What the financial industry needs to know about the EU Taxonomy

As the EU prepares to finalise its green taxonomy, Ingmar Schuurmans offers a refresher on what the controversial new framework really is, and how it will impact investors

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The EU Green Deal will give rise to a regulatory storm that will stretch far into the future, deep into today's profit models, and way beyond Europe's borders. This post focuses on the effects of the new EU Taxonomy, a central tool for the actual implementation of the EU Green Deal, specifically in financing Europe’s sustainable growth.

What qualifies as a sustainable economic activity? For example, can the manufacturing of steel through iron casting be sustainable? How about the construction of new buildings? What about heating and cooling using bioenergy? 

No need to worry if you don’t have the answer – the new EU Taxonomy (EUT) addresses these and many other questions.

The EU Green Deal and EUT defined

Before we talk about the EUT, we need to understand how it fits into the bigger picture – namely the EU Green Deal. In a nutshell, the EU Green Deal is a new European economic growth strategy to realise a climate neutral, competitive and circular economy by 2050. Its goal is to ensure that Europe lives and grows within the planet's boundaries and provides a sustainable future for the next generations to come.

The EUT is a central tool for implementing the vision of the EU Green Deal, specifically in terms of financing sustainable growth and the transition to a climate-resilient Europe. You could consider the EUT as the instruction manual for answering the questions at the beginning of this blog post: a new type of classification system designed to outline what is considered a sustainable business activity or investment. In other words, if a business or investment activity is aligned with the EUT, it will be considered as sustainable under the EU Green Deal. 

The EUT’s classification system for sustainable activities is based on technical screening criteria established by a Technical Expert Group (TEG). The draft criteria are now going through the EU legislative process, before they are formally adopted and can enter into force. Those criteria are categorised into three main elements (i.e. green, transition, and enabling activities), allowing for a more robust, accurate, and holistic way of assessing the real world environmental impact of economic activities. 

So how exactly is the EUT relevant for investors?

Investors can get ahead of regulation by better understanding the goals of the EUT, the potential ways of using the EUT to reinforce competitive positioning, and stress-testing existing and planned products against anticipated legal compliance.

Aligning with EUT goals: where the Sustainable Development Goals (SDGs) provide a common goal and ambition framework for the world’s macro-level sustainability agenda, the EUT does this on a micro level, i.e. by focussing on business and real world economic activities. It allows you as an investor to dig deeper into your investment portfolio. Are the underlying assets I manage really sustainable? 

Reinforcing competitive advantage: the EUT is also relevant for those selling financial products in the EU. Pioneers in the financial industry are starting to embrace the EUT and share best practice in the form of EUT case studies through the Principles for Responsible Investment, for example. But this is still early days: there is room for smart businesses to gain visibility and show leadership by being among the first movers. Moreover, as the ultimate goal of the EUT is to steer more investments in a sustainable direction, it’s also an opportunity to create economic advantage (impact funds outperformed their benchmarks in 2020)

Preparing for legal compliance: institutional investors and asset managers that promote their investment products as ‘sustainable’ will need to explain how exactly the EUT criteria have been applied to their products. The following legislative triad will be expected to drive the application of EUT criteria across new and existing sustainable investment products:

  • The NFRD (Non-Financial Reporting Directive) will be updated in Q1 2021, potentially expanding the scope of corporate ESG disclosures.
  • The SFDR (Sustainable Finance Disclosures Regulation) is linked to increasing transparency of sustainable investment products, and pushes the financial industry to share insights into how adverse impacts on sustainability are taken into account on the entity and product level. 
  • The Taxonomy regulation is the legislative text enforcing the application of the EUT.

How can investors get ready for the EUT?

The speed at which the EU wants to operationalise the EUT is highly ambitious. Dates are subject to change, but currently:

  • By the 1st of January 2022 financial market participants will be required to complete disclosures following the EUT, covering activities that substantially contribute to climate change mitigation and/or adaptation. The analysis covers the reporting year 2021.
  • By the 31st of December 2021 technical screening criteria for the remaining environmental objectives of EUT will be issued, as developed by the EU Platform on Sustainable Finance.
  • As of 2022 companies will be required to disclose the percentage of their turnover, investment and expenditures that are taxonomy-aligned for two objectives: climate mitigation and adaptation. The analysis covers the reporting year 2021.

Now, to try and answer the questions posed at the beginning of this article:

Can the manufacturing of steel through iron casting be sustainable? 

Well… only if emissions are lower than 0.325 tCO2e/t product.

What about the construction of new buildings? 

Only if the thresholds regarding Primary Energy Demand (PED) are met. 

How about the production of heating and cooling using biomass or biofuel? 

Only if facilities operate above 80% of GHG emissions-reduction relative to a fossil fuel comparator.

Ingmar Schuurmans is a Senior Consultant for Sustainable Finance at South Pole