On October 21, 2024, Nepal took a significant step towards sustainable finance with the launch of the Nepal Green Finance Taxonomy . This makes Nepal one of only 21 countries worldwide to have developed a taxonomy aimed at fostering green finance. With 32 taxonomies globally, this move aligns with the global push toward sustainable economic systems, ensuring the country’s commitment to climate action and sustainable development.

Establishing a Framework for Green Finance

The taxonomy, issued by the Nepal Rastra Bank (NRB), provides guidelines for implementing green finance initiatives. It establishes clear criteria for identifying green financial activities thereby ensuring that investments promote climate change mitigation, enhance climate adaptation and support sustainable economic growth. The taxonomy outlines how various stakeholders — including banks, insurance companies and investors — should approach environmental responsibility.

The taxonomy aims at classifying economic activities such as assets, projects and sectors that are eligible to be labelled as "green" or environmentally sustainable. This classification is crucial for assisting financial institutions in identifying, tracking and demonstrating the credentials of their green activities, while directing capital and resources toward building Nepal’s green, resilient and inclusive economy.

One of the primary goals of the taxonomy is to offer financial institutions clear guidelines on investing in sustainable projects. The framework prioritises financial support for initiatives focusing on climate change mitigation, pollution control, natural resource conservation, and environmental sustainability.

“Prioritising economic activities that adhere to low carbon emissions and sustainable development principles is the need of the hour,” said Guru Prasad Paudel, Executive Director at NRB. He added that while the taxonomy is not yet mandatory, it will serve as a reference for environmentally conscious investments.

Nepal's Climate Vulnerability and Goals

Despite contributing only 0.04% to global carbon emissions in 2022, Nepal is among the countries most vulnerable to climate change. The Climate Risk Index ranks Nepal in the top 10 most affected nations between 2000 and 2019. A World Bank report warns that Nepal could lose up to 2.2% of its annual GDP by 2050 due to climate-related impacts. Recent extreme weather events, such as the floods and landslides in late September, highlight the urgent need for sustainable practices.

Nepal has set ambitious climate goals, including achieving net zero emissions by 2045, ahead of neighbouring China and India's targets for 2060 and 2070. However, meeting these goals will require substantial financial investments, with an estimated $77 billion needed by 2030 for climate adaptation, mitigation and sustainable development. According to Paudel, the taxonomy could be instrumental in securing climate-related compensation in the future.

Development and Implementation of the Taxonomy

The development of Nepal Green Finance Taxonomy involved extensive collaboration among various stakeholders. In December 2022, NRB partnered with the Alliance for Financial Inclusion (AFI) to develop the taxonomy. A governance mechanism, comprising NRB, the Securities Board of Nepal (SEBON), Nepal Insurance Authority (NIA), the Ministry of Finance and the Ministry of Forest and Environment, was formed to guide the process.

The taxonomy applies to financial sectors regulated by NRB, SEBON, and NIA. It is also designed to support private-sector entities interested in green finance. It facilitates the use of several green financing instruments, such as green bonds, venture capital, blended finance, impact investing and carbon offset schemes.

The taxonomy is based on four key environmental principles: Climate Change Adaptation (A), Climate Change Mitigation (M), Natural Resource Conservation and Management (N), and Pollution Prevention and Control (P). These principles align with national policies promoting green, resilient and inclusive development (GRID). Central to the taxonomy is the 'Do No Significant Harm' (DNSH) principle which ensures that activities contributing to one environmental objective do not undermine others.

Classification of Economic Activities

The taxonomy classifies economic activities into three categories: green, amber and red. Green activities fully align with environmental sustainability goals and are prioritised for investment. Amber activities are in transition toward sustainability, while red activities, which do not meet environmental objectives, are discouraged.

The taxonomy employs both principle-based and whitelist-based approaches. The principle-based method focuses on core guiding principles to assess economic activities, while the latter specifies eligible projects or activities for green investments.

Paudel emphasised the importance of transparency in implementing the taxonomy. "Market actors are encouraged to promote green activities and provide transparent reporting based on global best practices," he said, adding that “green audits” may become necessary to certify adherence of financial institutions to green finance standards.

The phase-wise implementation of the taxonomy will enable regulators and market participants to identify activities, assets and revenue segments that align with sustainability goals. It will also support Nepal in accessing international carbon markets and attracting capital that aligns with environmental, social and governance (ESG) principles.

Challenges in Implementation

Yulanda Chung, a Board Trustee at the Climate Bonds Initiative (CBI), highlighted challenges in adopting the green finance taxonomy, including the availability of data on customers' emissions profiles and cost concerns. However, she acknowledged that Nepal's taxonomy incorporates international best practices and expressed optimism about its implementation.

Sunil KC, President of the Nepal Bankers’ Association, cautioned that a lack of readiness among stakeholders could pose an immediate challenge in implementation of the taxonomy. “There is a concern regarding costs,” KC said, warning that without adequate support, implementing entities may face an uneven playing field.

Siddhanta Raj Pandey, Chairperson of the Nepal Private Equity Association, said the taxonomy provides foundational criteria for green financing. However, he raised concerns about the effective monitoring of its implementation.

While the taxonomy does not currently offer specific incentives for implementation, Paudel indicated that future discussions on incentives could take place. Banks that adopt the taxonomy may benefit from reduced interest rates and risk-weight management which would help lower their operational costs.

NRB Governor Maha Prasad Adhikari recently said the central bank’s policies on green financing aligns with the National Climate Change Financing Framework introduced in 2017. Since then, NRB has implemented Environment & Social Risk Management (ESRM) guidelines for banks and financial institutions (BFIs), which became mandatory in 2020 and were revised in 2022.

Global Context

The rise of green finance dates back to the 1990s, marked by the launch of the United Nations Environmental Program Finance (UNEPF) Initiative and the Clean Development Mechanism which paved the way for carbon markets. This period also saw the adoption of the Equator Principles and the Principles for Responsible Investment - the first investor network dedicated to responsible and green investments. As green finance gained traction, the European Investment Bank and the World Bank issued the first green bonds in 2007 and 2008, respectively.

China quickly became a leader in the field, establishing one of the largest markets for green finance and renewable energy.

Over the past decade, green finance has grown exponentially, with global assets surpassing $1 trillion. Many countries are adopting green taxonomies to build sustainable finance markets and attract international investment. Two major approaches, from China and the European Union, influenced the development of regional and national taxonomies.

The European Union’s taxonomy, introduced in 2020, is among the most comprehensive, covering six environmental objectives and 170 economic activities. It uses strict criteria to ensure activities make a "substantial contribution" to environmental goals without causing harm to others. China’s Green Bond Endorsed Project Catalogue, while simpler, is advanced, reflecting a convergence of national taxonomies within China.

Nepal’s green finance taxonomy is part of this global movement toward a sustainable financial ecosystem. According to a 2017 International Finance Corporation (IFC) study, Nepal has a climate-smart investment potential of $46 billion between 2018 and 2030 which green finance could help unlock.

The introduction of the Nepal Green Finance Taxonomy marks a significant step in the country’s quest to build a sustainable economy. As Nepal looks to meet its ambitious climate goals and mitigate the impacts of climate change, the taxonomy provides a clear path for aligning financial investments with environmental objectives. While challenges remain in terms of data availability, costs and stakeholder readiness, the taxonomy offers a framework for fostering a green finance ecosystem that will benefit both the country and the planet.

(This news report was originally published in November 2024 issue of the New Business Age Magazine.)