The EU Taxonomy Regulation: 5 reasons to start aligning today

The European Union is committed to becoming the first climate-neutral bloc in the world by 2050. This requires significant investment from both the EU and the national public sector, as well as the private sector. The European Green Deal's Investment Plan - the Sustainable Europe Investment Plan - will mobilise public investment and help to unlock private funds through EU financial instruments which would lead to at least €1 trillion of investments.

Given that the first EU Taxonomy disclosures are due by the end of 2021 and throughout 2022, and that it is a quite complex and extensive framework, it is key to start aligning with the EU Taxonomy as soon as possible. If in doubt; just ask anyone involved in EU’s GDPR alignment. Things take time.

As part of the EU action plan to finance sustainable growth, which aims to direct and boost such investments, the EU Commission has assembled a Technical Expert Group for Sustainable Finance (TEG) to develop a classification system for economic activities that contribute to sustainable development: the EU Taxonomy. As the Commission forgot to consult a naming expert, let us just say up front that the EU Taxonomy is more straight forward and more crucial than it sounds.

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Before presenting our five reasons to get going, let us first look at what we are dealing with. The EU Taxonomy Regulation, or simply the Taxonomy, is the first uniform and credible standard that allows economic parties to align with the transition to low carbon, resilient and sustainable pathways. It establishes a common understanding of what economic activities qualify as environmentally sustainable throughout the EU, provides visibility for investors who want to invest in sustainable activities and assists in preventing “greenwashing”.

The Taxonomy applies to two different parties 1) financial institutions that offer financial products on the European market and 2) non-financial companies that already have to submit a non-financial statement under the Non-Financial Reporting Disclosure (NFRD) regulation.

A common understanding is established via a classification system for sustainable activities. This is done by setting performance thresholds, outlined in the “Technical Screening Criteria”, to help parties identify environmentally friendly activities. The EU Taxonomy focusses on six environmental objectives as outlined below.

The Technical Expert Group is developing the technical screening criteria to outline what economic activities can contribute to each of the six environmental objectives.

The screening criteria includes metrics and thresholds for each economic activity to define whether it is substantially contributing to the environmental objective. Furthermore, criteria are provided to ensure that the activity does no significant harm to any of the other objectives. For an economic activity to be aligned with the EU Taxonomy, it must:

objectives of climate change mitigation and climate change adaptation. Financial institutes are to comply with this new regulation for these two environmental objectives by the end of 2021, and non-financial companies throughout the year 2022.

The technical screening criteria for the remaining four environmental objectives will be established meanwhile and both parties will have to comply to these by the end of 2022.

The EU Taxonomy will be mandatory for a significant number of European financial institutions and companies. All those offering financial products on the European market and those falling under the Non-Financial Reporting Disclosure (NFRD) regulation will have to comply.

Depending on whether you are a financial or non-financial company seeking to comply, different disclosure regulations apply. A financial institution should disclose to what extent it uses the EU Taxonomy, to what environmental objectives its investments contribute, and the percentage of underlying investments that are EU Taxonomy-aligned.

Non-financial companies are to disclose the financial metrics aligned with the EU Taxonomy (this can be either the turnover, CAPEX or OPEX), whether and how it complies with the social safeguards, and that it does not significant harm to any of the environmental objectives. This should be disclosed in the companies’ non-financial statement, included in the annual reporting or in a dedicated sustainability report.

The Taxonomy aims to provide clarity to investment professionals and protection against “greenwashing” claims. Once a company discloses its alignment with the screening criteria, it will provide detailed information on the actual environmental impact and sustainable performance of its economic activities.

As the EU Taxonomy will indicate whether and to what extent a company is contributing to environmental objectives, it is likely that alignment with the EU Taxonomy will have an impact on a company’s reputation. When a high alignment is indicated for the financial institutions, it means that many of their investments and other financial products are contributing to environmental sustainability, which could generate positive publicity. This of course, on the other hand, means that there is a risk for bad publicity when a financial institution indicates a low alignment with the EU Taxonomy.

A business’ or company’s reputation is its most valuable asset. Negative publicity or public perception directly impacts upon revenue and in a world of instant news and images, reputation is even more critical.

A high taxonomy alignment for non-financial companies means that their economic activities are contributing to environmental sustainability, which would enhance the company’s reputation. An enhanced reputation will also likely attract more investors that are seeking to distinguish sustainable investments from regular investments.

Alignment with the EU Taxonomy Regulation may also reduce risk across company supply chains. A common sustainability language and criteria across a supply chain can help mitigate disruption and delay as well as build supply chain resilience.

Besides attracting investors through a good reputation, companies will also have better access to finance by disclosing their alignment with the EU Taxonomy. Financial institutions that wish to increase their share of taxonomy-aligned investments will look to invest in companies that have taxonomy-aligned activities and that have disclosed this.

Whether and to what extent an economic activity is taxonomy-aligned should be assessed by the company performing the economic activity. When this information is not provided by the company, the investor must assess this themselves, leading to extra work. Therefore, an institution seeking to invest sustainably will more likely choose to invest in a company that has disclosed the alignment of their economic activities to the EU Taxonomy.

Due to the timeline of the EU Taxonomy Regulation, financial institutions will have to comply first before the non-financial companies. Companies that voluntarily align their activities with the EU Taxonomy before it is mandatory will, most probably, experience a first-mover advantage. As financial institutions can foresee that it will spare them quite some assessment efforts when the data is already provided for by the end of next year, non-financial companies that have already disclosed the alignment, or indicate to do so by then, could be favoured for investments.

By assessing economic activities with the best-practice metrics offered by the Taxonomy, companies will achieve an increased understanding of the sustainable impact of their activities. This assessment will allow them to benchmark themselves against the best practices in order to indicate where possible improvements can be made.

Not only will this lead to a better alignment ‘score’, but it will also allow for better insights in their sustainability efforts and guide their decision-making towards more sustainable practices.

To ensure that the technical screening criteria are always up to date and that it reflects the fast-changing nature of science and technology, it is to be reviewed constantly by the recently EU-assigned Platform for Sustainable Finance. This assures that the metrics used for the assessment and benchmarking will be up to date and in line with the most recent findings concerning environmentally sustainable practices.

The alignment process also enables both financial institutions and non-financial companies to utilise it as a means of communication internally throughout their organisations. One of the greatest obstacles to an institution or company transitioning to a more sustainable organisation is the people within an organisation. Impact, especially positive, can be communicated providing encouragement and motivation to continue upon the journey whilst helping to adapt the overall culture within an organisation.

Key to future proofing a business or enterprise is to build resilience. By illustrating overall preparedness some uncertainty is alleviated and this can raise overall company value i.e. stocks and bonds. By aligning with the EU Taxonomy Regulation, companies can identify potential hazards, measure exposure and determine overall vulnerability.

Taking proactive action with respect to alignment can assist companies in ensuring that, for example, climate change does not undermine specific company objectives. Alignment will also help in ensuring that initiatives or programmes do not inadvertently increase vulnerability to a particular hazard. However, alignment may also present opportunities to make future development and programs resilient to climate change and associated risks, and that any opportunity is identified and indeed exploited.

Resilience is key to enabling a business or organisation to take proactive, forward-looking steps to engage in sustainable behaviours. Aligning with the Taxonomy will assist business and enterprises in building resilience thus providing greater overall confidence be it as shareholders, investors or customers.

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Having zoomed in on five reasons to start aligning, we want you to zoom out again. Because there is one more thing before we wrap up: Addressing the EU Taxonomy Regulation purely from a compliance perspective will hinder both financial institutions and companies alike from unlocking the true value potential of the EU Green Deal and, more broadly, the green transition.

Taking advantage of the EU Taxonomy Regulation, as apart from complying with the regulation, provides financial institutions with investment portfolios that are more resilient to fluctuation and more in line with the future that we must aspire to.

For business, companies and enterprises it provides an opportunity to be recognised as a sustainability leader, one that is embracing the inevitable green transition. Furthermore, we think it makes business sense to take advantage of an opportunity that builds resilience, enhances reputation, inspires employees and attracts customers as well as of course increasing overall share value.

Therefore, we encourage both financial institutions and non-financial companies alike to be proactive with respect to alignment and compliance but also to use the EU Taxonomy Regulation to assist them in guiding the transformation driven by more sustainable business practices.