Sustainable finance is rapidly becoming an increasingly relevant theme, in particular for financial institutions. However, there is a lack of industry-standard measures on how to grade the overall sustainability of a business or an investment. Therefore, a relevant benchmarking tool is offered by the EU Taxonomy: a unified classification system on what can be considered an environmentally sustainable economic activity.
In this brief overview, part one of two short articles, we go over how an economic activity is tested on 'sustainability' under the EU Taxonomy.
What is the European Taxonomy on Sustainable Finance?
The EU Taxonomy is intended as a toolkit for determining which economic activities are environmentally sustainable. It aims to give clarity to stakeholders across all facets of the financial system as to whether, and how, something contributes to the objective of sustainable growth.
It is expected that financial market participants will be required to complete their first set of disclosures against the Taxonomy, covering activities that substantially contribute to climate change mitigation and/or adaptation, by 31 December 2021.
The broader regulatory framework around sustainability
From a political perspective, the Taxonomy sits within a wider framework called the EU Green Deal which seeks to ensure that the EU is carbon neutral by 2050. The EU Taxonomy encompasses the Commission’s response to the realisation that the trajectory of the economy was not consistent with EU’s obligations as a signatory to the Paris Agreement.
The Commission envisioned the taxonomy in order to give investors in the European market a clear and comparable picture of the investment opportunities that were scientifically proven to be environmentally sustainable, and thus in line with the EU’s obligations under the Paris Agreement.
1. Testing an economic activity on sustainability
The Taxonomy identifies an eligible economic activity in accordance with the so-called NACE industrial classification system. It assesses, by reference to technical performance standards, whether that activity meets certain criteria.
2. Sustainability requirements
In brief, under the Taxonomy, in order to be 'sustainable' an economic activity must meet the following requirements:
(a) it must substantially contribute to at least one of the following six objectives as defined in the Taxonomy Regulation:
- climate change mitigation;
- climate change adaptation;
- sustainable use and protection of water and marine resources;
- transition to a circular economy;
- pollution prevention and control; and
- protection and restoration of biodiversity and ecosystems.
(b) it cannot significantly harm any of the other environmental objectives as defined above (a); and
(c) it must comply with minimum safeguards.
3. Application of the sustainability requirements in practice
Following the EU Taxonomy, an economic activity can substantially contribute to the environmental objective of transitioning to a circular economy in several ways. Some examples are:
- increasing the durability, reparability, upgradability and reusability of products. This can be done by reducing the use of resources through the design and choice of materials, facilitating repurposing, disassembly and deconstruction in the buildings and construction sector;
- transitioning to a circular economy by developing new business models, such as ‘product-as-a-service’ business models and circular value chains, with the aim of keeping products, components and materials at their highest utility and value for as long as possible; or
- transitioning to a circular economy by reducing food waste in the production, processing, manufacturing or distribution of food.
4. Who decides if an economic activity is sustainable?
The EU Commission established a Technical Expert Group (TEG) made up of various experts and stakeholders. The role of the TEG is mainly to create the performance standards, the so-called 'technical screening criteria', which would render an eligible economic activity truly sustainable and thus aligned with the EU Taxonomy.
The TEG has now created technical screening criteria for the first two requirements: the climate change mitigation and the climate change adaptation.
The Commission will also establish a Platform on Sustainable Finance (PSF). The PSF will develop equivalent technical screening criteria for the remaining four environmental requirements: the sustainable use and protection of water and marine resources; the transition to a circular economy; the pollution prevention and control; and the protection and restoration of biodiversity and ecosystems.
In our next article, we go over the application of this Taxonomy in practice and discuss the implications of the EU Taxonomy on the loan market and on market practice and on how the EU Taxonomy is changing financial regulation.