Quick Guide: The EU Taxonomy on sustainable finance & why it is important

Why Create a Taxonomy?

The 2015 Paris Agreement and 2030 Agenda for Sustainable Development were created to tackle world’s biggest global risk – climate change. But these agreements created a problem. Plans to decarbonise economies had to actually be put into action. So the EU Commission developed the Action Plan for Sustainable Development and then the Technical Expert Group (TEG) on Sustainable Finances to tackle this issue.

The TEG set to work and developed the Taxonomy on Sustainable Finance. The Taxonomy creates a shared language, a lingua franca for investors, governments, policy makers and anyone else interested in defining sustainable activities.

This emerged into a pack including the EU Taxonomy Climate Delegated Act which came into force in April 20201 as well as a Corporate Sustainability Reporting Directive, These along with another a further delegated act will define the technical criteria for identifying the economic activities which contribute to climate change mitigation.

The Green List

Described as a “Green list” or classification scheme for sustainable activities as well as a pioneering piece of legislation. The Taxonomy will create a common language and principles for firms and investors around green investing. It will be a living document designed to change overtime to adapt to new circumstances. The Act is part of efforts to enact the EU’s Green New Deal which promises to shift the EU to a more sustainable future.

The Taxonomy dodges (for now) some critical issues such as nuclear power, natural gas and the climate impact of agriculture. Despite these shortcomings it represents a major milestone in driving Environmental, Social and Governance (ESG) driven investment. It is also likely to influence other nation’s legislation and standards as well as being used by investors across the world as a reference point and guide for their own investing plans.

The Taxonomy lists six environmental objectives which economic activities must help achieve:

1. Climate change mitigation (aka reducing greenhouse gas emissions).

2. Climate change resilience & adaptation (helping the world adapt to a changing climate).

3. Sustainable use and protection of water and marine resources.

4. Transition to a circular economy, waste prevention and recycling.

5. Pollution prevention and control.

6. Protection of healthy ecosystems.

An activity must contribute to at least one of the above points and do no harm to the others in order to be eligible for the criteria. Interpreting the full text of the legislation is likely to keep ESG financing experts, lawyers and environmental specialists busy for a long time.

Who should Use the Taxonomy?

The Taxonomy will be used by banks, insurers and other financial institutions that want to invest in sustainable activities and companies.

How will Users adopt the Taxonomy?

1. Identify the activities conducted by the company, issuer or covered by the financial product (e.g. projects, use of proceeds) that could be eligible.

2. For each activity, assess whether the company or issuer meets the relevant criteria for a substantial contribution e.g. electricity generation <100g CO2 /kWh.

3. Verify that the Do No Significant Harm (DNSH) criteria are being met by the issuer. Investors using the Taxonomy would most likely use a due-diligence like process for reviewing the performance of underlying investees.

4. Conduct due diligence to avoid any violation to the social minimum safeguards stipulated in the Taxonomy regulation (article 13).

5. Calculate alignment of investments with the Taxonomy and prepare disclosures at the investment product level.

What Information do investors need

Investors will need data about company or issuer performance on the Taxonomy activity criteria for the taxonomy to operate. Data markets will take time to develop as issuers and ESG research and rating companies gather information and data. The data will need to include:

A. Revenue breakdown by Taxonomy – eligible activities, or expenditure allocation to each Taxonomy criteria.

B. Performance against the technical screening criteria, or environmental management data where this is an acceptable proxy for compliance with the technical screening criteria – including DNSH assessment.

C. Management data on social issues: Labour rights policies, management systems, audits, reporting.

Asset managers will then use this investment to create sustainable products and portfolios which will be able to state their levels of sustainability

Sustainable Finance Disclosure Regulation

This information can then be used to demonstrate which products are “light green” (partially sustainable development as objective) or those which are “dark green” – investments contributing to an environmental or social investment.

What do Companies Receiving Investment have to do?

Large or listed firms will have to report on their sustainability risks, the impact of their business on climate and the impact of climate on their business. Firms will have to report what percentage of their future revenues and current activity is aligned with the Taxonomy.

This information will go to investors (see above) who can then use the information to develop financial products and identify in a transparent manner how green firms and financial products really are. This in turn will help the buyers of financial products, shareholders and other stakeholders to get a firm grip of how green their portfolio is.

What Comes Next?

Now the Taxonomy has been published it will come under a great deal of scrutiny as it is a major tool in delivering the Green New Deal. Firms have to start publishing their percentage of their activities which are Taxonomy aligned as soon as 2022.

Doubtless there will be arguments on what should and shouldn’t be included (for example there is a relatively relaxed view on burning wood). The true test will be how much it encourages investors to back sustainable investments. In order to meet the target of carbon neutrality by 2050, there needs to be roughly EUR 1 trillion in sustainable investment a decade. The Taxonomy needs to help investors by establishing a transparent sustainable finance market, free of greenwash for this to be achieved.

The other major achievement may be geopolitical. The Taxonomy could provide an impetus and model for other countries to create similar or complementary legislation, this could be neighbouring UK, the USA, China and Japan. If other countries follow suit this could give sustainable finance the boost it needs to help to truly decarbonise the global economy.