What is the EU Taxonomy?
To meet the climate and energy targets for 2030 and reach the objectives of the European Green Deal, the European Union believes it is vital to direct investments towards sustainable projects and activities as well as provide a comprehensive definition of the term sustainable. This is why the action plan on financing sustainable growth called for the creation of a common classification system for sustainable economic activities, or an “EU taxonomy”.
The Taxonomy is therefore a regulatory classification system helping companies to define which of their economic activities are environmentally sustainable. In other words it is a tool to "support investors, companies, issuers and project promoters navigate the transition to a low-carbon, resilient and resource-efficient economy”.
At its core, the Taxonomy it sets out four key thresholds to ensure that activities are consistent with environmental objectives:
- Make a substantive contribution to one of six environmental objectives:
- Climate change mitigation
- Climate change adaptation
- Sustainable and protection of water and marine resources
- Transition to a circular economy
- Pollution prevention and control
- Protection and restoration of biodiversity and ecosystems
- Do no significant harm (DNSH) to the other five, where relevant
- Meet minimum safeguards (e.g., OECD Guidelines on Multinational Enterprises and the UNGuiding Principles on Business and Human Rights)
- Comply with the technical screening criteria developed by the EU Technical Expert Group (TEG)
To be classified as a sustainable economic activity according to the Taxonomy, a company must not only contribute to at least one environmental objective but also must not violate the remaining ones.
While the taxonomy is focused on sustainability in terms of climate, it is also intended to establish rules and other environmentally sustainable objectives and expand into social objectives later on. You can find the full taxonomy regulation here, including recommendations on taxonomy design as well as information about who has to do what, and by when. There is also a shorter summary document available here.
Why should businesses care?
The Taxonomy essentially allows the market to define when a company or enterprise is operating sustainably or environmentally friendly. Therefore, compared to their competitors, companies that align with the taxonomy will stand out positively and thus should benefit from higher investments.
Moreover, the regulation places a reporting obligation on several companies to disclose what proportion of their investments align with sustainable activities. It considers different circumstances and obligations for 3 distinct economic actors:
- Financial market participants, and issuers offering financial products, including pension funds, insurance providers, private equity funds, and corporate and investment banks.
- Large companies –with more than 500 employees – that fall under the scope of the European Union(EU) Non-FinancialReporting Directive (NFRD).
- EU Member States setting public measures, standards or labels for green financial products or green bonds.
To comply with the EU Taxonomy and its performance thresholds, companies will need to start disclosing their sustainable investment objectives’. Among other details, this includes the percentage of sustainable economic activity in terms of turnover, capital expenditure (CapEx) and, if applicable, operating expenses (OpEx).
The disclosure requirements start applying on 1 January 2022 in relation to the climate objectives, and on 1 January 2023 in relation to the other four environmental objectives. The reporting will cover the previous financial year respectively, meaning that the first reporting, related to climate change mitigation and adaptation, is due in the course of 2022 for the financial year 2021, while the set of disclosures for the rest of the environmental objectives will be due in the course of 2023 for FY2022.
What about SMEs?
Disclosures are only mandatory for large companies within the scope of the CSRD, but small companies could find it useful to disclose theTaxonomy alignment of their activities on a voluntary basis – particularly as it relates to their engagement with investors and other key stakeholders.
While the regulation may seem complex, responding to it may be simpler for SMEs. For example, SMEs whose business models are focused on one green activity covered by the Taxonomy will have only one set of criteria applicable to their business model. For instance, a small manufacturer of energy efficient windows could check relatively easily what share of its turnover, capital expenditure or operating expenditure is related to the sale of windows that comply with the Taxonomy criteria.
What should businesses do?
In our view, companies that want to effectively and efficiently respond to the increasing reporting demands and regulations, such as the EU Taxonomy, will need to:
- Understand their reporting obligations: as disclosure is increasingly a legal matter, it is crucial that companies understand which regulations apply to them, what they mean, and how to respond. Make sure you begin your preparations as early as possible and understand what data you need.
- Develop their reporting objectives and strategy: while disclosure can seem a box-ticking exercise, companies tend to fare much better if this fits within a broader sustainability and reporting strategy. Make sure you engage your board and top executives, develop your overall strategy, and define specific goals and KPIs.
- Adopt the right tools for the job: the Taxonomy is not the first not the last initiative that requires sustainability related disclosures. To meet these requirements simultaneously, make sure you seek digital tools that allows you to manage yourESG data and respond to requests efficiently.
- PRI’s EU Taxonomy explanation video
- EU Commission’s “FAQ:What is the EU Taxonomy and how will it work in practice?”
Author: Gerard Coenen, Senior Manager ESG, Diginex