces a Social Climate Fund and establishes the world’s first carbon border tax, among other measures. So, the legislation must be formally ratified by the European Council before it’s in force but it will likely influence the measures taken by States looking to implement a robust climate change mitigation and adaptation reform. The European Commission has also proposed a Directive on Green Claims which will require the substantiation of voluntary green claims through the use of scientific and evidence-based methodologies. So, the Directive is considered to introduce best practice for combatting greenwashing, which is likely to influence Australian regulation.

Alison: Thanks, Emmanuel. What are we seeing in Australia regarding greenwashing enforcement action?

Emmanuel: Onshore in Australia, greenwashing enforcement actions are showing no signs of slowing, Alison. As we’ve seen in the media over the past year, ASIC have issued 11 infringement notices and commenced three civil penalty proceedings to date for making false or misleading representations, including representations about the applications of ethical exclusions in financial products. So, I guess now that we’ve talked about enforcement, maybe we can speak about how clients could potentially adapt their activities to align with the development of Australian taxonomy and maybe also some broader regulatory trends, Alison?

Alison: So, as always, preparation is key. Our clients should consider the nature of operations, activities and their value chain, and including whether you operate in a sector, which will be prioritised in the transition to net zero, and also how you can access financing to achieve this. If your organisation has made sustainability commitments or has sustainability targets, you need to consider how these commitments would achieve sustainability objectives set by your organisation, and what measures you already have in place to monitor and track activities against these targets. And the development of an Australian sustainable finance taxonomy is an exciting opportunity for Australia’s financial sector to support sustainability objectives and facilitate Australia’s transition to a net zero economy. Expect to see considerable movement in this space as the Government reviews submissions to its consultation paper on climate-related financial disclosures and the development of the Australian taxonomy gets underway by mid-2023.

Emmanuel: Well, Alison, I think that’s actually a really great place to finish. So, as a part of our miniseries on sustainable finance, please look out for our final upcoming podcast which will incorporate human rights into investment decisions and comments. Alison, thanks very much for your time again. I look forward to another one.

Alison: A pleasure as always.

Emmanuel: Speak to you soon.

Alison: Thanks.