The EU Taxonomy for sustainable finance: FAQs for financial market participants
This article is written by Nadia Humphreys, Business Manager for Sustainable Finance solutions at Bloomberg.
The final EU Taxonomy report published this week formally kicks off a period of adaptation for investment firms and large corporates in Europe. The objective of this science-based body of work is to help direct private capital towards long-term, environmentally sustainable activities, and prevent false claims on the environmental nature of an investment product.
The Taxonomy will help market participants ensure they invest in truly green opportunities that align with the Paris Agreement on greenhouse-gas emissions, and don’t fall foul of ‘greenwashing’ attempts. As a corner stone of the European Commission’s Sustainable Finance Action plan, it will underpin new regulations, notably requiring investment firms to clarify the ‘greenness’ of their investment strategies using a common language.
On the launch of this important document, we wanted to dispel some commonly held misconceptions, explain how the Taxonomy will fulfill its objectives, and outline how financial market participants should prepare.
What is the Taxonomy?
The Taxonomy was developed by a technical expert group set up by the European Commission. It is a technical document that was developed after consultations with over 200 industry specialists and scientists. The aim is to provide clarity to both corporates and investment firms on how environmentally friendly different activities are, and to drive more capital to fund greener economic activities.
The Taxonomy takes the shape of a glossary that defines Paris agreement-aligned performance criteria over a set of economic activities, such as the manufacture of aluminium. To claim alignment with the Taxonomy, economic activities need to substantially contribute to one of 6 environmental objectives, and not significantly harm any other (Do Not Significantly Harm, DNSH in the figure below).
The 6 environmental objectives defined in the Taxonomy are:
I. Climate change mitigation: a company’s impact on the environment
II. Climate change adaptation: the environment’s impact on a company
III. Sustainable use and protection of water and marine resources
IV. Transition to a circular economy, waste prevention and recycling
V. Pollution prevention and control
VI. Protection of healthy ecosystems
The March 2020 version of the Taxonomy report details which assessments are required to demonstrate substantial contribution to either a mitigation or adaptation criteria. A subsequent version is expected to cover substantial contribution criteria for the remaining 4 environmental objectives.
As with all existing sustainable investment strategies, minimum social and governance safeguards need to be met. This aligns well with the pre-existing due diligence that investors typically make on corporates they intend to invest in.
What are its objectives?
The Taxonomy is one of the key tools that European legislators are using to:
- Create common definitions for sustainable activities and investment practices
- Provide clarity on what it takes, within specific industries, to achieve the commitments made under the Paris Agreement
- Put environmental data in context, creating a holistic set of expectations to claim Taxonomy alignment
- Reward companies who follow the direction set by this science- and evidence-based framework
- Allow investors to compare financial products promoting or presenting environmental characteristics
What does it mean for corporates and investment firms?
The Taxonomy is a regulation that will underpin three legislative initiatives with direct implications for corporates and investment firms.
- Reporting: Under the Disclosure Regulation, financial market participants will need to report the extent to which their financial product aligns with the Taxonomy. Financial products will include investment and mutual funds, insurance-based investment products, private and occupational pensions, individual portfolio management, and both insurance and investment advice. The reporting framework will take the shape of a “comply or explain” requirement. This means that if an investment firm claims its products have environmentally sustainable objectives, it will need to disclose the nature and extent to which the product aligns with the Taxonomy. If not, it will have to have to state that the product does not align.
- Disclosure of turnover and capital or operational expenditure: Financial and non-financial companies under the scope of the Non-Financial Reporting Directive (NFRD) will need to disclose, in their annual accounts, any turnover and capital or operational expenditure associated with Taxonomy-aligned activities. The objective is to focus the minds of corporates on investing and delivering returns from these activities, and to provide investors with the data they need to be able to direct their capital to sustainable practices.
- New eco-labelling and standards: The EC is planning to introduce eco-labels and the extent of respective alignment with the Taxonomy will dictate whether or not these can be applied to a financial product. Detailed eco-labelling requirements are yet to be set. Standards for green debt are also in development, notably a Green Bond Standard that will require debt instruments to outline, with verification, the use of proceeds that align with the Taxonomy.
What economic activities are included in the Taxonomy?
The Taxonomy consists of 70 NACE-defined industry sectors[1]. A common misconception is that the Taxonomy contains only ‘green’ or ‘good’ industries and anything outside the scope of the document is therefore ‘bad’. This is not true. In-scope industries were initially decided based on their greenhouse gas emissions profiles[2], where ‘greener’ alternative practices exist for them to follow. For some industries, such as aviation, the technology does not yet exist for these criteria to be set.
NACE industries such as growing of stone fruits, growing of citrus fruits and growing of grapes are included under the Taxonomy activity “Growing of perennial crops.” Testing criteria are set at the activity level.
The technical expert group recognizes that detailed screening criteria will be updated over time, in recognition of the speed with which new technology and science-based solutions are emerging. In addition, a number of economic activities are yet to be assessed. In order to assess these new activities, the European Commission have formed a Platform on Sustainable Finance where criteria can be set and added to future iterations of the Taxonomy.
The following figure summarizes what the Taxonomy is and isn’t:
What are enabling activities?
These are economic activities that enable another economic activity to meet its environmental thresholds. For example, the construction and operation of pipelines and associated infrastructure for distributing heating and cooling is eligible, if the system meets the definition of efficient district heat/cool systems in the EU Energy Efficiency Directive. The new report provides clarity on how to assess an activity as enabling in the context of the proposed regulation.
What are transitioning activities?
The transition to a low-carbon economy will likely lead to the phasing out of certain activities. While improvements to existing processes are valuable, they need to hit certain targets to count. The financing of an activity’s transition to lower emissions could qualify under ‘Transitioning Activities’ so long as it meets the requirements laid out in the report. For example, to qualify for property renovation a company needs to deliver > 30% energy efficiency in the completed build.
What about nuclear and gas?
The Taxonomy defines emissions targets for energy suppliers. If a nuclear power operator can demonstrate it meets the substantial contribution criteria and does no significant harm (via appropriate waste management practices without harm to eco-systems, for example), then its activity would qualify. For gas suppliers to align, they need to demonstrate suitable carbon capture to meet the tight emissions threshold. The key here is defining whether an activity can be conducted in a ‘green way’ and this is discussed in detail in the energy sector commentary of the report.
How can firms start applying the Taxonomy in investment strategies?
For those who are new to sustainable finance, understanding how to apply the Taxonomy to an investment strategy can feel daunting. The Taxonomy report includes a usability guide that lays out the technical expert group’s guidance on how users of the Taxonomy can develop their disclosures and reporting frameworks.
The best starting point would be to segment the turnover or revenue of companies a fund has invested in by its activities, and determine which ones are eligible. Once you understand how your portfolio aligns with these activities, you can then look to conduct screening tests. For example, if 10% of a fund is invested in a company that makes 20% of its revenue from Taxonomy-aligned activities, the fund is 2% Taxonomy-aligned for that investment, and so on.
Once the Non-Financial Reporting requirements are live, companies will have to disclose their Taxonomy-aligned turnover and capital expenditure, which will make the reporting process easier for investment firms.
Is there a minimum requirement to claim Taxonomy alignment for a financial product?
In short, no, but the Taxonomy will help investment firms explain their strategies in a way that is consistent, coherent, and easily comparable for their clients. For example, if a financial product is only investing in companies with greater than 20% capital expenditures aligned to Taxonomy criteria, it can use it as a percentage value across a whole fund, stating, for example, that the fund is currently 10% Taxonomy aligned, with the aim of becoming 30% aligned over the next 5 years.
Work is also underway to define the terms of eco-labels, in which a minimum expected percentage of turnover or capital expenditure will have to align to the Taxonomy criteria.
What about international use of the Taxonomy?
As with other European legislation, third country impact remains an important consideration. If there is demand from European investors for investment products that deliver a higher percentage of Taxonomy alignment, then international corporates may wish to attract these investors by making their own claims on EU-aligned substantial contribution to environmental objectives.
Due to the nature of globally integrated capital markets, those selling products into the EU will fall in scope. As a consequence, the Taxonomy is likely to have influence on international reporting frameworks over time. The technical expert group is conscious of extraterritorial considerations and has provided recommendations on how to bridge the gaps in performance data and EU expectations in the usability guide.
What next?
The Taxonomy Regulation will come into force 20 days after its publication in the Official Journal. After that, in December 2020, the EU will adopt detailed implementing rules, which will go live 12 months later.
The disclosure regulation is a parallel piece of legislation that will refer to the Taxonomy. The first reporting requirements for investment firms under those rules will start to apply in December 2021, with additional criteria included annually thereafter.
However the Taxonomy will develop over time, with additional testing criteria and the inclusion of further industry sectors.
If you would like to find out more about this regulation or how Bloomberg’s data can support a Taxonomy-aligned disclosure, please contact euesg@bloomberg.net
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