This content is from: ESG

Supporting sustainable investment with the EU Taxonomy

Nadia Bonnet of Arendt & Medernach and Antoine Peter of Arendt Regulatory & Consulting explore how the EU Taxonomy works in practice and the challenges that may arise from its implementation

The EU Taxonomy is a tool with the primary goal of supporting sustainable investments, by giving a clear indication of which economic activities contribute to the EU’s environmental objectives.

Simply put, it is a standardised classification system. Using this system, various economic activities can be assessed against the EU climate neutrality objectives by reference to science-based technical screening criteria (TSC). The EU Taxonomy is therefore not a list of must-invest economic activities, although it is meant to create the first-ever ‘green list’.

The EU Taxonomy is a ‘living’ framework. It is intended to change over time, and its effects are expected to unfold gradually. The EU Platform on Sustainable Finance (the ‘Platform’) is set-up with the mission to update the EU Taxonomy’s scope as well as associated TSC.

In April 2021, the European Commission published the first delegated acts (the Delegated Acts), supplementing the EU Taxonomy framework and establishing the first set of TSC. These TSC determine the conditions under which economic activities can be considered as contributing substantially to the first two environmental objectives under the EU Taxonomy: climate change mitigation and climate change adaptation. They also determine the conditions for respecting the principle of Do No Significant Harm (DNSH), under which in addition to making a contribution to at least one of the six environmental objectives, the activity does no significant harm to any of the other objectives.

The Delegated Act will apply from January 1 2022 for the first two environmental objectives. Other delegated acts should be adopted before the end of 2022 with respect to the remaining four environmental objectives: pollution prevention, circular economy, sustainable use of water resources and healthy ecosystems. These additional delegated acts are expected to apply from January 1 2023.

Technicalities – how and to what extent

How does it work?

This section explores how the EU Taxonomy can be used in practice – in particular as a transparency exercise, with direct application for non-financial undertakings required to disclose their ratio of taxonomy-aligned green activities, as well as financial undertakings required to report on their Green Asset Ratio (GAR) (pursuant to Article 8 of the EU Taxonomy and the corresponding delegated act).

When using the EU Taxonomy, the first step is to determine which, if any, of the economic activities pursued by the company in question are covered by the tool, and thus eligible to be characterised as taxonomy-aligned.

The second step is to assess whether any eligible economic activities meet the TSC of substantial contribution, which may include quantitative or qualitative thresholds.


“The Delegated Act will apply from January 1 2022 for the first two environmental objectives.”


The third step is to apply the TSC for DNSH to ensure that economic activities that substantially contribute to an environmental objective also do no significant harm to another objective. The conditions for this can differ from one economic activity to the next, as detailed in the various delegated acts. For instance, a company that generates electricity using solar photovoltaic technology is viewed as substantially contributing to climate change mitigation.

However, to be considered EU Taxonomy-aligned, it must also be demonstrated (among other things) that in generating this electricity, the company assesses the availability of – and, where feasible, uses – equipment and components that are of high durability and recyclability, and that are easy to dismantle and refurbish. Only then will the activity of electricity generation respect the DNSH principle.

The fourth step is for investors to verify that each non-financial undertaking performing the eligible economic activity complies with minimum social and governance safeguards set out in Article 18 of the EU Taxonomy. This must be done to ensure alignment of the undertaking and its activities with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles. This step will not be discussed further in this article.

These four steps reflect the four conditions under which an economic activity will be recognised as EU Taxonomy-aligned.

The fifth and final step is to calculate the degree of taxonomy alignment, in the form of a percentage, of the relevant investment or non-financial undertaking itself. This is done using various key performance indicators (KPI) such as turnover, capital expenditure (CapEx) and operational expenditure (OpEx).

Applications

EU Taxonomy as a transparency exercise for non-financial undertakings under Article 8

The EU Taxonomy applies directly to certain large non-financial undertakings subject to the Non-Financial Reporting Directive (NFRD), under which they must disclose information to the public on how and to what extent their business is associated with environmentally sustainable economic activities.

On the basis of Article 8, non-financial undertakings will be able to communicate the environmental performance of their economic activities and assets to financial institutions, stakeholders and peers. It will enable them to translate long-term climate transition and environmental objectives into tangible business strategies.

For this reason, non-financial undertakings that are not subject to the NFRD (in particular, SMEs and non-EU companies) may still voluntarily submit themselves to the transparency exercise in order to attract sustainable financing, or for other business-related reasons.

EU Taxonomy as a transparency exercise for financial market participants under Article 8

Translating the environmental performance of non-financial undertakings into financial variables (KPI like turnover, CapEx and OpEx) supports the homogenous and rigorous evaluation against environmental criteria of the underlying companies and assets financed by financial market participants (banks and asset managers in particular).


“The EU Taxonomy is a ‘living’ framework. It is intended to change over time and its effects are expected to unfold gradually”


These KPI enable such actors to calculate the overall EU Taxonomy alignment of their own portfolios and balance sheets through weighted aggregation (for financial undertakings subject to the NFRD, such calculations will be mandatory).

While there are expected to be different variables assigned for banks, investment firms, asset managers and insurance companies, the main KPI for financial undertakings is the GAR. The GAR represents the proportion of assets invested in taxonomy-aligned economic activities as a share of total covered assets (excluding sovereign exposures).

EU Taxonomy as a transparency exercise for financial products in the context of Regulation (EU) 2019/2088 on SFDR

Under the Sustainable Finance Disclosure Regulation (SFDR), financial market participants are required to disclose the extent to which their financial products are environmentally sustainable, and the extent to which some of their financial products are aligned with the delegated act on climate and the future delegated act on the environment.

This is notably the case for financial products subject to Article 9 of the SFDR that follow environmental objectives, or financial products subject to Article 8 of the SFDR that commit to partial investment in sustainable investment assets with environmental objectives. The forthcoming Regulatory Technical Standards (RTS) that are currently being developed to support the SFDR will further specify the format and content of taxonomy-alignment disclosures for financial products.

Challenges

Incomplete scope

Incomplete in terms of economic activities covered

To date, the criteria under the EU Taxonomy and associated delegated acts cover the economic activities of roughly 40% of EU-domiciled listed companies, in sectors responsible for almost 80% of direct greenhouse gas emissions in Europe.

This restricted scope represents a particular challenge during the first step in using the EU Taxonomy (i.e. identifying eligible economic activities). Still, it should be noted that just because an economic activity is not covered does not mean that it is unsustainable or environmentally harmful. It only means that the activity cannot be characterised as aligned with the EU Taxonomy at this stage.

It is important to bear in mind the ‘living’ nature of the EU Taxonomy and delegated acts, and the fact that over time and based on advice from the Platform, the European Commission may add other activities to the list of those which make a substantial contribution to the environmental objectives. In particular, the European Commission is expected to issue another delegated act setting out TSC for climate mitigation and adaptation objectives for the gas, nuclear and agriculture sectors.

Incomplete in terms of sustainability objectives covered

As mentioned above, the second step in using the EU Taxonomy ensures either that the economic activity has a substantial positive environmental impact, or that it substantially reduces existing negative impacts.

For climate change mitigation, the taxonomy’s first environmental objective, this means that the performance of the relevant economic activity is aligned with climate neutrality and contributes to limiting the increase in global temperatures to 1.5 degrees celsius.

Acknowledging climate change as one of the most pressing issues of our time, the work of the European Commission has primarily focused on environmental objectives. However, one mandate of the Platform is to advise the European Commission on extending the EU Taxonomy to social objectives as well.

Timeline issues

As the EU Taxonomy impacts a number of market participants and non-financial undertakings with diverse, yet interconnected reporting and transparency requirements, some timeline issues relating to its implementation emerge that will require a solution.

In particular, because reporting under Article 8 only applies for financial and non-financial undertakings together as from January 1 2022, financial undertakings will not be able to access the relevant information to comply with taxonomy-related disclosure obligations for the first reporting period: data reported by non-financial undertakings with respect to 2022 will only become available in 2023.

In the absence of disclosures from these non-financial undertakings to furnish data at underlying-company level, financial market participants can neither calculate their accurate GAR at entity level nor prepare meaningful product disclosures on taxonomy alignment under the SFDR.

Need for consistent taxonomy alignment methodologies at entity and product level

Discrepancies currently exist between the proposed methods for calculating the GAR under Article 8 of the EU Taxonomy for financial undertakings, and those for calculating the degree of taxonomy alignment of financial products under the SFDR (pursuant to Articles 5 and 6 of the taxonomy). The most notable differences relate to the treatment of sovereign bonds, which are to be included for SFDR disclosures, but not for the purposes of GAR calculation, the treatment of derivatives or reporting the share of taxonomy-eligible economic activities.

EU Taxonomy is well underway

The EU Taxonomy is a cornerstone of the European Commission Action Plan on financing sustainable growth. It is not a mandatory document or list of conditions that investments must meet; rather, it is a tool designed to help the financial sector redirect capital flows towards environmentally sustainable activities, with a view to achieving the EU’s long-term objective of climate neutrality.

As a transparency tool, however, it will help facilitate the mandatory transparency exercise for EU financial and non-financial undertakings that fall within the current scope of the NFRD and the enlarged scope of the CSRD (the Corporate Sustainability Reporting Directive, proposed to amend the NFRD).

The EU Taxonomy also supports sustainability-related disclosures in the context of SFDR, the design of the EU Green Bonds Standard, the design of the EU Ecolabel for Retail Financial Products and the revision of the MiFID and IDD delegated acts on sustainability preferences, fiduciary duties and product governance.

While many unknowns and practical challenges remain regarding its implementation and the associated timeline, it is safe to say that the train has left the station, and the EU Taxonomy is well underway. Far from a static set of rules, it is an organism that will evolve over time to cover more economic activities and sustainability objectives, with TSC that will adapt to account for technological breakthroughs and feedback from the market.

The journey has just begun.

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Nadia Bonnet
Counsel
Arendt & Medernach
T: +1 212 554 3546
E: nadia.bonnet@arendt.com

Nadia Bonnet is a counsel in the fund formation practice at Arendt & Medernach. Her practice focuses on alternative investment (funds) vehicles and their managers (AIFMs) addressing all relevant regulatory matters.

Nadia advises international clients on the structuring, setting-up, organisation and ongoing assistance of investment vehicles in the real estate, private equity, venture capital, private debt and infrastructure asset classes (both regulated and non-regulated investment structures). She also regularly advises international institutional clients on the formation of joint ventures, corporate restructurings, mergers and acquisitions.

Nadia is a Luxembourg qualified lawyer and studied law in France, the US and Luxembourg. She holds a master’s degree in European business law from the Université de Besançon, France.


Antoine Peter
Manager
Arendt Regulatory & Consulting
T: +352 26 0910 7771
E: antoine.peter@arendt.com

Antoine Peter is a manager at Arendt Regulatory & Consulting SA. He gives regulatory and operational advice to clients in Luxembourg and abroad in the asset management and asset servicing businesses.

Antoine also assists clients by providing general compliance support and reviewing operating models related to governance, as well as to investment management, risk management frameworks and valuation models. Specialising in environmental, social and corporate governance (ESG) and sustainable finance solutions, he assists clients, among others, with the set-up and implementation of ESG strategies, the preparation of sustainability-related disclosures and the integration of sustainability risks in internal processes.

Antoine holds a master’s degree in corporate finance and financial markets from the University of Strasbourg, and is a graduate of Sciences Po Strasbourg.

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