1. Introduction

The report addresses the challenge of directing capital towards climate mitigation, particularly in emerging markets where investment needs are substantial (approximately USD 1 trillion annually by 2025 and USD 2.4 trillion by 2030). Over 30 jurisdictions have developed or are developing sustainable finance taxonomies, yet differences in design and stringency hinder cross-border green capital flows. The paper investigates whether ‘common-ground endorsement’—the formal recognition by a developed market of activities in an emerging market’s taxonomy that overlap with its own—effectively increases green investment aligned with developed-market criteria. It emphasises potential green capital leakage, where capital may flow to projects misaligned with the developed market’s taxonomy.

1.1 Research questions

The study examines: (1) how common-ground endorsement affects cross-border green capital flows; (2) whether such endorsement increases projects aligned with developed-market taxonomies; and (3) what criteria should inform policymakers when selecting emerging-market partners.

1.2 Literature review

The paper situates its contribution within three bodies of literature: sustainable finance taxonomies, barriers to international climate investment, and portfolio-selection theory. Prior research documents challenges in taxonomy design, investor uncertainty regarding green credentials, and macroeconomic frictions (e.g., higher perceived risk, exchange-rate exposures). Few studies address how taxonomy misalignment affects international capital flows, creating a gap this report aims to fill.

2. Taxonomy misalignment

Two forms of misalignment are identified: differences in design and stringency.

Design misalignment includes divergent scopes and incompatible classification systems, as seen where the EU taxonomy recognises landfills under specific criteria while the China taxonomy excludes them. Screening approaches also differ: some taxonomies rely on quantified technical screening criteria (e.g., emissions thresholds), while others adopt whitelist or principle-based systems.

Stringency misalignment arises when taxonomies apply different thresholds to the same activity. For instance, hydropower eligibility in the EU requires adherence to strict emissions intensity thresholds, whereas China applies qualitative criteria. Renewable energy projects such as solar PV may face more stringent technological criteria in China. Obfuscation of misalignment occurs when taxonomies reference domestic standards not directly comparable across jurisdictions (e.g., building standards, palm-oil sustainability criteria).

3. The model setup

The microeconomic model features two markets: A (developed) with a more stringent taxonomy, and B (emerging) with a more inclusive one. Green bonds are categorised as Type 1 (market A; aligned with both taxonomies), Type 2 (market B; aligned with A), and Type 3 (market B; not aligned with A). Supply functions are iso-elastic, with higher supply elasticity expected in emerging markets. Demand is represented by two investors with CES utility functions capturing substitution between domestic and foreign green bonds. Key assumptions include stronger preference in market A for taxonomy-aligned bonds and positive domestic demand in market B for both Type 2 and 3 bonds.

4. Microeconomic analysis

Common-ground endorsement raises the perceived non-financial benefit of Type 2 bonds for investor A. The model predicts: (1) A reallocates capital from Type 1 to Type 2 bonds; (2) B reallocates capital away from Type 2 towards Type 1 and Type 3; and (3) prices of Type 2 and 3 bonds increase while Type 1 prices fall. This substitution leads to capital leakage into Type 3 bonds. The real effect on total aligned green investment depends on four ratios: the green bond price ratio (p1/p2), supply elasticity ratio, taxonomy misalignment ratio (t3/t2), and preferential treatment ratio (b2/b3). Endorsement can be counterproductive when leakage outweighs gains in aligned Type 2 issuance.

5. Discussion

Numerical scenarios show leakage may reach 26% of capital flows from A to endorsed Type 2 bonds. Preferential treatment in market B (e.g., differentiated recognition or financial incentives) can reduce leakage to 7%. When market B has low supply elasticity, endorsement may reduce total aligned investment.

5.2 Policy implications

Developed markets should assess partner taxonomies using the four ratios, employing proxies such as NDC conditionality for supply elasticity. Emerging markets can improve alignment prospects by differentiating between Type 2 and Type 3 bonds, enhancing screening criteria, and introducing incentives for higher-quality green bonds. Market capitalisation ratios of Type 2 and 3 bonds provide actionable data for partnership decisions.