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Taxonomy Regulation - why a classification system?
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As part of the EU's comprehensive plan to make Europe the first climate-neutral continent by 2050 - the European Green Deal - a number of ambitious initiatives have been launched in different areas, including agriculture, industry or transport, to name but a few. Alongside these strategies, sustainable finance emerged from the outset as an undisputed central tool in achieving the objectives and targets of the European Green Deal, which explains why the Taxonomy 1 Regulation was adopted in mid-2020, shortly after the European Commission's announcement of the European Green Deal in December 2019.
While there was certainty that implementing a green and just transition would require an unprecedented level of investment from both public and private actors, there was also a growing realization that the redistribution of financial flows to sustainable activities needed to be done in a transparent and orderly way, in order to avoid what has come to be known as "greenwashing", thus generating the confidence capable of attracting investment to such activities, while guaranteeing the protection of investors.
The Taxonomy Regulation is therefore a response to the need to create a "(...) technically robust classification system at Union level to clarify which activities qualify as 'green' or 'sustainable', starting with climate change mitigation." 2, as a much-needed tool to encourage sustainable investments. Thus, in essence, the Taxonomy Regulation constitutes a unified classification system for sustainable activities, with the aim of providing clear guidance on which criteria need to be met for an economic activity to be considered environmentally sustainable.
The fact that the Taxonomy Regulation was conceived as a classification system makes it a versatile and comprehensive instrument, since it can be "plugged in" to a variety of other regulations and frameworks, as has effectively happened. The classification system itself is not intended to directly create obligations for companies and other economic agents, but simply to establish the criteria that must be met for a given economic activity to be considered "sustainable" from an environmental point of view under other laws and regulations that may make reference to this classification system - this includes, in particular, the Sustainable Finance Disclosure Regulation (SFDR), the Corporate Sustainability Reporting Directive (CSRD) or the European Green Bond Standards.
So how does this classification system work?
The Taxonomy Regulation establishes a "test", requiring an economic activity to meet four criteria in order to be considered "sustainable" or "green":
1. The activity must contribute substantially to one or more of the following environmental objectives:
2. The activity must not significantly harm any of the aforementioned environmental objectives;
3. The activity must be carried out in compliance with the minimum safeguards (it should be noted that this requirement is assessed at the level of the entity carrying out the activity) set out in the Taxonomy Regulation (basically covering the observation of certain international standards of responsible business conduct, such as the Organization for Economic Cooperation and Development Guidelines for Multinational Enterprises (OECD MNE's) and the United Nations Guiding Principles on Business and Human Rights (UNGP); and
4. The activity complies with the technical screening criteria established for this specific activity in separate regulatory acts to be approved by the European Commission.
Source: Platform on Sustainable Finance Technical Working Group, August 2021
First of all, it should be pointed out that there is a fundamental step that is not immediately reflected in the 4-step test above: in order to assess whether or not an activity is sustainable under the EU Taxonomy Regulation (i.e. whether it is "aligned" with the Taxonomy Regulation), it is important to assess whether such an activity falls within the scope of the Taxonomy Regulation - i.e. whether it is an activity for which technical screening criteria are available.
It should be noted that not all activities are covered by the Taxonomy Regulation, as we will detail later. Thus, a company can carry out various activities, some of which fall within the scope of the Taxonomy Regulation and others which do not.
To make it easier to identify the relevant activities and requirements, the European Commission has developed the EU Taxonomy Navigator 3, which offers various tools, including the Taxonomy Compass and the EU Taxonomy Calculator, that can help companies and individuals classify their activities.
If an activity falls within the scope of the Taxonomy Regulation, it will naturally contribute to one or more of the six environmental objectives identified above. In relation to the "do no significant harm" assessment, the "minimum safeguards" and the substantial contribution requirements, companies must adopt internal processes (due diligence) to be able to determine whether or not the relevant activity is compliant. The densification of the substantial contribution, as well as the assessment of "do no significant harm", are included in the technical screening criteria for each activity and can imply a fairly complex and detailed analysis and collection of information - which is one of the criticisms that the Taxonomy Regulation faces, as we shall see.
The Taxonomy Regulation applies to certain economic activities, which are currently identified in Climate Delegated Act 4, Supplementary Climate Delegated Act 5 and Environmental Delegated Act 6, which also establish the technical screening criteria for each of the relevant activities.
As mentioned, only certain economic activities are currently covered by the delegated acts, following the priorities established by the expert groups that worked on the regulatory proposals. As explained by the European Commission in the document "FAQ: What is the EU Taxonomy and how will it work in practice?" 7, it was estimated that the criteria included in the Climate Delegated Act of the Taxonomy Regulation covered the economic activities of approximately 40% of listed companies, in sectors responsible for almost 80% of direct greenhouse gas emissions in Europe. Therefore, the intention was primarily to target sectors and activities considered to be carbon intensive, with the aim of encouraging the flow of investment into such activities when carried out in a sustainable manner.
The European Commission has repeatedly made it clear that the list of activities covered by the Taxonomy Regulation is set to increase, as the work of the technical expert groups advising policymakers progresses in identifying (scientifically-based) criteria for additional activities.
Given that what we have described above is simply a classification system, the Taxonomy Regulation needs to be combined with other legal and regulatory frameworks that make use of this classification system to create rules that apply to companies and economic agents.
In particular, and given its mission to promote investment in sustainable activities, the SFDR was one of the first pieces of legislation to make use of the Taxonomy Regulation. The SFDR is aimed at financial market participants (which include notably fund managers and generically asset managers, investment firms, insurance companies and financial advisors) and contains disclosure requirements that apply both at the entity level (i.e. the financial market participant) and at the product level (i.e. the products or services manufactured or distributed/offered by these entities, including funds, insurance-based investments or financial advisory services, for example). In particular, financial market participants are required to explain whether and how they consider sustainability in the context of their investment decisions, so that potential investors are properly informed about the intended impact of their investment decisions on sustainability factors.
The SFDR 8 delegated act includes detailed information requirements and (in its annexes) standard forms to be used by market agents, specifying
(i) the details of the content and presentation of the information related to the'do no significant harm' principle,
(ii) the content, methodologies and presentation of information related to sustainability indicators and adverse sustainability impacts, and
(iii) the content and presentation of information related to the promotion of environmental or social characteristics and sustainable investment objectives in pre-contractual documents, on websites and in periodic reports.
According to the SFDR, whenever a financial product that is required to disclose this information claims to invest in an economic activity that contributes to an environmental objective or claims to promote environmental characteristics, then it must also disclose the information required by the Taxonomy Regulation in relation to those products - which means that it will have to consider and disclose, if applicable, whether such activities are within the scope of and aligned with the European Taxonomy Regulation (by applying the corresponding criteria, as we have seen above).
The system of environmental classification of economic activities contained in the Taxonomy Regulation is therefore used by the SFDR in its objective of generating consistency and comparability in the disclosure of information related to sustainability in the financial sector, which is achieved, whenever environmental activities are concerned, by using the classification of the EU Taxonomy Regulation. The transparency generated by these frameworks is extremely important in protecting investors and promoting the integration of environmental, social and governance (ESG) factors in investment decision-making and the prevention of greenwashing.
The Corporate Sustainability Reporting Directive is another key piece of legislation in the European Green Deal, which is initially aimed primarily at large public interest companies (including listed companies) already obliged to disclose non-financial information alongside financial information under the Non-Financial Reporting Directive (the NFRD) (the CSRD is progressively beginning to apply to other not-so-large companies and certain SMEs, as well as non-EU companies).
The CSRD regulates the disclosure of non-financial and sustainability information by the entities covered by the directive, also mandating the European Commission to promote the adoption of sustainability reporting standards, which further increase the harmonization and comparability of disclosures.9
The CSRD and its delegated acts make use of the activity classification system contained in the Taxonomy Regulation to identify and detail the non-financial information that companies covered by the directive are required to disclose in relation to their activities associated with environmentally sustainable economic activities.
In fact, Article 8 of the Taxonomy Regulation itself creates an obligation for large companies subject to the NFRD/CSRD to publicly disclose information on how their activities are associated with environmentally sustainable economic activities - as an example, and especially for credit institutions, the main KPI adopted was the "green asset ratio", or the proportion of a credit institution's assets invested in environmentally sustainable economic activities as a share of total relevant assets. In doing so, covered entities are required to consider not only the list of economic activities covered by the Taxonomy Regulation (activities in scope), but also the extent to which their own activities comply with the applicable criteria that determine whether or not such activities are sustainable.
This creates an increased level of transparency and harmonization of disclosures as far as the mentioned activities are concerned, also allowing for better comparability among information disclosed. Although at first glance the application of disclosure and reporting obligations is restricted to large and public interest companies, it should be noted that in many cases the extent of the information needed to comply requires these companies to gather information from a number of other inter-related players, especially integrated in their value chain, thereby impacting significantly a very significant portion of players operating in the EU.
The SFDR and the CSRD are good examples of application of the Taxonomy Regulation classification system, but it can be expected not only that increasingly regal and regulatory instruments in the EU make use of this tool (including in the context of national and European investment programmes, for example), but also that it will be developed in the coming years not only to include additional activities, but also to reflect adjustments resulting from perceived challenges in its practical application.
As highlighted above, there are certainly many positive aspects to the European Taxonomy, which plays an incredibly important role in increasing transparency and promoting disclosures and comparability in relation to sustainability information and characterizations.
In fact, the EU Taxonomy Regulation has been instrumental in increasing standardization and transparency by providing a standardized framework for assessing environmental performance, thus improving transparency and comparability between companies and financial products. This clearly has a positive impact on facilitating decision-making for investors, and consequently allows them to allocate capital more effectively to sustainable activities.
As a result, it facilitates access to capital in relation to sustainable investments, in a context where an increasing number of investors seem to prioritize environmental objectives, which will ultimately lead to companies and projects that align with the requirements of the Taxonomy Regulation accessing a greater volume of capital and reducing their financing costs.
The confidence generated in investors is also related to the fact that there is a perception that companies whose activities align with the Taxonomy Regulation reduce their exposure to regulatory risks associated with environmental non-compliance, as well as the consequent risks and losses derived from potential penalties and litigation resulting from environmental violations.
Finally, it is considered that the differentiation created by the Taxonomy Regulation is a driver of competitiveness in the market for companies that make the effort to increasingly align their economic activities with the applicable requirements, as it is a sign of commitment to environmental goals, resulting in a better brand reputation and the attraction of conscious consumers.
The application of the Taxonomy Regulation and the disclosures under it are still in their infancy, as mentioned above. Given the complexity and ambition of its requirements and the effort needed to gather information and apply the criteria, the impression is that the initial disclosures have revealed, on average, relatively low percentages of activities aligned with the Taxonomy Regulation.
The application of the Taxonomy Regulation represents a significant practical challenge, and its usability has been questioned and criticized by both market players and the expert groups responsible for advising in the context of its creation. This does not mean that abolishing the Taxonomy Regulation altogether is on the table, but rather that efforts will probably continue to adjust and adapt it in the light of the lessons learned through its practical application.
There are obvious difficulties in its implementation, related to the complexity of applying certain criteria (especially those that require subjective assessments), the resources that need to be allocated to gathering information to comply and the associated costs, as well as the scarcity of data available for reporting, to name but a few factors. The Platform on Sustainable Finance has produced a report in which it makes specific recommendations related to some of the problems identified, which details the points for improvement proposed.10
Overall, it looks like the Taxonomy Regulation is here to stay and the EU has certainly pioneered the movement to approve relevant criteria for classifying economic activities with environmental relevance. So this is an element of legislation that we will continue to monitor and keep on our radars as the EU's sustainability landscape evolves.
1 - Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to promote sustainable investment, and amending Regulation (EU) 2019/2088 - EUR-Lex (euro.eu) Regulation - 2020/852 - EN - taxonomy regulation - EUR-Lex (europa.eu)
2 -Recital (5) of Regulation (EU) 2020/852 of the European Parliament and of the Council of June 18, 2020
3 - https://ec.europa.eu/sustainable-finance-taxonomy/
4 - Delegated Regulation - 2021/2178 - EN -EUR-Lex (europa.eu)
5 - Delegated Regulation (EU) 2022/1214of 9 March 2022 (Complementary Climate Delegated Act)
6 - Delegated Regulation (EU) 2023/2486 of 27 June 2023
7 - FAQ: What is the EU Taxonomy and how will it work in practice?
8 - Commission Delegated Regulation (EU) 2022/1288 of 6 April 2022
10 - The document can be consulted here
Rita Rendeiro
Rita Rendeiro - Partner at CCSL Advogados / Sustainable Finance / Financial Regulation
