The EU Taxonomy is a new classification system that will help direct investors towards sustainable projects and activities.
It sets a common standard for defining those projects and performance thresholds for economic activities that significantly contribute to climate mitigation.
The taxonomy operates by assigning key performance indicators or KPIs to an exhaustive list of eligible activities, Lorena Dunne, partner, asset management and investment funds at William Fry says.
“Any eligible activity that meets the relevant KPIs can be classified as green under the taxonomy on the basis that it ‘substantially contributes’ to one or more of the EU’s six environmental objectives and, at the same time, does not significantly harm any of the remaining environmental objectives.
“This dual approach to classification – ie positive impact without a negative impact, is a fundamental aspect of the taxonomy’s system and one which tries to ensure that even if an activity has a positive impact on the environment it will not meet the Taxonomy standard if it also impedes the achievement of other EU environmental objectives,” she says.
So, to qualify as green under the taxonomy, an activity must have both a substantial positive environmental impact as well as not have a significant negative impact on the environment, both of which can be judged using the taxonomy KPIs.
In the future, the taxonomy will be expanded to set thresholds for contribution to protection of freshwater and marine resources, the transition to a circular economy, and other environmental priorities, says Courtney Lowrance, managing director, sustainability and corporate transitions at Citi.
“As sustainable finance and ESG investing pick up pace, financial market participants (corporates, investors, and banks) need a common definition of sustainable activities. The thresholds laid out in the taxonomy are grouped by economic activity, and financial market participants will be required to disclose their alignment with the taxonomy by December 31st, 2021,” she says.
For corporates that are already subject to the non-financial reporting directive, this means reporting the proportion of their business aligned with the thresholds in the taxonomy. For banks and investors offering financial products, it means disclosing the proportion of underlying investments that are taxonomy-aligned.
“For example, green bonds issued in Europe are now expected to include a statement on how eligible capital expenditure and operating expenses align with the taxonomy. Investors in the green bond will then be able to assess the proportion of investment that is taxonomy aligned,” Lowrance says.
In order to assist investors in comparing financial products and identifying whether their investments contribute to environmental objectives, the taxonomy seeks to introduce a common language in the area of sustainable investing and to provide a clear definition of what should be considered to be a "sustainable" investment, Brónagh Maher, professional support lawyer, Asset Management and Investment Funds, Matheson says.
“To this end, it builds upon and complements the detailed disclosure requirements imposed on financial market participants, which include investment funds, certain insurance entities and credit institutions, and pension product providers by other legislation forming part of the EU’s Sustainable Finance Action Plan – that is, the Sustainable Finance Disclosure Regulation,” she says.
“The combined effect of the legislation is to ensure that investors are given detailed information in relation to the extent to which a financial product provider takes into account environmental, social and governance (ESG) factors in its investment decisions and policies and the extent to which those investment decisions and policies contribute to environmental objectives. This detailed information should assist investors who are keen to pursue sustainable, environmentally-friendly investment opportunities in comparing the financial products available in the market and choosing appropriate products to meet their investment needs,” she adds.
The taxonomy regulation, in conjunction with the proposed Corporate Sustainability Reporting Directive, will also require investee companies to make more information available in relation to the sustainability of their activities, which will assist financial product providers in making the required disclosures to potential investors and increase transparency in general in relation to the impact of companies’ economic activities on the environment.
Climate change
At a minimum, the EU Taxonomy Regulation will give investors greater confidence that the green investment products they invest in are indeed green which is a “very welcome development” says Lorraine McCann, director, climate change and sustainability services, EY Ireland.
“It will become increasingly important as the popularity of such investments increase in the coming years in line with the EU’s carbon reduction goals. More generally, the hope is that the introduction of a formal categorisation such as the EU Taxonomy Regulation, will help reorientate capital towards sustainable investments. This flow of capital will further act as an incentive for companies to improve their overall environmental performance – either by upgrading current activities or starting new activities. Mobilising corporates to act in a more environmentally responsible manner is one very necessary step to addressing the global climate change crisis,” McCann says.
Conor Holland, director, ESG at KPMG in Ireland says the aim is to prevent "greenwashing" by defining the criteria under which a financial product or activity can be described as "environmentally sustainable".
“The nature and extent of disclosures required will vary based on the extent to which sustainability factors are integrated into the firm’s business, and industry,” he says.
The taxonomy system includes environmental performance criteria for activities in the sectors that are most relevant for achieving climate neutrality and delivering on climate change adaptation for example energy, forestry, manufacturing, transport and buildings, Dunne says.
However this is to be expanded to include performance criteria for activities that support other environmental objectives – ie the 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. In addition to further green activities, work is also under way to create an EU standard for socially sustainable activities and investments.