Criteria to support capital market participants in better understanding climate investments
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What is the Climate Investment Taxonomy Regulation?
The Climate Investment Taxonomy criteria’s objective is to provide financial market participants with greater clarity on what constitutes a climate investment.
Specifically, these regulations were intended to lay out the criteria for investments and other economic activities that can contribute to Canada’s ambition to reach net-zero emissions by 2050.
The regulation was introduced by the Canadian Sustainable Finance Action Council (SFAC) in March 2023. In its current form, participation in and engagement with the Taxonomy is not mandatory.
This taxonomy was designed to help financial market participants make more informed capital allocation decisions around climate projects.
It uses “green” and “transition” labels to help categorize projects and securities.
The taxonomy was implemented to help mobilize capital into projects and investments that will support national level net-zero climate targets.
The taxonomy is expected to provide clarity for investors, management teams, and the general public alike.
What is a Taxonomy Regulation?
Taxonomy is another word for classification. Taxonomy regulations have been implemented worldwide, with the EU’s Sustainable Finance Taxonomy and the U.S. SEC Taxonomies as prominent examples.
Each set of regulations uses the concept of a “green label,” providing a category for financial activities that address climate and environmental issues.
Similarly, the Canadian Taxonomy also uses the term green label, and defines it as activities that generate low or zero GHG emissions, or that otherwise directly enable lower-emitting activities (like the production of goods or the delivery of services) that will support a net-zero economy.
An example of a green label investment is a renewable energy project, like solar arrays and wind power stations.
What’s Different about the Canadian Regulation?
The Canadian Taxonomy Regulations added a new concept to its Taxonomy and pioneered the term “transition label.”
This label categorizes investments and financial products that can significantly reduce the emissions of high-pollution activities, help the transition to net-zero, and aid in meeting a global temperature goal of 1.5 degrees Celsius.
A transition label activity, for example, would be installing an electric arc furnace at a steel plant or transitioning a transportation fleet to all electric vehicles.
“Green Label” Qualification Standards
Three key requirements must be met in order to issue green and/or transition labels under this taxonomy:
General requirements: Company-level net zero target setting, transition planning, and effective climate disclosure.
Specific requirements: Evaluation of project against framework criteria to determine whether it is a “green” or “transition” activity, or both.
“Do no significant harm” requirements: Companies will need to assess a project against the new “do no significant harm” criteria set in the regulations. This focuses on protecting Indigenous rights and workers while promoting positive environmental outcomes and climate resilience. This means companies must assess and ensure that a project does not have any adverse impacts on the environment, local community, or other broader ESG objectives.
Why is the Climate Investment Taxonomy Important?
Canada must rapidly scale up climate investment to achieve a net-zero economy by 2050. By some estimates, Canada’s climate investment gap is as high as $115 billion annually.
In recent years, many countries facing similar investment gaps have been developing taxonomies as part of broader policy frameworks to help mobilize and accelerate capital deployment to achieve climate objectives.
Beyond providing clarity to market participants, this taxonomy also provides a framework for more sustainable companies to reap the reputational value and financial opportunities that come with being a recognized leader in Canada’s net-zero transition.
Additional benefits include:
Making more informed climate decisions
These regulations set screening criteria that allow users, such as investors, companies, and financial intermediaries, to evaluate the climate credentials of economic activities (e.g., in connection with investment and business decisions).
Accelerating the deployment of climate capital
This is accomplished by providing a tool to benchmark climate and transition activities. The specific definitions that the Taxonomy Regulations provide for green and transition activities will allow investment to flow into the most appropriate projects, thus helping with Canada’s climate-related goals.
Mitigating greenwashing risks and net-zero skepticism
By setting a benchmark that aligns Canada’s transition plan with actual climate objectives, these regulations help eliminate information gaps and create alignment between an investment and its intended impact.
Who Does the Climate Investment Taxonomy Regulation Impact and Why?
The Climate Investment Taxonomy concerns a broad scope of stakeholders because it promotes transparency, accountability, and climate awareness across the financial services sector at large. It also protects the interests of investors and the general public.
Stakeholders of note include:
Investors: at first, the Climate Investment Taxonomy regulations will focus on setting green and transition criteria to mobilize private capital. Investors should consider this as they assess current and future investments and evaluate the associated risks and opportunities.
Additionally, adding ESG and climate risk factors to companies’ reporting means investors must acquire additional capabilities to meaningfully analyze and assess these factors.
Management teams: these regulations can help companies identify and manage their climate risks and opportunities. By using the three categories of requirements mentioned above (General, Specific, and “Do no Harm”), companies can be well-positioned to ensure that activities and projects qualify under these new regulations. This will also demonstrate their commitment to sustainability and corporate transparency.
The general public: these regulations provide important information about the environmental impact of the companies that consumers support. By understanding a company’s climate impact, the public can decide which companies they want to support, advocate for, and invest in (retail investors).
Key Considerations for Compliance with the Climate Investment Taxonomy
Organizations should view the Taxonomy as a guide to help inform what constitutes a climate investment and how they can align activities with these categories and objectives.
Leveraging this classification system can help management teams proactively meet stakeholder demands and regulatory requirements, as well as inform new opportunities and sources of capital.
Given the focus on funding Canada’s Net Zero transition, entities that are more thorough and sophisticated in their reporting are likely to receive more capital, experience reputational tailwinds, and build stakeholder confidence.
Here are a few key questions for every management team and/or portfolio manager, in light of the Climate Investment Taxonomy:
Do we have investments or activities that almost fit a green or transition label? If so, can we adapt plans to fit one (or more) of these categories in order to access capital more easily, reap reputational benefits, or compete more effectively in future procurement bids?
Does our investment thesis reflect any of the criteria within the green or the transition labels? Might it be prudent to reconsider elements of our thesis in order to qualify?
Does our firm’s ESG strategy include tracking financed emissions? If so, improving alignment with this Taxonomy and focusing on transition activities may support meaningful action toward this objective.
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