The EU taxonomy: What is it, and what does it mean for investors?

When it comes to conversations about sustainable finance in 2020, there is no escaping the EU taxonomy.

First pitched as an idea by the High Level Expert Group on Sustainable Finance – appointed by the European Commission back in 2016 to advise it on its approach to “greening” financial markets – the taxonomy got the final seal of approval from European Parliament last week, meaning its legal foundation is now set in stone.

Essentially, the taxonomy is a detailed list of business activities that can credibly be called “green”. Green, in this instance, covers six areas:

1.       Climate change mitigation

2.       Climate change adaptation

3.       Sustainable use and protection of water and marine resources

4.       The circular economy

5.       Pollution prevention and control

6.       Biodiversity.

To get the nod under the green taxonomy, a business activity must be proven to substantially support one of those six areas without doing any significant harm to another, and without breaching minimum social safeguards (as laid out in existing conventions and UN guidelines). To test whether a business activity truly contributes to one of the six areas, it must comply with technical screening criteria. Those criteria are still under development, but by the end of the year, details of the first two pillars – climate adaptation and mitigation – should be confirmed in law. The Commission is currently mulling over the proposals it received in March from a Technical Expert Group on Sustainable Finance (TEG) it appointed two years ago to draft those technical screening criteria.

The TEG comprises 35 members and more than 100 advisors and observers from the financial markets, industry, science and civil society. The report it gave to the Commission in March was nearly 700 pages long and outlined what it believes to be the most appropriate climate mitigation criteria and thresholds for 70 sectors, covering more than 90% of Europe’s emissions. Climate adaptation criteria is included for 68 of them. Eligible activities can fall under one of three categories:

• Business activities that are already low carbon
• Business activities that contribute to the transition to net-zero emissions by 2050, but aren’t low-carbon quite yet; or
• Business activities that enable others to become low-carbon

The advice recommends that all asset classes be treated the same, and that assessments should be based on the proportion of revenues a company derives from taxonomy-aligned activities. Capital expenditure can also be taken into account, in a bid to capture the transition plans of companies, and to encourage them to package eligible capex into green bonds.  

The Commission has worked closely with the group over the past 18 months, so it is not expected to reject much – if anything – of what the TEG has suggested in the report.

The legal part

It’s not just talk about the taxonomy that is hard for many to escape, though. In December last year, it became clear that it would be hard for most to get away from its legal implications, too. Originally, the taxonomy was expected to rein in greenwashing, by forcing asset managers that offered “green” products to be transparent about how those products stacked up against an official definition of “green” (there was never any plan to force investors to invest in line with the taxonomy – just to disclose points of overlap and difference).

However, the final legal agreement was much broader than that. Now, all financial products being offered in the EU (UCITS funds, Alternative Investment Funds, portfolio management and Insurance-based Investment Products) will be covered by the taxonomy. In reality though, it is a “comply or explain” process, so those that don’t feel they have any commitment to being green – either through their mandate or the promises they make in their marketing – can technically get out of disclosing against the framework, by carrying a disclaimer. To address concerns about how investors that do have to comply will be able to get the data from their investee companies to enable them to do so, all firms covered by the EU Non-Financial Reporting Directive (defined as large public-interest companies with more than 500 employees) will also have to disclose the alignment of all their business activities.

The legal requirements of the taxonomy will come into force in phases, to allow the market to prepare, and to allow the Commission to roll out the other four environmental pillars over time. Consequently, investors and companies will have to report their alignment with the climate mitigation and adaptation components of the framework by December 2021. At that point, the other pillars will be introduced, and investors and companies will have to be ready to report against the whole set by the end of 2022.

Still to come 

And it may not be the only legal requirement to come from these efforts. The taxonomy is expected to lay the foundations of some other regulatory interventions by the European Commission in coming years. For example, there is currently a study underway on if and how the EU might want to tweak its existing capital requirements for banks – the rules on how much lenders must hold back on their balance sheets to ensure liquidity and manage risk – to encourage green lending. The plan is essentially (and controversially) to give banks better conditions if their lending supports business activities in the taxonomy. The taxonomy may also form the basis of an EU Green Bond Standard and other potential “green” labels.

It is also expected that the taxonomy will expand further in the future, to capture “social” benefits, too. And there is a lot of pressure for the Commission to identify environmentally harmful activities, and neutral ones.