ESG – Taxonomy Overview
The Taxonomy Regulation sets the criteria for determining if and to what extent an economic activity qualifies as environmentally sustainable. The aim is to prevent distribution of a financial product as environmentally friendly, where such product does not meet environmental standards (greenwashing).
The European Union and its Member States will determine the areas of law to which the qualification of environmental sustainability under the Taxonomy Regulation shall apply. Currently, this will be the case for the upcoming EU Green Bond Standard and the EU Eco Label.
Degree of Sustainability
Under the Taxonomy Regulation, an economic activity shall qualify as environmentally sustainable where that economic activity contributes substantially to one or more of the environmental objectives, does not significantly harm any of the environmental objectives, is carried out in compliance with the minimum safeguards, and complies with technical screening criteria.
For each environmental objective, the Taxonomy Regulation (along with technical screening criteria) defines what exactly is understood as a substantial contribution. For example, an economic activity shall qualify as contributing substantially to climate change mitigation where that activity contributes substantially to the stabilization of greenhouse gas concentrations in the atmosphere at a level which prevents dangerous anthropogenic interference. Such contribution can be facilitated by
- generating, transmitting, storing, distributing, or using renewable energy
- improving energy efficiency
- increasing clean and climate-neutral mobility
- switching to the use of sustainably sourced renewable materials
- increased use of environmentally sound technologies
Transitional & Enabling
The Taxonomy Regulation recognizes that while certain technologies are not actually "green", they are indispensable for the economy (transitional). The Taxonomy Regulation also establishes rules for "enabling activities" facilitating other green activities. Both areas can be classified as environmentally sustainable, subject to rather narrow preconditions.
No Significant Harm & Minimum Safeguards
An economic activity is environmentally sustainable only if it substantially contributes to at least one environmental objective while – at the same time – it does not significantly harm any other environmental objective. One objective must not be fostered at the detriment of other objectives, considering the entire life cycle of products and services.
An economic activity can further only be classified as environmentally sustainable if it is delivered in accordance with minimum social standards and a good governance structure. Compliance requires the implementation of procedures to ensure alignment with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work and the International Bill of Human Rights.
Compliance with the Taxonomy Regulation requires the implementation of new governance structures, also addressing environmental and social requirements. The allocation of responsibilities and due diligence requirements need to be clearly defined.
Disclosure of Environmental Sustainability
Any undertaking subject to an obligation to publish non-financial information shall include in its non-financial statement or consolidated non-financial statement information on how and to what extent the undertaking’s activities are associated with economic activities that qualify as environmentally sustainable. Non-financial undertakings shall disclose the following:
- The proportion of their turnover derived from products or services associated with economic activities that qualify as environmentally sustainable.
- The proportion of their capital expenditure and the proportion of their operating expenditure related to assets or processes associated with economic activities that qualify as environmentally sustainable.
The turnover-based disclosure is meant to measure the extent to which an economic activity is already taxonomy aligned. Capital and operating expenditures reflect investments to improve environmental sustainability. Both proxies raise significant concerns and questions in practice. In the banking sector, a green asset ratio (GAR) shall be applied instead.
Annual financial statements are not geared towards the assessment of environmental sustainability. Accordingly, financial variables derived from the annual financial statements are only partially suitable for assessing environmental sustainability. If, for example, the price of CO2 filters increase, so does the related capital expenditure of the company, but not necessarily the filter performance: a twice as expensive filter does not necessarily perform twice as much.
Similar problems arise in terms of revenue. In addition to the costs of the products and services sold, revenues also include a mark-up, which results, among other things, from the company's market position. Thus, if two companies sell the same number of products from the same environmentally sustainable activity, the company with the greater market power (and therefore higher sales prices achieved) will be “more” environmentally sustainable.