The EU Taxonomy in 2023 – More clarity or more confusion?

Comparing disclosures

As annual reports are published in February and March, it will be interesting to compare how companies disclose their alignment. Already, some erratic patterns are apparent with respect to eligibility in certain economic activities and different interpretations regarding Taxonomy alignment are expected.

For the first time, the opportunity to compare companies with the same economic activities will be possible. With particular interest, we will await to see if inconsistencies lie in the interpretation of the technical screening criteria for substantial contribution or if they, for example, derive from a loose approach to the application of the Minimum Safeguards.

Will companies that deliver the same economic activity have similar or completely different scores?

The decision by some companies to be cautious with their alignment scores may prove to be wise, as those that may not have been as cautious may become the focus of attention, with the justification of a particularly high score being sought by various stakeholders.

Environmental Delegated Act

The Environmental Delegated Act will be open for public consultation in Q1 of 2023 and subsequently finalised and adopted in 2023. Some revisions to the draft have been carried out as recently as November 2022 . A noteworthy consequence is that additional economic activities will be introduced to the Taxonomy e.g. textiles, consumer electronics, and pharmaceuticals.

The introduction of a whole new set of economic activities will cause confusion. For example, they are different to the climate delegated acts and numbered differently. Also, many companies will be presented with an opportunity to illustrate substantial contribution to more than one activity. This will inevitably bring more confusion, particularly with KPI allocation.

The Environmental Delegated Act will introduce a whole suite of new criteria. CO2eq is a metric we all have become accustomed to. However, circular economy, as an example, will introduce new metrics and thresholds that will differ depending on economic activity. The complexity of metrics, indicators and targets will grow, as will the emphasis on data tracking and collection.

In contrast to the above, however, the Environmental Delegated Act will also bring opportunity. Companies that are either not eligible with respect to the Climate Delegated Act, or unable to substantially contribute, may find that the Environmental Delegated Act provides them an opportunity to illustrate their sustainability credentials.

Minimum Safeguards coming to the fore

One of the more challenging elements of the EU Taxonomy has been the interpretation and application of the Minimum Safeguards. Companies’ interpretation and application have not been helped by the final publication of the Minimum Safeguards as recently as October 2022, giving little time to address issues before the close of the financial year.

Also, many companies have assumed that their operations would easily align with the Minimum Safeguards. This, however, has proven not to be the case. Only a few companies, upon first assessment, have managed to align.

In general, the requirement to align with the Minimum Safeguards has been underestimated in terms of its importance and the resources required to reach alignment.

However, this has started to change in the course of 2022; with mounting pressures for companies to be sustainable and responsible, incl. investor demands, and not least due to approaching reporting deadlines, we see companies investing considerably living up to the Minimum Safeguards. And this trend is likely to continue going into 2023 considering the expansion of EU legislation e.g. with CSRD and CSDDD.

Growing engagement from the public sector

During 2022, much of the discussion has revolved around the “why”: Why should companies take it seriously? Why should companies that perhaps are not in the scope of reporting on the EU Taxonomy still decide to disclose? The answers to these questions will be influenced by how the public domain reacts and is expected to react to the Taxonomy in 2023.

First, public agencies will start including EU Taxonomy related criteria in public procurement, with examples of this already occurring. Companies wishing to tender for such contracts will need to disclose alignment. Indeed, scores could become a deciding factor in the tendering process.

Secondly, public agencies will increasingly use the language of the Taxonomy. This can potentially make complying with the Minimum Safeguards a potential prerequisite for receiving permission, license or permit. Illustrating Taxonomy alignment for eligible activities will hence form part of the license to operate e.g. for data centres, real estate, etc.

Continuing revisions & guidance

The whole process is “learning by doing”. Compared to legislation and regulation in general, the EU Taxonomy is moving at a lightning pace. This comes with flaws that are identified and rectified only via trial and error.

In October 2022 the document titled Supplementary: Methodology and Technical Screening Criteria  was published by the Platform on Sustainable Finance. This document, among others, revises the technical screening criteria for eligible activities in the transport sector included in the Climate Delegated Act. It acknowledges that the original criteria were unrealistic offering little incentive for that economic activity to align. Such revisions are expected to continue bringing much-needed clarity but also frustration.

As recently as December 2022, further guidance  was published by the European Commission on how to interpret and apply the Climate Delegated Acts. For example, further guidance is provided for climate change adaptation both for substantial contribution and DNSH.

Although welcome, the arrival of the guidance will have come too late for many companies who have spent the better part of 2022 assessing and calculating their Taxonomy alignment. For such companies, the guidance may be a root of frustration, as they might have to reconsider their assessment and KPI allocations considering the guidance.

The revisions and further guidance, e.g. on the application of the Environmental Delegated Act, are expected to continue in 2023 with the new mandate of the Platform on Sustainable Finance.

The CSRD to overshadow?

The CSRD will apply to companies that are already in the scope of the Non-Financial Reporting Directive in 2024 with reporting due in 2025. These are the companies that already report on the EU Taxonomy.

However, the CSRD will bring many new disclosure requirements across ESG topics, and the scope of it will enlarge to cover more companies in the years following 2024. In-scope companies should therefore start planning for the CSRD sooner rather than later. The sheer scale of the CSRD will require significant planning effort and resources in 2023 and beyond.

But, will attention then divert from Taxonomy to the CSRD both internally and externally? Will the relevance of the Taxonomy degrade as companies grapple with the complexity of the CSRD and multiple European Sustainability Reporting Standards (ESRS)? With disclosure requirements being constant across all entities, it seems certain that companies, whose economic activities are not Taxonomy eligible, will see the CSRD come to the fore, with the Taxonomy taking the back seat for a while.

Moving into 2023

2023 will be a year like no other with regard to regulatory demands in the realm of sustainability and ESG. The swathe of regulation and the confusion that it will invariably bring will lead to much frustration. However, it is important to remember that Taxonomy, albeit an imperfect language, is a necessary one.

The disruption it has created in 2022 and will continue to create in 2023 is indeed much needed. Companies need to be challenged, their impact on sustainability needs to be measured and compared, but above all, their overall sustainability ambition needs to be greater.

Clarity or confusion aside, the expectations towards companies’ ability to evolve, to improve and to have a real sustainable impact is only going to increase from regulators, shareholders and customers alike. Those companies that see the Taxonomy as a continuing opportunity in 2023, beyond the confusion, will reap the rewards as they move into 2024.