The EU Taxonomy for Sustainable Activities explained

Erich Molz

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6 minutes

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Knowledge

The EU Taxonomy is meant to establish a common understanding of environmental sustainability in order to spur financial investments into those activities with the greatest positive impact on sustainability. It is the EU’s classification system for economic activities, defining specific criteria under which an activity can be regarded environmentally sustainable. Virtually every larger company in the EU and every financial market participant will have reporting obligations under the EU Taxonomy – because of its linkages to the disclosure requirements for listed and large companies and for financial market participants. These reporting obligations are substantial and will gradually enter into force.

January 6, 2022
Image: 
Lukas Tennie (Unsplash)

Background & Goals

To fulfill its commitments in the Paris Agreement and become the first Net Zero continent, the European Commission launched the Action Plan of Financing Sustainable Growth in 2018. The goal of the Action Plan is to direct finance toward environmentally sustainable economic activities in order to decarbonize high-carbon economic sectors and grow low-carbon ones.

A major obstacle has been the lack of a common definition of “environmental sustainability” for such activities, leading to fragmentation in sustainable financing practices and even green-washing with financial products. Thus, the top item on the Action Plan is the creation of an EU classification system for economic activities with specific criteria defining when an activity can be regarded environmentally sustainable – the EU Taxonomy.

Over time, so the idea goes, access to financing will be conditioned upon a company’s contribution to environmental objectives while financial market participants will offer more and more sustainable investment products.

Who is affected?

  • Financial market participants falling under Sustainable Finance Disclosure Regulation (SFDR) reporting requirements;
  • Companies falling under Non-Financial Reporting Directive (NFRD) reporting requirements;
  • Companies falling under Corporate Sustainability Reporting Directive (CSRD) reporting requirements;
  • Companies not falling under NFRD/CSRD reporting requirements because they may decide voluntarily to disclose their activities’ alignment with the Taxonomy to obtain access to “green financing”.

What is inside?

The Taxonomy sets out sustainability criteria (“Technical Screening Criteria”) with respect to 6 environmental objectives:

  • Climate change mitigation
  • Climate change adaptation
  • 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

For basically every sector in the economy, including agriculture and forestry, manufacturing, energy, water supply, waste management, transport, construction, real estate, ICT, finance, education, health, and leisure, the Taxonomy identifies the economic activities that are most crucial for achieving each of the 6 objectives.

For example, for climate change mitigation, the majority of activities listed stems from the most energy-intensive sectors, i.e. those which currently contribute most to the EU’s total greenhouse gas emissions. In contrast, activities from sectors with low carbon footprints are barely covered.

All in all, at this moment in time 70 activities are listed with respect to climate change mitigation, 68 with respect to adaptation, and around 100 activities are currently under consideration for the other 4 objectives.

Activities listed in the Taxonomy are called “Taxonomy-eligible”. If a company performs eligible activities, it must assess if it does so in an environmentally sustainable way as defined by the Taxonomy – i.e. if its eligible activities are in fact also “Taxonomy-aligned”. This assessment consists of 3 steps:

1. Does this activity make a substantial contribution to 1 or more of the 6 environmental objectives?

  • The Technical Screening Criteria use strict thresholds to define when an activity is performed in an environmentally sustainable way. It is a binary pass/fail system with no shades of grey.
  • Example: Carbon emissions for electricity generation are less than 100 g CO2e/kWh.

2. In addition, does this activity any significant harm to any of the other objectives?

  • For each activity, the Technical Screening Criteria define do-no-significant-harm criteria with respect to the other 5 environmental objectives.
  • Example: Electricity generation from solar photovoltaic has to ensure high durability, easy dismantling, refurbishment, and recycling of PV panels, otherwise this activity does significant harm to one of the other objectives, in this case circular economy.

3. In addition, does my company comply with minimum social safeguards?

  • OECD Guidelines for Multinational Enterprises, and
  • UN Guiding Principles on Business and Human Rights, and
  • ILO Core Labor Standards, and
  • Universal Declaration of Human Rights

Reporting requirements

For companies, the reporting requirements are substantial: They have to report on

  • their eligible and non-eligible activities,
  • their aligned and non-aligned activities,
  • the turnover in %, capital expenditure (CapEx) in % and operational expenditure (OpEx) in % for eligible activities (divided into aligned and non-aligned ones) and non-eligible activities. For aligned activities, these have to be further broken down by environmental objective and by DNSH criteria (see Figure 1).

Under the CSRD, companies will also need to provide external assurance or audit (so far, limited assurance only).

EU Taxonomy reporting requirements, decision tree
EU Taxonomy reporting requirements

For financial market participants, the reporting requirements are just as extensive: For each product with environmental or social characteristics (SFDR Article 8) and each product with sustainable investment objectives (SFDR Article 9), they have to report on the proportion of the product that is Taxonomy-aligned and break this down by environmental objective and activities invested. Providing information on the contribution to the CapEx and OpEx of Taxonomy-aligned activities of investee companies is optional. External assurance or audit is not required so far.

Outlook & Timeline

On 22 June 2020, the EU published the Taxonomy Regulation that forms the legal basis for the EU Taxonomy. The Regulation entered into force on 12 July 2020. The first delegated act concerning the Technical Screening Criteria for economic activities with significant contribution to climate change mitigation and adaptation (the “Climate Delegated Act”) was adopted on 4 June 2021. Criteria for nuclear energy and natural gas were proposed by the European Commission on 31 December 2021 and are now intensely debated. Finally, a second delegated act for the remaining 4 objectives (the “Environmental Delegated Act”) is scheduled for publication in 2022.

For companies falling under the NFRD, mandatory reporting under the Taxonomy Regulation on eligibility for the climate change mitigation and adaptation objectives will generally apply from January 2022. From January 2023, when the CSRD is expected to come into force and supersede the NFRD, reporting on alignment for all six objectives will apply. (Note that small and medium-sized enterprises will only have to report from January 2026 onward.)

For financial market participants falling under SFDR, mandatory reporting under the Taxonomy Regulation on eligibility for the climate change mitigation and adaptation objectives will generally apply from January 2022. From January 2024, reporting on alignment for all six objectives will apply. (Note, however, that other SFDR-disclosure requirements may apply from January 2022, too.)

The upshot

The EU Taxonomy is a game changer for ESG investing. In fact, it is only the beginning of larger changes in the ESG realm. Complying with the EU Taxonomy will pose many challenges to companies and financial market participants alike. Working your way through the Taxonomy and obtaining the necessary granular data is going to be cumbersome, especially for financial market participants who are dependent on data from third parties. Hence the old adage “preparation is half the battle” also applies here.

Salacia Solutions is a Software-as-a-Service provider that simplifies environmental impact tracking and reporting for businesses and investors. We help you report in a transparent, traceable and consistent manner that is fully in line with legislation such as the SFDR, CSRD and the EU Taxonomy as well as underlying methodologies such as the GHG Protocol.

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