The Taxonomy of Everything: Does it make sense to extend the EU Taxonomy?

EU advisors recently said the EU Taxonomy should be extended to cover harmful activities and recognise a broad range of non-green transition efforts. RI looks closer at the draft proposal

When the European Parliament adopted the EU Taxonomy Regulation in June last year – its last legislative hurdle before entering into force – the Commission welcomed the news by saying: “It will help create the world’s first-ever ‘green list’ – a classification system for sustainable activities.” 

It is now looking like that green list could be accompanied by a red and amber list and potentially a neutral-coloured list for activities with no significant impact on the environment. These four categories would effectively see the entire economy recognised in the EU Taxonomy.

This would be a big departure from the original plans for a green-only taxonomy and will likely be divisive: naming and categorising certain business activities harmful – rather than focusing on encouraging green activities and investment – and potentially introducing additional reporting requirements for companies and investors aren’t exactly selling points. 

“If we would have had this tool six months ago, maybe we would have had a slightly different argument on some of the criteria in the Delegated Act” – Nathan Fabian, EU Platform on Sustainable Finance

But the pros outweigh the cons, according to the group of advisors from the EU Platform on Sustainable Finance tasked with making recommendations on whether the Taxonomy should be expanded to cover harmful and low-impact activities. 

“Whilst acknowledging that there are arguments for and against extending the EU Taxonomy beyond green, the Platform considers the balance of evidence is that sustainable finance initiatives to date have neither significantly increased transition finance nor driven sufficiently ambitious environmental transitions,” says the group’s interim report published on 12 July. 

There are two key reasons behind the group’s proposals, explained Nathan Fabian, Chief Responsible Investment Officer for the Principles for Responsible Investment and head of the Platform, during a launch webinar of the report. First, it would address a key concern around the perceived binary nature of the Taxonomy and would clarify that “just because you’re not identified as substantially contributing [to the green objectives] doesn’t mean you’re unsustainable” and “allow more of the economy to see itself in the taxonomy”. Second, the idea is that a broader taxonomy will help make more transition finance available “without diluting green”.

The creation of a ‘Significantly Harmful’ (SH) taxonomy should be the immediate focus, according to the group, calling for reporting requirements under such a framework to be implemented by 2023. This would also automatically pave the way for a third category of activities that don’t cause significant harm but also don’t meet the existing Taxonomy criteria of substantially contributing (SC) to one of the regulation’s six environmental objectives. This category would be called Intermediate Performance (IP) and be amber-coloured under a proposed traffic light system proposed by the group. 

Notably, the proposed IP category is distinctly different – and a lot broader – than the existing transitional criteria of the Taxonomy for activities that are ‘best-in-class’ for sectors where no green alternative is available. 

The SH taxonomy would be based on the Do No Significant Harm (DNSH) criteria that already exist for a range of business activities. This would mean, for example, that a business activity emitting more carbon than the DNSH criteria permits would fall into the SH category. If measures are put in place to reduce emissions below the DNSH criteria, the activity would transition into the amber IP space or the green space, depending on the level of improvement. The report noted there might be some caveats around the use of DNSH criteria and is reviewing whether it is always fit for purpose to define significant harm.

It is clear the Platform wants to move on this quickly. Reflecting on a politically sensitive and heated debate around the first set of detailed taxonomy rules for climate change mitigation and adaptation – particularly around gas, nuclear and forestry – Fabian even apologised that the proposals had not come forward earlier. “The irony of this is that we’ve spent six months arguing about the first Delegated Act,” he said, referring to the taxonomy’s rules for climate change-related activities, which found themselves at the centre of major backlash earlier this year after it was revealed that the European Commission was considering including fossil-based gas in the list. “If we would have had this tool six months ago, maybe we would have had a slightly different argument on some of the criteria in the Delegated Act because it would have been a deeper and wider understanding of how to recognise activities […] so please forgive us.”

The report is open for feedback until the end of August and Fabian said the consultation consists primarily of close-ended questions to ensure a final report can be delivered to the Commission by the end of the year. 

Certainly, there have been calls, perhaps most loudly by industry bodies in polluting sectors, but also from investors that the Taxonomy in its current form is not sufficiently encouraging the transition to green. This is important because of the huge level of transition needed to meet EU climate goals – the Commission says estimates and early testing of the climate taxonomy criteria shows a taxonomy alignment of company activities and investment portfolios of just between 1 to 5%. 

“The EU is putting the taxonomy within its broader transition efforts, under its Net Zero target, but the [Taxonomy] framework itself is focused on the substantial contribution that activities must already have already today – it's not about achieving this substantial contribution within a certain timeframe such as 2050,” says Gabriel Webber Ziero, Head of Policy Outlook at Swiss ESG research and advisory firm ECOFACT. “But 90% of economic actors in the EU aren’t there yet. And then you have a whole selling exercise – that the taxonomy is this holy grail to help companies get to Net Zero, but it doesn't tell companies how to get there, it just tells them what they need to achieve in order to be there. That’s what the current efforts on transition need to bridge.” 

But not everyone is convinced that extending the Taxonomy is the way forward. One industry source, who asked not to be named, said: “It’s like they’re trying to correct a mistake or address unforeseen consequences by creating new Taxonomy categories – a policy that’s even more complicated. It doesn’t sound right.” 

“Also, are they diagnosing the problem correctly and is this tool going to solve what we need to solve? The alleged risk is a very binary use of the Taxonomy by investors, which I’m not convinced will be the case – I still have a hard time believing that people who are not taxonomy-aligned will lose access to finance. There might be some cases, but on a wider scale, I don’t think that will happen.” 

But Webber Ziero is concerned about the potential development of what would likely be a very broad transition strategy under the proposed IP category. “I think it has the potential to be a minefield,” he says, likening it to Article 8 under the Sustainable Finance Disclosure Regulation (SFDR) covering light-green products that “promote” green or social characteristics. The category has caused market frustration with hugely different interpretations – funds self-certified as Article 8 include everything from basic exclusions to elaborate ESG strategies. 

“In this sense I think it’s the Wild West if non-clear rules are adopted for defining what can be considered as transition – as almost everything can fit under SFDR Article 8’s umbrella. For the taxonomy, this is something that I would be worried about if I were the EU.”

The proposed IP category will lead many to think of one particularly sensitive sector in Taxonomy discussions: gas. On the report launch webinar, a listener asked where gas would end up (“if anywhere”) – in the IP category or the existing green transitional category? Speakers largely skirted around the question, but one person close to the work of the Platform, speaking to RI anonymously, said because gas power doesn’t meet the SC criteria for emissions, it should go in the IP category (unless the activity exceeds DNSH emissions criteria, in which case it should be under SH).

“On a political level, ‘intermediate’ might work – it should be an acceptable political compromise and would avoid risking the entire integrity of the taxonomy.” The group’s report also includes a case study of how a gas power project could transition from SH to IP. 

However, there is a risk most industries will still push for their activities to be classified as green and will not buy the argument that investors will see their transition journeys under an IP category as sustainable, says the industry source. And there are early signs ‘transition’ is not as investable as green – for example, the labelled transition bond market has not taken off as some may have expected. 

There is also a risk of backlash at just the idea of naming a range of business activities as significantly harmful and requiring companies and investors to report on how much of their activities fall into this category. The group acknowledges numerous challenges around this in the report – such as that an SH extension may be seen as a departure from the “positive spirit” of encouraging sustainable activities, and may risk “blacklisting” companies in high-carbon intensity sectors looking to raise finance for transition. 

All of this could run the risk of not being politically palatable. “If you think the vicious reactions around green were a problem, just wait until you start labelling activities as really bad,” says the industry source. “I think it is very unlikely this will move ahead.” 

The plans do not necessarily require reopening the legislative process, however. The group outlined two options for how to implement an SH taxonomy: during a revision of the Taxonomy Regulation where it could be reopened to include new categories of SH and IP activities or by building on the current framework without reopening the regulation, primarily through a guidance document. 

With regards to reporting requirements on the suggested new categories, the group did not make any specific proposals – but a number of questions were asked about the topic on the launch webinar. “Is there an obligation to report significant harm whereas in the past you could have gotten away with saying nothing as you weren’t green? It’s a choice to be made,” said Fabian. “It’s possible to just recognise the transition – just recognising the capex that moves something from red to amber. That would be a legitimate reporting opportunity.” 

He noted there will be some trade-offs and that further reporting obligations may not be welcome. But, he said: “The big plus is the clarity you get. For lots of investors and companies this clarity is very valuable.”