Recent developments show how innovative sustainable finance instruments can help the transition to greener financial markets.

By Paul A. Davies and Edward R. Kempson

The EU Taxonomy Regulation[1] (the Regulation), which entered into force in July 2020, is one of the most significant developments in sustainable finance. The Regulation creates a classification system for green and sustainable economic activities (the Taxonomy) that is intended to be used by market participants in the EU and beyond to navigate the transition to a low-carbon, resilient, and resource-efficient economy. Under the Taxonomy, in order for an economic activity to be classified as “green”, it must (i) substantially contribute to one of six environmental objectives,[2] (ii) do no significant harm to the other five objectives, (iii) comply with certain governance safeguards,[3] and (iv) comply with specific science-based performance thresholds (or “technical screening criteria”).

The European Green Deal, which was established in 2019, concludes that it is necessary to halve net carbon emissions by 2030 and achieve net carbon neutrality by 2050 in order to retain the prospect of ensuring that global warming remains between 1.5 and 2 degrees Celsius, as mandated by the Paris Agreement.[4] The EU has acknowledged that public sector finance alone will be insufficient to achieve these goals, with the Organisation for Economic Co-operation and Development (OECD) estimating that, globally, €6.35 trillion a year will be required to meet Paris Agreement goals by 2030.[5] Accordingly, in its 2018 Action Plan on Sustainable Finance, the EU identified the development of sustainable finance as a critical tool to re-orientate capital flows towards sustainable investments, and concluded that the absence of a comprehensive green taxonomy was one of the main impediments to such development.

The Taxonomy is thus structured as a roadmap to change the trajectory of economic activities on an industry-by-industry basis and align those activities with the goals and targets of the Paris Agreement. The Taxonomy is intended to provide support for the continued development of sustainable finance, including the introduction of a higher level of certainty as to what is “green” in order to avoid issues of greenwashing.

Taxonomy Challenges

Unsurprisingly, with legislation as fundamental and ambitious as the Regulation, the Taxonomy has received criticism. The Taxonomy has been described as too strict and/or rigid, with discussions focusing on matters such as the extent to which natural gas, biofuels, nuclear power, and forestry management should be labelled as “green”. For example, critics have noted that under the Taxonomy, real estate is considered sustainable only if it achieves an “A” in its Energy Performance Certificate, despite the fact that only 1% of buildings in the EU currently satisfy this criterion.

While proponents of the Taxonomy note that the severity and urgency of climate change do not allow for partial or half measures, critics assert that the standards set by the Taxonomy (which are intended to be incorporated in the new EU Green Bond Standard) threaten to exclude large parts of the global economy from the sustainable finance market at exactly the time when economic actors should be encouraged to finance critical steps towards improving sustainability.

Others say the debate should focus on facilitating access to sustainable finance for companies with the heaviest carbon footprint — including companies that operate in carbon-intensive industries such as oil and gas and power generation, and particularly those located in emerging markets — as this approach offers the greatest opportunity to achieve aggregate improvements in sustainability. The argument follows that, even if such companies are unable to identify sufficient Taxonomy-compliant green expenditure and/or chart a course towards net carbon neutrality, they should still be encouraged and supported to take meaningful steps toward improving their carbon footprint and sustainability profile.

Flexibility in Sustainable Finance

As the Taxonomy creates more clarity around the concept of “greenness”, greater focus is required on facilitating the transition from “brown” to “dark green”. The importance of this transition has received support and acknowledgement from many in the market, including the Climate Bond Initiative[6] and AXA.[7] In a speech in the fall of 2019, Mark Carney, former governor of the Bank of England, called for flexibility and ingenuity to combat climate change, noting that “we need 50 shades of green”.[8] Earlier this year, Luca Bonaccorsi of the non-governmental organisation Transport & Environment suggested that the market requires “shades of green” that would allow “unsustainable activities, such as gas, to be labelled as green”.[9]

In recent months, two instruments that are particularly suited to financing sustainable transitions have received attention: sustainability-linked bonds and transition bonds.

Sustainability-Linked Bonds

The sustainability-linked bond (SLB) market has seen rapid growth since the publication of the International Capital Market Association’s Sustainability-Linked Bond Principles in June 2020. Companies are seeking to take advantage of the availability of significant green liquidity in financial markets in order to finance their sustainability strategy and are prepared to link their cost of capital to their sustainability performance. Freed from the constraint of identifying sufficient eligible green expenditures, issuers are using this flexibility to apply proceeds at their discretion in order to best progress their transition. Many recent issuances have come from sectors associated with high carbon emissions, including oil and gas, power generation, and the production of clothing and packaging.

Transition Bonds

Transition bonds (TBs) are the subject of the 2019 AXA Transition Bond Guidelines (the TB Guidelines) and the Climate Bond Initiative’s 2020 white paper “Financing credible transitions” (the White Paper).[10] Both acknowledge that the “transition” label may be particularly appropriate for companies from high-emitting sectors that may be unable to identify sufficient green expenditures, but nevertheless want to transition in a meaningful manner towards sustainability. The TB Guidelines expect a TB to be aligned with an issuer’s broader transition strategy, which should be both material to its sustainability profile and set by reference to short- and long-term measurable targets and objectives. The White Paper recommends that the relevant transition strategy should be aligned with the Paris Agreement.

The TB market is likely to develop as the focus on transitioning carbon-intensive sectors increases. Given this, various stakeholders’ expectations around transitioning activities are likely to coalesce.


While the value and relevance of the Taxonomy is clear, the facilitation of the transition from brown to dark green is equally important (and maybe even more so). Many issuers facing the most pressing sustainability challenges may look to innovative alternatives to the green bond in the form of SLBs,[11] TBs,[12] and green striped bonds, i.e. bonds which are only partly green.[13]

Latham & Watkins will continue to monitor developments in this area.



[1] EU Regulation 2020/852 dated 18 June 2020.

[2] These objective are: (a) climate change mitigation, (b) climate change adaptation, (c) the sustainable use and protection of water and marine resources, (d) the transition to a circular economy, (e) pollution prevention and control, and (f) the protection and restoration of biodiversity and ecosystems.

[3] The minimum safeguards are alignment with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work and the International Bill of Human Rights, and adherence to the principle of “do no significant harm”.








[11] Sustainability-Linked Finance Takes Off in 2020, Latham & Watkins Client Alert, December 2020.

[12] Transition Bonds Guidelines May Expand Sustainable Finance, Latham & Watkins Client Alert, June 2019.

[13] Is Green Striping the Future of Green Bonds? IFLR, September 2016.