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UK Green Taxonomy – GTAG provides further technical advice to the UK Government

The Green Technical Advisory Group (GTAG) has had a busy period recently, publishing several new pieces of technical advice for HM Treasury. 

Established in 2021 to provide non-binding technical advice in respect of the development and implementation of a Green Taxonomy in the UK (the UK Green Taxonomy) (as explained in this blog post), GTAG’s most recent advice includes the following papers published in August and September this year:

We have summarised the key proposals relevant to financial institutions below.  Given the potential impact on litigation risk in the financial services industry, we have also commented on the UK Green Taxonomy’s likely effect on sustainability-related litigation in the UK.

Aim of the UK Green Taxonomy

The UK Green Taxonomy will provide a common framework for determining which activities can be defined as ‘environmentally sustainable’. The aim is to improve the understanding of the impact activities and investments may have on the environment, help companies and investors make better informed choices and support the transition to a sustainable economy. Whilst GTAG’s focus is on the development of the UK regime, it recognises that it will be essential to ensure the UK approach is considerate of global differences in taxonomies and related disclosure requirements.

In March 2023, the UK Government provided an update as part of its 2023 Green Finance Strategy confirming that it expects to consult on the UK Green Taxonomy in Autumn 2023, which will likely build on the advice and recommendations provided by GTAG.

The Government should focus on implementing the UK Green Taxonomy, rather than extending it to cover transition or harmful activities at this stage

GTAG provides a clear recommendation that the UK government should prioritise the delivery of a UK taxonomy that clearly defines ‘green’ environmentally sustainable economic activities and is considered a ‘credible, robust and usable tool’ for the market. Any extension of the taxonomy beyond ‘green’ activities to cover transition activities and harmful activities should be considered at a later stage.

The focus is on implementation of the UK Green Taxonomy and avoidance of further complexity at this point. The first UK Green Taxonomy review (expected after three years) would provide an opportunity for revisiting the need for an extended taxonomy. GTAG suggests that the impact of other relevant policies and tools, including those relating to transition plans and sectoral pathways, as well as the international landscape of extended taxonomies (both best practice and challenges), can then be assessed as part of that review.

Given that there is no global consensus as to the approach to transition taxonomies, GTAG suggests that the UK Government promotes the UK’s transition rationale and approach internationally, on the basis that the UK’s approach of combining mandatory entity-level transition plans with a robust green taxonomy and sector roadmaps should provide a strong foundation for the UK to be influential on the global stage.

Expanding the UK Green Taxonomy to a wider range of economic activities could be beneficial

GTAG provides advice on the potential expansion in coverage of the UK Green Taxonomy to include additional UK sectors and industries.

Whilst a major divergence from the EU baseline based on emissions is considered of limited value, GTAG notes that certain gaps in the EU Taxonomy sectors could be addressed. In relation to expanding the UK Green Taxonomy on the basis of UK gross value added (GVA), GTAG suggests that consideration is given to increasing the coverage of certain sectors, including, potentially, financial and advisory services.

Taxonomy reporting should align with TCFD reporting

GTAG recommends that UK Green Taxonomy reporting should apply to companies subject to mandatory Taskforce on Climate-related Financial Disclosures (TCFD) reporting, as both frameworks will be integrated under the UK’s Sustainability Disclosure Requirements (SDR) regime.

However, reporting obligations should be phased in to ensure businesses have time to adjust. The GTAG recommends that corporates should report ahead of financial institutions on the basis that the latter are dependent on information disclosed by clients and investee companies for their own reporting.

It is important to get KPIs right if the UK Green Taxonomy is going to be useful and usable

GTAG recognises that if the UK Green Taxonomy is going to be both ‘useful and usable’, it will be essential to get right both the sequencing of the reporting and the Key Performance Indicators (KPIs) used in that reporting.

In particular, GTAG notes that the UK now has the opportunity to design ‘a more effective reporting framework’ taking into account the usability issues that have arisen under the EU regime. This includes reassessing the KPIs relevant to credit institutions and investors.

The approach to GAR for credit institutions should be reassessed

In respect of credit institutions, GTAG recommends that the approach to the green asset ratio (GAR) is reassessed by excluding certain non-relevant activities and investments from both the numerator and denominator of the calculation in order to more accurately represent the proportion of the bank’s green activities. GTAG also suggests that the GAR should be calculated based solely on the bank’s lending book to address concerns about comparability and potential bias towards specific banking models, such as retail banking over investment banking.

In addition, GTAG suggests that the Government sets up a working group for designing technical screening criteria (TSC) for financial services that capture and measure incentive schemes promoting green behaviour. These could potentially replace the GAR or complement a slimmed down version of it. Examples may include transition-plan lending activities, mortgage incentive schemes for energy efficiency or green advisory services, with the TSC evaluating the proportion of the bank’s income from these schemes and ensuring a comprehensive assessment of their contribution to the transition.

GTAG notes that if the UK diverges from the EU and chooses to omit certain KPIs, such as the GAR, from the reporting requirements, it will be essential to ensure proportionality to avoid an undue burden on reporting firms. Whilst divergence could reduce misreporting through the introduction of more straightforward KPIs, GTAG recognises that there is a risk that an EU investor could ask a UK institution to disclose under the EU regime.

Investment funds should report at fund level

For investment funds, GTAG recommends reporting at the fund level and disclosure of taxonomy components for all funds, irrespective of whether or not they have a sustainability label attached. This is aimed at enabling increased comparability between funds, reducing the likelihood of greenwashing and levelling the playing field with respect to data costs between sustainable and non-sustainable/non-designated products (as such costs may otherwise only impact management fees for sustainable products).

GTAG considers that this could encourage clients to express a preference for UK Green Taxonomy-aligned investments. The recommendation is based on the premise that clients are the true driving force for change in investment behaviour, rather that shareholders of investment firms.

HM Treasury must clarify how existing and future ‘green’ products will be treated when the UK Green Taxonomy is implemented and evolves over time

GTAG recommends that HM Treasury must provide clarity prior to implementation of the UK Green Taxonomy on:

  • how existing ‘green’ products will be treated when the UK Green Taxonomy comes into effect; and
  • how taxonomy-aligned products will be treated as the UK Green Taxonomy evolves over time.

GTAG suggests that existing green products (e.g., green bonds) may still be referred to as such, but that they cannot be referred to as UK Green Taxonomy-aligned if they do not meet the UK Green Taxonomy’s TSC.

There is also the concern that as the UK Green Taxonomy evolves over time, some products that were previously taxonomy-aligned may no longer meet the criteria.

A change in taxonomy criteria has the potential to negatively impact taxonomy-aligned financial products. In particular, issuers may not have confidence that their products will remain taxonomy-aligned over time, which could deter them from developing products aligned with the UK Green Taxonomy. In addition, there is a risk that investors could be misled as to the green credentials of products, leading to greenwashing concerns if products aligned with initial criteria could claim to be taxonomy-aligned indefinitely.

For these reasons, for both equity and debt, GTAG proposes the implementation of a ‘grandfathering’ clause with clear conditions to ensure there is market certainty as to how products will be treated, with the aim of reducing the potential negative impact on the development and issuance of UK Green Taxonomy-aligned products. For example, GTAG proposes that such ‘grandfathering’ provides a set time period for green debt issuers that will enable most green bonds and loans that are ‘green’ or UK Green Taxonomy aligned at the time of issuance to remain aligned until maturity, and reduce lock-in risk for longer-term investments if the criteria they are aligned to change. More generally, GTAG makes it clear that HM Treasury must work closely with the FCA to agree a consistent approach to green and sustainability bonds, including in respect of updates to FCA guidance to support decisions made on grandfathering.

Appropriate sequencing of taxonomy disclosure requirements is one of the most important ways to reduce data gaps

As initial market data is unlikely to be perfect, GTAG provides recommendations on how to assess and deal with data gaps.

Appropriate sequencing of disclosure requirements (with non-financial companies required to report ahead of financial institutions) is seen as one of the most important ways to reduce data gaps. The UK can learn from the experiences of taxonomies in other jurisdictions to ensure issues around sufficient information being available to those making disclosures are addressed. In relation to the EU Green Taxonomy, GTAG notes that companies struggled to meet disclosure requirements because they were dependent on the disclosures of others, which were not yet mandatory.

Data availability, consistency and reliability challenges need to be addressed

Looking beyond data availability, GTAG notes that there are likely to be challenges with data consistency and reliability during the first years of UK Green Taxonomy reporting.

With respect to the EU Taxonomy, the ‘do no significant harm’ criteria (DNSH) are often cited as one of the most difficult elements of reporting, in particular as certain criteria involve interpretation which leads companies to make judgement calls as to whether they meet the requirements. GTAG has suggested streamlining DNSH to reduce the subjective nature of certain criteria and improve data reliability.

It will also be important to be mindful that many companies have global activities, and to address challenges relating to the international applicability and interoperability of criteria and the collection of data from outside the UK.

GTAG also suggests that the upcoming Government consultation on the UK Green Taxonomy should explain current thinking on expectations relating to the use of estimates and proxy data. For interoperability, GTAG recommends that the UK Green Taxonomy should accept estimates from data vendors and allow international estimates to the UK Green Taxonomy and domestic disclosures against other countries’ taxonomies. For example, if an EU company applies the EU Taxonomy, a UK investor should be able to make use of that information. If no disclosure is available, financial institutions could estimate, provided a set of standards is created.

The Government should consider the use of reporting templates and further guidance

The Government is encouraged to consider developing a reporting template to inspire consistency in disclosures during the initial voluntary reporting period. Any such template would need to be developed or tested with stakeholder groups to ensure it will be used by the market. Further guidance is also encouraged, including examples of assessments against the UK Green Taxonomy and clear instructions on the use of estimates.

In addition, GTAG recommends providing a forum during the voluntary reporting period to allow stakeholders to raise data issues, challenges and questions, as a means to encourage engagement from those leading on transparent disclosure of sustainability information and to support others in the process.

Likely impact on sustainability-related litigation

To date, despite regulators’ concern about the marketing of sustainable products in the UK, the sustainability-related litigation in the financial services sector in the UK has focussed on the adequacy of disclosure of climate risk and the investment decisions made by trustees and directors rather than the misrepresentation of sustainable products and sustainability credentials.  However, the risk of greenwashing-related litigation remains high for financial institutions.

The introduction of the UK Green Taxonomy is intended to clarify the position on what is and is not a sustainable activity, and how to present sustainability characteristics (or KPIs) for financial institutions and investors alike.  Once in force, it should therefore reduce the likelihood of litigation related to sustainable finance (particularly, litigation alleging greenwashing).  However, this assumes that the UK Green Taxonomy will be drafted clearly and in a usable way; the GTAG specifically noted that large firms are struggling with interpretation of the EU’s Taxonomy, for example, which does not bode well for a reduction in litigation risk.  In the UK, there is therefore the continued potential for litigation where there is scope for differing views on interpretation of the UK Green Taxonomy.  There is also potential for continued litigation where the UK Green Taxonomy’s provisions change (as anticipated above), and firms have either failed to align with changes or to explain clearly the basis for any claims that a product or service is taxonomy-aligned (such as the point at which it is taxonomy-aligned and how the firm will approach any grandfathering provisions).

Finally, there is also regulatory risk to consider: the FCA has specifically said that it is monitoring the market for indications of greenwashing, which is consistent with its focus on building trust in sustainable markets.  Its expectations may go beyond what a claimant is required to establish in any greenwashing claim, given that it will take a more holistic view of the circumstances.

Next steps

The Government is expected to consult on the UK Green Taxonomy in Autumn 2023. This consultation will likely build on the advice and recommendations provided by GTAG to date. The Government will also need to work closely with the FCA as it develops its rules and guidance relevant to the UK Green Taxonomy, including with respect to SDR and investment labels.