Explainer: 10 Questions About Canada’s Green & Transition Finance Taxonomy, Answered

By Dustyn Lanz, Senior Advisor, ESG Global Advisors

On March 20th, the Intergovernmental Panel on Climate Change (IPCC) – a United Nations-backed group of climate scientists – published its latest report warning about the imminent risks of climate change. The message was clear: urgent climate action is needed to secure a “liveable future for all.”

In its report, the IPCC positioned finance as a “critical enabler” to accelerate the actions needed to get climate change under control. But, in order for climate-focused finance to accelerate, capital markets need classification systems – or taxonomies – to identify business activities that support the transition to a net-zero emissions economy.

Since countries and regions have different economies and different geographies, each country or region has a different pathway to net zero. 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 such a classification system, or taxonomy, might look like in the Canadian context.

After 21 months of development and deliberation, the SFAC delivered said advice last month via its Taxonomy Roadmap Report – a 79-page proposal to develop a taxonomy that defines “green” and “transition” activities. All finance and corporate professionals in Canada should be familiar with the taxonomy because it will likely have a significant impact on capital markets in the years ahead.

Here are 10 key questions about the Taxonomy Roadmap, answered:

1. What is it?

The Taxonomy Roadmap represents a group of finance leaders’ proposed approach for classifying business activities in terms of their “greenness” and their ability to support Canada’s transition to a net-zero economy by 2050. It was developed by the SFAC, an advisory group comprising 25 of Canada’s largest financial institutions including pension funds, insurance companies, banks, and credit unions.

The objective is to create a common language that enables the issuance of financial instruments, such as bonds and loans, that are consistent with Canadian and global climate objectives.

The SFAC leveraged experts from the Canadian Climate Institute and the Institute for Sustainable Finance to incorporate science-based analysis into its report, in alignment with global standards and best practices.

Importantly, Canada’s green and transition finance taxonomy has not been finalized yet; the Roadmap represents a detailed proposal for the federal government to bring it to life in collaboration with the finance sector, civil society, and others. However, it represents a giant step forward and a consensus among 25 of the country’s largest financial institutions, which I can assure you from my time leading an investment association, is no easy feat. A critical mass of the finance sector is saying, “We’re ready to go.”

2. Why is this taxonomy important to know about?

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

• 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 inventors 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.

• 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.
  
• It paves the way for transition finance: The Taxonomy Roadmap outlines a vision for classifying not only “green” business activities, but “transition” activities as well. This is  vital for a resource-based economy like Canada’s. Canada’s taxonomy initiative represents 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.
• 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” among corporate issuers because there will be a framework to determine what counts as “green” and what doesn’t.

3. How will the taxonomy be used?

In addition to classifying financial instruments such as bonds and loans, the SFAC said the taxonomy could provide a common language for procurement policies and net-zero transition plans, among other use cases. In the public sector, the federal government could use it for communication related to climate and economic policies, such as identifying investment gaps that need to be addressed in order to achieve Canada’s climate targets.

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 specific application was not discussed in the Roadmap.

4. How will the taxonomy be governed?

The SFAC proposed a governance model that is “transparent and results-oriented” and that “safeguards the scientific integrity of the taxonomy,” with joint leadership from the government and the financial sector including “strong participation” from the provinces and Indigenous rights holders to foster credibility and usability.

The proposed governance model includes the following bodies:

• Taxonomy Council – A governing body led by the federal government and the financial sector, with “strong participation” from provincial and Indigenous leaders. This Council would function like a board, responsible for governance, oversight, strategic direction, performance, and approvals of the taxonomy. Federal representatives would hold a controlling vote over approvals.
• Taxonomy Custodian – An independent organization that carries out the technical work to develop the taxonomy for Council approval. Also responsible for education and awareness-raising activities and stakeholder relations.
  
• Technical Working Groups – External experts, including academics, engaged to support the development of technical criteria that are “scientifically robust, credible, and usable.”
• Stakeholder Advisory Forum –  An advisory group of stakeholders affected by the taxonomy initiative such as nonprofits, climate advocates, communities, industry, and others to provide input and feedback on taxonomy drafts and implementation processes.

The SFAC intends for the governance model and “all other aspects of the taxonomy” to comply with the United Nations Declaration on the Rights of Indigenous Peoples Act.

5. What business activities would be eligible for financing under the envisioned taxonomy?

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

• Company-level (“general”) requirements – All issuing companies must establish net-zero emissions targets, transition plans, and effective climate disclosures. This applies to issuers of both green and transition products.
• Project-level (“specific”) requirements – All projects would be evaluated against screening criteria to determine whether they qualify as a green or transition activity.
• “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.

According to the SFAC’s proposal, a “green” project is one that generates low or zero emissions across its entire life cycle (i.e. scope 1, 2, and 3 emissions) 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.

The SFAC sees a “transition” project as one that decarbonizes an industry as follows:

• An industry that generates high emissions during production (i.e. scope 1 and 2 emissions), such as steel and cement. Project example: investing in an electric arc furnace for a steel production facility.
• An industry whose products generate high emissions when they are consumed by end users (i.e. scope 3 emissions), such as oil and gas. In the case of oil and gas, eligible projects would need to significantly reduce emissions from existing assets. Project example: installing a world-leading methane capture process on existing natural gas production (with a short to moderate lifespan).

The SFAC emphasized the importance of establishing science-based criteria, “anchored in emissions thresholds and metrics” to clearly outline which 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.

A disclaimer runs throughout the report to emphasize that all examples are provided for illustrative purposes only, with final decisions to be made by the taxonomy’s governing body.

6. What’s ineligible for financing under the envisioned taxonomy?

In addition to excluding business activities doing “significant harm,” the SFAC proposed the following projects to be ineligible for financing under the taxonomy:

• Any projects related to solid fossil fuels, such as thermal coal mining and coal-fired power generation;
• Projects that create “carbon lock-in or path dependency” such as exploration and development of new oil fields;
• Projects at a high risk of becoming stranded due to high downstream emissions (from end-usage) and declining global demand;
• Projects that generate high emissions during production and are inconsistent with net-zero pathways;
• Projects that are unable to scale in the transition to a net-zero future.

7. What does Canada’s Taxonomy Roadmap say about natural gas and nuclear power?

The European Union (EU) attracted criticism when it decided to classify some natural gas and nuclear power projects as “green” subject to certain conditions, such as safety and waste management requirements in the case of nuclear. In the case of natural gas, an eligible project is subject to multiple conditions including emissions thresholds and reduction targets, the need to replace an existing coal facility that can’t be replaced by renewables, and fully switching to renewables or low-carbon gases by 2035.

In its proposal for Canada, the SFAC avoided taking a binary “yes or no” approach to these specific fuel sources, instead focusing on the use of “science-based criteria, anchored in emissions thresholds and metrics,” in alignment with Canada’s net-zero pathway. On natural gas, the SFAC wrote:

“Under this proposed framework for Canada, natural gas-fired electricity projects would be considered to have material scope 1 and 2 emissions (and therefore face high carbon costs in the future) and would therefore need to demonstrate significant emissions reductions to be categorized as transition-eligible.”

Translation: Natural gas doesn’t qualify as “green” under the SFAC’s proposal and the question of whether it qualifies as a “transition” activity would be determined by a specific project’s emissions profile. The SFAC encourages the taxonomy’s governing body to examine Europe’s approach to gas and consider whether it can work in the context of Canada’s pathway to net zero.

Although, the SFAC notes that Canada’s emissions intensity from natural gas-fired electricity was 489g of carbon dioxide equivalent per kilowatt hour (CO2eq/kWh) in 2020, which is much higher than the EU’s taxonomy thresholds of 100g CO2e/kWh to qualify as “green” and the near-term threshold of 270g CO2eq/kWh for projects permitted before 2030 (the latter of which is comparable to a “transition” provision).

Nuclear power, on the other hand, could be categorized as green under the SFAC’s proposal, as the SFAC noted that nuclear power has a median lifecycle emissions intensity of 12g CO2eq/kWh, which is low carbon by any standard.

8. What about blue hydrogen and carbon capture technologies?

The SFAC attracted criticism from environmental groups for positioning blue hydrogen and carbon capture, utilization and storage (CCUS) projects as potential “transition” activities in Canada’s green and transition finance taxonomy. (Whereas “green” hydrogen is produced from low-carbon electricity, “blue” hydrogen is produced from natural gas supported by carbon capture and storage).

Debating the merits of these technologies requires more space than this article can accommodate. But, generally speaking, concerns about these technologies are valid: Research led by academics at Stanford and Cornell found that blue hydrogen projects can generate more emissions than fossil fuels over their lifecycle, mainly due to “fugitive” methane emissions. And there is evidence of CCUS projects missing their carbon capture targets by a wide margin.

However, it would be a mistake to read the Taxonomy Roadmap as an unqualified endorsement of these technologies, as all projects would be evaluated against technical screening criteria to ensure they lead to significant emissions reductions. The SFAC repeatedly emphasized the importance of safeguarding scientific integrity and developing “rigorous, scientific-based screening criteria that are reviewed regularly to reflect innovation and climate science.” Furthermore, the SFAC noted all of the examples it provided were for illustrative purposes only, with final decisions to be made by the taxonomy’s governing body which includes representatives from federal and provincial governments.

So, if the taxonomy is as well governed as the SFAC proposes, with engagement from academics and nonprofits, then we can expect to see some debate about the eligibility of blue hydrogen and CCUS projects as the taxonomy develops.

9. Is the proposed Taxonomy Roadmap credible?

While the details of the taxonomy have not yet been finalized, the proposal is a credible starting point as it clearly incorporates the design principles of good governance, transparency, accountability, stakeholder and rightsholder engagement, and alignment with climate science and global standards.

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 get Canada on a pathway to net-zero emissions, and the Taxonomy Roadmap represents a good-faith effort by finance leaders to create a vital building block to link capital markets to that pathway.

10. What’s next?

Looking ahead, the SFAC proposed getting to work right away to bring a “short-form” taxonomy to life by mid-2023, with the full version to be delivered by the end of 2025.  The SFAC highlighted the importance of moving quickly on the taxonomy to get capital moving, while acknowledging that expedience should not come at the expense of quality and credibility.

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