Definition

 

The EU Taxonomy is defined as a “green classification system” which translates the EU’s climate and environmental objectives into criteria for the determination as to what classifies as ‘environmentally sustainable’ or ‘green’. It is part of the EU’s overall efforts to reach the objectives of the European Green Deal and make Europe climate-neutral by 2050. It attempts to define, through science-based transparency, economic activities that make a substantial contribution to at least one of the EU’s climate and environmental objectives.

The EU Taxonomy is not a mandatory list of economic activities for investors to invest in, however it is expected that over time the EU Taxonomy will be a catalyst for the transition toward sustainability. As matters stand today, there is no obligation for companies to be Taxonomy-aligned and investors are free to choose what to invest in.

The EU Taxonomy forms part of a broader sustainable finance network and is one of three disclosure tools. The other two tools are the Non-Financial Reporting Directive (NFRD) and the Sustainable Finance Disclosure Regulation (the SFDR)¹.

Non-Financial Reporting Directive (NFRD)

The NFRD is in the process of being revised and will be renamed as the Corporate Sustainability Reporting Directive (CSRD). The aim of this Directive is to provide a comprehensive corporate reporting framework with qualitative and quantitative information to assess the sustainability impacts and risks of companies.

Sustainable Finance Disclosure Regulation (SFDR)

The SFDR on the other hand, which came into force on the 10th of March 2021, created a comprehensive reporting framework for financial products and financial entities. The SFDR distinguishes reporting requirements for financial products that claim to have ‘sustainable investment’ as their objective from financial products that claim to be promoting social or environmental characteristics.

The Taxonomy Regulation together with the SFDR, the CSRD, the EU Ecolabel for retail financial products and the EU Green Bond Standard are meant to ensure that activities which are aligned with the Taxonomy are immediately recognised in investment decisions.

While disclosures are only mandatory for large companies that fall within the scope of the CSRD, small companies could still voluntarily disclose the Taxonomy alignment of their activities while also taking the opportunity to explain to investors or stakeholders whether they carry out or intend to carry out Taxonomy-aligned green activities.

The Taxonomy Regulation is expected to be more far reaching in scope than is immediately apparent, and as matters stand the EU already requires Member States to use the Taxonomy as the basis of any EU labels for green corporate bonds or financial products that fall within the scope of the SFDR.

Furthermore, the EU Climate Benchmarks Regulation² which determines who can use the labels ‘EU Climate Transition Benchmark’ and ‘EU Paris-Aligned Benchmark’ will be made consistent with the EU Taxonomy by the end of 2022. It is presumed that benchmark administrators will have to select companies that have a certain percentage of their activities classified as green as per the Taxonomy (or that others are excluded because they do not comply).

The Taxonomy Regulation

The Taxonomy Regulation³, which entered into force on the 12th of July 2020 (Regulation 2020/852) lays out six EU environmental objectives:

  • Climate change mitigation (Article 10)
  • Climate change adaptation (Article 11)
  • Sustainable use and protection of water and marine resources (Article 12)
  • Transition to a circular economy (Article 13)
  • Pollution prevention and control (Article 14)
  • Protection and restoration of biodiversity and ecosystems (Article 15)

It further sets four conditions for an economic activity to be recognised as ‘Taxonomy Aligned’:

  • Making a substantial contribution to at least one environmental objective
  • Doing no significant harm to any other environmental objective
  • Complying with minimum social safeguards
  • Complying with the technical screening criteria (developed in delegated acts)

An economic activity as contributing substantially to climate change mitigation is defined as one which contributes substantially to the stabilisation of greenhouse concentrations in the atmosphere at a level which prevents dangerous anthropogenic interference with the climate system consistent with the long-term temperature goal of the Paris Agreement through the avoidance or reduction of greenhouse gas emissions or the increase of greenhouse gas removals.

Substantial contribution is further defined as an activity that directly enables other activities to make a substantial contribution provided it does not lead to a lock-in of assets that undermine long-term environmental goals and has a positive environmental impact on the basis of life-cycle considerations.

As part of the activities which substantially contribute to one or more environmental objectives two categories are further included: enabling activities and transitional activities. Enabling activities are those which allow other activities to make a substantial contribution to one or several of the Taxonomy’s objectives and which do not lead to a lock-in of assets which would undermine long-term environmental goals. Transitional goals on the other hand are those for which low-carbon alternatives are not available and that have emissions which classify as the best performing in the sector.

The Delegated Acts

The EU subsequently the EU Taxonomy Delegated Act, being applicable from the 1st of January 2022⁴ and a subsequent delegated act⁵ (the Second Delegated Act) being currently in the scrutiny period and is expected to come into force on the 1st of January 2023. The Second Delegated Act will amend the first Delegated Act by adding technical screening criteria for certain economic activities in the natural gas and nuclear energy sectors that were not included in the original Delegated Act.

It also provides for specific disclosure requirements for the natural gas and nuclear sectors. The idea behind the Delegated Acts is that the Commission was tasked with establishing technical screening criteria and wanted to clarify further (there is very little specific reference to activities in the Taxonomy Regulation) which economic activities most contribute to meeting the EU’s environmental objectives. To this effect the Delegated Act delivers the first set of technical criteria for defining such activities.

In the preamble to the Second Delegated Act the European Commission specifies that:

“Renewables will play a fundamental role in meeting the climate and environmental goals of the Union. In that light, investments in renewables need to scale-up to meet the needs of the energy market of the Union for more renewable and clean energy.”
The decision by the Commission to include nuclear and gas activities as “environmentally sustainable” has been touted as one which is controversial and during the scrutiny period it is still subject to being blocked by Member States or by the European Parliament. Should it come into force in January 2023 however it would mean that gas and nuclear activities would be considered as green investments and would also be granted access to public funds under the EU’s Next Generation Investment Program.

Conclusion

It is clear that while the run up to the last decade seemed to lack dedicated ESG focused regulation, the past four years have been marked by a focus from a regulatory perspectives to attempt to incentivise investors and stakeholders at large to follow more sustainable business practices. The EU’s ambitions to become climate-neutral have spurred it to push forward with the framework of regulations and directives which fall within the ambit of the EU Taxonomy and it seems to be having a positive effect with corporates responding to investor and regulatory pressure on ESG reporting.
The EU Taxonomy is just the starting point and it is clear that corporate reporting is about to become increasingly regulated. Companies need to be monitoring these latest steps closely to evaluate activities which they engage in and investments they are planning to ensure whether they fall within or outside the Taxonomy’s current and future scope.