Managing Partner at Kreston Romania
With over 20 years of professional experience in accounting, Business Process Outsourcing, audit and tax as a certified accountant, financial auditor and tax advisor, Carmen Cojocaru (Managing Partner at Kreston Romania) focuses on helping business clients with their accounting, tax and audit world.
The EU Taxonomy Regulation explained
March 8, 2023
The EU Taxonomy Regulation is an ongoing piece of legislation with a major impact on the way we assess, measure and report sustainable activity. It’s essential to understand the rules as the world moves towards a green economy.
Green finance continues to be a crucial factor in tackling the world’s climate challenges: the more investment can be funnelled towards environmentally responsible activities, and away from harmful ones, the closer we’ll get to a sustainable economy.
But while there are many people who are eager to make investments that are good for the planet, the field has been plagued by a lack of clear definitions and regulated language around environmental, social and governance (ESG) investments. The use of so-called ‘greenwashing’ by companies to brand themselves as sustainable has also damaged public trust in such claims.
To tackle this problem and finance sustainable growth, the European Commission has created an action plan with two objectives: to ensure transparency and reorient capital flows toward sustainable investment.
To reach these objectives, the Commission has presented the concept of taxonomy.
What is the EU Taxonomy Regulation?
The Taxonomy Regulation (2020/852) is a piece of EU legislation that took effect in July 2020.
Its mission is to define environmentally sustainable economic activities, and move more capital towards activities that substantially contribute to the EU’s Green Deal objectives: climate neutrality, zero pollution, preservation of biodiversity, a circular economy, and a high degree of energy efficiency.
By establishing a list of environmentally sustainable economic activities and informing companies, investors, and policymakers about them, the taxonomy has a number of benefits, including:
● security for investors
● protecting private investors from greenwashing
● helping companies to become more climate-friendly
● mitigating market fragmentation
● shifting investments where they are most needed.
In short: the EU taxonomy is a classification system that translates the EU’s climate and environmental objectives into clear criteria, to create a common language around green activities.
Objectives and activities: what counts as sustainable?
The Taxonomy Regulation establishes six environmental objectives:
- Climate change mitigation: the process of keeping the global average temperature to below 2°C by 2050 and pursuing efforts to limit it to 1.5°C above pre-industrial levels, as set out in the Paris Agreement
- Climate change adaptation: adjusting to actual and expected climate change and its impacts
- The sustainable use and protection of water and marine resources
- The transition to a circular economy
- Pollution prevention and control
- The protection and restoration of biodiversity and ecosystems
The Regulation also provides three classes of activities that can be included in the taxonomy:
- Primary: activities that directly contribute to one of the six environmental objectives above.
- Transitional: activities that support the transition to a climate-neutral economy.
- Enabling: activities that facilitate the primary activities indirectly.
For an activity to be considered eligible, it should substantially contribute to at least one of six environmental objectives from any of the three activities.
So far, the EU has only formally adopted the first two environmental objectives – climate change mitigation and adaptation.
Disclosure requirements associated with natural gas and nuclear energy activities have also been adopted.
Alignment: what counts as a substantial contribution?
Defining an economic activity’s eligibility according to the taxonomy is one step of the process. Next is a very important one: alignment.
The activity’s taxonomy alignment must be defined by technical screening criteria (TSC) – the specific requirements and thresholds that each activity will need to meet to be considered as significantly contributing to a sustainability objective and doing no significant harm to others.
The TSC is set out in secondary legislation from the EU, called Delegated Acts.
These set out the following criteria to define aligned activity as environmentally sustainable:
- Making a substantial contribution to at least one environmental objective. The economic activity should have the potential to do any of the following:
○ replace high-impact activities (e.g. renewable energy)
○ make a substantial positive environmental impact
○ substantially reduce adverse effects on the environment (e.g. substantially reduce levels of greenhouse gas emissions).
- Doing no significant harm (DNSH) to any other environmental objective. The economic activity should not impede the other environmental objectives from being reached.
- Complying with minimum social safeguards. The activity must be compliant with minimum standards on:
○ human rights
○ social responsibility
○ labour rights
○ anti-corruption procedures
Organisations must follow the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the International Labor Organization’s (‘ILO’) declaration on Fundamental Rights and Principles at Work, the eight ILO core conventions and the International Bill of Human Rights.
- Complying with the TSC.
Activities that meet these four conditions are considered environmentally sustainable by the Taxonomy Regulation, but this doesn’t necessarily mean activities that do not meet these four conditions are ‘unsustainable’.
In the EU’s view, activities can make a substantial contribution when they have a low impact on the environment and have the potential to replace high-impact activities (e.g. renewable energy), reduce impact from other activities (e.g. wastewater treatment) or make a positive environmental contribution (e.g. restoration of wetlands).
These types of activities are not explicitly listed in the Taxonomy Regulation but there are ways to understand the meaning of ‘substantial contribution’ as it applies to them.
Reporting: what do companies need to do?
As of January 2023, companies subject to the Corporate Sustainability Reporting Directive (CSRD) must disclose information about how and at what scale activities are environmentally sustainable by demonstrating proportions of turnover, capital expenditure (CapEx) and operating expenditure (OpEx) with KPIs in their management report, as part of a sustainability report.
Companies that fall within the scope of the Non-Financial Reporting Directive (NFRD) were already required to prepare a non-financial report, presenting environmental and social matters, respect for human rights, anti-corruption and bribery, diversity on company boards and allocations of turnover, OpEx and CapEx across environmentally sustainable activities.
(Those in scope of NFRD include large public-interest companies with more than 500 employees: listed companies, banks, insurance companies, and other PIEs.)
You can read more about corporate sustainability reporting on the European Commission’s website.
Operating the rules: tools to help
If you’re still puzzled by the rules or wondering where your organisation’s activities fit, you’re not alone. The EU recognises that the Taxonomy Regulation is highly complex and difficult to integrate into business databases and other systems.
To make things easier, the Commission has come up with the EU Taxonomy Compass, which includes taxonomy-eligible activities, objectives they substantially contribute to, and what criteria they must meet.
Another platform that helps stakeholders from the public and private sectors is the Platform on Sustainable Finance, an advisory body which provides advice on the EU Taxonomy, the broader sustainable finance framework, the TSC and monitoring capital flows into sustainable investments.
The Taxonomy Regulation — along with the SFDR, CSRD, and ongoing policy initiatives such as the EU ‘ecolabel’ for retail financial products and the Green Bond Standard — will ensure that taxonomy-aligned activities are visible and recognised in investment decisions.
The green transition
Meeting the TSC might still be optional for some companies, but anyone can benefit from improving their green performance. Eventually, all businesses will need to adapt to more sustainable ways of working, in what many are seeing as a ‘green transition’.
Companies wishing to contribute substantially to climate and environmental objectives can voluntarily decide to use these criteria when planning their transition to sustainability.
Companies with taxonomy-aligned activities will benefit from institutional and retail investors that want to make a positive environmental impact, and banks interested in green investments and considering the possibility of being incentivised (for example, through lending).
To transition, companies should understand the concept and the mechanism of taxonomy – which, as we can see, is no easy task. The EU Taxonomy is moving at a lightning pace, which comes with its flaws.
A common challenge is dealing with the ambiguity of the criteria. For example, the application of DNSH and the minimum safeguards for activities around climate change adaptation can be difficult to define. Another challenge is the different interpretations and comparisons of disclosures.
On the bright side, it will be possible to compare companies with the same economic activities for the first time.
More revisions and further guidance (for example, on applying the Environmental Delegated Act) are expected to continue in 2023, with the new mandate of the Platform on Sustainable Finance.
The process of applying the EU Taxonomy is yet to be learned from experience, but companies are expected to improve and have a natural, sustainable impact. Those companies that see the taxonomy as a continuing opportunity and act on it will benefit in the future. One thing is sure: the EU Taxonomy sets the new gold standard in economic activities.
Talk to us about how the EU Taxonomy Regulation might affect you.