Fifty shades of green: Governments are on a mission to standardize climate labels on investments

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Last December, Ottawa announced—with the kind of muted fanfare that has characterized the Carney government’s climate policies—that it will construct “made-in-Canada” sustainable investment guidelines intended to help environment-minded institutions and individuals cut through the ESG sound-and-light show. With funding earmarked in the 2025 budget, the federal government’s dance partners for this exercise include the Canadian Climate Institute, a pro-business environmental think tank, and a newly formed investor body dubbed Business Future Pathways. Said guideline, the press release adds, is “also known as a taxonomy.”

Thanks to the European Union, “taxonomy” has joined the jargon-rich collection of sustainable investing concepts intended to provide assurance to those looking to invest in projects or firms that won’t wreck the Earth. But as anyone who’s trudged through a sun-dappled corporate ESG report knows, this is a crowded and confusing space, not least because of a mid-pandemic explosion in greenwashing that transformed mutual funds and ETFs into paragons of virtue-signalling.

Companies use third-party ESG ratings, supplied by outfits like Morningstar or MSCI, as labels designed to help investors gauge risk and return. Such “stickers,” says Jan Mahrt-Smith, an associate professor of finance at the University of Toronto’s Rotman School of Management and a sustainable finance scholar, “are not interested in some sort of moral or ethical standard.”

Sustainable investing taxonomies, he says, come at this topic from an entirely different direction. They are classification systems that aim to quantify how specific industrial sectors or economic activities impact the environment. Then, companies looking to raise capital can use these classification systems to show whether what they do fits the bill, and how well. More generally, taxonomies, proponents argue, are designed to nudge the economy in the direction of the Paris 2050 climate accord and the much-vaunted transition to a net zero future.

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B.C. economist Jonathan Arnold, head of sustainable finance for the Canadian Climate Institute (CCI), says the best analogy is the nutrition label on food products: The package and the branding may make all sorts of buzzy claims—boosts energy! gluten-free!—but that white-and-black box gives you the lowdown on what’s inside. “It allows you, as a consumer, to make informed choices about what you want and don’t want in your diet, and it provides a standard for how that’s done,” he says. “This is the exact same thing for financial products.”

The EU enacted its sustainable finance taxonomy in 2020 as part of the European Green Deal. Today, EU investment funds are required to evaluate their holdings and disclose to clients how their firms measure up in terms of the taxonomy, i.e., calorie count, fats, sugars, other nutrients, etc. In the EU system, these metrics include measures of a sector’s climate mitigation activities, water use, circular-economy features and biodiversity protection, among others. A small industry has sprung up to help companies comply.

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Many other countries have followed suit, albeit more tentatively, and often through a voluntary approach in which companies or issuers can choose to opt into a classification system (the nutrition label) developed by some arm’s-length body. Australia published its taxonomy last year, focusing on the emission profiles of key sectors like agriculture, mining, construction and electricity generation.

Skeptics might be forgiven for wondering whether the advent of such taxonomies is more likely to muddy the waters than provide investors with the information they need to cut through all the ESG noise. What’s more, the aggressive climate denialism of the Trump administration and its dismantling of environmental policy is providing sustenance for dirty industries while kicking the foundations out from under their clean-energy rivals.

There’s some newly released empirical evidence suggesting investors will pay a premium, or so-called “greenium,” for bonds or equities that are “aligned” with the EU’s taxonomy—the thinking being that investments in sustainable projects or business ventures are less exposed to the cost of climate disasters. An Italian study published earlier this year, for example, examined the results of 770 European companies between 2007 and 2022, and found that firms operating in sectors identified under the EU taxonomy enjoyed lower debt costs, regardless of their individual ESG ratings.

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In another paper, published in the Journal of Banking & Finance last year, a team of scholars from Germany, Liechtenstein and Hong Kong looked at EU stock market returns in the late 2010s, when the EU was in the process of developing and approving its taxonomy. Investment fund portfolios were becoming more aligned with the EU’s classification system between 2017 and 2020, the authors note. Early on, there wasn’t much of a gap in returns between companies that were highly aligned and those that weren’t (think a box of high-fibre cereal vs. one that’s high in sugar). By the end of their study period, that gap had widened.

“We conjecture that this is due to investors paying greater attention to the implications of the [taxonomy] for the investment decisions of financial market participants,” the study’s authors conclude. “Our results are compatible with the interpretation that EU legislators’ intention to redirect capital flows towards green assets resulted in higher realized returns for these assets. Moreover, the alignment premium cannot be explained by traditional ESG ratings. This finding supports the perspective that investors adopted the [taxonomy] to assess the sustainability of companies as an alternative to ESG ratings.”

Mahrt-Smith points out that the premium isn’t huge—a few dozen basis points—suggesting that the taxonomy needs a bit of a push to drive more capital into the green economy. “The German government,” he says, “has gone as far as issuing two twin bonds, meaning two loans, same expiration date, same interest rates and coupon payments. One has a green sticker [indicating taxonomy alignment], one doesn’t. Then they measure the difference in the cost of capital for the German government. They do that because they want these things to take off.”

CCI’s Arnold, who will be in the thick of the development of Canada’s first pass at a taxonomy, points out that the growing number of such national or transnational classification systems won’t necessarily align with one another. Rather, they’ll reflect what’s going on in their own economies. By the summer, his team intends to recommend three Canadian industrial sectors as priorities for all the analysis and measuring that will show their respective roles in our overall emissions picture, and progress toward lower carbon operations; three more will be released in 2027.

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Because Canada is opting for a voluntary system, we’ll be up against the old horse-to-water problem when it comes to investors and climate information. Some care and others don’t. In a global survey by Morgan Stanley, however, 84% of institutional investors polled expect the proportion of sustainable assets under management in their portfolios to rise in the next two years. That suggests a growing appetite for a reliable classification system for investors as a counterweight to the profusion of dubious ESG claims that flooded stock markets in recent years, and provided the political momentum behind Canada’s 2024 greenwashing regulations.

Once Canada has a complete taxonomy that categorizes firms by their climate impact, determining what’s green and what’s not will be more straightforward, Mahrt-Smith predicts. “Maybe it doesn’t reduce their cost of capital very much,” he says. “But it makes it quicker and easier to issue bonds. It allows the firms to put in their annual reports how green they are because they issued a green bond. It allows firms to attract young people because it’s hard to hire a 25-year-old while your portfolio is all going to fossil fuels. There are lots of reasons why we’d like a list that is credible to some extent, and this will be a credible list.”