There are few sectors of the global economy that have taken the call to achieve impact, sustainability and resilience through their activities as seriously as those involved in allocating capital. In the past few years, asset managers, insurers, reinsurers and investment firms have led the way in embedding environmental and social outcomes in their investment and operational decision making; and trillions of dollars in investors’ capital is now being invested within the broad environmental, social and governance (ESG) construct.
There is a growing realisation that allocators of capital, most notably asset managers and life insurers, will be key contributors to the success or failure of the ambitious net-zero targets set during the Paris Agreement and reinforced at the 2021 United Nations Climate Change Conference (COP26). But as asset management brands trip up over each other to be acknowledged as most ‘green’, there are growing concerns about the suitability of the various tools available to measure ESG outcomes. A common thread at investment conferences is that firms can achieve different ESG ratings depending on which rating methodology they follow. The solution, it seems, will be for governments and regulators to lead the way insofar as setting benchmarks for ESG measurement.
Enter the so-called green finance taxonomy. A taxonomy, per its dictionary definition, is simply a scheme of classification. And that, says the World Bank, means that a green finance taxonomy is a set of rules that will “identify the activities or investments that deliver on environmental objectives, [thereby] helping to drive capital more efficiently toward priority environmentally sustainable projects”. Allocators of capital conducting business in the southernmost country in Africa have already received their first taste of such a taxonomy following the May 2022 publication of South Africa’s first draft Green Finance Taxonomy. The project is being developed by the Taxonomy Working Group as part of the country’s Sustainable Finance Initiative, chaired by National Treasury (NT).
“Investors, issuers and lenders and other financial sector participants can use the taxonomy to track, monitor, and demonstrate the credentials of their green activities in a more confident and efficient way,” wrote NT, in a media release announcing the paper. Its description of the green finance taxonomy phrase turns out to be more useful than those already provided, as “an official classification or catalogue that defines a minimum set of assets, projects and sectors that are eligible to be defined as ‘green’ or environmentally friendly; it reduces costs and uncertainty in classifying a core set of green activities”. In this context, decision makers at asset managers, banks, insurers and retirement funds will immediately be able to determine whether or not their investment activities measure up against the E and S components under ESG.
South Africa’s taxonomy incorporates recommendations from NT’s 2021 Technical Paper: Financing a Sustainable Economy, which calls for the development or adoption of “a taxonomy for green, social and sustainable finance initiatives, consistent with international developments, to build credibility, foster investment and enable effective monitoring and disclosure of performance”. NT says that its technical paper “focuses on addressing climate risk and the opportunities for the financial sector to contribute positively to sustainability objectives and support a just transition to a low-carbon, socially inclusive and resilient economy”. No surprise then, that many of the asset managers that Africa Ahead has spoken to in recent months defer their ESG measurement methodology to the as yet un-finalised taxonomy.
The question becomes: what factors should be considered when conjuring up a green finance taxonomy? South Africa’s NT 2021 Technical Paper offers up eight, including:
- Adopting a definition of sustainable finance, in this case, “as contributing to the delivery of the sustainable development goals, a ‘just transition’ to a low-carbon and climate-resilient economy and financial stability, and encompassing financial models, services, products, markets and ethical practices to deliver resilience and long-term value in each of the economic, environmental, social and governance aspects”.
- That regulators and industry co-develop or adopt technical guidance, standards and norms for use across all financial sectors in identifying, monitoring and reporting and mitigating their environmental and social risks, including climate-related risks, at both portfolio and transaction level. This includes risk management frameworks, the use of science-based methodologies, and the incorporation of the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD).
- To develop a benchmark climate risk scenario for use in stress tests by the sector.
- To develop or adopt a taxonomy for green, social and sustainable finance initiatives, consistent with international developments, to build credibility, foster investment and enable effective monitoring and disclosure of performance.
- To include disclosure of progress in environmental and social risk management, including climate risks, in supervision activities carried out by the Prudential Authority (PA) and Financial Services Conduct Authority (FSCA), and incorporate voluntary codes of principles for good practice into regulatory regimes.
- To work with the Institute of Directors, trustees, professional and industry associations and academic institutes to build governing body capacity and fit-for-purpose skills necessary for the identification and management of long-term risks and sustainability challenges.
- To build capacity across the sector and in the implementing arms of government to ensure environmental and social risks are addressed within local infrastructure and development planning, capital raising and insurance planning.
- To finalise an action plan to give effect to the recommendations, using a technical working group to be comprised of regulators and industry representatives.
It sounds like a mouthful, but these eight points will become the foundation for South Africa’s green finance taxonomy, and therefore inform the measurement of all future capital allocations insofar as their environmental and social credibility. Financial services firms will also have to evaluate portfolio and transaction-level environmental and social risk exposures and opportunities using science-based methodologies and best practice norms, before linking these methodologies to products, activities and capital allocations.
Much has been written about the need for developing economies to achieve a just transition away from fossil fuel, and South Africa’s green finance taxonomy is quick to recognise the need. According to NT, the taxonomy will “ensure that national priorities are reflected while remaining aligned with international trends”.
They say that once finalised, the living document will give certainty in selecting green investments; help to unlock large-scale capital for climate-friendly and green investment in South Africa; reduce financial risks through enhanced management of environmental and social performance; and reduce the costs associated with labelling and issuing green financial instruments.