EU Taxonomy Regulation: What to expect

Based on research provided by ECOFACT

Our previous Client Alert of 10 March 2021 discussed the Sustainable Finance Disclosure Regulation (SFDR) and its implications for the real economy.

This Client Alert reviews how EU Regulation 2020/852 on the establishment of a framework to facilitate sustainable investment (the Taxonomy) impacts companies in their capacities as investees, borrowers, and issuers.

KEY TAKEAWAYS

• The Taxonomy seeks market harmonization by creating legal criteria to classify economic activities as environmentally sustainable. While the Taxonomy is a technical document with only a few disclosure obligations for companies, it requires robust preparatory work, including thorough data collection and analysis.
• Companies subject to the non-financial reporting obligations in Articles 19a and 29a of Directive 2013/34 on annual and consolidated financial statements and related reports (as transposed into national law) (the Accounting Directive) must report the extent of their alignment with the Taxonomy. However, smaller companies may also benefit from reporting on a voluntary basis.
• While the Taxonomy currently focuses on environmental objectives, companies must also respect minimum social and governance requirements within the scope of environmentally sustainable economic activities (ESEAs).

BACKGROUND

Sustainable development (economic, social, and environmental) is an objective of the internal market reflected in the Treaty on European Union. The Taxonomy, adopted in June 2020, is a significant step towards achieving climate neutrality by 2050, and is part of the EU’s wider effort to promote sustainability that includes the adoption of the SFDR and launch of the European Green Deal in November and December 2019, respectively.

While many market participants/players currently do not disclose environmental, social, and governance (ESG) information related to their activities, others disclose such information using non-uniform criteria. This leads to a lack of comparability for capital providers, who are then disincentivised to allocate funds based on ESG information. Sustainable finance and investments are critical to meeting regional and international environmental goals, including the UN Paris Agreement and the Sustainable Development Goals. With this in mind, the Taxonomy introduces a standard classification to enhance investor confidence in sustainable finance, mitigate the risk of greenwashing[1], reduce transaction costs, and optimize the ability of sustainability-minded companies to raise capital.

THE CAPITAL PROVIDER’S PERSPECTIVE

The Taxonomy supplements the requirements of the SFDR that are applicable to capital providers, i.e. financial market participants and financial advisers. In particular, it specifies certain disclosure obligations concerning periodic reports and pre-contractual disclosures. Another relevant link between the Taxonomy and SFDR pertains to the definition of “sustainable investment” in Article 2(17) of the SFDR, which includes investments in ESEAs as described in Article 3 of the Taxonomy.

As discussed in our previous Client Alert, companies that are ready to provide ESG information to their capital providers at an early stage, as required by the SFDR and the Taxonomy, could gain a competitive advantage in the corporate finance market.

THE COMPANY’S PERSPECTIVE

The Taxonomy also supplements non-financial reporting obligations in Articles 19a and 29a of the Accounting Directive on annual and consolidated financial statements and related reports (as transposed into national law). Specifically, Article 8 of the Taxonomy requires companies to publish a non-financial statement with information on:

(i) how and to what extent their activities are associated with ESEAs;

(ii) the proportion of their turnover derived from products and services associated with ESEAs; and

(iii) the proportion of their capital and operating expenditures related to assets or processes associated with ESEAs.

These disclosure obligations apply to companies with an average number of employees exceeding 500 in a fiscal year and that have a balance sheet total of EUR 20 million or a net turnover of EUR 40 million. However, smaller companies can make such disclosures voluntarily.[2]

The Taxonomy also serves as a key component to the proposed EU Green Bond Standard (EU GBS). Companies seeking to issue green bonds in accordance with the EU GBS will be required to ensure that proceeds from green bond issuances fund projects that are aligned with the Taxonomy.

According to Article 3 of the Taxonomy, ESEAs are those that meet four conditions:

1. Make a substantial contribution to one or more of the following environmental objectives:

(a) climate change mitigation;

(b) climate change adaptation;

(c) the sustainable use and protection of water and marine resources;

(d) the transition to a circular economy;

(e) pollution prevention and control; and

(f) the protection and restoration of biodiversity and ecosystems, each as specified in Articles 10 to 15.

The recitals of the Taxonomy refer to several documents such as the Treaty of the European Union, Sustainable Development Goals and the Paris Agreement issued by the EU and by the United Nations, which companies can use to comprehend and interpret the framework of each environmental objective.[3]

An economic activity that directly enables activities that make a substantial contribution to one of the six objectives listed above may also qualify as an ESEA. However, it must also meet the other three ESEA conditions, not lead to lock-in effects, and have a substantial positive environmental impact.

2. Do not significantly harm any other environmental objective.

A company’s economic activity that makes a substantial contribution to climate change mitigation must avoid significant harm to the other five objectives. Article 17 of the Taxonomy explains how each of the six environmental objectives can be significantly harmed by a given economic activity. When assessing the risk of harm, a company must look at the potential long-term environmental impacts of the whole life cycle of the economic activity and its related products and services.[4]

3. Comply with minimum social safeguards.

Companies pursuing ESEAs must also implement procedures to ensure respect of social rights, including the recommendations in the OECD Guidelines for Multinational Enterprises, the UN Guiding Principles on Business and Human Rights, the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work, and the International Bill of Human Rights, as per Article 18 of the Taxonomy. Moreover, they must adhere to the “do no significant harm” principle stated in Article 2(17) of the SFRD.

4. Comply with technical screening criteria (TSC).

While the EU continues to develop and refine TSCs, the EU has set out TSC for certain economic activities for the first two environmental objectives, (1) Climate Change Mitigation and (2) Climate Change Adaptation in the March 2020 Taxonomy Report: Technical Annex.[5] TSCs provide thresholds and other criteria for categorising the environmental sustainability of specific economic activities.

What’s next?

The Taxonomy was adopted in June 2020 and companies’ obligations under Article 8 become applicable on different dates:

• January 2022 (climate change mitigation and adaptation); and
• January 2023 (the other environmental objectives).

Under the Taxonomy, the EU Commission has the mandate to adopt delegated acts, including those related to Article 8(4)[6] and the TSC regarding each of the six environmental objectives, as well as to update concepts like “significant harm” and “substantial contribution” as technology and scientific understanding evolves.

For the environmental objectives other than climate change and climate change adaption, the EU Commission is expected to adopt TSC by December 2021, with application from January 2023.[7]

What can companies do?

As first steps to comply with the Taxonomy’s requirements, companies are encouraged to start by collecting data to assess whether their economic activities:

• contribute to an environmental objective and/or directly enable such contribution within their value chains;
• harm any of the Taxonomy’s environmental objectives; and
• fulfill the minimum social safeguards stated in Article 18 of the Taxonomy (and consider the adherence to such international guidelines, principles, and standards).

Based on this assessment, companies may define future targets for maintaining or increasing their contribution to an environmental objective.

Moreover, companies may engage finance, risk management, and sustainability staff to:

• produce data on the proportions of their capital and operating expenditures related to ESEAs;
• implement procedures to mitigate the risk of harming any ESG objectives; and
• prepare data to support disclosure within the scope of Article 8 of the Taxonomy, making use of the EU Commission’s Guidelines on non-financial reporting (methodology for reporting non-financial information), Guidelines on reporting climate-related information, and draft delegated act on climate change mitigation and adaptation, as well as the European Securities and Markets Authority’s consultation paper on Article 8.

The next alert of the Sustainable Finance Series will focus on selected standards for ESG-linked loans from a borrower’s perspective.

[1] Recital 11 of the Taxonomy defines “greenwashing” as “the practice of gaining an unfair competitive advantage by marketing a financial product as environmentally friendly, when in fact basic environmental standards have not been met”. In practice, the concept applies to the marketing of any economic activity as environmentally friendly, where minimum standards have not been respected.

[2] Directive 2013/34 is under review as part of the EU sustainable corporate governance initiative. As a result of this review, non-financial reporting may become required for smaller and non-listed companies.

[3] The Taxonomy currently covers only environmental objectives, but it is expected to be extended to social objectives in the future.

[4] According to recital 40 of the Taxonomy , “where scientific evaluation does not allow for a risk to be determined with sufficient certainty, the precautionary principle should apply in accordance with Article 191 Treaty on the Functioning of the European Union”.

[5] The draft TSC for climate change mitigation and adaptation are available on the EU Commission’s website.

[6] A consultation paper regarding Article 8 of the Taxonomy is available on the European Securities and Markets Authority’s website.

[7] According to recital 44 of the Taxonomy, the TSC should promote appropriate governance frameworks integrating environmental, social, and governance factors as referred to in the United Nations-supported Principles for Responsible Investment at all stages of a project’s life cycle. This statement recognizes the relevance of social and governance aspects within ESEAs.