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By Sharini Adaman · Mar 27, 2022
The EU Taxonomy: Steering the region’s sustainability journey
With climate change, sustainability, and carbon neutrality growing into global watchwords, the European Union (EU) has been eager to convert broad discourse on these topics into meaningful action aimed at achieving climate neutrality. The EU Taxonomy, the first regulation to scientifically outline what a sustainable activity is, goes a long way in accomplishing this. It may even serve as a gold standard for other regions and countries pursuing similar legislation.
What is the EU Taxonomy?
The EU Taxonomy is a classification system issued by the European Commission (EC) that defines which economic activities can be considered environmentally sustainable.
Although climate change has been a global hot topic for decades, the EU is taking strong measures to be the world's first “climate-neutral bloc” by 2050. The region has been at the forefront in tackling the climate crisis by drafting action plans, regulations, and directives.
Note: Not an exhaustive list of climate conferences
Source: Compiled by SPEEDA Edge based on information from the Council on Foreign Relations and other sources
The EU Taxonomy identifies six environmental objectives under which sustainable economic activities should be classified. They are: 1) climate change mitigation, 2) climate change adaptation, 3) protection and restoration of biodiversity and ecosystems, 4) pollution prevention and control, 5) sustainable use and protection of water and marine resources, and 6) transition to a circular economy.
To qualify as being sustainable, an economic activity must:
- Contribute substantially to one (or more) of the six environmental objectives,
- Do no significant harm (DNSH) to any of the other objectives, and
- Meet the minimum social safeguards laid out in the OECD Guidelines for Multinational Enterprises (the UN's guiding principles on responsible business conduct), the International Bill of Human Rights, and ILO Conventions.
The Technical Working Group (TWG) on Sustainable Finance, which was established in July 2018, is developing technical screening criteria for the economic activities identified under each environmental objective. These are defined by legal instruments called delegated acts, which also establish metrics and thresholds for each activity to assess its alignment with the taxonomy.
The Climate Delegated Act, which covers the first two objectives of climate change mitigation and climate change adaptation since they are the most immediate priorities, was published in June 2021. It sets out a timeline within which companies must publish their first Taxonomy Eligibility Report. It was followed up with a Complementary Climate Delegated Act in February 2022, which included specific nuclear and natural gas energy activities on the list of economic activities. It will be formally adopted when all languages are available for scrutiny by co-legislators. The delegated acts for the remaining four criteria are yet to be established and are expected in 2023.
Source: Compiled by SPEEDA Edge based on various sources
What does it aim to achieve?
The EU Taxonomy supports the European Green Deal. Approved by the European Parliament in 2020, the European Green Deal is a set of policy initiatives that requires the region to reduce carbon emissions by 55% from its 1990 levels by 2030 and be climate-neutral (i.e., achieve net zero greenhouse gas emissions) by 2050. To finance and reach this goal, for which private sector involvement is essential, the EU Taxonomy Regulation was implemented in July 2020. Its purpose is to help direct capital flows towards sustainable investment. The taxonomy pledges EUR 1 trillion to mobilize sustainable investments over the next decade, of which EUR 500 million is set to arrive from the EU budget with the balance intended to come through national and private investments.
The EU Taxonomy promotes capital flows for sustainable finance by encouraging investors to take ESG factors into account in their decision making. It does so with the aim of:
- creating security for investors,
- protecting stakeholders from greenwashing,
- planning a clean transition for companies, and
- mitigating market fragmentation.
The EU Taxonomy thus becomes a “green compass” and improves transparency, with companies required to disclose the extent of their compliance.
Note: The CSRD amends the Non-Financial Reporting Directive (NFRD) which has been in force since 2018
Source: Compiled by SPEEDA Edge based on EY information
To whom does it apply?
The taxonomy applies to two parties—financial market players and corporations—with differing disclosure requirements.
Experts have identified several ways in which the EU Taxonomy and related screening criteria impact the European corporate sector:
- Provide the financial community with a framework to consider when investing in financial market products linked to sustainable activities.
- Promote the development of sustainable financial products, such as the EU Green Bond Standard, and the EU Ecolabel for financial products.
- Result in banks’ assets related to environmental objectives being assigned a lower risk rate.
- Can be used by banks in their decisions to grant loans.
- Can be used by risk managers to assess the risk of financial services firms’ portfolios.
- Can be used by companies to set targets on their sustainability journey.
- Can be used by the EU as screening criteria for public procurement, public aid, and recovery plans.
To make it easier for users to access its contents, the EC published the EU Taxonomy Compass, which summarizes the taxonomy and Climate Delegated Act, listing all taxonomy-eligible activities, the objectives to which they substantially contribute, and their technical screening criteria. The compass, which will be updated to include the Taxo4 and future delegated acts, also allows users to integrate the criteria into their business databases and other IT systems.
How will it impact company strategy?
The Taxonomy cannot be ignored. Companies need to adopt a stance on it after considering how it will affect their financing and reputation.
- Enhanced reputation. Being Taxonomy-aligned, or supportive of the alignment, will affect a company’s future reputation and relevancy. High taxonomy alignment leads to an enhanced reputation and an opportunity to be recognized as a sustainability leader. This, in turn, should lead to increased investment and customers, a higher share value, and an inspired workforce.
- Improved supply chains. Taxonomy alignment may also reduce risk across company supply chains. Parties “speaking” a common sustainability language across a supply chain may help minimize disruptions and delays, and build supply chain resilience.
- Better access to finance. Financial institutions that want to increase their share of Taxonomy-aligned investments will look to invest in companies that not only have Taxonomy-aligned activities but also disclose them. (When companies do not disclose these, financial institutions and investors need to carry out the assessment themselves.)
- Improved understanding of activities and their impact. The assessment helps companies better understand the sustainable impact of their activities, allowing them to benchmark themselves against best practices and identify possible improvement areas, thereby guiding decision making.
- Future-proofing. The assessment helps businesses identify vulnerabilities to hazards and exposure to risk, and financial institutions’ investment portfolios become more resilient to fluctuation.
- Attitudinal shift. While it does not prevent companies from investing in activities that are not aligned with it, the Taxonomy (along with other regulatory measures) promotes the transition to engage in more sustainable activities. Even if the Taxonomy does not prompt a shift in a company’s business model, it is hoped that it would lead to a shift in thinking.
How does it work?
The five steps involved in screening a sustainable activity are illustrated below using the example of an automotive manufacturer with three divisions.
What criticism does it face?
One criticism of the EU Taxonomy is that natural gas and nuclear power do not fall within the EU’s path toward sustainability.
Some countries view natural gas as a compromise between coal and renewable energy and believe it should be considered sustainable subject to certain conditions. They assert that it can act as an intermediate fuel option for coal-dependent nations as they transition to renewable energy sources since it emits less CO2 than coal, is easy to transport, and supports energy security. Opponents to this view argue that it is contradictory to the Taxonomy’s aim of promoting sustainable activities and harms the EU Green Deal’s objectives. They stress that natural gas still emits methane, a greenhouse gas, and classifying it as “green” would increase the region’s fossil fuel dependency.
Meanwhile, proponents of nuclear power argue that it is a carbon-free and dependable energy source. However, they face resistance from those who question whether nuclear energy can be considered transitional, since nuclear plants have an operating life of 40–60 years, or sustainable, given that nuclear waste requires management and protection for several years.
Nevertheless, proposals to classify natural gas and nuclear energy as “green assets” gained traction and, in February 2022, the EC approved (in principle) a Complementary Climate Delegated Act which included specific nuclear and natural gas energy activities on the list of economic activities covered by the EU Taxonomy.
Other criticisms levelled against the classification system include the involvement of corporations in its design and that it is too narrow and not ambitious enough.
How does it impact entities outside its scope?
According to the TEG, “The EU Taxonomy is one of the most significant developments in sustainable finance and will have wide-ranging implications for investors and issuers working in the EU, and beyond.”
Will be implemented in the UK. Despite Brexit, the EU Taxonomy’s implementation is part of the package the UK government has agreed to incorporate into domestic law in an effort to establish a possible free trade agreement.
Companies seeking European investors need to comply. Listed and large companies that are not based in the EU or do not have operations within the regional bloc will need to comply with the taxonomy if they want to attract European investors.
Companies dependent on PE funds and bank financing need to comply. EU-based, non-listed companies and SMEs, although not falling within the taxonomy’s scope, will need to comply if their shareholders include PE funds or they require bank financing, as all financial market participants offering financial products must comply.
How does Russia’s invasion of Ukraine impact the Taxonomy?
The EU is dependent on natural gas imports from Russia; would accelerate inflation if halted. Russia is the largest single supplier of natural gas to the EU, meeting about 45% of the region’s demand or 150 billion cubic meters annually, with certain member states’ dependency greatly exceeding that of their peers.
Following Russia’s invasion of Ukraine, natural gas now carries a higher geopolitical risk. But ceasing its import from Russia is not an option for the EU. Since 2021, EU consumers have contended with steeper gas bills and inflation due to high post-Covid-19 economic recovery demand coupled with insufficient supply and weather-related factors. The crisis in Ukraine has increased energy prices further and stopping imports would only exacerbate this situation. Besides, higher gas prices will translate into higher prices for other commodities, leading to higher manufacturing costs and, ultimately, reduced business competitiveness and higher poverty rates.
The EC plans to reduce its dependency on Russian fossil fuel imports. In March 2022, the EC published “REPowerEU”, a plan to build a more resilient and sustainable EU energy market. It highlights the risk of overreliance on one source of essential resources and seeks a two-thirds reduction in the region’s dependence on Russian gas by end-2022 and independence from all Russian fossil fuels by 2030. Proposed measures include:
- Replacing Russian gas dependency with increased biomethane and renewable hydrogen use—35 billion cubic meters of biomethane and 15 million tonnes of renewable hydrogen by 2030,
- Importing natural gas from alternate sources*—50 billion cubic meters annually from Qatar, the US, Egypt, and West Africa, and 10 billion cubic meters annually through the diversification of pipe sources,
- Ensuring sufficient gas storage to counter Russian supply disruptions,
- Accelerating the transition to clean energies such as solar, wind, and geothermal by incentivizing investments and fast-tracking proposals,
- Allowing member states to offer temporary aid to companies affected by high energy prices and help reduce their exposure to energy price volatility, and
- Allowing member states to intervene and regulate electricity prices to protect the energy poor and vulnerable households and businesses.
* Subject to capacity availability. Another alternative is buying natural gas on the spot market but this may cost more and not fully meet demand.
Experts are calling for the exclusion of natural gas and nuclear energy activities from the Taxonomy. The Complementary Climate Delegated Act approved by the EC in February 2022 allows specific nuclear and natural gas energy activities to be included in the EU Taxonomy. Following Russia’s invasion of Ukraine, international NGOs (such as the WWF) and European Parliament lawmakers are calling for the act’s withdrawal, citing its contradiction with the region’s plans to be independent of Russian fossil fuels as detailed in REPowerEU. Experts also point out that the increased carbon footprint associated with importing natural gas from alternate sources that are farther away contravenes the taxonomy’s goals.
What is the status of the Taxo4?
In March 2022, the TWG submitted its report and recommendations for the four remaining environmental objectives—the “Taxo4”—to the EC. The report consists of a methodological report and technical screening criteria, and seeks to 1) specify the technical screening criteria for activities that can make a substantial contribution to the four objectives and 2) define a headline ambition level (or an aspirational goal) for each objective.
The timing of the commencement of regulatory obligations will become known after the EC reviews the report and recommendations, and proposes a delegated act towards the end of 2022.
The report lists economic activities across eight different sectors—agriculture, forestry, and fishing; mining and processing; manufacturing; energy; construction and buildings, ICT, and emergency services; transport; restoration and remediation, and tourism; and water supply, sewerage, and waste management. The activities are classified using NACE, a standard industry classification used in the EU, and supplemented where necessary.
None of the four objectives stand alone but rather overlap with each other and the first two objectives covering climate mitigation and adaptation. Given these overlaps, an activity may be classified under more than one objective. Therefore, the TWG has endeavored to ensure consistency across the criteria in the taxonomy and deter “criteria shopping”.
Source: Platform on Sustainable Finance: Technical Working Group - Part A: Methodological report, March 2022
What can we expect in the future?
Continuous development
The EU Taxonomy was not designed to be static. The Platform for Sustainable Finance, a permanent expert group formed through the Taxonomy Regulation, is responsible for advising the EC on how to further develop the EU Taxonomy and improve its usability. Expected improvements include:
Integrating the social taxonomy. In February 2022, the TWG published a social taxonomy that promotes the development of social objectives. By classifying activities as “social”, the taxonomy promotes the flow of investment into socioeconomic activities. While not yet passed into law, the social taxonomy may be incorporated into the environmental sustainability taxonomy (the EU Taxonomy), the CSRD, the SFDR, and the Sustainable Corporate Governance (SCG) initiative currently under development.
Reviews of objectives, activities, and screening criteria. The platform may review technical screening criteria and transitional activities to reflect scientific and technological advancements and may recommend changes to the environmental objectives themselves.
Bringing smaller entities within scope. Initially applying to “large entities” averaging more than 500 employees, the definition of large has been extended to encompass more establishments, including SMEs (from 1 January 2026 onwards). SMEs may be affected even before that since banks are required to report a green asset ratio from 2022 onwards on their loan portfolio, which includes loans to SMEs.
A green asset bubble?
There is speculation that the EU Taxonomy will create a green asset bubble, resulting in a shortage of financing for activities that are not taxonomy-aligned. Experts counterargue that:
- Even if it does create a bubble, it would burst only when the climate crisis is resolved and there is no risk of that happening anytime soon.
- The redirection of capital away from activities that are neither environmentally nor socially sustainable was the purpose of the Green Deal in the first place. The taxonomy increases investors’ awareness of sustainable investments. Therefore, companies that have not aligned or are not seeking to align their activities with the taxonomy will carry a higher transition risk and a lower valuation, resulting in investors avoiding them.
Anticipating the other four objectives
Experts believe businesses should start aligning with the remaining four objectives even before their delegated acts have been published.
- Get a head start on identifying related activities. Businesses can then work on increasing their attractiveness to investors.
- The screening criteria may be more complex. They may involve several indicators compared to the relatively straightforward criteria governing climate-related objectives.
- The timelines may be tighter. Businesses may have as little as one year from the time the EC adopts the criteria to meet their reporting obligations.
- There may be assessment overlap. By identifying activities that contribute to more than one objective early, businesses may be able to minimize the duplication of effort. For instance, there may be some overlap between climate change mitigation and pollution prevention and control objectives as well as water and ecosystem objectives.
- Prepare for other EU regulations. By aligning their activities with the four objectives, businesses will be better prepared for other taxonomy-aligned EU legislation.
The EU Taxonomy is a key component of a comprehensive set of measures adopted by the EU to reach its goal of being carbon neutral by 2050. It sets a high standard for the rest of the world that is yet to adopt as strong an approach. It is also inescapable: all eligible entities must comply and those beyond its scope must choose how to engage in sustainable activities or risk jeopardizing their reputation and capital flows. Moreover, the taxonomy is evolving: the environmental objectives, activities defined as sustainable under each objective, and screening criteria for such activities are subject to continuous review. Therefore, time is of the essence. Entities that scrutinize their activities without delay will be better positioned to meet current deadlines and get a head start on meeting the requirements of forthcoming regulations.
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