ASEAN Taxonomy threads the needle between pure threshold-based and principles-based taxonomies

• ASEAN Taxonomy version released outlining how it would connect and provide a common language for different ASEAN member country taxonomies
• Provides substantially greater flexibility than other taxonomies like the one adopted for the European Union, but how national taxonomies use it remains to be seen
• ASEAN Taxonomy outlines the critical role for finance, but its unclear how taxonomy would apply to companies operating across multiple countries to limit opportunities for regulatory arbitrage

The ASEAN Taxonomy Board has released the first proposed version of a regional taxonomy for its Southeast Asian member countries. The sustainable finance taxonomy straddles the line between a strict-threshold taxonomy and one that is principles-based, allowing the two to coexist side-by-side. It is a somewhat complex formulation that provides three Foundation Framework levels, three Plus Standard Framework levels, and then three Tiers for adapting to the starting point.

Some of the confusion between the taxonomy frameworks and tiers will be resolved once they are adapted by different countries. Each country will presumably only be able to choose one approach — whether that is the Foundation or Plus Standard Framework, where the latter includes and goes beyond the Foundation Framework.

One of the immediate questions in terms of practicality with the ASEAN Taxonomy is whether the conceptual clarity for each avenue within the Taxonomy will be lost as “each [ASEAN Member State] develop[s] its own national sustainable finance taxonomy to meet its individual needs and domestic stage of development”.

Having a multi-tiered framework work seamlessly would rely on each country’s economy being independent of the others, which to a degree contradicts ASEAN’s aspirations for integration within economic and capital markets. In few other ways are ASEAN member countries more connected to one another, and to countries outside of ASEAN, than through financial markets and banks.

There are international banks and regional banks each operating within and between multiple ASEAN member countries and it is not clear how differences in national taxonomies would be unified for the purpose of disclosure on taxonomy-aligned assets. The report acknowledges the central role that financial institutions and investors will play in implementing the Taxonomy screening and also undertaking engagement to promote improvements by companies over time.

In one section, the draft explains that:

The risk that the multi-tier taxonomy raises in this context is that financial institutions may not share the same motivations as the regional or national authorities who are developing the taxonomy. Their role and ability to report on the degree of Taxonomy-alignment is not clearly defined, which presents a risk that they abuse the trust as gatekeeper in the financial resource allocation role they hold. For example, they could aid companies’ responses to taxonomy adoption through regulatory arbitrage so that their customers find ways to become subject to the least restrictive taxonomy among ASEAN member countries, or by having more of their own assets subject to a less restrictive framework.

A taxonomy is useful when it creates firm boundaries between sustainable and unsustainable activities, this strength also creates vulnerability where the thresholds are not uniform. It leaves an opportunity for institutions to gain advantage while others are challenged. The ASEAN Taxonomy was developed in a way that will address the challenges faced by ‘one-size-fits-all’ taxonomies such as the one adopted in the European Union, but it also creates some new challenges.

The ASEAN Taxonomy helps to blunt the importance of binary divisions between sustainable and unsustainable by allowing for different national standards and gradients of sustainability while explicitly considering the role of ‘transition’ activities. Where the EU Taxonomy’s challenge, especially for companies from emerging & developing countries, lies in losing market access if they cannot economically meet the standard, the challenge for the ASEAN Taxonomy is different.

In order for the ASEAN Taxonomy to sidestep the pitfalls of regulatory arbitrage that have accompanied similar differences in policy between countries, transparency can help. The use of the ASEAN Taxonomy as a common language between the ASEAN member countries can strengthen disclosures relating to sustainability.

Specifically, it will be important to avoid allowing vague disclosures about proportion of assets that are ‘ASEAN Taxonomy-aligned’ for multinational companies or financial institutions who have activities in more than one ASEAN member country. Taxonomy reporting should use the precision the taxonomy affords to provide clarity about what proportion of reported alignment is following which type of framework and aligned to which national taxonomy so as to forestall any efforts at regulatory arbitrage.

Want to learn more about responsible finance in Islamic markets? Subscribe to RFI’s weekly email newsletter