Market fragmentation or market failure? A dilemma of harmonizing green finance taxonomy designs

Governments are making efforts to create policy frameworks to help mobilize finance for climate action. Standardized eligibility criteria for labeling financial instruments as ‘green’ are deemed critical to the credibility required to scale this burgeoning market. Paradoxically, as different taxonomies emerge, there is greater risk of fragmentation between definitions. In response to an observation made by G20, this paper seeks to understand how the ‘varying contexts of individual countries’ may conflict with the call for international harmonization of green taxonomies. To illustrate the dilemma, we develop an economic theory to explore how a country's external review capacity, among other institutional parameters, factors in its optimal taxonomy design. We find that a technology-agnostic, technical-screening-criteria design is most effective for mature markets; however, such a design is not always appropriate for markets with low capacity in providing reliable external reviews for green financial instruments. Numerical examples of the model show that emerging markets could forfeit as much as 23% of their expected green impact by adopting the wrong taxonomy design.