EU Taxonomy Regulation

Background

On 22 June 2020, the long-awaited Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment (the “EU Taxonomy Regulation”), and amending Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (the “SFDR”) was published on the Official Journal of the European Union. 

The EU Taxonomy Regulation is the unified classification system for sustainable activities at the core of the EU action plan on financing sustainable growth published by the European Commission in March 2018.

Primary Change

The EU Taxonomy Regulation should enable investment fund managers (“IFMs”) to gather reliable, consistent and comparable sustainability related indicators from in-scope investee companies and incorporate this data into their investment decision and risk management process and fulfil their disclosure duties under SFDR or applicable sectorial legislation.

The EU Taxonomy Regulation also provides further details on the content of sustainability-related disclosures required in pre-contractual and periodic reports of environmentally sustainable investment funds and investment funds promoting environmental characteristics.

Key Dates

Key Points

The EU Taxonomy Regulation aims to define EU-recognized criteria for identifying sustainable activities. This defines the minimum criteria that economic activities should comply with in order to be considered environmentally sustainable.

• An environmentally sustainable economic activity contributes substantially to one or more of the following environmental objectives:
  • Climate change mitigation
  • Climate change adaptation
  • Sustainable use and protection of water and marine resources
  • Transition to a circular economy
  • Pollution prevention and control
  • Protection and restoration of biodiversity and ecosystems
• It does not significantly harm (“DNSH”) any of the other environmental objectives
• It is carried out in compliance with minimum safeguards set out in the Regulation (including the OECD Guidelines for Multinational Enterprises, the International Labour Organisation, etc.)
• It complies with the technical screening criteria developed by the Technical Expert Group in the form of delegated acts, applicable from 1 January 2022 for climate-related objectives and from 1 January 2023 for the other environmental objectives

An activity, referred to as ‘enabling activity’, can be considered to be contributing substantially to one or more environmental objectives laid down by the Taxonomy if it directly enables other activities to contribute to these objectives, provided that such economic activity:

• Does not lead to a lock-in of assets that undermine long-term environmental goals, considering the economic lifetime of those assets
• Has a substantial positive environmental impact, on the basis of life-cycle considerations

An activity, referred to as ‘transitional activity’, can be considered to be contributing substantially to the environmental objective of climate change mitigation under the following conditions:

• There is no technologically and economically feasible low-carbon alternative
• It supports the transition to a climate-neutral economy consistent with a pathway to limit the temperature increase to 1,5 ⁰ C above pre-industrial levels
• That activity:
  • has greenhouse gas emission levels that correspond to the best performance in the sector or industry
  • does not hamper the development and deployment of low-carbon alternatives, and
  • does not lead to a lock-in of carbon-intensive assets, considering the economic lifetime of those assets

The EU Taxonomy Regulation also lays down disclosure obligations that supplement the SFDR and the Non Financial Reporting Directive[1] (“NFRD”) with regards to activities that contribute to an environmental objective:

• Undertakings that are required to report on non-financial information under the NFRD must include in their non-financial statement:
  • The proportion of their turnover derived from products or services associated with environmentally sustainable economic activities
  • The proportion of their capital and operating expenditures related to assets or processes associated with environmentally sustainable activities
• Financial products that invest in environmentally sustainable economic activities must disclose the proportion of investments in environmentally sustainable activities selected for the financial product, including the proportion of enabling and transitional activities, as a percentage of all investments selected for the financial product. This information shall be disclosed in the pre-contractual disclosures and in the periodic report

The EU Taxonomy Regulation will be further developed over time to cover economic activities that are socially sustainable.

Practical Considerations

The Disclosures of investee companies should enable investment funds to report the proportion of their fund invested in Taxonomy-aligned activities for each investee company. For climate change mitigation, turnover can be recognised where an economic activity meets the Taxonomy technical screening criteria for substantial contribution to climate change mitigation and relevant DNSH criteria. For climate change adaptation, turnover can be recognised only for activities enabling adaptation but not for adapted activities.

Companies that disclose their capex in economic activities as part of a plan to be Taxonomy-aligned should provide invaluable information for constructing green portfolios, and for analysing companies’ transition plans and/or environmental sustainability performance and strategies.

As part of their risk-based due diligence, IFMs should pay attention to what extent investee companies, and other issuers disclosures cover Taxonomy required information on :

• Compliance  with minimum safeguards
• embed responsible business conduct into their policies and management systems
• identify, assess, prevent or mitigate actual or potential adverse impacts 
• gain and use leverage to prevent and mitigate the impacts
• track performance 
• communicate and report publicly
• enable remediation when appropriate

Significant challenges are expected for investments in EU companies and bond issuers that do not fall under the scope of the NFRD, and non-EU companies. In such situations, the EU Technical Expert Group recommends a five-step approach:

• identify the activities conducted by the company or issuer or those covered by the financial product (e.g., projects, use of proceeds) that could be aligned, and for which environmental objective(s) 
• for each potentially aligned activity, verify whether the company or issuer meets the relevant screening criteria – e.g., electricity generation <100 g CO2e/kWh 
• verify that the DNSH criteria are being met by the issuer. IFMs would most likely use a due diligence-type process for reviewing the performance of underlying investees and would rely on the legal disclosures of eligibility from those investees
• conduct due diligence to avoid any violation of the social minimum safeguards 
• calculate alignment of investments with the Taxonomy and prepare disclosures at the investment product level

Read EU Taxonomy Regulation

Read EU TEG Final Report on Taxonomy