In 2015, with the adoption of the Paris Agreement and the UN 2030 Agenda for Sustainable Development, governments around the world chose a more sustainable path for the planet and the economy. The financial system was recognised as a critical enabler for the transition to a low-carbon, more resource-efficient and more sustainable circular economy.
With this in mind, the European Commission appointed a High-Level Expert Group to develop a sustainable finance strategy for the EU, taking into account environmental, social, and governance considerations. This resulted in the Action Plan on Financing Sustainable Growth in 2018.
The Action Plan has set forth 10 action points aimed at three main objectives, namely:
- reorienting capital flows towards a more sustainable economy,
- mainstreaming sustainability in risk management,
- fostering transparency and long-termism in financial and economic activities.
Within this framework, the primary action was to set up a unified EU classification system, or taxonomy, to provide clarity on which activities can be considered sustainable. On December 17, 2019, the Expert Group agreed on the text of the Taxonomy Regulation as a legal base for a EU taxonomy. The ambition of the EU Taxonomy is to provide legal certainty, a basis for future legal initiatives, and a benchmark for the economy.
On 22 June 22, 2020, the Taxonomy Regulation was published in the Official Journal of the European Union. The Regulation entered into effect on July 12, 2020.
What is the EU Taxonomy?
The EU Taxonomy is a tool for entities and investors to identify whether an economic activity is environmentally sustainable.
To be environmentally sustainable, an economic activity (as identified by the Taxonomy) must first substantially contribute to one of six environmental objectives. These objectives are:
- climate change mitigation,
- climate change adaptation,
- sustainable use and protection of water and marine resources,
- transition to a circular economy,
- pollution prevention and control,
- protection and restoration of biodiversity and ecosystems.
On top of contributing to one objective, the economic activity may not significantly harm any of the other objectives. It must also comply with certain minimum social and governance safeguards.
These safeguards are the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights. They include the International Labour Organisation’s declaration on Fundamental Rights and Principles at Work; the eight ILO core conventions; and the International Bill of Human Rights.
Sectors responsible for climate change under scrutiny
The Taxonomy Regulation requires further finetuning and determination of relevant screening criteria per objective. To date, an expert group developed recommendations on the technical screening criteria for climate change mitigation and adaptation. It also identified and prioritised sectors responsible for a substantial majority of direct greenhouse gas emissions in the EU, namely:
- agriculture, forestry, and fishing,
- electricity, gas, steam, and air conditioning supply,
- water, sewerage, waste management and related remediation,
- transportation and storage,
- information and communication technologies,
- buildings (construction and real estate activities).
More technical screening criteria and a categorisation of relevant economic sectors for the other objectives are expected to follow in due course.
The EU Taxonomy is also the basis for disclosure by financial market participants and large companies of information on economic activities that substantially contribute to climate change mitigation and adaptation.
Financial market participants
The financial market participants within the scope of the EU Taxonomy are most insurance, pension, and portfolio management providers. They must disclose in pre-contractual disclosures and periodic reports how and to what extent the investments that underlie certain financial products – e.g., pension schemes, alternative investment funds, UCITS, and IBIP – support economic activities that meet the Taxonomy criteria for environmental sustainability.
The large (financial and non-financial) companies within the scope of the Taxonomy are companies subject to the Non-Financial Reporting Directive. Examples are large public-interest companies with more than 500 employees, including listed companies, companies with convertible bond loans, banks, and insurance companies.
These companies will need to disclose how, and to what extent, their activities are aligned with the Taxonomy. The description must include the proportion of turnover, Capex, and – when relevant – Opex, aligned with the Taxonomy.
With this information, investors will be able to situate a company relative to the EU Taxonomy and get a good sense of a company’s direction of development in this respect.
Companies which are not within the official scope may decide to voluntarily publish EU Taxonomy aligned information.
The EU Taxonomy is also linked to other EU tools and may have certain more indirect impacts.
For instance, the green bond standard, low carbon benchmarks, and guidance for climate reporting will all make use of the EU Taxonomy.
The EU Taxonomy will also be an important enabler of the EU Green Deal’s comprehensive sustainable economy reforms. Individual Member States and the EU are required to use the EU Taxonomy for certain future legislation or other measures, such as when setting standards for green labels or green (corporate) bonds.
For investors, be it asset owners, asset managers, insurance companies or banks, the EU Taxonomy is an additional tool for analysing investment targets, for risk management and for diversification of portfolios. In this sense, it will also serve ESG (Environmental, Social and Governance) reporting.
Finally, companies in general would do well to understand the changing market demands and needs, and their own position compared to their peers in the context of the EU Taxonomy. Ignoring this might ultimately even result in a higher cost of capital.
An understanding of the EU Taxonomy and of the related reporting requirements will become increasingly useful, even necessary. Sustenuto can help you navigate this uncharted territory.
NOTE: the original article has been updated to reflect the date of publication in the Official Journal and the date of effect. Since those dates, the EU Taxonomy has further evolved.
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