How To Think About Adaptation Investment Taxonomies

Sustainable taxonomies are all the rage. The idea behind them is simple: classify economic activities that support climate and environmental goals and nudge companies and financial institutions to do (or finance) more of them.  

The European Union was first out of the gates with a full taxonomy for sustainable activities, which entered into force in 2020¹ . The EU taxonomy established a common definition of pro-environment activities, which is now being incorporated into mandatory disclosure obligations, like the Corporate Sustainability Reporting Directive. Since then, taxonomies have sprung up all over the world. As of July 2023, 45 jurisdictions (or groups of jurisdictions) had either implemented, developed, or planned to develop taxonomies.

Some taxonomies are broad in scope, covering multiple sustainability aspects. The EU version encompasses six sustainability objectives: climate mitigation, climate adaptation, water use, circular economy, pollution control, and biodiversity. Others are narrower. For example, the first iteration of the Thailand Taxonomy has one objective — climate mitigation.

However they’re constructed, one thing is clear: a world in which two-thirds of risk experts are worried about extreme weather events must have sustainable taxonomies that clearly identify pro-climate adaptation activities and encourage investors to funnel capital toward them.

Why Taxonomies Matter

From an adaptation investment standpoint, the clarity taxonomies can impart is doubly useful. First, they can augment regulatory disclosures, forcing companies and investors to make plain the amount they’re spending on adaptation. This data in turn can be used to pile pressure on adaptation laggards. Second, they can provide the blueprints for new financial products that catalyze further investment in adaptation solutions.

On this second aspect, though, taxonomies could do better. Take the EU. The Sustainable Finance Disclosure Regulation (SFDR) created a de facto labeling system for funds, but how this system interacts with the EU taxonomy is ambiguous to say the least. In fact, it’s so unclear that a consultation on the SFDR launched last year is committed to clarifying the linkages between them.

What’s interesting is that while policymakers are struggling to classify sustainable activities, financial institutions and the third sector are tinkering with their own quasi-taxonomies. Some are focused on sorting potential investments into specific categories that can be marketed to end investors. Others seem more keen on rallying support for overlooked activities that make a meaningful dent on our adaptation needs.

Sorting it out

One of the (many) reports out of Davos this week discusses the emerging set of climate adaptation technologies that can help manage risks and catalyze opportunities. It describes an “adaptation cycle” that sorts adaptation technologies, strategies, and investments into one of three stages: “Comprehend risks (and opportunities)”, “Build resilience”, and “Respond dynamically.” The first stage encompasses activities that help identify, and plan for, climate shocks. Think data gathering, climate modeling, and risk analytics. The second is about protecting communities, businesses, and environments. It’s more hardware-focused than the first stage, though smart technologies can amplify their effectiveness. Finally, the third stage is all about what happens in the aftermath of climate shocks — encompassing activities from initial emergency responses to post-disaster analytics. 

Though building an adaptation investment taxonomy is not the purpose of the paper, the authors write that “[o]ne way of increasing financial flows into climate adaptation is to change its framing,” by linking adaptation with technological innovation. Slotting adaptation investments into the stages outlined above could be one way to do this.

A similar division of adaptation activities was discussed last month by Kari Nadeau, an academic at the Harvard T.H. Chan School of Public Health. Presenting on climate resilience investing, Nadeua cited “Preparedness”, “Infrastructure”, “Biodiversity”, and “Social support” as four broad solutions categories.

“Preparedness” covers those activities that facilitate planning for climate disasters and rapid response when they strike. In this context, Nadeau talks about software and satellite data that supports emergency preparedness, as well as “climate toolkits” for community health workers. “Infrastructure” solutions are those that improve the resilience of existing essential physical assets, like the electricity grid, against extreme weather events. “Biodiversity” encompasses nature-based solutions that can protect against unpredictable weather and also sequester carbon, supporting both climate mitigation and adaptation goals. Finally, “social support” includes solutions that provide “physical and emotional support to families and especially communities that are inequitably exposed to environmental justice issues.” (Nadeau doesn’t go into much more detail, but “wellness” solutions sound like they’d fit in here).

One could imagine her categorization being adopted as a loose, action-oriented taxonomy by investors looking to build thematic portfolios that address adaptation holistically.

Other entities are taking a more sectoral approach to classifying these kinds of investments. JP Morgan Asset Management published a white paper series last year on adaptation opportunities in three areas: nature and ecosystems; health and healthcare systems; and cities. The selection wasn’t random — it was informed by the Intergovernmental Panel on Climate Change (IPCC), which identified these three as hot spots for rising climate risks.

Each paper in the series defines investable solutions for their respective area, broken down by industry. For example in the cities paper, JP Morgan highlights activities that investors could support in the transport industry (erosion control measures, adapting vehicles for altered climatic conditions), infrastructure (upgrading water storage and supply, increasing cooling system capacity for energy generation facilities) and real estate (urban greening, designing for storm resilience). 

By mapping solutions to well-understood industry categories, JP Morgan is talking about adaptation in a language that investors already understand. It’s a straightforward rubric. First, look at what sectors most need adaptation financing based on their climate vulnerability and exposures, then within those sectors find potential solutions. 

Invest Through the Cycle

I wonder whether a taxonomy based on stages in the “adaptation cycle”, or whatever you want to call it, isn’t more sensible from a financial risk management point of view.

The issue with the sectoral approach is that investments could be concentrated at certain points along the cycle at the expense of others, based on their return profiles, maturity, or simply an investor’s comfort with a given sector. This is a problem since the different types of adaptation activities described in the cycle are mutually reinforcing. Together, they provide more resilience and protection than the sum of their parts.

For example, perhaps it turns out that investing in “Build resilience” solutions is an easier sell than “Respond dynamically” options. Does that mean that private capital is channeled away from solutions that help communities and businesses deal with the aftermath of disasters? And wouldn’t this ultimately undermine those “Build resilience” solutions? After all, if a business can’t bounce back from a disaster, it’s not going to be able to invest in protecting itself from the next one.

Maybe it’s a false concern, but we’ve already seen in the history of climate tech deals how investment skews towards specific verticals and sectors. For example, Sightline Climate found that less than US$7bn of 2020-2023 climate tech investment went towards the built environment, whereas US$53bn went toward transport, predominantly battery manufacturing. Considering the vast adaptation demands of the former category, that US$7bn is not near enough.

Adaptation has to be advanced across multiple solutions categories in parallel if it is to be effective. Investors should keep this in mind as they build out adaptation portfolios.

1. China published a “green bond catalogue” in 2015, which is often referred to as a taxonomy, but doesn’t share the EU framework’s detailed classifications and quantitative thresholds.