EU Taxonomy Article A practical guide for navigating troubled waters

EU Taxonomy: A practical guide for navigating troubled waters

What is the EU taxonomy and what are its implications for financial market participants? In this article you fill find a practical guide on how to comply with the EU Taxonomy

What is the EU Taxonomy?

The EU Taxonomy is one of the main pillars of the EU’s Action Plan for Financing Sustainable Growth (2018), whose one fundamental aim is to reorient capital flows towards a more sustainable economy.

The Action Plan assigns private finance a pivotal role in reaching the EU’s ambitious goal of transitioning to a low-carbon, more resource-efficient, resilient, and competitive economy – in line with its commitment to fully implement the UN 2030 Agenda and the Paris Agreement, both being an integral part of its Green Deal.

However, it is posited that no shift of capital flows towards more sustainable activities can be truly achieved without a common definition of what “sustainable” means.

Through Regulation 2020/852 (“Taxonomy”), the EU establishes a unified classification system aiming at helping financial market participants (FMPs) channel investments towards financial products that truly pursue environmentally sustainable objectives, addressing, therefore “greenwashing” concerns.

The Taxonomy is complementary to the SFDR (Sustainable Finance Disclosure Regulation, Reg.2019/2088), in the sense that it mandates additional transparency requirements (both in pre-contractual, website, and periodic disclosures) in case financial products promote environmental characteristics (article 8 products) or pursue an environmental objective (article 9 products).

What does the EU taxonomy specify?

In particular, the EU taxonomy specifies that such financial products should first disclose to which of the following environmental objectives they contribute:

  • 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

Within its Final Report on the EU Taxonomy, the Technical Expert Group (TEG) recommends that investors should estimate Taxonomy-alignment separately for each of the environmental objectives for which substantial contribution technical screening criteria (TSC) have been developed. This means that it should be completed separately for climate change mitigation and adaptation (the objectives for which TSC are available as of now).

This is just one and the simplest step in assessing portfolio compliance with the Taxonomy. In the next section, we explore in detail the full process that has to be followed.

How does the Taxonomy work in practice?

As with all other regulations, nothing comes easy. This is particularly true in case investors have companies in their portfolios that are not subject to the EU Non-Financial Reporting Directive, such as non-EU companies and small-medium enterprises (SMEs). For such cases – which are not negligible especially for private debt investors – the TEG advises to follow a 5-steps approach:

Step 0 – Map in-use industry classification systems to NACE sectors eligible under the EU Taxonomy

A pre-requisite for estimating the Taxonomy-alignment of investment portfolios is the mapping of in-use sector classification systems (e.g. SIC, NAICS, BICS, GICS, ICB, RBICS, TRBC, etc) with the European industry classification system (NACE).

The Platform for Sustainable Finance (a permanent expert group of the European Commission) has elaborated a table providing an indicative mapping of selected industry classification systems, and how they relate to the description of economic activities in the EU Taxonomy Delegated Act adopted by the Commission.

Step 1 – Eligibility screening

Identify the companies whose turnover, CAPEX, or OPEX match the economic activities listed in the Taxonomy

For each entity, investors need to be able to assess the proportion of turnover derived from economic activities eligible under the Taxonomy (approx. 70 activities). If data can be obtained, investors should look also into CAPEX and OPEX. 

The turnover KPI (or revenue, if appropriate) is particularly relevant for the climate change mitigation objective. For climate change adaptation the assessment is rather more complicated (especially in the absence of reported data): for an activity to be eligible, there should be evidence that the entity has implemented tailored solutions to prevent physical climate change risks based on the performance of a vulnerability assessment.

It is recommended at this stage to also group eligible activities in two clusters:

  • economic activities that are “enabling” other activities to make a substantial contribution to one or more environmental objectives (e.g. the manufacturing of renewable energy equipment in the case of climate change mitigation);
  •  “transitional” activities, i.e. those activities for which there is no technologically and economically feasible low-carbon alternative (e.g. manufacturing of iron and steel), but that shall qualify as long as their technology is consistent with a 1.5C scenario (they “pass” certain technical screening criteria).

Economic activities such as electricity generation from Solar PV are considered to substantially contribute to climate change mitigation through their own performance.

Step 2 – Substantial contribution screening

Validate if the eligible companies meet the technical screening criteria (TSC) provided for the economic activity

This is likely the most difficult step to verify, especially in the absence of reported data. While some economic activities (e.g. electricity generation from wind) do not have technical thresholds to comply with, most of them have. As an example, electricity generation from geothermal is Taxonomy-eligible, but it should meet the technical criteria of no more than 100g CO2-e emissions per kWh over the life-cycle of the installation, as calculated using specific methodologies (e.g. ISO 14067:2018) and verified by a third party.

The final Delegated Act on climate objectives containing all the TSC has been published on the 9th of December. For ease of consultation, FMPs can use the Taxonomy compass.

The Taxonomy Regulation recognizes that in the absence of reported data, this step can be particularly burdensome. For this reason, it allows for complimentary assessments and estimates, as long as financial market participants explain the basis for their conclusions and the reasons for having made such estimates.

Step 3 – Do Not Significant Harm (DNSH) screening

Validate if the eligible economic activities do not significantly harm other environmental objectives

The Taxonomy Regulation mandates that once the TSC are deemed as satisfied, FMPs should check also that the economic activity that, e.g., contributes to climate change mitigation, does not significantly harm the other five environmental objectives. 

The third step requires investors to conduct due diligence to verify if the company’s activities meet some qualitative, quantitative, and process-based requirements for each other environmental objectives, not only at the production stage but over the life-cycle of the activity itself. 

Also here the lack of data could be a challenge for FMPs. The TEG recommends the reliance on existing credible information sources, such as reports from international organizations, civil society, and media, as well as established market data providers.

Step 4 – Social minimum safeguards screening

Validate if companies meet minimum human and labor rights standards

The Taxonomy mandates that for economic activity to be environmentally sustainable, it should also be aligned with the OECD Guidelines for Multinational Enterprises, the UN Guiding Principles on Business and Human Rights, the International Labour Organisation’s (ILO) Core Conventions, and the International Bill of Human Rights. As for step 3, the TEG recommends relying on internal due diligence processes as well as on external credible information sources.

Step 5 – Calculate the alignment of the investment with the Taxonomy 

Economic activity is to be considered Taxonomy-aligned only if it complies with steps 1-4. Once the aligned portions of the companies in the portfolio have been identified, investors can calculate the alignment of their funds with the taxonomy (as an example, if 10% of a fund is invested in a company that makes 10% of its revenue from Taxonomy-aligned activities, the fund is 1% taxonomy-aligned for that investment, and so on).

FMPs can find use cases studies on the application of Taxonomy requirements for several asset classes available on the PRI (Principles for Responsible Investment) website.

What is the relationship between the SFDR and the EU Taxonomy?

As stated previously, the Taxonomy Regulation is complementary to the SFDR, since it requires additional disclosure requirements for FMPs in case they market financial products promoting environmental characteristics (article 8) or the attainment of an environmental objective (article 9).

As Regulation 2019/2088 mandates, Taxonomy-alignment disclosure of financial products it’s not only due in pre-contractual documents (article 8, 9) but also on websites (article 10) and through periodic reporting (article 11). 

An important point to underline is that website disclosure shall provide, for each art.8 and art.9 product, “information on the methodologies used to assess, measure and monitor the environmental or social characteristics or the impact of the sustainable investments selected for the financial product, including its data sources […] and the relevant sustainability indicators”. In case such products have an environmental focus, there should be also disclosure on the methodology used to estimate Taxonomy-alignment.

Last but not least, DNSH screening for Taxonomy-aligned products should not be confused with PASI (Principal Adverse Sustainability Impacts) reporting, due at entity level pursuant to article 4 SFDR, and at product level pursuant article 7.

Article 4 demands FMPs exceeding 500 employees or stating considering “principal adverse impacts of investment decisions on sustainability factors” to publish on their websites a description of such impacts. The ESAs (European Supervisory Authorities, EBA, EIOPA, ESMA) have developed draft Regulatory Technical Standards (RTS) supplementing Reg.2019/2088, according to which financial undertakings will have to disclose on their websites selected aggregate ESG metrics (approx.20) estimated across all investee companies. Companies with less than 500 employees not considering adverse impacts on sustainability factors of investment decisions will have to publish as well a clear motivated statement for not doing so. In both cases, FMPs will have to disclose relevant information by 30 June 2023.

What are the deadlines for reporting Taxonomy alignment?

The SDFR started applying on 10 March 2021 and the Taxonomy from 1 January 2022. However, the design of the Regulatory Technical Standards – which provide the detailed requirements for pre-contractual, website, and periodic disclosure pursuant to both the SFDR and the Taxonomy – has proven longer than expected. 

In an effort to jointly develop RTS for both the SFDR and the Taxonomy, the European Commission has postponed the application of the Delegated Act containing the RTS to January 2023.

However, financial undertakings subject to an obligation to publish non-financial information pursuant to Article 19a or Article 29a* of Directive 2013/34/EU, shall start disclosing the proportion of Taxonomy-eligible activities within their portfolios from January 2022. Full disclosure of Taxonomy-aligned activities will be required instead from January 2024. Furthermore, Reg.2021/2178 clarifies that exposures to national and supranational issuers including central banks shall be excluded from the calculation of Taxonomy KPIs altogether, while derivatives and exposures to undertakings are not subject to non-financial disclosure regulation (e.g. SMEs) shall be excluded only from the numerator.

It should be borne in mind that such a timeline applies only to matters regarding the publishing of non-financial statements. FMPs considering adverse impacts on sustainability in their investments (PASI) and/or marketing article 8 and 9 products, should follow closely the developments linked to the Delegated Act containing the Regulatory Technical Standards.

(*) Article 19a and 29a pertain to non-financial disclosure requirements for large undertakings

For more details and recommendations on EU, Taxonomy implementation does not hesitate to contact us.

About the Author

Cristina Hanga

Cristina Hanga

Cristina is the ESG Expert at CARDO AI, working across the company’s product suite.

Prior to joining CARDO,  she has worked as an ESG Analyst at Sustainalytics, where she was Lead Quality Control for the Consumer Goods sector, and contributed to several methodology developments. Cristina has also spent a period in KPMG, where she advised companies on ESG disclosure and ESG Ratings.

She holds a Master’s Degree in International Cooperation and Development from the University of Bologna, where she focused particularly on climate change policy.

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