Our Services
What we’re all about

Tell us how we can deliver content that’s right for you.

Commercial Real Estate
Financial Services
Hotel & Leisure
Professional Services
Retail & Manufacturing
Technology & Telecoms
*This selection will make changes across the site
cancel
Confirm Selection

Demystifying the EU Taxonomy Regulation

By Alison Mungall
15th June 2020

Introduction

There has been a lot of talk recently about the proposed EU Taxonomy, and some concern about compliance deadlines. It’s a complicated topic, so I hope this summary will be useful.

This paper has been organised into the following sections:

  • Policy background
  • What about the UK?
  • What is the obligation?
  • Who will be affected?
  • The Taxonomy Technical Report: What does it cover?
  • When will the EU Taxonomy Regulation come into force?
  • Timeline for disclosure
  • Implementing the EU Taxonomy: Five step approach
  • How will data be provided?
  • Conclusion

 

Policy background

In December 2019, the European Council and the European Parliament reached political agreement on the text of the proposed Regulation on the Establishment of a Framework to Facilitate Sustainable Investment, theTaxonomy Regulation“. This regulation will establish an EU-wide classification system (or taxonomy) intended to provide firms and investors with a common framework for identifying to what degree economic activities can be considered to be “environmentally sustainable”. Together with the regulation on sustainability‐related disclosure in the financial services sector, the Disclosure Regulation (Regulation 2019/2088) and the Taxonomy Regulation will require the financial sector to disclose the degree of environmental sustainability of funds and pension products that are promoted as environmentally friendly, or to include disclaimers where they do not. Also, firms which are subject to the Non-Financial Reporting Directive will have to provide certain information in relation to the Taxonomy Regulation in their filings.

 

The EU Technical Expert Group on Sustainable Finance (TEG) completed the Taxonomy Technical Report  in June 2019. This report provides an implementation tool that can enable capital markets to identify and respond to investment opportunities that contribute to environmental policy objectives. It presents a list of industrial sectors and environmental objectives which can make a “substantial contribution” to climate change mitigation and the criteria to “do no significant harm” to other environmental objectives. It also presents a framework for evaluating substantial contribution to climate change adaptation. The mandate of TEG has been extended to 30 September 2020 to complete technical reporting and to provide further advice to the Commission.

The EU Taxonomy can also be used on a voluntary basis by companies within and outside the EU, treating the criteria as a benchmark to compare local activities to EU environmental standards.

 

What about the UK?

The position of the UK is currently unclear. The Disclosure Regulation was made in November 2019, when the UK was a member state of the EU. Many British financial institutions have subsidiaries domiciled in the EU and offer financial products internationally. It would therefore make sense for UK financial institutions to use the EU Taxonomy, whether or not bound by the Disclosure Regulation.

 

What is the obligation?

Financial products offered in the European Union will be required to make reference to the EU Taxonomy. The requirement differs depending on the type of fund, as defined in the Disclosure Regulation on sustainability-related disclosures in the financial sector. Products that have sustainable investment as their objective (Article 9 products) or which promote environmental characteristics, either alone or in combination with other objectives (Article 8 products), will have to disclose:

  • How and to what extent they have used the taxonomy in determining the sustainability of the underlying investments;
  • To what environmental objective(s) the investments contribute; and
  • The proportion of underlying investments that are taxonomy eligible.

All other products can disclose against the taxonomy or carry a disclaimer that “the investment(s) underlying this financial product do not take into account the EU criteria for environmentally sustainable investments”.

 

The legal obligations can be summarised as follows:

 

table for blog

 

Large companies which are already required to provide a Non-Financial Statement under the Non-Financial Reporting Directive will also be required to disclose how and to what extent their activities are aligned with the EU Taxonomy.

 

Who will be affected?

The proposed Taxonomy regulation envisages three main mandatory users of the Taxonomy:

  1. Financial market participants offering financial products as environmentally sustainable investments. Financial market participants (as defined in the Disclosure Regulation, and including most insurance, pension and portfolio management providers) will be required to provide in pre-contractual disclosures and periodic reports information on how and to what extent the investments that underlie their “financial products” support economic activities that meet the criteria for environmental sustainability under the Taxonomy Regulation.

 

Under this definition, ‘financial market participants’ comprise any of the following:

  • An insurance undertaking which makes available an insurance-based investment product (IBIP)
  • An alternative investment fund manager (AIFM)
  • An investment firm which provides portfolio management
  • An institution for occupational retirement provision (IORP) or a provider of a pension product
  • A manager of a qualifying venture capital fund
  • A manager of a qualifying social entrepreneurship fund
  • A UCITS (Undertaking for Collective Investment in Transferable Securities)management company

 

‘Financial products’ may mean:

  • Portfolio management
  • UCITS funds
  • Alternative investment funds
  • Insurance-based Investment Products (IBIP)
  • Pension products
  • Pension schemes
  1. Financial and non-financial companies falling under the scope of the Non-Financial Reporting Directive. Firms in scope of the Non-Financial Reporting Directive will need to disclose information on how and to what extent the undertaking’s activities are associated with environmentally sustainable economic activities. The Commission will publish the detailed reporting requirements by 1 June 2021.
  2. Member States and the EU, when they adopt measures or set requirements in respect to financial products or corporate bonds marketed as environmentally sustainable.

 

The Taxonomy Technical Report: What does it cover?

The Taxonomy Regulation provides a framework for the development of an EU-wide classification system for environmentally sustainable economic activities. The Taxonomy Technical Report, published in June 2019, provides a list of economic activities with the performance criteria for their contribution to six environmental objectives.

 

To be included in the EU Taxonomy, an economic activity must contribute substantially to at least one environmental objective and do no significant harm to the other five, as well as meet minimum social safeguards. Technical screening criteria are set out in the report for “determining Substantial Contribution” and “Doing No Significant Harm” (DNSH).

 

The NACE industrial classification system of economic activities has been adopted by the TEG as it was established by EU law, and is largely compatible with international and Member State frameworks.

The framework sets out the criteria to be considered for a product or activity to be considered environmentally sustainable. The detail of what constitutes an environmentally sustainable activity or product will be built up gradually over time through delegated legislation.

The 6 environmental objectives used to assess whether activities qualify as environmentally sustainable activities are as follows:

 

  1. Climate change mitigation: the activity contributes to greenhouse gas stabilisation consistent with the goals of the Paris Agreement, through certain prescribed means, for example including the generation of renewable energy.

 

  1. Climate change adaptation: the activity includes adaptation solutions that substantially reduce the adverse impact (or the risk thereof) of the current and future climate, on either (i) other people, nature or assets or (ii) the economic activity itself, in each case without increasing the risk of an adverse impact on other people, nature and assets.

 

  1. Sustainable use and protection of water and marine resources: the activity substantially contributes to achieving the protection of water bodies or marine resources through certain prescribed means, including, for example, through waste water management.

 

  1. Transition to a circular economy: the economic activity contributes substantially to waste prevention, re-use and recycling, through certain prescribed means, including, for example, by improving the recyclability of certain products.

 

  1. Pollution prevention and control: the activity contributes substantially to pollution prevention and control through certain prescribed means, including, for example, by preventing or (where that is not practicable) reducing pollutant emissions into air, water or land (other than greenhouse gases).

 

  1. Protection and restoration of biodiversity and ecosystems: the activity contributes substantially to protecting, conserving or restoring biodiversity and to achieving the good condition of ecosystems through certain prescribed means, including, for example, sustainable land use and management.

 

No significant harm: The activity must not significantly harm any of the environmental objectives above. For example, an activity that leads to significant greenhouse gas emissions harms the climate change mitigation objective.

 

Comply with technical screening criteria: The activity must comply with technical screening criteria for each of the six objectives. This will be based on the technical input of a multi-stakeholder Platform on Sustainable Finance (described below). The detailed screening criteria will be updated regularly in recognition of the fast-changing nature of both science and technology, and will set out in detail the conditions to be met for an activity to constitute a substantial contribution towards one of the six objectives or that the particular activity is not resulting in significant harm.

 

When will the EU taxonomy regulation come into force?

The requirements relating to the climate-related objectives of the Taxonomy Regulation are due to apply from December 2021, with other requirements due to apply at the end of the following year:

table 2

 

What is the timeline for disclosure?

The first disclosures will be for the climate change mitigation and adaptation objectives for the designated economic sectors. There will be disclosed from December 2021. From December 2022, all 6 environmental objectives will be reported:

December 2020 –> 1st Technical Screening Criteria published: Climate Change Mitigation and Adaption

December 2021 –> 1st disclosures required: Climate change Mitigation and Adaption, 2nd set of Technical Screening Criteria published: Other Environmental Objectives

December 2022 –> Disclosure required on all environmental objectives

 

Implementing the EU Taxonomy: Five step approach

The implementation of the EU Taxonomy requires financial actors (that might delegate it to their data providers or other third parties) to conduct a five-step check process:

  1. Identify the activities conducted by the company or issuer or those covered by the financial product (e.g. projects, use of proceeds) that could be eligible.
  2. For each potentially eligible activity, verify whether the company or issuer meets the relevant screening criteria. TEG defines thresholds for the eligibility of activities according to metrics such as carbon (gCO2/kWh).
  3. Verify that the DNSH criteria are being met by the issuer. Investors using the Taxonomy would most likely use a due diligence like process for reviewing the performance of underlying investees and would rely on the legal disclosures of eligibility from those investees.
  4. Conduct due diligence to avoid any violation to the social minimum safeguards stipulated in the Taxonomy regulation Article 13.
  5. Calculate alignment of investments with the Taxonomy and prepare disclosures at the investment product level.

 

The objective of this process is to identify the proportion of the underlying assets that is eligible under the Taxonomy criteria. If an activity is eligible, the investor could determine the percentage of revenues or expenditures per investment.

 

The overall percentage of Taxonomy alignment will be determined by the portfolio asset value invested in Taxonomy-eligible activities. That percentage could be calculated as the weighted sum of the percentage of revenues generated by Taxonomy-eligible activities per company in the fund, in the case of equities or corporate bonds. For loans or project financing, the percentage will be determined by the expenditures made in those activities.

 

How will data be provided?

In the absence of a universally accepted taxonomy, service providers have developed their own data models or taxonomies. An example identified in the Taxonomy Technical Report is CDP. Currently, company-reported information is extracted from many sources, such as financial filings, annual reports, sustainability reports and company websites. The data is then pulled through to trading systems, portfolio management tools, risk management systems and reporting done by financial institutions. Where reported information is missing, modelled information fills the gaps through estimated data points and industry comparisons.

For the EU Taxonomy to be used successfully, the proprietary data models used by data providers need to be updated and synchronised. TEG recognised that data providers will play an important role by standardising information from different sources and jurisdictions, to provide financial institutions with comparable global datasets for capital allocation.

 

How will the technical details be developed?

The proposed Taxonomy Regulation is the first stage. In future, delegated acts (legally binding acts that enable the Commission to supplement or amend non‑essential parts of EU legislative acts) will be used to develop the EU Taxonomy.

The technical screening criteria and other elements of the delegated acts will be made by the Commission on the basis of recommendations of a new body to be established under the Taxonomy Regulation: the Platform on Sustainable Finance (the “Platform”). The Platform will be composed of experts from the European Environmental Agency, the European Supervisory Authorities, the European Investment Bank and the European Union Agency for Fundamental Rights, together with private sector experts including from financial markets, business and experts representing civil society, including those with expertise in the field of environmental, social, labour and governance issues.

 

What about social and other objectives?

The Taxonomy Regulation is expected to develop over time, both in terms of the detail of the technical requirements, but also in terms of the scope of its coverage. For example, by December 2021, the Commission is obliged to publish a report describing the potential for the further development of the current taxonomy and expansion of its scope beyond environmentally sustainable economic activities, to include social objectives.

 

Conclusion

In summary, the objective of the EU Taxonomy is to enable investors to identify:

  1. The percentage of holdings relating to companies carrying out environmentally sustainable economic activities, and
  2. The share of the investment funding environmentally sustainable economic activities, as a percentage of all economic activities.

 

Importantly, the EU Taxonomy is not mandatory for investment decisions. Instead, for each relevant product, investors will disclose the proportion of investment funding for taxonomy-eligible activities. Under this regulation, financial market participants who offer a fund which targets sustainability objectives in the EU must disclose what these objectives are and the methodologies used, as well as provide an assessment of the overall sustainability-related impact of the financial product.

 

 

References:

  • REGULATION (EU) 2019/2088 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 27 November 2019 on sustainability‐related disclosures in the financial services sector
  • Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the establishment of a framework to facilitate sustainable investment – Approval of the final compromise text 17/12/19
  • EU Technical Expert Group on Sustainable Finance: Taxonomy Technical Report June 2019
  • EU Commission Press release 18 June 2019: Sustainable finance: Commission publishes guidelines to improve how firms report climate-related information and welcomes three new important reports on climate finance by leading experts
  • MSCI: ESG Research on EU Taxonomy Alignment in company and portfolio assessment
  • PRI: EU Taxonomy political agreement flash briefing
  • PRI All staff briefing – translating global challenges into investment tools
  • Ashurst: Agreement reached on the final text of the EU Taxonomy 7 January 2020