EU Taxonomy Regulation: what does it do and what happens next?
The Sustainable Finance Taxonomy Regulation was published in the Official Journal of the European Union on 22 June 2020 and came into force on 12 July 2020. However, it will not start applying in practice until 1 January 2022 at the earliest.
What is the aim of the Taxonomy Regulation?
The Taxonomy Regulation sets out an EU-wide framework (a classification system known as a “taxonomy”) according to which investors and businesses can assess whether certain economic activities are “sustainable”. Think of it as an EU dictionary of what activities may and may not be called sustainable. The initial focus has been on defining what is sustainable in climate terms but the intention is to come up with rules on other environmental sustainability objectives, and to extend this to social objectives at a later stage.
The Taxonomy Regulation is one of the pillars of the EU’s sustainable finance and climate change agenda and forms part of a wider package of sustainable finance legislation, which includes the Disclosure Regulation and the Low Carbon Benchmarks Regulation. For more information on those two Regulations and the EU’s sustainable finance strategy, see our publications: Trio of new EU rules will shake up how funds approach ESG: what you need to know and European Commission Consultation on the Renewed Sustainable Finance Strategy.
The ultimate aim is to encourage investment flows from the financial sector to companies engaged in or transitioning to more sustainable activities so that the EU can become carbon neutral by 2050 and meet its climate change goals. That’s what the EU sustainable finance agenda and the European Green Deal are all aiming for. And in order to do that, the EU needs investors to redirect a vast amount of capital into the right type of projects and companies. Investors say they need better information on which to base their investment decisions so that they are not led astray or discouraged by “greenwash” claims. The EU taxonomy is designed to combat greenwash and help everyone identify what is or is not sustainable.
Who does the Taxonomy Regulation apply to?
The Regulation is designed for use by:
- Member states and EU institutions when setting rules about financial products and corporate bonds that are made available as environmentally sustainable – so the taxonomy will be used to define green bond standards in due course;
- Financial market participants (FMPs) who offer financial products and market these as environmentally sustainable (see below) - as noted below, the definition of FMPs captures primarily buyside firms and institutional investors; and
- Organisations covered by the Non-Financial Reporting Directive (see below).
To begin with, the taxonomy will therefore only apply to certain stakeholders in the market, but we expect it to become the dictionary for financial services and business activities more broadly in due course (either due to legal or market intervention).
The Taxonomy Regulation does not require parties to invest in taxonomy-eligible activities. Rather, it provides the toolkit for assessing whether a financial product or business is environmentally sustainable. It also introduces a requirement on FMPs and large public interest entities to disclose information on how, and to what extent, their products and businesses are aligned with the taxonomy - so that investors can make more informed decisions.
How is “environmentally sustainable” defined in the taxonomy?
There are four tests that an economic activity must satisfy to be “environmentally sustainable” under the taxonomy. The activity must:
- contribute substantially to at least one of the environmental objectives;
- “do no significant harm” to any of the other environmental objectives;
- be carried out in compliance with minimum social and governance safeguards; and
- comply with technical screening criteria to be adopted under the Regulation (see below).
The Regulation sets out six environmental objectives:
- climate change mitigation;
- climate change adaptation;
- circular economy;
- pollution control; and
Technical screening criteria
The Commission needs to adopt technical screening criteria (TSC) for each of the six environmental objectives, fleshing out in detail what it means for an economic activity to substantially contribute to an environmental objective. This will be done through delegated acts. The taxonomy cannot apply in practice until the TSC for the relevant objectives have been adopted.
The delegated acts for the TSC for the first two environmental objectives (climate change adaptation and climate change mitigation) must be adopted by 31 December 2020 so that the taxonomy can start to apply from 1 January 2022 to those two environmental objectives. This will give those affected by the Regulation a year to prepare for it in relation to those objectives.
The delegated acts for the TSC for the remaining four environmental objectives (water, circular economy, pollution control and biodiversity) must be adopted by 31 December 2021 so that the taxonomy can start to apply to those objectives from 1 January 2023.
Work on the TSC for climate change adaptation and mitigation is already quite advanced (see TEG final report and TEG technical annex) – but by no means finalised. The European Commission said in an FAQ that we can expect a consultation on the draft delegated act for the climate TSC in September/October 2020.
One of the remaining sticking points in this context is how nuclear power should be treated in the TSC. The Commission has asked the Joint Research Centre (JRC), its in-house research body, to assess whether nuclear power should be included in the EU taxonomy as an environmentally sustainable activity. Proponents argue that it should be included because it is a low-carbon source of energy, whilst critics claim the problems associated with radioactive waste mean it does not meet the “do no significant harm” principle under the Regulation. The JRC will submit a technical report on the “do no significant harm” aspects of nuclear energy in 2021. In the meantime, work on adoption of the TSC for the other economic activities that can substantially contribute towards climate change mitigation and adaptation will continue irrespective of the separate assessment on nuclear energy. To accommodate the possible inclusion of nuclear in the taxonomy later on, the Commission has said it would consider amending the delegated act on the TSC for climate change mitigation and adaptation by the end of 2021. For more information, see p.13 in the Commission’s FAQ.
Much of the work on the TSC for climate change adaptation and mitigation has been done by the Commission’s Technical Expert Group (TEG) but the TEG’s mandate is due to run out in September 2020 and the TEG will be replaced by a new Platform on Sustainable Finance – which will develop the TSC for the other four environmental objectives.
But a word of warning: the TSC are not for the faint hearted. We would advise you pour yourself a large glass of your favourite tipple and wrap a nicely chilled towel around your head before delving into that detail. You are going to need it.
Taxonomy Regulation amends Disclosure Regulation
The Taxonomy Regulation amends the Disclosure Regulation to require “financial market participants” (FMPs) to disclose, either:
- information on how, and to what extent, the investments that underlie their financial product support economic activities that meet the four tests for environmental sustainability under the Taxonomy Regulation, or
- for those products that do not invest in taxonomy-compliant activities, a statement that they do not take into account the EU taxonomy.
It also amends the Disclosure Regulation to require the European Supervisory Authorities (i.e. ESMA, EBA and EIOPA) to develop, jointly, regulatory technical standards specifying the details of the presentation and content of the information in relation to the principle of “do no significant harm”.
FMPs are defined in the Disclosure Regulation, and include institutional investors and asset managers. The same goes for the definition of “financial products”: these include funds, portfolio management, insurance-based investment products and pension schemes.
For more information on the Disclosure Regulation, see our publication: ESG Disclosure Regulation.
Taxonomy Regulation amends Non-Financial Reporting Directive
Article 8 of the Taxonomy Regulation requires financial and non-financial organisations covered by the Non-Financial Reporting Directive (NFRD) to include information in their non-financial information statements on how, and to what extent, their activities are “associated with” environmentally sustainable economic activities. The Regulation does not explain what is meant by “associated with”.
The Taxonomy Regulation requires the European Commission to adopt, by 1 June 2021, a delegated act specifying the content and presentation of the information to be disclosed under Article 8, including the methodology to be used.
Article 8 also requires non-financial undertakings (i.e. companies) to disclose the proportion of their turnover derived from products or services associated with environmentally sustainable economic activities and the proportion of their capital and operating expenditure related to assets or processes associated with environmentally sustainable economic activities.
The NFRD at present applies to large public interest entities (PIEs)) – which can include organisations in the financial and non-financial sectors. So it is relevant to banks, insurers and companies with securities traded on a regulated market, in each case if they have more than 500 employees. However, the Commission is currently carrying out a wider review of the NFRD and one of the issues being considered is whether the NFRD should be extended to cover other types of companies. Which in turn would have a knock-on impact on which organisations need to comply with the disclosure requirements in Article 8 of the Taxonomy Regulation. For more information on the wider NFRD review, see our blog post: Non-Financial Reporting Directive: the pursuit of data that is relevant, reliable and comparable.
Article 27 states that the reporting requirements in Article 8 should apply:
- from 1 January 2022, as regards the first two environmental objectives; and
- from 1 January 2023, to the other four environmental objectives.
However, it is still not clear whether this means that the disclosure obligations in Article 8 will apply, in respect of the first two environmental objectives (climate change adaptation and mitigation), to financial years commencing on 1 January 2022 or to reports published after 1 January 2022.
In July 2020, the Commission published a consultation on an inception impact assessment (also known as a “roadmap”) on the delegated act needed under Article 8. The consultation closed on 8 September 2020. EU consultations on inception impact assessments/roadmaps are typically very high-level, designed to indicate the general direction of travel that the Commission is thinking of taking and are usually followed by a more detailed consultation on the proposals afterwards. And although this consultation document is particularly light on detail, it does say that the Commission will consider whether the three indicators (turnover, Capex and Opex) against which companies are to disclose the proportion of their activities which are sustainable need to be specified in more detail and whether different indicators should be developed for financial undertakings disclosing under the NFRD (i.e. large banks and insurance companies). It also clarifies that this delegated act is separate from the other delegated act needed under the Taxonomy Regulation to implement the TSC, and that it will complement the wider NFRD review (mentioned above).
However, so much attention has been focused on how the taxonomy will be defined and the TEG reports on this that some may have missed, or failed to fully appreciate, the other requirements in the Taxonomy Regulation - including the changes that the Regulation will make to the NFRD and the impact this will have on large corporates by requiring clear disclosure of the proportion of corporate activities that are or are not taxonomy compliant.