The EU Taxonomy Regulation: application & implications

In our quickscan on the EU Taxonomy Regulation, our first brief article on this subject, we looked at how an economic activity is tested on 'sustainability' under the Taxonomy and on the application of the Taxonomy in practice. In this article we continue looking at the application and implications of the Taxonomy on the loan market and on market practice and on how the Taxonomy is changing financial regulation.

The application of the Taxonomy and how it is intended to work in practice

EU Member States, financial market participants and companies and firms will be subject to the requirements of the EU Taxonomy.

Financial Market Participants

The Taxonomy Regulation applies to financial market participants who offer financial products in the European market. Qualifying Financial Market Participants will be required to provide prospectuses, periodic reports, annual reports, marketing documentation and websites on:

(a) how and to what extent they have used the EU Taxonomy in determining the sustainability of the underlying investments;

(b) to what environmental objective(s) the investments contribute; and

(c) the proportion of the underlying investments that are taxonomy-aligned. This proportion must be expressed as a percentage of the fund and must specify both the enabling activities as well as the transition activities.

Companies and firms

The Taxonomy Regulation also applies to companies and firms within the scope of the Non-Financial Reporting Directive (EU Directive 2014/95/EU). The Non-Financial Reporting Directive enhances the transparency of the social and environmental information provided by undertakings in all sectors. 

Qualifying entities will be required to include an analysis of the alignment of their activities with the Taxonomy in their annual non-financial corporate reporting. This reporting will have to include a description of how, and to what extent, their activities are associated with Taxonomy-aligned activities by reference to:

(a) the proportion of turnover aligned with the EU Taxonomy;

(b) capex; and

(c) if relevant, opex aligned with the EU Taxonomy.

The implications of the EU-Taxonomy

In practice, a company that wants a certain economic activity to be 'sustainable', first has to consult the relevant article of the EU Taxonomy Regulation. It will then be able to determine what constitutes (i) a substantial contribution to climate change adaptation and (ii) a possible significant harm to the other relevant EU environmental objectives. 

The criteria for establishing what constitutes a 'substantial contribution to climate change adaptation' are context-specific and will be assessed on a case-by-case basis. In addition, the company will undertake an impact assessment to ensure that the measures to be implemented are consistent with local and regional adaptation efforts. 

On the basis of the assessments carried-out, the company will then establish the cost of the envisaged 'sustainable' economic activity. 

Reporting

In relation to reporting, currently the LMA applies the Green Loan Principles or the Sustainability Linked Loan Principles. Compared to the EU Taxonomy, both sets of LMA principles are relatively light on obligations to provide information and leave this up to the parties to negotiate. This is understandable for a voluntary initiative. 

As a result of the disclosure regulations, a significant part of the financial industry will need to start gathering data on green assets within their portfolios. Whilst there will be increased back-office requirements to manage this, these information requirements will also land on the companies and borrowers that own or operate the underlying assets. 

Market practice

As financial institutions are required to report on their compliance with the EU Taxonomy, they are likely to want to bring certain assets into line with the Taxonomy requirements. We therefore expect to see the EU Taxonomy and the Disclosure Regulations increasingly impacting on market practice.

Also, banks are increasingly advancing green loans and withdrawing from markets which have an adverse effect on the environment. 

The EU-Taxonomy could provide a common market standard method of evidencing that institutions have met these objectives and obviate 'greenwashing' accusations. Indeed, the ultimate goal of the EU Taxonomy is to render it unacceptable to call something 'green' if it does not meet with its conditions.

How the implementation of the EU Taxonomy is changing financial regulation

In terms of regulation, it seems that the EU Taxonomy is gaining traction beyond regulators in Europe. Many central banks are already working on regulation that treats climate change as a systemic risk to financial systems.

This means that corporate governance regulations, rating agencies, banks, insurance companies and asset managers and their advisers will also have to integrate the Taxonomy into their analysis frameworks. In terms of business, prompted by and despite recent events, business leaders across the board continue to make commitments to more sustainable business practices.

While the implementation of the EU Taxonomy helps eliminating the confusion in the market as to exactly what is 'green', there remain a number of other questions to be addressed by governments, regulators and the financial sector relating to the value and treatment of green or sustainable lending in order to achieve the Taxonomy’s ultimate goal of facilitating the transition of our present economy into a carbon neutral one.

Tips: how to get ready for managing sustainable economic activities under the EU Taxonomy

1. Timely produce and have available the required information and data on your economic activities;
2. Timely analyze your economic activities, products and services in terms of the sustainability requirements under the EU Taxonomy;
3. Develop a recording system for recording the outcomes of the analysis under (2);
4. Align your communications, prospectuses, periodic reports, annual reports, marketing documentation and website in order to include the relevant information on your sustainability policy and sustainable activities; and 
5. Align your general policies, including internal policies such as sustainable investment, human resources and diversity policies.