The EU Taxonomy Regulation - Part 1

Source: Pixabay

Every person who follows the news will be somewhat aware of the numerous policies and plans put in place by the European Union to achieve ambitious environmental goals, such as reducing GHG emissions by 55% by 2030 compared to 1990 levels and achieving net zero by 2050. BloombergNEF’s New Energy Outlook 2023 report for Europe estimates that this latter goal will require a cumulative USD 32.6 trillion of investments into the European energy system alone, in the period from 2022 to 2050. This staggering amount cannot of course be reached through public spending alone, as European Commissioner for Financial Stability, Financial Services and Capital Markets Union Mairead McGuinness has also stated at the press conference on the sustainable finance package, held in June 2023; rather, the private sector will play a crucial role in delivering part of the financing. It is then decisive for the EU to be able to stir private investment in the right direction, effectively shifting the flow from unsustainable to greener assets and entities. 

Something that must be avoided at all costs is therefore greenwashing, defined by the UN as the promotion of false solutions to the climate crisis that distract from and delay concrete and credible action (...), by misleading the public to believe that a company or other entity is doing more to protect the environment than it is. Some common greenwashing practices include false claims, cherry-picking of information, vagueness and misleading labelling. 

To address these misconducts, the EU has undertaken an operation that definitely falls within its expertise as a “bureaucratic giant”: classification and standardisation. Throughout this article I am going to illustrate the main aspects of the EU Taxonomy Regulation, from the viewpoint of non-financial undertakings: what it consists of, its implementation timeline, some critiques that have been moved towards it. 

THE TAXONOMY FRAMEWORK

What is commonly known as the “European Taxonomy” comprehends multiple regulations, directives, and delegated acts that have been developed by the main EU Institutions from 2018 and published from 2020 onwards, as part of the European Green Deal initiatives. Most of them then reference other pieces of legislation, concerning specific sectors (such as the Water Framework Directive, 2000/60/EC) or technical definitions (such as the Accounting Directive, 2013/34/EU). These are the most relevant items of the overall structure: 

1. Regulation (EU) 2020/852, the central document from which the Taxonomy takes its name. It provides the scope, the criteria and, most importantly, the objectives of the framework. 

2. Directive (EU) 2022/2464, also known as the Corporate Sustainability Reporting Directive (CSRD). It specifies all the nitty-gritty about the obligations to which firms of different types, sizes, and geographical locations need to report about, as well as the implementation timelines they will have to follow.

3. Commission Delegated Regulation (EU) 2021/2178, also known as the Disclosures Delegated Act. It defines the key performance indexes (KPIs) that firms need to disclose, as well as the graphical representation they have to be presented in. 

4. Commission Delegated Regulation (EU) 2021/2139, also known as the Climate Delegated Act. It  provides a breakdown of different industries’ activities and the technical criteria to assess their sustainability. 

5. Commission Delegated Regulation (EU) 2022/1214, also known as the Complementary Climate Delegated Act. As its name suggests, it expands on the Climate Delegated Act, in particular adding activities regarding nuclear energy and gaseous fossil fuels to the energy section.

The EU Taxonomy normative framework

THE OBJECTIVES OF THE TAXONOMY

As briefly mentioned above, the climate objectives are a fundamental part of the Taxonomy, which states six of them, as well as general information on what it means for them to be achieved: 

1. Climate change mitigation: reduction or removal of GHG emissions. 

2. Climate change adaptation: risk management and reduction of the adverse impacts of climate change. 

3. The sustainable use and protection of water and marine resources. 

4. The transition to a circular economy: waste prevention, re-use, and recycling. 

5. Pollution prevention and control. 

6. The protection and restoration of biodiversity and ecosystems: protection, conservation, and achievement of the good condition of an ecosystem. 

The undertakings drafting their sustainability reports need to assess how each of their activities relate to each objective on the list.

THE IMPLEMENTATION TIMELINE

The Climate Delegated Act was first published in 2021, but only contained the technical screening criteria for the first two objectives; the criteria for the latter four have been published as annexes in June 2023. Therefore, the first useful financial year (FY) to apply the Taxonomy in its integrity is going to be 2024, with reports being published in 2025. 

Keeping this information in mind, we can have a look at the implementation deadlines of the Taxonomy for different types of undertakings: 

• Reporting in 2022 - 2024 for FYs 2021 - 2023: large undertakings (as defined in the Accounting Directive) which are public-interest entities with more than 500 employees, but disclosing only about the first two objectives. 

• Reporting in 2025 for FY 2024: large undertakings which are public-interest entities with more than 500 employees, disclosing about all six objectives. 

• Reporting in 2026 for FY 2025: all other large undertakings, excluding subsidiaries and branches of non-EU unlisted companies. 

• Reporting in 2027 for FY 2026: SMEs listed in an EU-regulated market. 

• Reporting in 2029 for FY 2028: non-EU listed companies which have a subsidiary or branch in the EU that is considered a large undertaking. 

It is worth to note that the Taxonomy is not a complete piece of legislation, but rather very much still in-the-making: in the following years new rules and standards applying to SMEs and specific sectors will be published, as a one-size-fits-all regulation would be absurd and extremely impractical. For the same reason, lots of disclosure obligations are not required yet, as the EU has decided to go for a gradual implementation of the new regulation, to give firms some time to adjust. If you are interested in the details of the phase-in, you can find them in the Disclosures Delegated Act. 

THE CONCEPT OF DOUBLE MATERIALITY

The underlying methodology of the EU Taxonomy is the concept of double materiality, which itself has two facets: 

1. Impact materiality and financial materiality: undertakings need to provide both a qualitative and quantitative assessment of their activities with respect to the objectives. 

2. From the outside in and from the inside out: undertakings need to report on the potential environmental threats on its activities coming from the outside (as the concept of materiality is traditionally conceived), but also on the impact that its activities have on the external environment. 

As every economics student will know, information has a crucial role in determining the actions and expectations of agents, when it comes to spending, consumption, and investment too. On one hand it is important for stakeholders to understand how climate change may damage a company’s activities, but in a context of growing environmental awareness and concern, more available transparent information can also change investors’ behaviours, pushing them to orient their capital towards more sustainable and accountable undertakings. 

THE THREE-LEVEL CLASSIFICATION OF ACTIVITIES

Each one of the firms’ activities will need to be classified in either one of these three categories: 

1. Taxonomy-aligned economic activity: this activity contributes significantly to the achievement of one or more of the six objectives and it satisfies all the technical screening criteria. To be considered aligned, this economic activity must be (or fall within the scope of a more generic one that is) explicitly mentioned in the Climate Delegated Act (or in the Complementary one). 

2. Taxonomy-eligible economic activity: this activity contributes significantly to the achievement of one or more of the six objectives; however it does not satisfy at least one of the technical screening criteria. This activity is therefore explicitly mentioned too, but cannot be considered aligned. 

3. Taxonomy non-eligible economic activity: this activity does not contribute significantly (i.e. its impact is negative or non-material) to the achievement of the objectives. This activity is not mentioned at all in the Climate (or Complementary) Delegated Act.

A point that is important to notice is that, since the Taxonomy is not complete yet, it may happen that some activities which could actually be sustainable, end up classified as non-eligible, because EU policymakers have not taken it into consideration yet, most likely because they do not consider it as much of a priority as other sustainable activities already mentioned. There is therefore the possibility that, in the future, the same activity that is now not-eligible will become eligible and even aligned. 

THE TECHNICAL SCREENING CRITERIA

Once the undertaking has identified all its activities to carry out its business, it needs to evaluate each one of them with respect to each objective. For example, taking as an activity the production of solar panels, the undertaking will have to screen it six times, each time comparing it to the technical criteria that identify sustainability with respect to climate mitigation, adaptation, pollution prevention, etc…

Technical screening criteria are divided into the following three pillars: 

1. The first pillar comprises certain rules (qualitative) and metrics (quantitative) that can apply to either all activities or to some specifically. For example, all energy production must meet some requirements; then, some more specific requirements are only in place for certain technologies, such as rules for offshore wind farms. To give you a general idea of these criteria, they usually require the technology to be among the most efficient available, to not produce over a certain threshold of GHG emissions per unit of output, and to be respectful of the surroundings of the factory / farm / plant…

2. The second pillar consists of the Do No Significant Harm criteria (DNSH); the rationale behind these criteria is that although an activity could be very useful to the objective of climate mitigation, it could be harmful to one of the other five objectives. The idea is therefore that, for an activity to be classified as aligned overall, it must do no significant harm to any of the objectives. 

3. The third pillar are the minimum safeguards, meaning alignment with: 

4. The OECD Guidelines for Multinational Enterprises. 

5. The UN Guiding Principles on Business and Human Rights. 

6. The Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work. 

7. The International Bill of Human Rights. 

They thus ensure that the fundamental rights of humans and workers are upheld.  

THE KEY PERFORMANCE INDEXES

There are three key performance indexes that the undertaking needs to compile, which are the proportion of net turnover, capital expenditures and operational expenditures that are aligned, eligible and non-eligible to the Taxonomy (therefore, the sum of the proportions should amount to 1, or to 100% if we consider the proportions as percentages). Precise procedures for the computing of these figures can be found in the Disclosures Delegated Act. 

First of all, the undertaking identifies one of its activities and classifies it according to the criteria explained above. Second of all, it needs to estimate how much of its, for example, turnover, is related (comes from) this activity (and then the same is done for CapEx and OpEx). Finally, once every activity has been classified and quantified, the undertaking can sum up all the estimates for taxonomy-aligned activities; by dividing this quantity by the total amount of the respective measures it obtains the share of turnover, CapEx and OpEx that is sustainable according to EU regulation. 

THE CLIMATE DELEGATED ACTS

As mentioned above, the Climate Delegated Act and the Complementary Climate Delegated Act contain a breakdown of various activities and the related technical screening criteria in the following sectors: 

1. Forestry;

2. Environmental protection and restoration activities; 

3. Manufacturing; 

4. Energy; 

5. Water supply, sewage, waste management and remediation;

6. Transport; 

7. Construction and real estate activities; 

8. Information and communication; 

9. Professional, scientific and technical activities. 

The Complementary Climate Delegated Act adds activities related to nuclear energy and gaseous fossil fuels to point 4 of the list. Obviously, not every activity of these kinds can be considered green; for example, nuclear energy is defined as sustainable only if it is employed through the most innovative technology available, or if it comes from pre-commercial stages of production, thus tied to R&D. For gaseous fossil fuels: they are considered sustainable only if they are employed as means of transition; they are not the best, but still better than oil and coal, so the EU would rather for firms to use natural gas as long as they are working towards exploiting other energy sources, such as renewables. 

WHAT IS NEXT?

To wrap things up, let’s go through an example: you need to draft the sustainability report for your firm, operating in the energy sector, following the rules set by the EU Taxonomy. First of all, you identify the activities your firm engages in; then, you focus on the first one, let’s say electricity production using wind farms. You thus go through the list of activities in the Climate Delegated Act, and find out that your activity is described by paragraph 3 in point 4 (energy): “electricity generation from wind power”. Your activity is therefore at least taxonomy-eligible. You then start comparing it to the criteria outlined for the first objective, climate change mitigation: your technology is the most innovative on the market, the noise levels are sufficiently low, and the turbines do not hamper the good status of their surrounding environment; you also respect all the minimum safeguards. Congratulations! Your activity is taxonomy-aligned. Now you can proceed and evaluate the same activity according to the criteria set out for the other five objectives (most of them will be similar), and then with the evaluations of all other activities, in the same manner. 

Once you have evaluated all your activities, it’s time to compute the KPIs: let’s say that 20% of your turnover and 15% of your CapEx and OpEx are tied to electricity generation from wind power; then, you known that at least 20% of your earnings are sustainable, as well as at least 15% of capital and operational expenditures. You have taken care of financial materiality. 

Now you are left with impact materiality: how to report it? The answer is that you will have to use the very recent ESRS standards, developed by EFRAG in collaboration with the EU. But we will explore them next week, when we will also draw some conclusions: does this procedure seem burdensome to your firm? Do you think its potential impact is worth all the hassle? We’ll see together some taxonomy critiques.