EU Taxonomy on Sustainable Economic Activities

Over the last year, the EU Commission’s technical expert group (“TEG”) 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 for sustainable economic activities (the “Taxonomy”) and thus form the principle reference point for the EU’s plan to mobilise capital at scale for environmentally sustainable growth.

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 which was published in March 2018. The Action Plan came about 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.

The Taxonomy, by identifying what can be defined as a “green” activity therefore provides a universal standard which will, in due course, be implemented as a regulation in 2019 differentiating it from the numerous other voluntary standards which are currently available e.g. the Green Loan Principles and the Climate Bonds Initiative.

The EU has also advanced on other 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 key structural areas for the markets. While environmentally responsible corporate governance has been driven by market demand and board level initiatives to date, these legislative proposals signal that the regulators are catching up with, and formalising, corporate best practice.

Background

Over the last year, the EU Commission’s technical expert group (“TEG”) 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 for sustainable economic activities (the “Taxonomy”) and thus form the principle reference point for the EU’s plan to mobilise capital at scale for environmentally sustainable growth.

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 which was published in March 2018. The Action Plan came about 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.

The Taxonomy, by identifying what can be defined as a “green” activity therefore provides a universal standard which will, in due course, be implemented as a regulation in 2019 differentiating it from the numerous other voluntary standards which are currently available e.g. the Green Loan Principles and the Climate Bonds Initiative.

The EU has also advanced on other 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 key structural areas for the markets. While environmentally responsible corporate governance has been driven by market demand and board level initiatives to date, these legislative proposals signal that the regulators are catching up with, and formalising, corporate best practice.

The Audience

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 “offering financial products as environmentally sustainable investments”. TEG also hoped that the Taxonomy will be used voluntarily by other financial players such as banks where they are marketing products such as green loans, mortgages and bank accounts.

Why is it relevant?

The Taxonomy seeks to create an international standard against which financial products self-identifying as “green” are measured. Financial market participants going to market with green products within the EU will be required to disclose whether those products are “Taxonomy compliant” green products and/or the percentage of the product which meets the criteria. There is no obligation to otherwise comply with the Taxonomy however the underlying intention (which may eventually be enshrined in law) seems to be that non-compliant products currently labelled as green 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. Implicit within this is the identification of those activities which are not considered to be environmentally sustainable and there is speculation as to whether that negative classification might be used for future supervisory measures.

Taxonomy Framework

Economic Activities

In selecting relevant economic activities, the TEG adhered to the NACE industrial economic activity to identify those activities which either are, or can, achieve net-zero emissions by 2050 (and 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.

Four Taxonomy Criteria

In order 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

The proposed economic activity must fall within one of the six environmental policy objectives of the proposal (the first two of which are addressed in this version of the Taxonomy ):

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

A “substantial contribution” to the mitigation objective will “avoid or reduce greenhouse gas emissions or enhance 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. 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 tend to be more location and context specific and as such are determined by reference to current climate projections as well as technical screening criteria.

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

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. This will be analysed by reference to wider sectoral, regional laws or initiatives in the environmental space. Where evidence is inconclusive on whether the DNSH criteria has been met, the Taxonomy provides that the 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 .

3. Comply with the minimum social safeguards

Social well-being is also another key 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 requires the “minimum social safeguards” provided for by the International Labour Organisation’s core directives.

4. Comply with the technical screening data

The TEG has created technical screening data for each of the specified economic activities in 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.

Impact on Finance

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 for example, a reduced capital ratio requirement (a “Green Supporting Factor”).

The financing, revenues and expenditures relating to activities which are either (a) low carbon or transitioning to zero net emissions by 2050 or (b) enable other activities to achieve emissions reductions will be “Taxonomy eligible”. Eligible activities would attract the Green Supporting Factor. In order to qualify however, the activity must be properly identified. 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 not necessarily expenditure on the building itself unless it satisfied the technical screening data for real estate.

Conclusion

The TEG envisages that the Taxonomy will be a “dynamic, flexible tool” responding to feedback, technology and market changes. Only time will tell how successful the Taxonomy will be in achieving its goal of re-directing investment to sustainable economic activities however it does seem that the introduction of a Green Supporting Factor could be key to its effectiveness.