Beyond Compliance: Unlock the Hidden Potential of the EU Taxonomy

The first of January 2022 marked not only a start to a new year but also a start to the long-waited EU Taxonomy Regulation (Taxonomy) entering into force. As part of the EU’s Sustainable Finance Strategy also known as the Action Plan on Financing Sustainable Growth, the Taxonomy is intended to establish a clear definition of which economic activities are considered ‘environmentally sustainable’. The objective of the Taxonomy is to set a clear, standardised definitions and classification of sustainable activities throughout the EU which could help minimise the risk of greenwashing, help companies to better communicate their sustainability credentials to investors and create tools to measure progress towards climate-oriented goals, which ultimately can help reorient capitals towards a more sustainable economy. Check out our previous article to read more about the background of the Taxonomy.

For an economic activity to be recognised as ‘environmentally sustainable’ under the Taxonomy, it has to substantially contribute to one of six environmental objectives (shown in the figure on the next page) including climate change mitigation, climate change adaptation, protection and restoration of biodiversity and ecosystems, while at the same time not significantly harming any of the remaining five objectives and complying with minimum social safeguards.. To prove substantial contributions to one of those objectives while not significantly harming the other five, the economic activity needs to meet technical screening criteria, known as substantial contribution criteria and do no significant harm (DNSH) criteria.

The basis of compliance with Taxonomy disclosure requirements

In addition to the classification system, the Taxonomy Regulation implements reporting mandates for European large companies and financial market participants. In a nutshell, organisations within the scope of the Taxonomy are required to report the extent to which their own business activities are Taxonomy-aligned (and Taxonomyeligible).

The Taxonomy reporting mandate is regulated in Article 5 to 8 of the Taxonomy Regulation, which covers two groups of affected parties: companies subject to Non-Financial Reporting Directive (NFRD) and financial market participants scoped by Sustainable Finance Disclosure Regulation (SFDR). While NFRD companies are required to provide company-level reporting in their non-financial statements, financial market participants under SFDR are required to provide product-level reporting in their financial products’ precontractual disclosures and periodic reports.

Taxonomy disclosure requirements for NFRD companies: This group covers all European large public-interest companies with more than 500 employees. Within this group, companies are further divided into non-financials and financials.

Non-financial companies will need to disclose the proportion of their turnover, capital expenditure, and operational expenditure (if applicable) associated with Taxonomy-aligned and -eligible activities. Meanwhile, reporting KPIs for financial companies vary with different types of financial activities. For instance, the main KPI for credit institutions (banks) is the proportion of total covered assets that are exposed to Taxonomy-aligned and -eligible activities, known as Green Asset Ratio (GAR) while for asset managers, the main KPI is the Green Investment Ratio (GIR) indicating the proportion of investments in Taxonomy-aligned and -eligible activities in the value of all covered assets under management (AUM).

Taxonomy disclosure requirements for financial market participants (SFRD companies): This group covers financial market participants within the scope of the SFDR. The disclosure requirements apply to financial products which claim to contribute to an environmental objective (Article 9 SFDR products) and to those that promote environmental characteristics (Article 8 SFDR products). For Article 9 SFDR products, financial market participants have to disclose which environmental objective(s) the investments underlying the financial products contribute to as well as how and to what extent the investments are in economic activities qualified as environmentally sustainable under the Taxonomy. Meanwhile, Article 8 SFDR products and other financial products that do not contribute nor promote EU environmental objectives should provide a negative declaration statement.

While disclosure timelines for each group differ from one to another, in general, for the first disclosure period (during the course of 2022), companies are required to disclose only Taxonomy-eligibility before being required to disclose full Taxonomyalignment from 2023 onward.

Four ways to go beyond compliance:

While compliance is the key reason for companies and investors to align with the EU Taxonomy, it is predicted that there is also a strong economic case which results from the Taxonomy disclosure and alignment processes. Four potential benefits that organisations can reap from the EU Taxonomy are presented here:

1. Future proof businesses

The WEF Global Risk Report 2022 predicts businesses will face increasing pressure to transition to more sustainable netzero economies. The pressure originates not only from an increasingly stringent regulatory landscape (regulatory/transition risks) but also from the changing physical environment (physical risks) and increasing consumer expectation (market risks). The more exposed businesses are to ‘nonsustainable’ activities, the more vulnerable they are to losing market share and the license to operate.

Evaluating Taxonomy-alignment of a business is essentially one way to assess its exposure to those risks. Knowing how much a company or portfolio is exposed to unsustainable economic activities is the first step (perhaps the most important step) to setting up a future-proof business strategy. Although the current Taxonomy only covers environmentally sustainable activities (“Green” Taxonomy), hence not providing guidance on the identification of exposure to unsustainable activities or those that have social impact, progress has been made in refining the scope of the Taxonomy. The working group of the EU Taxonomy, known as the Platform on Sustainable Finance has published draft reports that, once become effective, will extend the Taxonomy framework to also cover economic activities contributing to social objectives (“Social” Taxonomy) and activities that are significantly harmful to environmental sustainability as well as those which do not have a significant impact on it (“Brown” Taxonomy). With the extended framework, companies will have a significant tool at their disposal to identify exposures to not only sustainable activities but also to the most harmful ones.

2. Impact measurement and management

What gets measured, gets managed. In addition to risk exposure assessments, Taxonomy evaluation will also help businesses to better understand the sustainability impact of their own activities or their portfolio.

By assessing economic activities with the methodology offered by the Taxonomy, businesses can identify their environmental and social performance. Having understood the sustainability performance proxied by the Taxonomy-related metrics will allow companies to set strategic targets for mitigating negative sustainability impact and improving the performance of business.

3. Attract and develop sustainable investments

As originally intended, the Taxonomy and its reporting implications can lead to more sustainable investment opportunities. Nonfinancial companies that report their Taxonomy disclosures and have higher proportions of Taxonomy-eligible and -aligned activities are likely to be favoured by ESG and impact-savvy investment firms. It is observed that numerous asset owners and managers are looking to increase the percentages of Taxonomy-eligibility and -alignment of their portfolio in the near term.

Investment firms can also use this opportunity to create innovative sustainable investment products which are based on Taxonomyalignment. This can look like the use of Taxonomy-alignment criteria in investment selection processes or the creation of Taxonomyaligned funds that are targeting certain sustainable objectives covered by the Taxonomy.

4. Stand out to buyers/customers

The year 2020 saw a significant jump in companies asking their suppliers for environmental transparency according to a report by CDP. More and more companies are expected to assess their suppliers against environmental and social criteria. Although it seems that companies have not started assessing their suppliers against Taxonomy-related criteria, it is very likely that Taxonomy disclosures might be used by companies to inform their procurement decisions in the near future. When they do, suppliers with higher Taxonomy-alignment will therefore be more likely to be preferred by buyers.

What are the next steps?

With the reporting deadline approaching and excitement growing around the opportunities presented by the Taxonomy, one might ask – what are the next steps? Below is a summary of a few things companies and investors could consider doing in order to comply with and leverage the EU Taxonomy.