White List or Technical Screening Criteria? Optimal Pathways for Green Finance Taxonomy Development

Governments are making efforts to create policy frameworks to help mobilize finance for climate action. Standardized eligibility criteria for labelling 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. This paper seeks to understand how countries can determine the taxonomy-adoption pathway that most likely reduces market failure given their individual contexts, while also taking into account the need for international harmonization. We develop an economic theory of how the optimal taxonomy-design option depends on various institutional parameters. We show that a technology-agnostic, technical screening criteria design is most effective for mature markets; but such a design is not always appropriate for markets with low capacity in providing reliable external reviews for green financial instruments