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03-03-2021

The EU Taxonomy Regulation: A Framework for Sustainable Investment

EU taxonomy
The acronym ESG stands for Environment, Social and Governance. ESG criteria are prevalent in determining sustainable economic activity. There are several frameworks and guidelines on the subject of ESG, but there is still a lack of comparability and standardization. Driven by EU harmonization efforts and sustainable policy considerations, the EU created an EU taxonomy to tackle the problem, which was published in the form of Regulation (EU) 2020/852 (Taxonomy Regulation) on 22 June 2020. The taxonomy is a unified classification system for environmentally sustainable economic activity. Social and corporate governance aspects are not part of the taxonomy, which focuses exclusively on the environmental aspect. Strictly speaking, the taxonomy criteria are therefore not purely ESG criteria. The disclosure obligations laid down in the Taxonomy Regulation supplement the rules on sustainability-related disclosures laid down in Regulation (EU) 2019/2088 (SFDR), which is to be applied from 10 March 2021. Both regulations target financial market participants.

Recitals
The Taxonomy Regulation contains a total of 60 recitals. Among them: the climate policy aspirations of the Paris Agreement, the importance of sustainability for securing the long-term competitiveness of the economy in the Union and the action plan “Financing Sustainable Growth” are mentioned.

The EU argues that a unified classification system for sustainable activity is necessary to remove barriers to the functioning of the internal market with respect to raising funds for sustainable projects as these could then be compared against uniform criteria applying across the Union. Furthermore, the EU emphasizes that despite the focus of the current regulatory regime on financial market participants, the taxonomy may encourage other economic operators not covered by the Regulation, on a voluntary basis, to publish and disclose the environmentally sustainable activities they carry out.

Environmental objectives
The overarching goal of the Taxonomy Regulation is to direct capital flows into sustainable investments. The Taxonomy Regulation provides criteria for determining sustainable economic activity. The criteria are based on six overarching environmental objectives (Articles 10-15):

  1. climate change mitigation;
  2. climate change adaptation;
  3. the sustainable use and protection of water and marine resources;
  4. the transition to a circular economy;
  5. pollution prevention and control;
  6. the protection and restoration of biodiversity and ecosystems.

The EU taxonomy already applies to goals (i) and (ii) for the 2021 financial year; reporting must take place in 2022. Objectives (iii) to (vi) are applicable from 1 January 2023 under the EU taxonomy.

What is taxonomy compliant?
Economic activity that conforms to taxonomy is one that meets the following four criteria:1

  1. contributes substantially to one or more of the environmental objectives;
  2. does not significantly harm (DNSH) any of the environmental objectives;
  3. is carried out in compliance with the minimum safeguards laid down in the Regulation (including the OECD Guidelines for Multinational Enterprises, the International Labor Organization, United Nations Guiding Principles on Business and Human Rights, etc.);2
  4. complies with the technical screening criteria established by the European Commission.

The technical screening criteria apply from 1 January 2022 for climate-related objectives. The Technical Expert Group (TEG) will develop the technical screening criteria for the other environmental objectives, these criteria will be issued in from of delegated legal acts and apply from 1 January 2023.

 There is a substantial contribution to one of the six environmental objectives if:

  1. an own contribution is made by virtue of Articles 10-15;
  2. economic activity directly enables other activities to make a significant contribution to one or more of those objectives,3 provided that such economic activity

(a) does not lead to a lock-in of assets that undermine long-term environmental goals, considering the economic lifetime of those assets; and

(b) has a substantial positive environmental impact, on the basis of life-cycle considerations;

  1. An economic activity by virtue of Article 10(2) – this only applies to the first environmental objective of climate change mitigation – for which there is no technologically and economically feasible low-carbon alternative supports the transition to a climate-neutral economy.

Scope
This Regulation applies to:4

  1.  Measures adopted by Member States or by the Union that set out requirements for financial market participants or issuers in respect of financial products or corporate bonds that are made available as environmentally sustainable;5
  2. financial market participants that make available financial products;6
  3. undertakings which are subject to the obligation to publish a non-financial statement or a consolidated non-financial statement pursuant Directive 2013/34/EU.7

Transparency and reporting requirements
Financial market participants as defined in Article 2 (1) of the SFDR, must observe the transparency provisions for financial products as set out in Articles 5-7 and 25 of the Taxonomy Regulation. This is an extension of the SFDR and includes, for example, a quantitative disclosure of the percentage share of ecological sustainability per financial product.

Disclosure obligations
The Taxonomy Regulation provides for disclosure obligations for non-financial companies.

The disclosure obligations - in the form of the non-financial declaration – which apply to companies in accordance with Directive 2014/95/EU (NFRD), are expanded on the basis of the Taxonomy Regulation:

In particular, non-financial undertakings shall disclose the following:8

  1. the proportion of their turnover derived from products or services associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9; and
  2. the proportion of their capital expenditure and the proportion of their operating expenditure related to assets or processes associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9.

The disclosure of capital- and operating expenditure pursuant to (b) only apply to the first environmental objective.

The transparency provisions for financial products have an impact on the disclosure requirements according to Article 8 of the Taxonomy Regulation. Requirements that apply to the financial investors’ own reporting may have an impact on the reporting expected by companies. Sustainable financial products form the foundation for taxonomy-compliant economic activity, which must be disclosed.

Relevant industry classes, taxonomy-relevant activities and technical screening criteria
The assessment of alignment with the taxonomy should be done by economic activity rather than sector or branch. The TEG recommandations are based on the NACE (Nomenclature des Activités Économiques dans la Communauté Européenne) industry classification system of the EU. The TEG has established technical screening criteria for economic activities within important macro sectors.

So far, the TEG has laid down technical screening criteria in the Technical annex to the TEG final report on the EU taxonomy (Technical Annex) for sector-specific economic activities – identified by the associated NACE code – which make a significant contribution to (i) climate change mitigation (pages 39-387) and (ii) climate change adaption (pages 391-578). The TEG has also compiled an Excel tool which should enable users of the taxonomy to implement it in relation to their own economic activities. There are economic activities that do not fall under the specified industrial sectors. Technical review criteria for the other environmental goals are developed by the TEG.

Impact on Business
Investors will inquire about the product compositions of companies. It is also possible that lending banks screen companies with regard to sustainability points and possibly charge a premium if companies lag behind in green criteria. In short, this means that companies that pursue taxonomy-compliant economic activities will constitute more attractive investments and possibly have cheaper financing options. However, it should be expressly taken into account that there are no reporting obligations or obligations to collect taxonomy-relevant information at the company or asset level. However, as described above, there are factors that speak clearly in favour of collecting taxonomy-relevant information at company level.

Further information on the EU taxonomy and its application can be found in the TEG final report on the EU taxonomy and in the Technical Annex.

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1 Article 3 (a)-(d) EU Taxonomy Regulation.

Article 18.

Article 16.

Article 1 (2)(a)-(c).

For scope see Article 4.

6 ibid Article 6-7 and 25.

7 ibid Article 8 (plus delegated act).

8 Article 8 (2) (a) and (b).

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