knowledge 11 July 2019 |

EU Developments in Sustainable Finance: Taxonomy

1.  a taxonomy technical report which aims to provide practical guidance for policy makers, industry and investors on how best to support and invest in economic activities that contribute to achieving a climate neutral economy (the “Taxonomy Report”);

2.  a report on EU Green Bond Standards which recommends clear and comparable criteria for issuing green bonds (the “EU GBS Report”); and

3.  a report on benchmarks which sets out the methodology and minimum technical requirements for indices that will enable investors to adopt a climate-conscious investment strategy, and address the risk of greenwashing.  The report also sets out disclosure requirements for benchmark providers in relation to environmental, social and governance (“ESG”) factors and their alignment with the Paris agreement (the “Benchmarks Report”).

In addition, the EC has published new guidelines on corporate climate-related information reporting.  These are aimed at providing companies with practical recommendations on how to better report the impact that their activities are having on the climate as well as the impact of climate change on their business.

This briefing is the first in a short series that places those TEG reports and guidelines in context and outlines their more important features.

Background to TEG

In March 2018 the EC published its Action Plan on Financing Sustainable Growth (“Action Plan”) which sets out a comprehensive strategy to develop a financial system that supports the EU's climate and sustainable development agenda.  Specifically, the Action Plan aims to: (1) reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth; (2) manage financial risks stemming from climate change, resource depletion, environmental degradation and social issues; and (3) foster transparency and long-termism in financial and economic activity.

Following publication of its Action Plan, the EC set up the TEG to assist with four key areas of the Action Plan by developing:

1. a taxonomy or unified classification system to define what constitutes a sustainable economic activity (“Taxonomy”);
2. a proposal for a European Green Bond Standard (“EU GBS”);
3. benchmarks for low carbon investment strategies; and
4. guidance to improve the corporate disclosure of climate-related information.

The TEG’s members come from civil society, academia, business and the finance sector as well as additional members and observers from EU and international public bodies.  Members have been appointed as representatives of their organisations, individuals appointed in their personal capacity or as representatives of European entities.

Draft Taxonomy Regulation

Following the publication of the Action Plan in May 2018, the EC set about developing the Taxonomy.  A two-stage approach was adopted.  Firstly, in May 2018, the EC published a proposal for a regulation on the establishment of a framework to facilitate sustainable investment (the “Taxonomy Regulation”). 

Under the draft Taxonomy Regulation, in order for an activity to be considered to be an ‘environmentally sustainable economic activity’ it must:

• contribute substantially to one or more of the environmental objectives set out in the Taxonomy Regulation;
• do no significant harm to any other of those environmental objectives;
• comply with minimum social safeguards; and
• comply with technical screening criteria.

The draft Taxonomy Regulation identifies six environmental objectives for the purposes of the Taxonomy.  These are:

• climate change mitigation;
• climate change adaptation;
• sustainability use and protection of water and marine resources;
• transition to a circular economy, waste prevention and recycling;
• pollution prevention and control; and
• protection of healthy ecosystems.

The draft Taxonomy Regulation provides for the establishment of technical screening criteria through a series of delegated acts, the first of which will cover economic activities generating a substantial contribution to climate change mitigation and adaptation.  The TEG was mandated to focus and deliver a recommendation to the EC on these activities and their technical criteria, including criteria for assessing any ‘significant harm’ to the other environmental objectives. The TEG’s recommendations are designed to support the EC in the development of future delegated acts in accordance with the Taxonomy Regulation.

The draft Taxonomy Regulation establishes obligations on Member States and financial market participants to use the Taxonomy in specific cases.  Specifically, it provides that both Member States and the European Union (“EU”) use the Taxonomy when setting out the requirements for marketing financial products or corporate bonds as environmentally sustainable.  It sets out a disclosure obligation on asset managers and institutional investors offering financial products, which are marketed as environmentally sustainable or as investments with similar characteristics.  These obligations will become applicable only once the EC specifies the technical criteria to be used to determine when an activity contributes substantially to a given environmental objective and does not cause significant harm to the other objectives.

Draft Taxonomy Report

On 18 June, the TEG produced its Taxonomy Report which contains technical screening criteria for 67 activities that can make a substantial contribution to climate change mitigation across the sectors agriculture, forestry, manufacturing, energy, transportation, water and waste, ICT and buildings.   Almost all activities have also been assessed for significant harm to other environmental objectives.  In addition, the Taxonomy Report contains a methodology and worked examples for evaluating substantial contribution to climate change adaptation.  Furthermore, the Taxonomy Report contains guidance and case studies for investors preparing to use the Taxonomy. 

The TEG has adopted the NACE industrial classification system of economic activities as the sector framework for the development of the Taxonomy on the basis that it has been established by EU law, is largely compatible with international and Member State frameworks, is comprehensive in its coverage of EU economic sectors, is used by EU institutions such as Eurostat and has already been implemented by some financial institutions.

In producing the Taxonomy Report, the TEG had to work within the parameters of Article 14 of the draft Taxonomy Regulation which sets out certain requirements to be adhered to when developing the Taxonomy.  In addition, the TEG established certain additional principles to guide its decision making process including by:

• supporting ease of use in developing its recommendations by considering the users and uses of the Taxonomy;
• aiming to build a dynamic, flexible tool by including quantitative criteria wherever possible;
• being inclusive of economic sectors such that economic sectors and activities that are not already low carbon have been included in the Taxonomy to provide an incentive for their substantial contribution to mitigation objectives;
• supporting transition from brown to green by focussing on classifying economic activities and not investable entities; and
• considering economic activities within an entire economic system.  Consequently, the technical screening criteria for substantial contribution to adaptation incorporate a “system approach” to ensure that the activity in question is consistent with broader adaptation efforts and does not lead to increased risks for others or hamper adaptation elsewhere.

The TEG considers that three kinds of activity can make a substantial contribution to climate change mitigation. These are:

• activities that are already low carbon. These activities are already compatible with a 2050 net zero carbon economy. Examples include zero emissions transport, near to zero carbon electricity generation and afforestation;
• activities that contribute to a transition to a zero net emissions economy in 2050 but are not currently operating at that level; and
• activities that enable those above. For example, manufacture of wind turbines or installation of highly efficient boilers.

In terms of next steps, the TEG’s mandate has been extended until the end of the year to:

• refine and further develop some incomplete aspects of the proposed technical screening criteria for substantial contributions and avoidance of significant harm;
• seek additional feedback on criteria that have not yet been subject to public consultation (a call for feedback was launched on 4 July 2019 and submissions can be made here until 13 September 2019); and
• develop further guidance on implementation and use of the Taxonomy.

Conclusion

As the old saying goes, “the devil is in the detail” and the Taxonomy Report is a significant step towards setting out the detail of what will be required of market participants under the Taxonomy Regulation and, more generally, the EC’s Action Plan.  For the many market participants whose business and processes will be affected, the opportunity to provide feedback to the TEG via the public consultation is an important one to consider.