Social Taxonomy - the way ahead and its linkages with the EU Taxonomy

In the second quarter of 2021, the final Delegated Act covering climate change mitigation and adaptation was adopted by the EU. Later in July 2021, the Technical Expert Group (TEG) published a working paper on Social Taxonomy indicating a possible extension of the scope of EU Taxonomy.

Need for social Taxonomy

The current EU Taxonomy focuses on the environmental part of ESG and leaves a lot of doubts regarding the Minimum Social Safeguards (MSS) as no stricter provisions have been made for their compliance. Therefore, concrete and detailed guidelines for the promotion of social objectives were needed.

Additionally, the need for Social Taxonomy is demonstrated by the following:

1. The need for investment in affordable housing, healthcare, training, respect for human rights, workers, consumers, communities, etc
2. The need for socially inclusive measures to accompany the green transition; a just transition
3. An increased demand from investors for social investment opportunities
4. The absence of considerations of social issues by businesses carries valuation risks (owing to litigation and penalty) for investors
5. A lack of standardised classification system to redirect the capital towards socially sustainable activities

The introduction of the Social Taxonomy will streamline the data collection, verification, and sharing process for social parameters similarly on the lines of environmental data points making ESG reporting comparable across businesses. The incorporation of social parameters in reporting processes will also provide a fillip in the advancement of Sustainable Development Goals.

Structure of the Social Taxonomy

The TEG proposed a two-dimensional structure in the form of horizontal and vertical dimensions reflecting the multiple ways in which a business can contribute to sustainable development.

The horizontal dimension takes into account the impacts on a different group of stakeholders owing to economic activities such as workers including value chain workers, consumers and communities. The screening criteria for a horizontal dimension are expected to include entity and activity level criteria.

On the other hand, the vertical dimension focuses on the products and services for basic human needs and infrastructure. Therefore, those economic activities that make these products and services accessible, while not harming other social objectives could be considered social.

Difference between Environmental and Social Taxonomy

• Environmental criteria are generally developed based on scientific research and evidence whereas social criteria are built on international norms and principles that are already in place such as the United Nations General Principles on Business and Human Rights, OECD Guidelines for Multinational Enterprises, etc.
• Environmental taxonomy is focused on reducing the negative externalities caused by the businesses while social taxonomy is concerned about reducing the negative outcome for stakeholders affected by economic activities.
• Environmental taxonomy could have inherent social benefits such as on-the-job training, contributing to social protection, providing products and services with social benefits but social taxonomy is solely focussed on social benefits accruing from business activities.

A proposed relationship between Environmental and Social Taxonomy

The TEG is currently extrapolating two possible models:

1. Model 1: Two different taxonomies where environmental criteria will be having superficial DNSH for the social criteria and vice-versa.
2. Model 2: Only one single taxonomy has the environment and social objectives and DNSH criteria. Further, there would only be one DNSH that incorporates both environmental and social criteria making companies less compliant.

Having a stand-alone taxonomy will pose significant challenges as investors basing their decisions solely on EU Taxonomy alignment will divest from businesses that contribute very little towards the social objective but are environmentally sustainable. There will be more clarity on the exact relationship once the final report is published at the end of 2021.

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