EU Taxonomy Regulation Overview

The final part in a series of four articles by Svarmi on the European Union's green action plan, taxonomy and what these policies mean for the reporting and transparency requirements for companies in 2022 and beyond.

Based on the EU 10 -Point Action Plan, the EU adopted the EU Taxonomy Regulation to meet the EU’s nature and biodiversity, as well as climate and energy targets for 2030. The regulation facilitates reporting on sustainable investment and introduces a common language and common requirements for reporting. It enables investment fund managers to gather reliable, consistent, and comparable sustainability related indicators from in-scope investee companies and incorporate this data into their investment decision and risk management process and fulfill their disclosure duties under Sustainable Finance Disclosure Regulation (SFDR) or applicable sectoral legislation. 

The EU Taxonomy Regulation also provides further details on the content of sustainability-related disclosures required in pre-contractual and periodic reports of environmentally sustainable investment funds and investment funds promoting environmental characteristics. It establishes a classification tool to determine whether an economic activity is environmentally sustainable. As a classification system, the Taxonomy was created to address greenwashing by enabling market participants to identify and invest in sustainable assets with more confidence. 

The EU Taxonomy Regulation defines EU-recognized criteria for identifying sustainable activities:

An environmentally sustainable economic activity contributes to one or more of the following environmental objectives: 

  1. Climate change mitigation 
  2. Climate change adaptation 
  3. Sustainable use and protection of water and marine resources 
  4. Transition to a circular economy, waste prevention and recycling 
  5. Pollution prevention and on control 
  6. Protection and restoration of healthy diversity and ecosystems 

The economic activities that are eligible for screening are defined in the Technical Screening Criteria and are assessed on three main principles to determine alignment with Taxonomy objectives. To be deemed sustainable, an activity must: 

  • Substantially contribute to at least one of the six environmental objectives mentioned above.
  • Do no significant harm to any of the other environmental objectives (DNSH criteria).
  • Comply with minimum safeguards created to avoid negatively impacting societal stakeholders

Activities that are aligned to one or more of the six objectives may either substantially contribute to environmental performance of industry directly, or function as an enabling or transition activity. Direct activities are those performed in an environmentally sustainable manner and Taxonomy-aligned in their own right—things like afforestation and the production of solar energy.

The intent with a common taxonomy is to establish criteria that leave no shade of gray, acting as stark pass/fail metrics for companies. An activity as performed by a company either meets the criteria or not, and if not, it cannot claim any degree of taxonomy alignment regarding that activity. Eligible economic activities and screening criteria will be reviewed frequently by the newly assigned EU Platform on Sustainable Finance to ensure the Taxonomy is up to date with the most recent findings related to sustainable practices—it is likely therefore that the Taxonomy framework and requirements will change over time.

The Regulation places new Taxonomy linked disclosure obligations on companies and on financial market participants. It applies to:

  1. Financial market participants offering financial products in the EU, including occupational pension providers. 
  2. Large companies who are already required to provide a non-financial statement under the Non-Financial Reporting Directive (NFRD). 
  3. The EU and Member States, when setting public measures, standards, or labels for green financial products or green (corporate) bonds.

Financial institutions and non-financial companies within the scope of the NFDR were required to report on eligible activities (i.e., Taxonomy eligibility) at the start of 2022. This is for the first two objectives of the EU Taxonomy: Climate Change Mitigation and Climate Change Adaptation.

Effective in 2023, non-financial NFRD companies will then have to start reporting their own Taxonomy alignment. Financial institutions only need to start reporting their Taxonomy alignment beginning in 2024, at which time the necessary 2023 reported data by the non-financial undertakings they hold in their portfolios and on their books is available. The criteria for the remaining Taxonomy objectives—water, circular economy, pollution prevention and biodiversity—is expected to apply from January 2023.

The key milestones in the ongoing rollout of the Taxonomy and its downstream adoption are listed below:

Non-financial companies that fall under the Non-Financial Reporting Directive—large EU public-interest companies with more than five hundred employees—will have to report on how much of their turnover, CapEx and OpEx are derived from EU Taxonomy aligned economic activities following the process below:

  1. Eligible economic activities are identified and turnover for each is defined. 
  2. Activities are screened against Technical Screening Criteria (those without thresholds automatically pass).
  3. Activities are deemed Taxonomy-aligned if they pass the screening, do no significant harm to any other environmental objective and minimum social safeguards are met.

Financial institutions will have to disclose how much of their portfolio is Taxonomy-aligned following the process below. This will only take effect in January 2024, by which time the necessary 2023 reported data by the non-financial undertakings they hold in their portfolios and on their books is available:

  1. Turnover for each activity of each company is identified. (If company alignment is not readily available, the financial institution will need to follow the same screening assessment detailed above). 
  2. ‘Do No Significant Harm’ and minimum social safeguards criteria need to be verified. 
  3. Total percentage of the financial institution’s portfolio that is Taxonomy-aligned is then calculated by assessing the size of investments and activities that have passed the Taxonomy screening. The Taxonomy Regulation does not currently specify a threshold that financial institutions must surpass in terms of alignment.

As the Taxonomy takes shape, it may be applied in new ways. For example, the forthcoming EU proposal for an EU Green Bond Standard is expected to use the Taxonomy as the benchmark for eligibility. Linking the Taxonomy to the Green Bond Standard would create a more direct link with the EU – and potentially global – capital markets. The latest draft report for an EU Ecolabel for retail financial products already includes Taxonomy defined thresholds for minimum investment in environmentally sustainable economic activities. Whether further EU policy measures may be tied to the Taxonomy remains to be seen. 

As the UK officially left the European Union on 31 January 2020, the disclosures are not part of ‘retained EU law’ and so firms in the UK do not need to comply with the EU Action Plan and the Taxonomy Regulation. However, those distributing or wishing to manufacture and sell products to EU clients, would be at a disadvantage with an un-comparable Taxonomy alignment. In short, any product sold in the EU will have to comply with the regulations. The UK is due to implement its own principles-based version of the EU Taxonomy (and the Sustainable Finance Disclosure Regulation) which the FCA is disclosing at the right time.

Just as the Sustainable Finance Disclosure Regulation (SFDR), the EU Taxonomy Regulation is generating a demand for more widely available and accurate information on wide aspects of sustainability. At Svarmi, we believe that in order to build high quality reporting metrics at the entity and product levels, companies need to establish consistent data collection at the asset level.

This is why we strive to help companies assess their nature & biodiversity impact by locating, prioritizing, and digitally evaluating their Areas of Influence, driving alignment to existing and emerging regulatory requirements as well as voluntary reporting frameworks.