A Turning Point in Sustainable Finance – The Taxonomy Regulation
The turning point, which paved the way for the taxonomy regulation (the “Taxonomy Regulation”) was presented as a follow up on the Action Plan1 on Financing Sustainable Growth (the “Action Plan”) of the European Commission (the “Commission”) in May 20182.
The root goes back to 2015 when the United Nations committed to sustainable development goals and the Paris Agreement, which was signed by 195 countries to commit and take action on sustainable development goals in 2015. The Action Plan recognizes the Paris Agreement and its purpose is to incorporate the ESG elements into investment analysis and decision-making processes of businesses to reorient capital flows towards a sustainable economy. The Action Plan is based on the recommendations presented by the High-Level Expert Group on Sustainable Finance (“HLEG”), which was delegated by the Commission in late 20163 . They recommended to draw a common sustainability taxonomy at the European Union (“EU”) level and finally, the European Council and the Parliament reached a political agreement on the Taxonomy Regulation on 18 December 2019. From a practical perspective, implementation time frame is based on two phases in line with the delegate acts timeframe. Hence,
The 1st phase focuses on the climate change mitigation and climate change adaption objectives and shall be adopted by the Commission by 31 December 2020 and will apply from 31 December 2021.
The 2nd phase on the other four objectives explained below shall be adopted by the Commission by 31 December 2021 and will apply from 31 December 2022.
It shall be noted that Taxonomy Regulation is the welcome first step, which represents only the “E” of Environment Social Governance’ (“ESG”) and not the social and governance components of ESG for the time being. In its Action Plan the Commission has already mentioned that the social part will be addressed after 2021. The priority focus is on the environmental side because for EU to reach its 2030 targets filling in an investments gap per year in amount of 180 bn EUR in energy efficiency and renewable energy is required. Not to mention that the measurement in social component is very difficult and requires an even larger scale of work on metrics. However, it is argued that this amount is not enough to reach a net-zero emissions economy by 2050.
What makes Taxonomy Regulation so important and distinctive is that so far all the initiatives for promoting sustainable finance has been mostly on a voluntary basis and there is an information asymmetry, which causes a contextual fragmentation in the markets. For the first time by the Taxonomy Regulation a uniform understanding is brought to the market as to what an environmentally sustainable activity means. The Taxonomy Report4 Technical Annex5 itself, which was out in March 2020 is 593 pages and is expected to bring a comprehensive clarity for the market, which is hoped to reduce green washing.
To the Board Members’ Attention
The evolution of the context of fiduciary duty of board members has been discussed for a while in order to include ESG within the scope of this duty by domestic legislations. Before switching to the core of the Taxonomy Regulation, board members shall be reminded that this regulation paves the way for a change in the extent of the fiduciary duty of the board members for risk management, strategy building and reporting/disclosure obligations. Unlike before, it is no longer an option to hide investments or activities, which are not in line with the objectives of the Taxonomy Regulation. Hence, board members shall be alerted in advance to be able to comply with relevant requirements depending on their sector-specific screening criteria and investigate the best practices to this end to take their companies a step ahead comparing them with peers in their sector.
Very briefly, on one hand, board members of financial market participants shall mainly analyse what proportion of the portfolios they manage are aligned with the taxonomy threshold outlined in the guidance of Commission’s Technical Expert Group6 (“TEG”) on Sustainable Finance.
On the other hand, board members of non-financial undertakings shall disclose the proportion of its turnover derived from products or services associated with environmentally sustainable economic activities; and the proportion of its total investments (capital expenditure - CAPEX) and/or expenditures (operating expenditure - OPEX) related to assets or processes associated with environmentally sustainable economic activities. This is closely linked to TEG’s recommendations of January 2019 and the updated non-binding guidelines on NFRD. The Commission will publish the detailed reporting requirements for non-financial companies by 1 June 2021.
Who Does It Apply To
“financial market participants” making available “financial products”, as defined in the related Disclosure Regulation7 , covers investment funds, product manufacturers and managers, including insurance undertakings, pension funds, AIFMs and UCITS management companies;
undertakings, which are subject to the obligation to publish a non-financial statement or a consolidated non-financial statement pursuant the Non-Financial Reporting Directive (NFRD, Directive 2013/34/EU); and
Individual Member States and measures adopted by the EU setting out any existing or potentially new eco-labeling requirements on financial market participants or issuers regarding environmentally sustainable financial products or corporate bonds.
The Action Plan has wider implications, -not only on finance companies but also on corporations especially the listed companies- in the below mentioned sectors8 , which play a key role in climate change mitigation and adaptation (the first two objectives of the Taxonomy Regulation):
Agriculture, forestry and fishing
Electricity, gas, steam and air conditioning supply
Water, sewerage, waste and the related remediation
Transportation and storage
Information and Communication Technologies (ICT)
Buildings (construction and real estate activities, with application to other sectors where appropriate)
The TEG developed 67 screening criteria in these sectors, which shall be taken into consideration as well.
General Scope and Objectives
Taxonomy refers to classification when an activity is assessed to be environmentally sustainable or not. For an activity to be accepted as environmentally sustainable, it must:
substantially contribute to one or more of the specified environmental objectives;
do no significant harm to any of the environmental objectives;
be carried out in compliance with minimum social safeguards9 ; and
comply with the technical screening criteria.
Environmental objectives are listed as following in Article 5 of the Taxonomy Regulation:
climate change mitigation;
climate change adaptation;
sustainable use and protection of water and marine resources;
transition to a circular economy,
pollution prevention and control; and
protection and restoration of biodiversity and ecosystems;
It is a very promising development to include EU labeling in the Taxonomy Regulation in order to reduce green washing activities. Accordingly, the technical screening criteria adopted shall “where, appropriate, build upon Union labeling and certification schemes, Union methodologies for assessing environmental footprint, and Union statistical systems” while taking into consideration the existing EU legislation.
Currently we are coming across eco-labeling initiatives in private sector as well as the long-established rating agencies, which are already being criticized for not having correlation in their metrics. However, in order to have a uniform and fair labeling for all market actors it could be said that having a standard under the EU labeling scheme would be more efficient to reach the objectives. This also could be extended to domestic labeling schemes approved under the EU roof.
If you check the Item Note “I”10 of the European Council, the objections of Luxembourg, Germany, Austria and Greece will be seen against the taxonomy to allow nuclear energy to be classified as sustainable. From the text of the objection it is not clear that if reference is made to the potential energy from nuclear fusion like the one under construction in Cadarache, France or the traditional nuclear energy.
In the current case, the ultimate decision on nuclear will be based on an expert technical assessment under ‘no significant harm principle’ due to ambiguity on that issue. Likewise, there is an ambiguity on inclusion of gas and this will be subject to a technical assessment before the delegated acts are adopted. Moreover, it is not clear that if transitional fuels are excluded too.
These points leave room for green washing still, given that they are sidestepped. But there will be a transitional period and perhaps amendments would come depending on negotiations and demands from pressure groups.
Written by Reyhan Gulec, Member of ILA’s Sustainability Strategy for Boards Committee.