The impacts of the climate crisis are already being felt globally, and we must drive for a just transition to achieve a climate-neutral world. When it comes to achieving a sustainable and environmentally-friendly economy, one sector that has an essential role to play is the financial sector. The European Union has responded to this challenge and has committed to achieving climate neutrality by 2050.
They have also established the European Green Deal, which is a system of guidelines and rules which will help us ensure a green transition. With the European Green Deal, the EU Action Plan on Sustainable Finance was also created. This will assist in financing the green transition and create more funds to flow from investors into environmentally sustainable projects, businesses, and assets.
The EU Taxonomy is a document of more than 550 pages, and it plays an essential part in this. However, due to its length, it can be challenging to understand fully. This is why we are going to explain everything there is to know about it.
The EU Green Taxonomy explained
The reason it was created was to address a deceitful practice which is becoming increasingly common as consumers begin to care more and more about sustainability.
That practice is greenwashing, which is where a brand makes false claims about its sustainability efforts. The EU Green Taxonomy allows consumers to identify environmentally sustainable products and services with greater confidence. In saying that, the Taxonomy is also linked to some disclosure obligations on financial market participants and businesses.
Moreover, the Taxonomy has a crucial role to play in assisting the EU with scaling up sustainable investment and implementing the European Green Deal. It offers policymakers, companies, and investors to understand what economic activities are sustainable. Therefore, the EU Green Taxonomy establishes protection for private investors from greenwashing and security for investors.
However, it also assists businesses in becoming more climate-resilient, shifting investments where they are most needed, and mitigating market fragmentation. The Taxonomy Regulation was published on the 22nd of June 2020 in the Office Journal of the European Union and came into force on the 12th of July 2020. Put simply; it is a screening tool that enables us to support investment flows into activities that are environmentally sustainable.
As mentioned previously, the Taxonomy defines whether economic activities are sustainable. They based this on two sets of criteria. The activity must contribute to a minimum of one of the six Taxonomy objectives for one. Secondly, the activity must do no significant harm to any of the other objectives. Simultaneously, the activity must respect labour standards and basic human rights.
Why do we need the EU Green Taxonomy?
If we are to achieve the EU’s climate and energy targets for 2030 and meet the goals outlined within the European Green Deal, we must direct investments towards sustainable activities and projects.
We need a clear definition of what is ‘sustainable’ and an action plan for financing sustainable growth. However, with this, a classification system is also required. Hence, the EU Green Taxonomy to determine and classify sustainable economic activities.
The six objectives of the Taxonomy
The Taxonomy Regulation was published on the 22nd of June, 2020, in the Official Journal of the European Union. It went into force on the 12th of July, 2020. The Taxonomy establishes the basis for the EU Taxonomy by outlining the four overarching conditions that an economic activity must meet to qualify as sustainable.
Environmentally sustainable or green economic activities are considered to be those that make a substantial contribution to at least one of the EU’s climate goals. Additionally, while not causing harm to any of the objectives and meeting the minimum social safeguards. It’s all about encouraging green business and responsible business that does not pose threats to the health of our planet or the people living on it.
The six objectives of the EU Green Taxonomy include the following:
- Climate change mitigation
- Climate change adaptation
- Sustainable use and protection of water and marine resources
- Transition to a circular economy
- Pollution prevention and control
- Protection and restoration of biodiversity and ecosystems
The requirements and guidelines for what is considered sustainable economic activity fall under the first two goals of the EU Green Taxonomy primarily: climate change adaptation and mitigation. They were the first to be released due to the urgency to act and curb carbon emissions by the 2030 timeline.
Technical Screening Criteria (TSC) define the specific thresholds and requirements for an economic activity to be deemed to contribute to a sustainability aim. These TSCs are being elaborated in Delegated Acts (DAs), a secondary legislation.
For activities that pursue one or more of the six objectives of the taxonomy to be deemed sustainable, they cannot have a negative effect on any of the other objectives within the taxonomy. The TSC must lay out thresholds for each activity to determine compliance with regard to Do No Significant Harm (DNSH).
Moreover, the taxonomy also defines two classification categories to determine activities that substantially contribute to one or more sustainable goals. These include enabling activities and transactional activities. The classification enables activities which may not be considered sustainable to the overall goal of promoting sustainability.
Enabling activities allows other activities to have a substantial contribution to one or more of the six objectives within the taxonomy. In saying that, they cannot result in a ‘lock-in’ of assets which would undermine the long-term environmental objectives of the activity. What’s more, the activity must have a substantial positive environmental impact over its lifecycle.
Transitional activities, by contrast, have to contribute to climate change mitigation and a course to keep in line with the commitments outlined in the Paris Agreement. Transitional activities only qualify when a number of criteria are met. These include ensuring greenhouse gas emission levels correspond to the best performance in the industry or sector. Additionally, that there are no economically or technologically feasible low-carbon alternatives. Finally, that the activity will not result in carbon lock-in.
For the most part, the taxonomy can be considered a classification instrument. However, it does have other functions. For instance, certain entities must share information regarding to what degree their activities align with the goals within the taxonomy. How is this achieved? Through amending the disclosure requirements in the EU’s Sustainable Finance Disclosure Regulation (SFDR) and the EU’s Non-Financial Reporting Directive (NFRD).
SFDR-scoped entities must disclose information on the Taxonomy-alignment of their services and products. The disclosure details products which have sustainable investment as their aim and for those with social or environmental characteristics. Any undertaking subject to the NFRD also must disclose how and to what extent their activities are aligned with activities that are deemed to be sustainable. They will have to disclose the proportion of their capital expenditure and operating expenditure associated with Taxonomy activities and the proportion of turnover derived from the activities.
What does the EU Green Taxonomy mean for businesses?
The EU Green Taxonomy gives businesses the opportunity to showcase their progress and performance toward more environmentally-friendly business models. This will enable financial markets to make more informed decisions surrounding investment. Businesses with more than 500 employees will be required to report on their activities from this month.
Businesses new to this should begin by assessing their current business models to identify how much of their activities qualify as sustainable. This information will be needed by insurers and investors because it will feed into their decisions. Another good step would be to think about your compliance with the minimum social safeguards. Social safeguards are achieved when economic activities are aligned with the UN Guiding Principles on Business and Human Rights.
It is vital to begin the process as soon as you can. Depending on the result of the assessment, internal controls may require updating or replacing to meet the new requirements. In some cases, a corporate strategy and business model could need to be re-considered or adjusted so as to safeguard the enterprise’s future. It is also vital to note there is a difference between activities eligible under new rules and aligned with the European Green Deal. Activities that are taxonomy eligible will be listed in the EU Taxonomy.
Do all businesses need to comply?
The taxonomy applies specifically to businesses subject to non-financial reporting. However, small and medium enterprises can also make use of the EU Taxonomy on a voluntary basis. For example, to explain to stakeholders or investors whether they carry out or plan to start implementing taxonomy-aligned green activities.
The EU Green Taxonomy identifies and promotes investments in sustainable activities to drive the EU to become net zero by 2050. The Taxonomy is very much needed to help us achieve the climate goals required of us by 2030. Looking into the future, the development of the Taxonomy is still taking shape, and it could be applied in numerous ways. The Platform on sustainable finance is tasked with advising the European Commission on other developments with regard to the EU taxonomy. This includes improving its usability and exploring expansion to social objectives as well as environmental.