Leakage in the common ground: how misalignment in sustainable finance taxonomies impacts cross-border capital flows

There is an urgent need to direct capital toward climate change mitigation in emerging markets. To facilitate cross-border green capital flows, developed countries can endorse the common ground between their taxonomies and those in emerging markets. However, little is understood about the effectiveness of this policy. In response, we analyze how misalignment can occur between taxonomies and construct a micro-economic model to show that four ratios (green bond price ratio, supply elasticity ratio, taxonomy misalignment ratio and preferential treatment ratio) should be considered to ensure that the policy is not counterproductive to climate change mitigation. Numerical examples of the model show that among the capital flows directed from a developed market to endorsed green bonds in an emerging market, as much as 26% can leak to those that fall short of the criteria in the developed market's taxonomy; nevertheless, regulatory intervention can reduce the leakage down to 7%.