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Taxonomy

EU Taxonomy Fundamentals

Sustainability is mainstream. Now we have to measure it, manage it and achieve it.

Denis Noonan

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Sustainability is Mainstream

Responsible investment and management has been around for centuries. We have heard it referred to by a number of different names, like 'Sustainability', 'Impact Investing', 'Sustainable Finance', 'Green' or 'Social Investment', 'Corporate Responsibility' and 'Environment Social and Corporate Governance' (or 'ESG'). In 2016, the Paris Agreement brought the concept to the forefront of global awareness, identifying an extreme urgency to limit the increase of global warming in this century to well below 2 degrees Celsius compared to pre-industrial levels.

The Paris Agreement stressed the need to adopt more environmentally sustainable economic activities. In 2019 the European Green Deal was launched to establish Europe as the first climate neutral continent and achieve ‘Net Zero’ greenhouse gas emissions in the EU by 2050. With these two pieces of legislation in place, awareness of the significant harm that older industrial practices were doing to the planet and the need for sustainability has truly become mainstream. The EU final report on environmental and social taxonomies hoped to enable substantial risk reductions, while the ambitious green taxonomy proposals aim to create more inclusive and sustainable communities.

But like the diverse range of terms that refer to sustainable finance - including investment and management - a wide range of definitions and interpretations have made it difficult to determine what ‘sustainability’ really is, how to measure it, and how to achieve it. In order to ensure that the sustainability objectives defined by the Paris Agreement are achieved, a single common framework is needed - one that can be understood by all stakeholders and which identifies the specific activities that materially impact the environment. Similarly, a standard set of definitions and classifications that can quantify sustainable impact in a straightforward manner and help involved parties manage it is required.

As a result, a number of global jurisdictions are taking steps to establish such a framework, and the EU Taxonomy (EUT) will be the first to be put into law. It is hoped that the EU social taxonomy, environmental taxonomy and sustainable finance disclosure regulations will also encourage other jurisdictions to introduce comparable taxonomy regulation, which will create more sustainable communities.

What is the EU Taxonomy?

The EUT is an encyclopaedia of economic activities that have a direct material impact on climate change mitigation and transition. It provides assessment criteria and logic to direct economic activity (and in particular investment) towards sustainable projects and activities called for by the Action Plan on Financing Sustainable Growth and achieve the objectives of the EU Green Deal. It also helps to prevent ‘Greenwashing’ - a practice where companies market activities or investments as sustainable, but without their actually making a material sustainable impact.

The EUT uses three pillars, referred to as 'Technical Screening Criteria', to determine if an activity qualifies as both environmentally and socially sustainable. The green taxonomy aims to significantly overhaul the entire basic economic infrastructure, and the minimum safeguards set by the EU classification system aim to prevent any significant harm being done to the environment.

The EUT establishes Technical Screening Criteria for individual economic/industry sectors and activities (NACE) and:

  • maps out the economic activities in each sector that already make a substantial contribution to climate change mitigation or adaptation, or which could do so in the future.
  • provides quantifiable environmental thresholds that each activity must achieve in order to qualify as ‘sustainable’.
  • requires proof that economic activities do not significantly harm other environmental factors not associated with the activity
  • ensures social sustainability is maintained by the company for all of its stakeholders, including the communities it is involved in.

Why is the EU Taxonomy Important?

In my first job after university, the most simple (and yet most lasting) piece of advice my boss gave me was: ‘if you can’t measure it, you can’t manage it’. This is what the EUT does. It enables us to consistently measure the specific impacts that individual economic activities and investments have on our progress towards achieving the environmental objectives established by the Paris Agreement, the EU Green Deal, and virtually any other sustainability objectives that may be put in place in the future.

The presence of EUT sustainable corporate governance framework has the following advantages in this area:

  • Companies can integrate clear ESG factors into strategy and policy, set measurable objectives to achieve specific sustainability objectives, and communicate those achievements to all stakeholders.
  • Management can make more informed business and investment decisions by overlaying sustainability factors on top of fundamental financial and risk components.
  • Commercial and financial institutions can create truly ‘sustainable’ products
  • Investors - both retail and institutional - can perform quantitative, comparative analysis of investment opportunities to support investment and portfolio allocation decisions.

Ultimately, greenwashing is eliminated thanks to this system being in place, because we either make a measurable impact on the environment which we can demonstrate…. or we don’t!

Who is impacted?

Who is impacted?

Everyone will benefit from using the EUT, but it will be mandatory for two types of institutions. First are large corporates in the EU with more than 500 employees that are already required to comply with the EU Non-Financial Reporting Directive (NFRD). The second are financial institutions that issue and/or distribute any type of financial products in the EU - a rule which applies even if the product marketed as green. In this case, the EUT augments the requirements of the sustainability-related disclosures in the Financial Services Sector (SFDR) by providing clarity on the definition of sustainable activities. Of course, all EU member states must also incorporate the taxonomy into rules and regulations regarding standards and labels for green and sustainable financial products and instruments.

For corporates, this means applying Technical Screening Criteria related to the company’s activities to identify the portion of Capital Expenditure, Operating Expense and Turnover that is aligned with environmentally sustainable activities. More importantly, it will provide quantifiable details that can enable a company to identify and prioritise actions that could further mitigate negative environmental impacts, or further enable the transition to a zero-carbon economy.

Financial institutions, such as asset managers intermediaries, lenders, pensions and insurance funds that distribute or market products that invest in environmentally sustainable activities will need to disclose the proportion of each product that is invested in those ESG activities. In addition they will need to provide further details to disclose whether the activities mitigate or enable the mitigation of environmental impact or if the activity is a transitional activity, and this will need to be done both pre-contractually as well as periodically for the life of the product.

Taxonomy Screening of an investment portfolio (fund) — A weighted average Taxonomy Screening of all assets owned by the fund

 

What are the biggest challenges?

Like any new regulation, the biggest challenge for implementing EUT requirements will be the cost and effort needed to assess and modify or create new procedures and systems to ensure compliance - and these improvements won’t make a direct contribution to profit. According to some estimates, the compliance cost is estimated to be more than €2.1 billion over the next 5 years, a cost primarily borne by asset managers. So is it good news that the biggest challenge is primarily related to only one specific topic?

Without question, the biggest challenge for meeting EUT requirements, as well as most other sustainability related regulations, is data. More specifically the challenge is based around a lack of available data, available data not being standardised, and the cost and effort required to build the tools to create, access, transform and manage EUT aligned data.

Think about your company or the assets in your underlying investment portfolio: 

  • Does sustainability data even exist for your company or portfolio?
  • If sustainability data exists, is it captured and managed along the same reporting structures as financial data?
  • Is the available sustainability data aligned with the EUT framework, or does it need to be transformed in some way first?
Financial and Sustainability reporting structures are not always aligned

Another challenge to consider is a lack of available ESG resources. As the EUT and sustainability initiatives in general are relatively new, finding qualified, experienced resources and staff is not easy, and in fact our recommended approach for addressing this issue is educating and up-skilling existing staff. Remember, sustainability is not about creating a stand-alone function. It is about incorporating a sustainability mindset into all areas of a company. It will be more beneficial to train existing resources in sustainability topics than hiring sustainability experts that don’t understand the core activities of your business.

What needs to be done and by when?

Very simply, the EUT will be implemented in two Delegated Acts, the first is expected to be published on April 20 of this year and requires disclosure starting in 2022. Below is a timeline indicating when each act will be released and the mandatory disclosure deadlines for each delegated act. 


 

A Final Point

‘This is not the end, it is just the beginning’-Mairead McGuinness, Commissioner for Financial Services, Financial Stability and Capital Markets Union at European Commission — Platform on Sustainable Finance presentation 26/2/2021

Complying with the EUT, and achieving environmental sustainability in general, is and will be, an iterative process of continuous improvement. We are all climbing a learning curve. We have to start somewhere, it won’t be perfect, but we will need to continually improve. We need to take steps to both improve our ability to disclose the sustainability of our commercial actives (better measurement, better data acquisition, etc.) and to ensure that those activities make continuous improvement to global environmental factors at the company and/or portfolio level.

Industry consensus and recommendations from key industry and regulatory stakeholders provide a common message: 

All market participants should do as much as possible, as soon as possible, while simultaneously establishing a mind-set and tangible plan to continuously improve sustainability and environmental impacts. 

This is not a one-off event, but an ongoing process. So our goal should be to identify the specific areas our activities have the most significant impact and establish a prioritised plan to achieve environmental improvements. We’ll talk about this in a future article.

COMING NEXT

Putting the Taxonomy into Action

In a future article, we will discuss the importance of establishing a process to identify and prioritise the specific sustainability factors a company or investment portfolio make a positive impact. This is all built from the implementation of the EUT and leads to executing a sustainability action plan to manage, monitor and communicate tangible progress towards achieving required environmental improvements.

We at Greenomy are developing award-winning digital solutions to help you tackle the Taxonomy/SFDR/NFRD/CSRD challenge: try it yourself, book a demo here !

 

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