Sustainable finance: the EU taxonomy

The importance of, and the need to take action on, the SDGs and the Paris Agreement is recognised in the European Commission’s Action Plan on Financing Sustainable Growth (the Action Plan)¹ launched in March 2018. The Action Plan has three broad aims: (i) to reorient capital flows towards a more sustainable economy; (ii) to mainstream sustainability in risk management; and (iii) to foster transparency and long-termism. To this end, the Action Plan sets out a strategy to encourage the integration of environmental, social and governance (ESG) factors into investment decision making, so as to facilitate the mobilisation of private capital – up to EUR 290 billion per year – to finance sustainable activities.

In supporting the diversion of capital flows towards more sustainable activities, the Action Plan outlines (amongst other things) the importance and urgency of developing a classification system, or “taxonomy”, which encourages a common understanding of the characteristics of a “sustainable activity”² . As a first step, in May 2018, the European Commission tabled the proposal for a regulation on the establishment of a framework to facilitate environmentally sustainable investment (the Proposed Taxonomy Regulation)³, noting that guidance on other sustainable activities may be developed at a later stage.

The Proposed Taxonomy Regulation is the backbone of a suite of legislative proposals to implement the Action Plan’s strategy. Two of the other proposals seek to impose new disclosure and transparency requirements concerning how institutional investors and asset managers integrate ESG factors into their risk and investment decision making processes (the Disclosure Regulation) and to establish a new category of benchmarks to assist investors in comparing the carbon footprint of their investments (the Low Carbon Benchmarks Regulation)⁴ . The European Parliament and Council reached political agreement on these Regulations in the first quarter of 2019 and, on 8 November 2019, they were adopted by the Council⁵. The Proposed Taxonomy Regulation is progressing through the EU legislative process. The Parliament⁶ and the Council⁷ have both adopted their positions on the Regulation but have not yet reached political agreement.

This article outlines the key components of the Proposed Taxonomy Regulation (as proposed by the Commission), how it will apply and the next steps towards its implementation.

What is the EU taxonomy?

The taxonomy is a classification framework according to which activities can be assessed in order to determine whether they are environmentally sustainable. To be environmentally sustainable, an activity must satisfy four tests under the proposed Regulation⁸:

• it must substantially contribute to the one or more of the specified environmental objectives outlined in the Proposed Taxonomy Regulation, being climate change mitigation; climate change adaptation; sustainable 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 ecosystems⁹;
• it must do no significant harm (DNSH) to any of the other listed environmental objectives;
• it must be carried out in compliance with minimum social safeguards (ie the eight fundamental International Labour Organisation conventions); and
• it must comply with the technical screening criteria, which, in effect, define what it means to “substantially contribute” and DNSH to an environmental objective.

The Proposed Taxonomy Regulation allows the Commission to establish the technical screening criteria through a series of delegated acts, the first of which are expected to cover the first two environmental objectives: climate change mitigation and climate change adaptation.

Given the technical complexity involved in developing the screening criteria, in July 2018, the Commission set up a technical expert group on sustainable finance (TEG) to make recommendations regarding the activities that are “taxonomy-eligible” and their associated technical criteria. Following initial stakeholder consultation, the TEG published its technical report in June 2019, which will guide the Commission in the development of the delegated acts for climate change mitigation and adaptation activities.

What activities are in scope?

In its report, the TEG sought to identify and assess activities that make a substantial contribution to climate change mitigation or adaptation on their own, as well as those activities that enable the overall transition to a low emissions, climate resilient economy.

Climate change mitigation

With respect to climate change mitigation, the TEG adopted the NACE¹⁰  industrial classification of economic activities to identify six priority sectors based on their significant contributions to greenhouse gas emissions¹¹:

• agriculture, forestry and mining;
• manufacturing;
• electricity, gas, steam and air conditioning supply;
• water, sewerage, waste and remediation;
• transportation and storage; 
• information and communication technologies; and
• buildings (construction and real estate activities, with application to other sectors as appropriate).

The TEG then developed quantitative screening criteria for 67 priority activities within these sectors that had the potential to contribute substantially to climate change mitigation by (i) being already low carbon (“green” activities); (ii) contributing to a transition to a net-zero emissions economy by 2050 (but which are not currently “green”) (“greening of” activities); or (iii) enabling low carbon performance or emissions reductions by other activities (“greening by” activities). The type of screening criteria applied to each priority activity was determined by its characteristics.

The inclusion of “greening of” and “greening by” activities (provided they meet the technical screening and other criteria) represents the broad approach taken by the TEG to enable a more holistic approach to climate change mitigation. It may also reduce, in principle, the risk of assets becoming stranded and unable to earn an economic return due to lower levels of investment and financial support.¹²

However, as the transition to a low carbon economy will involve the phase-out of some economic activities, such as unabated fossil fuel power generation, the TEG considered that these activities should be excluded from the taxonomy (as well as activities that enabled their operations to be “locked in”, such as renovations to assets dedicated to fossil fuels).

Climate change adaptation

In respect of climate change adaptation, the TEG emphasised that adaptation is location and context specific and that it is therefore not possible to produce a comprehensive list of activities that could be viewed as contributing to adaptation under all circumstances. Rather, investors should consider guiding principles and a set of qualitative screening criteria to identify whether an activity substantially contributes to climate change adaptation, which can be applied in any sector.

The guiding principles and criteria that should be applied will depend on the whether the activity in question is an “adaptation of” activity or an “adaptation by” activity. “Adaptation of” activities refer to those that are made more climate resilient by adopting measures to reduce the material physical risks of climate change, whereas “adaptation by” activities are those that support the climate change adaptation of other activities.

To test the application of the principles and screening criteria, the TEG developed an initial list of economic activities selected from six sectors on the basis that they were, amongst other things, particularly vulnerable to the impacts of climate change¹³. No activities were excluded from the scope of activities substantially contributing to climate change adaptation, on the basis that adaptation in all sectors is important to build a climate resilient future.

Other criteria – do no significant harm and social safeguards

Under the Proposed Taxonomy Regulation, no climate change mitigation or adaptation activity will be considered to be environmentally sustainable if it causes significant harm to any of the other environmental objectives (protection of water resources; transition to a circular economy; pollution prevention and control; and healthy eco-systems) or if it does not comply with minimum social safeguards (ie the principles and rights set out in the fundamental International Labour Organisation conventions).

The baseline for DNSH is compliance with the relevant EU environmental legislation, with additional criteria where appropriate. DNSH criteria have been set out for the 67 priority climate change mitigation activities identified in the TEG’s report. For instance, production of electricity from wind power will meet the DNSH criteria related to protection of eco-systems if an Environmental Impact Assessment (EIA) is carried out to recognised standards (eg under the EIA Directive¹⁴), the procedure for Appropriate Assessment in the Birds Directive¹⁵ and Habitats Directive¹⁶  has been followed, and any impacts on birds and bats and visual amenity have been minimised. No specific DNSH criteria for adaptation activities have been developed at this stage.

Who does it apply to?

The Proposed Taxonomy Regulation envisages two main mandatory users of the taxonomy¹⁷:

• member states and the EU when setting rules about financial products or corporate bonds that are marketed as environmentally sustainable; and
• financial market participants offering financial products as environmentally sustainable investments (or as investments having similar characteristics).

In essence, financial market participants are institutional investors and asset managers¹⁸. Financial products include portfolio management, funds, insurance-based investment products, pension products and pension schemes¹⁹.

The Proposed Taxonomy Regulation does not require financial market participants to invest in taxonomy-eligible activities but, rather, to disclose information on how and to what extent the taxonomy has been applied to determine the environmental sustainability of the products they offer. Future delegated acts will further specify the information required to be disclosed to comply with this obligation²⁰.

In implementing the taxonomy, the TEG envisages that financial market participants will identify potentially taxonomy-eligible activities covered by a financial product and assess whether each activity meets the taxonomy’s criteria. They will then need to calculate and disclose the percentage of the investment or investment portfolio that is comprised of environmentally sustainable activities (eg an infrastructure fund is 53% taxonomy-compliant). Ultimately, this is intended to put an end to “greenwashing” and to increase capital flows to the financing of activities that will have a meaningful impact in achieving the EU’s climate goals.

This is not to say that the taxonomy will not or cannot have other uses. For instance, it is expected to be used to define the characteristics of green bonds under the proposed EU “Green Bond Standard”²¹, and may be used on a voluntary basis by others for green loans, green finance or ESG analysis. The taxonomy could also be used outside the EU, using analogous local laws and standards as appropriate.

Challenges and opportunities

Through investing in and financing sustainable activities, investors can play a significant role in driving companies towards undertaking climate change mitigation or adaptation activities. However, the TEG recognises that gathering quality data on a company’s (i) revenue from, or expenditure on, taxonomy-eligible activities, (ii) performance against the screening and DNSH criteria, and (iii) social performance, is the main usability issue associated with the taxonomy. To varying degrees, companies and data providers will need to invest time, money and human resources to be able to disclose meaningful, comparable and quality information that allows investors and asset managers to carry out a due diligence exercise against the taxonomy’s requirements. Asset managers and institutional investors will similarly need the systems and expertise to fully analyse and apply this data. However, there is a growing consensus that this shorter-term commitment of resources will ultimately lead to a more streamlined and useable sustainable investment framework in the medium- to long-term, in comparison to the heavily fragmented, and often discretionary, reporting and data collection metrics currently in use.

Next steps

The TEG sought feedback on its report during a consultation period that ended on 16 September 2019. Until its mandate concludes (envisaged to be at the end of the year), the TEG will assess feedback and continue to refine and develop the incomplete aspects of the technical screening criteria. It will also develop further guidance on the implementation and use of the taxonomy, and make further recommendations to the Commission.

The TEG’s recommendations will then inform the Commission in developing proposed legislation to implement the taxonomy in respect of climate change mitigation and adaptation activities. The Commission will also establish a permanent Platform on Sustainable Finance to take on the role of the TEG in providing technical assistance, including on the development of technical screening criteria for new activities included in the taxonomy’s scope. The Platform will be comprised of representatives from the European Environment Agency, the European Supervisory Authorities, the European Investment Bank and the European Investment Fund, as well as individual experts and members from the private sector.

The Proposed Taxonomy Regulation is expected to apply in stages, with the provisions relating to each environmental objective becoming applicable six months after the technical screening criteria for that objective are established²². However, the timeline for the implementation of the taxonomy remains uncertain. The European Parliament supports a faster timeline, with the taxonomy available for use from July 2020, whilst the Council has proposed that the taxonomy should be in place by the end of 2021, to ensure its full application by the end of 2022.

In the event the United Kingdom leaves to EU without a withdrawal deal prior to the entry into force of the Proposed Taxonomy Regulation, it would need to introduce legislation to empower the Government to “onshore” the Regulation after its adoption. Previously, the Financial Services (Implementation of Legislation) Bill 2017-19 listed the Proposed Taxonomy Regulation as “in flight” EU legislation which could be onshored after the UK leaves the EU. However, the Bill has now fallen as it failed to complete its passage through Parliament before the end of the 2017-19 Parliamentary session. Whether a similar Bill will be introduced in the new Parliamentary session after the general election on 12 December 2019 remains to be seen.

In any event, while the implementation of the taxonomy remains uncertain, it is expected that the standards and requirements developed at the EU level will underpin the approaches taken across the UK financial sector, in line with the Government’s commitment to at least match the ambition of the objectives of the EU’s Action Plan²³. Indeed, the UK’s position as an international financial hub will mean that UK investors, asset managers and companies alike will continue to build internal capacity to be able to consider and, where appropriate, apply the taxonomy’s criteria moving forward.

For further information on any aspect of this article, or on sustainable finance more broadly, please contact the authors on this page or your usual contact within Allen & Overy LLP.

Footnotes

1. European Commission, Communication from the Commission: Action Plan: Financing Sustainable Growth (8 March 2018), available here: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52018DC0097.

2. In this respect, the Action Plan builds upon the recommendations made by the High-Level Expert Group on Sustainable Finance (HLEG) appointed by the European Commission at the end of 2016. The HLEG was mandated with recommending financial reforms on which to base the EU sustainable finance strategy (ie the Action Plan). The HLEG recommended, inter alia, that a common sustainability taxonomy be developed at the EU level.
3. European Commission, Proposal for a Regulation of the European Parliament and of the Council on the establishment of a framework to facilitate sustainable investment (24 May 2018), available here: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52018PC0353.
4. Two delegated acts are also proposed as part of this package, which amend delegated regulations made under the MiFIDD II Directive (2014/65/EU) and the Insurance Distribution Directive ((EU) 2017/2359). The proposed amendments will require investment firms and insurance distributors to ask their clients about their preferences concerning ESG and then take them into account when providing advice to their clients.
5. Council of the European Union, Press release: Capital Markets Union: Council adopts legislative reforms (8 November 2019) available here: https://www.consilium.europa.eu/en/press/press-releases/2019/11/08/capital-markets-union-council-adopts-legislative-reforms/. At the time of writing, the Disclosure Regulation and the Low Carbon Benchmarks Regulation have not yet been published in the Official Journal.
6. European Parliament, Establishment of a framework to facilitate sustainable investment: European Parliament legislative resolution of 28 March 2019 on the proposal for a regulation of the European Parliament and of the Council on the establishment of a framework to facilitate sustainable development (COM(2018)0353 – C8-0207/2018 – 2018/0178(COD)) (28 March 2019).
7. Council of the European Union, Proposal for a regulation of the European Parliament and of the Council on the establishment of a framework to facilitate sustainable investment – Mandate for negotiations with the European Parliament (23 September 2019). available here: https://data.consilium.europa.eu/doc/document/ST-12360-2019-ADD-1/en/pdf.
8. Article 3.
9. Article 5.
10. Nomenclature statistique des activités économiques dans la Communauté européenne (NACE) is a European industry standard classification system.
11. In total, the activities in the selected sectors represent 93.2% of greenhouse gas emissions by NACE code.
12. Article 14(1)(h) of the Proposed Taxonomy Regulation also requires that the technical screening criteria developed in delegated acts take into account the risk of assets becoming stranded and losing value.
13. The initial sectors are (a) agriculture, forestry and mining; (b) electricity, gas, steam and air conditioning supply; (c) information and communication technologies; (d) financial services and insurance; (e) professional, scientific and technical activities; and (f) water, sewerage, waste and remediation.
14. Directive 2011/92/EU.
15. Directive 2009/147/EC.
16. Council Directive 92/43/EEC.
17. Article 4(1), (2).
18. “Financial market participants” comprise any of the following: (i) an insurance undertaking which makes available an insurance-based investment product; (ii) an alternative investment fund manager; (iii) an investment firm which provides portfolio management; (iv) an institution or occupational retirement provision or a provider of a pension product; (v) a manager of a qualifying venture capital fund; (vi) a manager of a qualifying social entrepreneurship fund; and (vii) a UCITS management company.
19. “Financial products” may mean: (i) portfolio management, (ii) UCITS funds; (iii) alternative investment funds; (iv) insurance-based investment products; (v) pension products; and (vi) pension schemes.
20. Article 4(3), (4).
21. The Commission has sought the TEG’s assistance in developing an EU Green Bond Standard. The TEG published its final report in June 2019, which the Commission is currently considering.
22. Article 18.
23. Financial Conduct Authority, Climate Change and Green Finance: summary of responses and next steps, Feedback to DP18/8 (October 2019), available here: https://www.fca.org.uk/publication/feedback/fs19-6.pdf

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