Before getting to know more about EU Taxonomy, it is crucial to understand its contribution towards a holistic picture of the ‘EU Green Deal’. A new economic growth strategy, the EU Green Deal aims at achieving a circular, climate-neutral and competitive economy by 2050. Its mission is to ensure that Europe exists and develops within the boundaries of the well-being of the planet and contributes towards creating a sustainable future for the coming generations.
By mid-2018, Technical Expert Group (TEG) on sustainable finance was formed by the European Commission for providing recommendations regarding various reforms in the policies. The aim was to ensure that the policies comply with climate targets proposed in the Paris Agreement and the SDGs (Sustainable Development Goals) outlined by the United Nations in their Sustainable Development Agenda 2030.
The EU Taxonomy Regulation went into effect on June 18, 2020, ushering in a new age of sustainable financial regulations.
But what is EU Taxonomy really? What is its purpose? The framework can be highly intimidating for many; however, this article can help grasp the key takeaways of the Taxonomy.
What is EU Taxonomy?
According to the European Commission, EU Taxonomy is a tool which enables businesses, investors, project promoters and issuers undertake the transition toward an economy which is resilient, low-carbon and resource-efficient. It is a central tool for bringing the vision of EU Green Deal into action, especially in terms of funding long-term growth and enabling Europe to become climate resilient.
The Taxonomy is a part of the regulatory classification system that helps businesses determine their environmentally sustainable economic activities. Across a wide range of industries, the EU Taxonomy allows various economic activities’ environmental performance to be defined, in addition to the establishment of criteria that must be met for business activities to be deemed environmentally friendly.
Furthermore, the regulation requires certain businesses to report on their operations to ensure that they are aligned with the definition of sustainability as stated in the Taxonomy. Some may define the EU Taxonomy as the response to ‘What is green?’, helping companies gain greater understanding while implementing sustainable measures.
The EU Taxonomy is a 600-page manual that includes Taxonomy design guidelines as well as information about who is responsible for what and when. Being extremely extensive, the document aims at improving environmental performance. What’s expected to follow is that the EU Taxonomy will place more stringent reporting standards on organisations’ impacted by the law.
What is the purpose of EU Taxonomy?
The EU Taxonomy’s primary purpose is to support businesses, project promoters, and issuers in improving their environmental performance by providing performance thresholds that can be used to determine which initiatives are sustainable and which are not. The EU aims to ensure that money is invested in activities that are truly sustainable, by developing a list of universal rules describing what constitutes a green investment.
Economic activities must significantly contribute to one of the 6 environmental objectives in order to be considered aligned with the Taxonomy. Below are the 6 environmental objectives that are defined in the EU Taxonomy:
- Climate change mitigation: a company’s impact on the environment
- Climate change adaptation: the environment’s impact on a company
- Sustainable use and protection of water and marine resources
- Transition to a circular economy, waste prevention and recycling
- Pollution prevention and control
- Protection of healthy ecosystems
Figure: EU Taxonomy proposal, Source: Bloomberg
The goal is to reduce all emissions by 50% by 2030, in addition to achieving net-zero carbon targets by 2050. In order to meet the climate agreement deadlines, an environment classification system needs to be established.
Why is EU Taxonomy relevant for investors?
Investors can be head – to – head with the regulation by better understanding the EUT’s aims, appropriate ways to use the EU Taxonomy to strengthen competitive positioning, and stress-testing current and proposed products against expected legal enforcement.
Aligning with the goals of the EU Taxonomy
While the SDGs provide a framework that includes shared targets and goals of the sustainability agenda at a macro-level. However, on the other hand, the EU Taxonomy focuses on real world and business activities i.e. at a micro-level. This helps investors delve deeper in their investment portfolio.
Strengthening competitive advantage
The EUT also pertains to those who commercialise financial products in the EU. For example, leaders in the financial sector are beginning to adopt the EU Taxonomy and share case studies which include the best practices through the ‘Principles for Responsible Investment’. However, still in its early days, smart companies will gain exposure and demonstrate leadership by being a part of the group of first move makers. However, it is still early days, smart companies will gain exposure and demonstrate leadership by being amongst the first to lead the market. Furthermore, since the EUT’s ultimate aim is to direct more investments in a sustainable way, it’s an opportunity to generate economic benefit.
An investor’s guide to be ready for EU Taxonomy
The EU has set a high bar for itself in terms of putting the EU Taxonomy into action. As of yet, the following has been proposed for companies to be ready for the EU Taxonomy:
- Financial market participants are expected to carry out the disclosures in accordance with the EUT by the 1st of January 2022, encompassing activities that significantly contribute to the mitigation or adaptation of climate change.
- Technical screening requirements for the outstanding EUT environmental objectives, as created by the EU Platform on Sustainable Finance, will be released by December 31, 2021.
- Companies will be expected to report the percentage of their revenue, investment, and expenses that are aligned with the Taxonomy for two goals: mitigation and adaptation of climate change, beginning in 2022.
Challenges for companies
The Taxonomy’s operations remain unclear as of yet. To date, the most detailed research has been performed on companies whose securities are exchanged on the EURO STOXX 50, CAC 40, and DAX 30 stock exchanges. They are among the businesses that would be required to report in accordance with the Taxonomy. According to a report by Adelphi, in these indices, less than 30% of the turnover qualifies for the Taxonomy. A total of 2% of this group of companies’ turnover tends to be completely compliant with the Taxonomy. Take for example, the automotive industry, which has significant potential to contribute by producing electric cars. While 69% of the automotive industry has the potential, only about 1% can demonstrate that they meet the criteria for substantial contribution and no significant damage.
Companies will need to identify what data will be required, how the data has to be interpreted, as well as, analyze how to report on it in order to keep up with the EU Taxonomy and its thresholds for performance. In practice, the EU Taxonomy entails a more complicated reporting mechanism that necessitates organizations to fully comprehend what they need to do in terms of ESG reporting. Companies must also consider the impact of the new regulations on their marketing as well as their overall investment strategies.
The new EU policies would have a huge effect not only within the EU, but also far beyond. The EU Taxonomy would have an effect on the wider financial regulatory landscape, influencing investment flows and the operations of a variety of financial professions.