The EU taxonomy: could it take the grey out of ‘green’?

Responsible Investor’s latest instalment of The EU Action Plan: What Matters To Me

To view more coverage of the upcoming changes to EU policy as part of the Action Plan on Sustainable Finance, sign up for a free, no-strings trial to Responsible Investor.

RI has reopened its The EU Action Plan: What Matters To Me series, providing insights from market experts on the implications of the EU Action Plan on Sustainable Finance. Today, Michael Wilkins from S&P Global Ratings points out the ‘pain points’ the EU’s taxonomy will have to overcome. You can hear directly from the European Commission and the Technical Expert Group in our dedicated Action Plan webinar series here.

Europe has been on the frontline of sustainable finance over the past few years, so it is no surprise that almost all eyes in the market have been watching with acute interest the progress of the European Commission’s Action Plan on Sustainable Finance. At S&P Global Ratings we believe the proposed green taxonomy developed as part of the Action Plan is one of the most important sector initiatives of late.
The proposal aims to safeguard the credibility of the market by ensuring issuers, companies, and governments are speaking the same language when labelling, marketing and investing in sustainable finance products. It also looks to establish the value of green finance activities, encourage R&D investment and, crucially, help bridge an estimated €175bn-€290bn investment gap to meet the EU’s Nationally Determined Contributions under the Paris Agreement.
But with the consultation period for the proposal now over, and with some of the 10 actions put forward by the EU already being written into law, there is a level of uncertainty over what the taxonomy could actually mean for whom in the capital markets when fully implemented. And with certain pain points still to overcome, how effective is the taxonomy likely to be in terms of ultimately redirecting capital flows towards sustainable investment?

The scope of sustainability

While discussions are ongoing as to whether the taxonomy would apply to banks and issuers, the draft taxonomy currently covers EU member states and financial market participants who offer environmentally sustainable investments in the EU. Additionally, financial market participants offering other products would also fall under the taxonomy’s scope, unless they clearly state that achieving sustainability objectives is not the purpose of the underlying activity.
For an economic activity to be considered ‘green’ under the proposed taxonomy, certain criteria must be met. Firstly, the activity must significantly contribute to at least one of the six environmental objectives set out by the EU: (1) climate change mitigation; (2) climate change adaptation; (3) sustainable use or protection of water; (4) the circular economy; (5) pollution prevention or control; and (6) biodiversity or healthy ecosystems.
The taxonomy currently covers (1) and (2) across agriculture and forestry, manufacturing, electricity, gas, steam, air-conditioning supply, water, sewage, remediation, waste, transport, information and communication technologies and buildings. This, however, is expected to broaden in the future to span all six objectives. Mitigation activities can be those that are low carbon, or compatible with or enable achieving or transitioning to a net-zero carbon economy by 2050.
Given that they are defined by context and location, adaptation activities are treated differently under the taxonomy. Instead of listing eligible adaptation activities, the taxonomy sets out guidelines and screening criteria to appraise the potential contribution of a given activity to climate change adaptation and resilience.
Furthermore, any given activity must not pose a risk to any of these six objectives – passing what is known as the “Do No Significant Harm” (DNSH) test. The taxonomy also requires compliance with standard social and governance safeguards as well as (yet to be defined) technical screening criteria.Clearly, the taxonomy seeks to support those activities that contribute positively to systemic decarbonisation. This means that it is not enough for an asset or activity to produce short-term environmental benefits – it must be clearly sustainable in the long term too. As such, certain activities were omitted from the list of eligible green activities, such as those relating to coal power generation. Notably, the Commission’s Technical Expert Group on Sustainable Finance (TEG) has also clarified its current position on nuclear energy, recommending its exclusion from the taxonomy at this stage.

Flexibility vs. rigidity

Indeed, ongoing review of what can and cannot be classified as a sustainable economic activity is what we believe should now be the main focus of the taxonomy’s development if it is to effectively engage the broader market.
To this end, the TEG has built in a level of flexibility to temporarily allow lesser-green companies and sectors to access the kinds of incentives that will drive improvements in their sustainability practices and help smooth the transition to a low-carbon economy. Financing low-emission cars, for instance, is seen as a transitional activity and currently qualifies as ‘sustainable’. After 2025, however, only zero-emission cars and commercial vehicles will be considered eligible. This will be standard practice across the range of transitional activities currently permitted under the taxonomy, where ongoing revision will aim to phase out more emission-intensive activities in the longer term.

Ongoing review of what can and cannot be classified as a sustainable economic activity should now be the main focus of the taxonomy’s development if it is to effectively engage the broader market

Market participants have also taken issue with the rigidity of the taxonomy, however, particularly with regards to the thresholds it applies to certain sectors. Some within the concrete and aluminium manufacturing industries, for example, believe the guidelines to be unfeasible due to discord between the thresholds and current industry practices. If such disparities aren’t effectively ironed out, there may be a risk of the taxonomy only being implemented within already green sectors, with lesser green industries with potential to improve their environmental profile being dissuaded from engaging.
The taxonomy’s stringency in other areas could also be seen as a barrier to quick and effective implementation – namely, requirements for data on companies and issuers. The taxonomy calls for data points such as a breakdown of revenue or turnover by taxonomy-related activities or allocated expenditure to each activity – a level of detail which very few companies can claim to disclose currently.
In response, the TEG and EC have bolstered the Non-Financial Reporting Directive with a further set of climate-related disclosure guidelines to help companies and issuers navigate this complexity and are currently reviewing the taxonomy in line with feedback received during the proposal’s consultation period. How effectively the revised taxonomy will respond to the above pain points remains to be seen, but we nonetheless believe that its grounding in science and evidential data and its ambition to create EU-wide standardisation could help mitigate ‘greenwashing’, aid the EU in meeting its sustainability targets and ultimately help companies and investors create the long-term greener business models needed to underpin the switch to sustainability.

Michael Wilkins is Global Head of Analytics and Research for Sustainable Finance at S&P Global Ratings.