What does it mean to be green? Some remarks on the EU sustainable finance package

In its quest to make Europe the ‘first climate-neutral continent’, the EU has established a sustainable finance action plan that seeks to channel funds towards ‘greener’ economic activities and investments that will lead the world towards a net-zero circular economy with little environmental impact.

The EU Taxonomy Regulation – an EU-wide classification system for sustainable activities – forms part of this plan. On 21 April, the European Commission published its first delegated act to this Taxonomy Regulation. The act aims to establish so-called ‘technical screening criteria’ for determining whether a given economic activity qualifies as contributing substantially to climate change mitigation or adaptation. The consequences of this act will be significant; in the future, only investments contributing to either the above aims or four other environmental objectives laid down in the Taxonomy Regulation may be declared ‘sustainable’. In turn, companies carrying out activities deemed sustainable should be able to access both private and public funding in the EU with greater ease in the coming years.

Although the above rules will only apply directly within the European Union, their influence may reach far beyond Europe’s borders. As Anu Bradford argues in her book The Brussels Effect: How the European Union Rules the World, the EU has become a ‘global regulatory power’ capable of influencing the shape of regulatory solutions worldwide. Witnessing how the EU General Data Protection Regulation has in fact become the global standard, EU regulations on what is sustainable and what is not may soon also follow this path. This further demonstrates the need to meticulously scrutinise the design of these new rules.

The biggest controversy surrounding the EU Commission’s delegated act concerned the status of natural gas and nuclear power projects. A leak from March 2021 revealed that the European Commission, under pressure coming especially from Member States in Central and Eastern Europe, was planning to declare such investments (upon fulfillment of certain conditions) as sustainable. After the news triggered fierce criticism from environmental organisations and other stakeholders, the Commission erased any references to natural gas and nuclear power in the final text and postponed the decision on their status until December this year.

While, for some, it may be unthinkable to declare natural gas and nuclear power ‘sustainable’, recent discussions overlooked another ambiguous piece of the EU sustainable finance framework. The criteria used to define sustainable economic activities in the Taxonomy Regulation will directly influence labelling of financial products offered by financial market participants (a fairly broad concept encompassing investment firms, insurance undertakings, banks etc) in accordance with the EU Sustainable Finance Disclosure Regulation (SFDR). Financial products ‘with a sustainable investment objective’ (Article 9 of the SFDR) will have to disclose the proportion of their investments that count as sustainable economic activities according to the Taxonomy Regulation. Moreover, any remainder investments – those used for hedging purposes, for example – will have to be targeted at economic activities that ‘do not significantly harm’ environmental objectives through significant greenhouses gas emissions or emissions of other pollutants into air, water, land and so on.

Rigorous as the criteria for the above ‘dark green’ financial products may seem, they do not apply to ‘light green’ products – those that ‘promote environmental (or social) characteristics’ (Article 8 of the SFDR). In fact, these light green financial products do not have any clear definition under EU law – this weakens the coherence of the EU sustainable finance framework, which aimed at putting an end to greenwashing practices.  While technically a financial product promoting environmental (or social) characteristics will also have to disclose the proportion of underlying investments that are in taxonomy-aligned environmentally sustainable economic activities, it is not obliged to have any. Financial market participants offering such a product will only have to describe what environmental characteristics it promotes and how these characteristics are met. Furthermore, the ‘do no significant harm’ principle applied to dark green products does not apply to light green products. Under the current legal framework, it is therefore conceivable that a given product comprises no investments in economic activities qualifying as ‘environmentally sustainable’ in accordance with the Taxonomy Regulation, but may nevertheless still be labelled as ‘promoting environmental characteristics’.

There is no clear reason why the EU secondary legislation (comprising the above-discussed SFDR and Taxonomy Regulation) does not provide any definition and requirements for products ‘promoting environmental (or social) characteristics’ – this is despite concerns raised by participants during consultations that differences between dark green and light green products were not sufficiently clear to them. As these participants are usually professional entities, it is easy to imagine that for the clients it will be even harder to capture the differences. In their 2008 book Nudge: Improving Decisions About Health, Wealth, and Happiness, Cass Sunstein and Richard Thaler (the latter being a laureate of the Nobel Memorial Prize in Economic Sciences for his input into the development of behavioural economics) argued that people making investment decisions do not usually behave like ‘Econs’, thoroughly studying all the available options. They quote Harry Markowitz, another eminent economist and the founder of modern portfolio theory, who confessed that while allocating his retirement account he simply split his contributions ‘fifty-fifty between bonds and equities’.

Therefore, it is not improbable that – even among people willing to channel their savings to more ‘eco-friendly’ purposes – a financial product underpinned by investments in natural gas (which emits approximately 50% less CO2 than coal and therefore ‘promotes environmental characteristics’ by leading to lower greenhouse gas emissions) can become much more popular than any product focused on solar power or wind farm investments. This does not necessarily have to be detrimental to the climate – during the last decade, the UK’s decision to switch all their coal-fired power plants to those fired by natural gas led to a more significant percentage drop in CO2 emissions from the electricity sector than Germany’s massive investments in renewable energy sources. Nevertheless, such a state of affairs should be the product of a deliberately and consciously designed legal framework and not of an apparent loophole.

The Taxonomy Regulation offers some promising solutions for qualifying natural gas and nuclear power as transitional or enabling activities, protecting investments in these areas from an abrupt loss of access to funding without undermining the coherence of the sustainable finance regulatory landscape. As the EU is about to further develop its new regulations, it is the vague concept of products 'promoting environmental characteristics’ that deserves at least the same amount of discussion as the one devoted to the status of natural gas and nuclear power.

Michał Dorociak (MPP 2018) is an alumnus of the Blavatnik School of Government.

Photo: EU flags at the European Commission Berlaymont building by Guillaume Périgois on Unsplash.