Understanding Canada’s Proposed Climate Finance Taxonomy

Countries have different economies and geographies, so each country has a different pathway to a net-zero emissions economy. As a result, sustainable finance taxonomies are being developed around the world to help link regional capital markets with their respective net-zero pathways.

Here in Canada, the federal government convened the Sustainable Finance Action Council (SFAC) — a group of finance leaders — to advise the government on what a Canadian taxonomy might look like. The goal is to create a common language for the issuance of financial instruments, such as bonds and loans, that are consistent with Canada’s path to net zero.

The SFAC delivered its advice last month via its Taxonomy Roadmap Report — a 79-page proposal to develop a taxonomy that defines “green” and “transition” activities. Investment professionals should be familiar with this work as it will likely have a big impact on capital markets. Here are three key questions and answers about the Taxonomy Roadmap:

Why does this taxonomy matter?

The development of Canada’s green and transition finance taxonomy is a big deal for at least four reasons:

1. It will impact capital markets. Once the taxonomy is finalized and adopted in the market, it will impact companies’ access to the trillions of dollars in financing that lenders and investors are earmarking for green and transition-related initiatives. Companies lacking credible net-zero targets, transition plans and disclosures as required by the taxonomy simply won’t be able to access these large pools of climate capital.
2. It’s a crucial step to mobilize capital. A classification system like this is vital for climate capital to be mobilized with integrity and in alignment with Canada’s pathway to a net-zero economy.
3. It paves the way for transition finance. The Taxonomy Roadmap outlines a vision for classifying not only “green” business activities but also “transition” activities for high-emitting sectors. Canada’s taxonomy is one of the first in the world to do this, and it will help unlock a new market for transition financing that is urgently needed to reduce industrial emissions while green technologies and infrastructure scale up.
4. It will help mitigate greenwashing. A common language is needed to help mitigate greenwashing risks. With a common language available to corporate issuers, there will be less opportunity for misrepresentation or “greenwashing” at the issuer level because there will be a framework to identify what counts as green and what doesn’t.

While the Taxonomy Roadmap does not specifically address retail investment products such as mutual funds or ETFs, an asset manager could potentially construct a portfolio of green or transition bonds using the taxonomy and market it accordingly (subject to any current or future regulations pertaining to the marketing of such products). Furthermore, the taxonomy could eventually pave the way for a retail-specific product label, although this application was not discussed in the Roadmap.

What business activities are eligible for financing under the proposed taxonomy framework?

The SFAC proposed three sets of requirements for business activities to be eligible for financing under the taxonomy:

1. Company-level requirements. All issuing companies would be required to establish net-zero emissions targets, transition plans and effective climate disclosures. This applies to issuers of both green and transition products.
2. Project-level requirements. All projects would be evaluated against screening criteria to determine whether they qualify as a green or transition activity.
3. “Do no significant harm” requirements. All projects would be assessed against “do no significant harm” criteria with a focus on protecting Indigenous rights, workers, environmental outcomes and climate resilience.

A green project is one that generates low or zero emissions across its entire life cycle and produces goods or services that will likely see significant demand growth in the net-zero transition. Examples include green hydrogen, afforestation and electricity infrastructure projects.

A transition project is one that decarbonizes a high-emitting sector, such as steel, cement, or resource extraction. Examples include investing in an electric arc furnace for a steel production facility or installing a world-leading methane capture process on existing natural gas production.

The SFAC emphasized the importance of establishing science-based criteria “anchored in emissions thresholds and metrics” to clearly outline which types of projects qualify as transition versus those that do not. The group also advised that the taxonomy should be “interoperable” with major taxonomies globally to avoid fragmentation and promote confidence in the market.

Is the proposed taxonomy framework credible?

In assessing credibility, the devil is always in the details, and the details of the taxonomy have not yet been finalized. However, if credibility comes from good governance, transparency, accountability, stakeholder and rights holder engagement, and alignment with climate science and global standards, then it is reasonable to conclude that the SFAC’s proposal is a credible starting point, because the group clearly aimed to incorporate all of these criteria into its proposal.

Federal and provincial governments would be represented on the taxonomy’s proposed governing body, with federal officials holding control over the approval process. The Canadian public has the ability to elect or unseat these representatives (or their bosses), so public accountability is baked into the proposal.

Emissions are the ultimate performance indicator of any climate-related initiative. It is incumbent upon the government to define and support Canada’s pathway to net-zero emissions, and the Taxonomy Roadmap represents a good-faith effort by finance leaders to create a building block that links capital markets to that pathway.

For those who wish to dive deeper, I have written an extended version of this article covering the proposed taxonomy’s treatment of governance, natural gas, nuclear power, blue hydrogen and more.

Author Dustyn Lanz is a 2016 Clean50 Emerging Leader. This article was originally published by ESG Global Advisors where he was a Senior Advisor at the time, and also appeared in “Investment Executive”. You can find a longer and more detailed explanation at the link above, as well as similar articles at www.esgglobaladvisors.com