EU taxonomy: Steering capital flows towards a sustainable future for Europe

Last month a group of experts representing a range of European financial services sectors, international organisations and civil society published their recommendations for an EU taxonomy for sustainable economic activities.

This article explores the background and mechanics of the taxonomy and its intended effect on the European financial markets.

Over the last year, the EU's technical expert group (TEG) on the taxonomy has developed technical screening criteria with the aim of identifying sustainable economic activities which will enable the EU to meet its greenhouse emissions and carbon reduction commitments and promote economic transition towards these policy goals. These recommendations form the framework for the development of a common language, or "taxonomy", for sustainable economic activities and thus form the principle reference point for the EU's plan to mobilise capital at scale for environmentally sustainable growth.

To put TEG's work into context, the taxonomy is a roadmap for integrating sustainability into the financial system and arguably the cornerstone of the EU Commission's Action Plan: Financing Sustainable Growth.

Paris Agreement

The action plan came about broadly as a result of the EU's pledge, in the context of the Paris Agreement, to reduce greenhouse gas emissions in all sectors by 40% by 2030 and the long-term proposal to achieve carbon neutrality by 2050. To meet that target, an estimated 175-290 billion euros per annum in additional investment in sectors such as green energy and low carbon transportation will be necessary. The taxonomy, by identifying what can be seen as a "green" activity therefore provides a universal standard around which investment decisions can be made.

This standard will, in due course, be implemented as a regulation differentiating it from the numerous other voluntary standards which are arguably less comprehensive in any case. The framework proposal discussed below is now open for comments and will be finalised at the end of 2019. It is expected that the EU Commission will then put the taxonomy into law.

Allied initiatives

The EU published its ambitious action plan in March 2018 and has progressed since that time with numerous legislative and policy proposals in the fields of corporate sustainability disclosures (the Non-Financial Reporting Directive (adopted in April 2019)), benchmarking, green bonds (the EU green bond standard) and other important structural areas for the markets.

Who is the taxonomy for?

The proposed users of the taxonomy are on one side (a) member states and the EU where legislating in relation to "financial products or corporate bonds marketed as environmentally sustainable" and (b) financial market participants (this definition covers both insurers and specified fund managers), "offering financial products (these include portfolio management, UCITS funds and pension projects/schemes) as environmentally sustainable investments". In addition, it is hoped that the taxonomy will be used voluntarily by other financial players such as banks where they are marketing products as green e.g. green loans.

The overall desired result across the market would be that accusations of "greenwashing" might be more easily made and/or defended using the Taxonomy as the test.

It is also hoped that the taxonomy will be used outside the EU and as such the four taxonomy conditions (see below) are to be applied in a wide sense notwithstanding that they are underpinned by EU law and standards.

Why is the taxonomy relevant?

It is important to note that the taxonomy itself does not impose any positive obligation to invest in "green" assets but rather it seeks to create an international standard against which financial products self-identifying as green are measured. Financial institutions and asset managers going to market with green products within the EU will therefore be required to disclose whether those products are "taxonomy compliant" green products and/or the percentage of the product which meets the criteria.

They will not be required to remove the products from the market if they do not comply though the underlying intention (which may eventually be enshrined in law) seems to be that non-compliant "green" products are otherwise re-labelled and marketed.

In this sense the taxonomy seeks to create consistency and transparency in the market and a benchmark to allow investors to make well-informed decisions. An implicit by-product of the taxonomy is that, by exclusion, it identifies those activities which are not considered to be environmentally sustainable which again may have an indirect effect on investment choices and dialogue.

Possible future preferential treatment for green activities - a green supporting factor

The redirection of capital away from non-compliant activities towards taxonomy compliant ones is the ultimate goal of the EU Commission and to facilitate this, it is anticipated that in the near future EU banking regulation will be revised to provide investments into taxonomy compliant products with some form of preferential treatment.

Indeed, much of the buzz surrounding the taxonomy has arisen because it is the foundation upon which a so-called "green supporting factor" e.g. for example, a reduced capital ratio requirement for taxonomy compliant investments could be based. The clear rationale being that market participants are likely to pay more attention to the nature of their investments where being "encouraged" to do so by way of reduced costs.

Taxonomy framework

Economic activities

In order to identify economic activities, the TEG adhered to the NACE industrial classification system which is already in use and was thought to cover the majority of EU economic sectors. Using this classification system, the TEG identified those activities (of out of a total 615 classes of economic activity) which either are or can achieve net-zero emissions by 2050 (and those activities which will support this transition).

These activities and six "macro-sectors" identified as high carbon or emission producing sectors which have the "potential to contribute substantially to climate change mitigation" were prioritised within the taxonomy framework using the Eurostat 2016 emissions inventory. (In summary these are (1) Agriculture, forestry and fishing, (2) Electricity, gas, steam and air conditioning, (3) ICT, (5) Financial services and insurance, (5) professional, scientific and technical activities, and (6) water supply, sewerage, waste management and remediation activities. Each of these sectors was seen as being "vulnerable to the negative effects of climate change".)

Four taxonomy criteria

To be an "environmentally sustainable economic activity" the proposed activity must meet the following four criteria:

1. Contribute substantially to one or more of six environmental objectives;
2. Do no significant harm to any other environmental objective;
3. Comply with the minimum social safeguards;
4. Comply with the technical screening data.

1. Contribute substantially to the EU's six environmental policy objectives

To be eligible for the taxonomy framework the proposed economic activity must fall within one of the six environmental policy objectives of the proposal, known as the six principles (the first two of which are addressed in this version of the taxonomy (it is anticipated that the other four principles will be expounded in future versions):

1. Climate change mitigation;
2. Climate change adaptation;
3. Sustainable use of protection of water and marine resources;
4. Transition to a circular economy, waste prevention and recycling;
5. Pollution prevention and control;
6. Protection of healthy ecosystems.

The proposed economic activity will make a substantial contribution to the mitigation objective where it is avoids or reduces "greenhouse gas emissions or enhancing greenhouse gas removals". This can be achieved through a number of means including, but not limited to, improving energy efficiency, phasing out anthropogenic emissions and increasing clean or climate neutral mobility. These economic activities e.g. retrofitting, renewable energy and electric vehicles, are likely to be the most familiar and accessible to consumers and investors alike and we will focus more on mitigation activities in this article for this reason.

The adaptation objective relates to substantially "reducing the negative effects of the current and expected future climate or preventing an increase or shifting of the negative effects of climate change". These initiatives will be more location and context specific and as such are determined by reference to current climate projections and screening criteria for each activity set out in the taxonomy.

• Taxonomy-eligible financing

It is recognised that eligible mitigation activities may either (a) be low carbon or transitioning to zero net emissions by 2050 or (b) enable other activities to achieve emissions reductions.

The financing, revenues and expenditures relating to both classes of activities will be "taxonomy eligible"; however proper consideration must be given to which economic activity is to benefit. The example given in the proposal is the installation of a highly efficient boiler into a building. In this case, the expenditure on the boiler would be eligible but that would not necessarily make the building itself a taxonomy compliant asset and other performance factors would have to considered in the light of the real estate technical screening data to make that judgement.

2. Do no significant harm to any other environmental objective (DNSH)

If the proposed economic activity falls within the climate change mitigation or adaptation environmental objectives, it must also not cause significant harm to another of the other five environmental objectives. The taxonomy provides guidance as to what this means in each case. Broadly this requirement ensures that no eligible activity cuts across the other objectives or wider sectoral, regional laws or initiatives in the environmental space.

Where evidence is not conclusive on whether the DNSH criteria has been met, the taxonomy provides that a precautionary principle applies with the result that the activity is unlikely to be deemed to be sustainable until it can be proved scientifically not to cause harm. (1998 "Wingspread statement states when an activity raises threats of harm to human health or the environment, precautionary measures should be taken even if some cause and effect relationships are not fully established scientifically".

The EU Commission has its own guidance on how this principle should be applied however the inclusion of this principle underlines the EU's desire to take a holistic approach in its rulemaking in this arena.)

3. Minimum social safeguards

Social well-being is also another main component of sustainability from the perspective that non-observance of positive practices in this arena can give rise to risks at all levels of society. Many investors are already taking this into account using ESG (environmental, social and governance) risk assessment processes. At this time the taxonomy sets out "minimum social safeguards" in line with the International Labour Organisation's core directives which must be observed.

4. Technical screening data

The TEG created technical screening data for each of the classified economic activities meeting the above three conditions.

These proposals are designed to, among other things:

• In the case of mitigation, set criteria for activities presently capable of being low carbon, zero carbon or net negative in terms of their emissions where activities are yet to transition to low carbon status, shorter term criteria is provided although these activities are ideally not to be prioritised.
• Provide both qualitative and quantitative thresholds:
  • Broadly use existing EU standards where appropriate
  • Consider the full life cycle of the activity e.g. the impact of supply chains
  • Take the level of emissions produced by the activity into account.
• Mitigation technical screening criteria were developed for each of the following sectors:
  • Agriculture, forestry and fishing
  • Manufacturing
  • Electricity, gas, steam and air conditioning
  • Water, sewerage, waste and remediation
  • Transportation and storage
  • ICT
  • Construction and real estate activities.

Conclusion

The TEG envisages that the taxonomy will be a "dynamic, flexible tool" responding to feedback, technology and market changes. Activities which contribute to the remaining four environmental objectives are expected to be covered in future versions of the taxonomy.

Once the six environmental policy goals of the EU have been addressed by TEG the expectation is that "phase two" will see the creation of a taxonomy of socially sustainable economic activities. Obviously, political will, will play a key role in the nature and speed of these developments.

There are many challenges to the acceptance of the taxonomy. One of these is a lack of data which is currently not being collated on a scale that makes the screening processes easy to apply. Another issue is arguably a lack of professionals equipped to make the analysis required by the taxonomy. There are many other "sustainability codes" which have already been adopted by institutions and significant effort will be required to bring processes into line with the taxonomy.

The TEG reports that between 1980-2017, known direct economic losses "caused by weather and climate-related extremes in the EU" exceeded 453 billion euros. Essentially the taxonomy is the EU Commission's response to these losses which are expected to increase and exceed the costs required to modify the EU economy into a sustainable one.

It will take time to see how successful the taxonomy is in achieving its goal of attracting investment to sustainable economic activities though it does seem the implementation of a green supporting factor could be key in its effectiveness.

First published on Thomson Reuters Regulatory Intelligence on 23 July 2019