Contributed by: Jan Rošetzký, Senior ESG Consultant, Schneider Electric
As part of its Green Deal, the European Union is currently preparing a classification system for sustainable financing, known as the ‘Taxonomy’. Its intention is to create a common classification for sustainable economic activities to unleash the power of financial markets in the transition to a decarbonized, more sustainable economy. The set of rules primarily affects the financial sector and energy-intensive sectors, such as transport, housing, energy, as well as chemicals and steel. But what does that mean for the corporate world overall? And will the rules be strong enough to fuel a sustainable transition? We sat down with our experts to overview the new EU Green Taxonomy and discuss its implications for our clients.
Sustainable finance is an essential part of this plan the European Green Deal: a comprehensive package of initiatives aimed at transforming the EU into a carbon neutral continent with no net emissions of greenhouse gases by 2050. The plan not only ensures that economic growth can be decoupled from resource use but also will leave no person or place behind. As such, the Green Deal is an approach that combines the full scope of environmental, social, and governance (ESG) requirements into one climate action plan.
This blog covers the environmental taxonomy (the 'E' of ESG). The EU has also recently released the foundations of a social taxonomy, similarly created to support the opportunity of social investments.
Stay tuned, as we will dive into the details of this new regulation, its inherent relationship to the environmental taxonomy, and the implications for business.
To achieve the Green Deal’s ambitious climate and environmental goals, the EU needs to bridge an annual investment gap of approximately EUR 470 billion. The EU is also committed to mainstream social and governance considerations in investment strategies. The Taxonomy Regulation is core to enabling the 2018 Action Plan on Financing Sustainable Growth.
What is the EU Green Taxonomy?
The Green Taxonomy is a classification scheme to establish which economic activities are considered environmentally sustainable. The regulation was published on 22 June 2020 and entered into force on 12 July 2020. By defining what is “green” or “sustainable”, the EU Taxonomy creates a basic framework and performance thresholds that should help separate the legitimate from the greenwashing in sustainable finance claims. Making sustainability information more transparent and consistent enables investors, companies, and policy makers to make informed decisions by identifying activities that make substantial contributions to environmental objectives and thereby help to finance the transition to a more sustainable economy.
The Taxonomy defines the following six environmental objectives:
- Climate change mitigation
- Climate change adaption
- 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
These environmental objectives are translated into criteria Technical Screening Criteria (TSC), which will be used to evaluate the sustainability of any economic activity. The newly assigned EU Platform on Sustainable Finance will frequently publish and review eligible economic activities and screening criteria to ensure the Taxonomy is up to date with the most recent requirements and best practices.
Which market players are subject to Taxonomy requirements?
Financial market participants offering financial products in the EU - as in scope for the Sustainable Finance Disclosure Regulation (SFDR)
Large companies that are already required to provide non-financial reporting under the Corporate Sustainability Reporting Directive (CSRD)
Watch the recording of our recent webinar, From Requirement to Opportunity: The Evolving World of ESG, to hear from leading investors and corporates on how ESG reporting helps to mitigate risk, accelerate responsible growth, and attract capital
How will EU Taxonomy affect these market players?
In the future, organizations covered by the regulation will have to disclose how and to what extent their activities are associated with environmentally sustainable economic activities. The taxonomy disclosures should be made as part of the non-financial statement that is required under the CSRD, which may be located in a company’s annual report or in a dedicated sustainability report if the Member States allow that option. Reporting cycles will therefore synchronize with the organization’s existing annual reporting.
From 2022 on, the disclosure requirements of the Taxonomy Regulation will gradually come into force. First reporting on eligible activities (i.e., Taxonomy eligibility) are due during 2022 for the activities in the financial year 2021 that were related to climate change mitigation and adaptation criteria only.
At this stage, all three of the following parameters must be reported:
- The proportion of turnover derived from products or services associated with economic activities that qualify as environmentally sustainable,
- The proportion of their capital expenditure (Capex), and
- The proportion of their operating expenditure (Opex) related to assets or processes associated with economic activities that qualify as environmentally sustainable.
The criteria for the remaining Taxonomy objectives—water, circular economy, pollution prevention, and biodiversity— are expected to apply from January 2023 on, once all TSC have been agreed upon.
Effective in 2023, CSRD companies will have to start reporting their own ‘Taxonomy alignment’. Financial institutions need to start reporting their Taxonomy alignment beginning in 2024, at which time the necessary 2023 data reported by the non-financial undertakings they hold can be gathered.
Understanding the difference between eligibility and alignment is crucial. Eligibility only says an activity is qualified under Taxonomy rules. Alignment assesses the actual sustainability per the 3 layers of valuation below, and as such, the alignment figure is the true compass for the ‘green’ share of a company’s activities.
Read our other blog to learn about three ways to expand the Green Taxonomy and accelerate decarbonization, including sector-specific taxonomy, classification of more green technologies, and building a globally compatible standard.
How does the Taxonomy evaluate what is sustainable?
For an economic activity to be ecologically sustainable, the following criteria must be met:
- Comply with minimum safeguards: Are certain internationally recognized minimum standards for human and labor law complied with when doing business?
- Substantially contribute: Does the economic activity make a significant contribution to the achievement of one of the six environmental objectives?
- Do no significant harm: Does this economic activity harm any of the other five environmental objectives?
An economic activity or investment is only considered sustainable in the context of the Taxonomy if it is compliant with all three elements. By using the proportion of CapEx and OpEx that meet these criteria, organizations can report on the degree of Taxonomy alignment.
How can companies stay ahead of Taxonomy regulations?
The EU Taxonomy is a landmark regulation that will initiate a paradigm shift in how we do business and how we think of business success.
Success can no longer be based solely on profits and increasing shareholder value. Successful businesses of the future will contribute to increasing the wellbeing of multiple stakeholder groups at the same time.
The third criteria of the Taxonomy — that a sustainable activity does no harm to any of the other five objectives — will be especially key for companies to pay attention to. This clarification requires organizations to think holistically about their sustainability impact; to think of their negative externalities, which is something that has been neglected or on the periphery of many corporate ESG programs.
For example, the recent bans on single-use plastics, such as plastic straws and cutlery, have led some businesses to come up with an ‘eco-friendly’ alternative: single-use bamboo straws. In some cases, however, the farming practices and production of these straws with associated supply chain logistics can have a higher CO2e footprint than their plastic counterparts, thus, diminishing the intended objectives of the ban.
What this simplified example represents is that we’re still at the very beginning of the marathon we need to complete should we achieve the transition to a low-carbon economy. There is still much to learn, but the good news is we have moved from the starting line!
How does the Taxonomy fit into Europe’s sustainable finance agenda?
It’s important to notice that the Green Taxonomy is only one piece of Europe’s Sustainable Finance puzzle: Europe has also paved the way with its Sustainable Finance Disclosure Regulation (SFDR), Corporate Sustainability Reporting Directive (CSRD), and the European Sustainability Reporting Standards (ESRS), among more than 20 other proposals for new legislation that will make Europe the first climate neutral continent. We will explore the interlinks among these schemes in a follow-up.
These new initiatives will certainly not solve all the issues and we will surely learn many new lessons along the way. These learnings will require businesses to continuously improve in the coming years and decades. Expectations are high, but we are hopeful that one day, with government policy supporting voluntary action, the business world will transform to hold sustainability matters in the same high regard as financial profits.