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New EU Taxonomy Aims for a Rapid Increase in Sustainable Investing

April 2, 2020

Investor demand for sustainable investments is growing, but the exact definition of sustainable has traditionally relied on self-reporting or industry standards, creating confusion and a lack of traceability for investors.

The new European Union taxonomy, released in early March, aims to assist investors and companies by providing a common language for sustainable activities. By providing a detailed list of environmentally sustainable economic activities, the EU aims to reduce “greenwashing” and meet its long-term emission-reduction goals. By providing this common framework, the EU is also sending a signal to financial market participants to prioritize investment in these activities because they will play a significant role in the transition to a low-carbon economy.

Though the taxonomy is designed specifically for EU countries, its actual impact will stretch beyond the boundaries of European markets to any financial companies who sell products and services into the EU, and companies receiving capital investment and financing from European investors.

As European issuers, investors, banks and insurers leverage and incorporate the taxonomy in their business and investment processes, Canadian businesses should think about how their business or financial products would stack up against the taxonomy and their peers.

Confusion in the growing sustainable marketplace

Relying on self-labeling and various industry standards using different methodologies has enabled the growth of greenwashing – the labelling of financial products or company activities as environmentally friendly when they are not.

An analysis of 230 European retail funds labelled as sustainable found that 52 per cent of these funds made positive claims about the environmental impact of their products or services but none passed a “substantiation test”, which seeks to prove a verifiable environmental benefit or improvement. Furthermore, none of the funds could pass an “accuracy test”, which determines if the fund is being descriptive enough about their environmental impact.

To provide the booming sustainable investment and finance industry with the integrity and transparency it needs, the EU hopes use the taxonomy to answer the simple question: what qualifies as an environmentally sustainable economic activity?

What is the EU taxonomy?

The EU taxonomy is the backbone of the wider EU Action Plan on Financing Sustainable Growth, a regulatory package to promote sustainable finance within Europe by aligning private and public investment with the EU’s emission-reduction targets and sustainable development goals.

The taxonomy is a list of economic activities that help meet environmental objectives based on technical environmental performance criteria. This list of activities is flexible for use across asset classes and it can respond quickly to changes in technology, science, and new evidence by amendments or expansion to include new activities. Through the use of technical thresholds, the taxonomy doesn’t favour specific technologies, rather it sets ambitious standards to help kick-start innovation across industries.

The list is intended to be used as a tool by companies and financial market participants to determine their alignment with activities that meet environmental objectives. To be successful, companies will need to provide detailed disclosures on their revenues and expenditures and explain how they are aligned with the taxonomy. Investors and financiers will be able to use this information to invest in companies and projects that contribute to environmental objectives, and to position their portfolios for a low-carbon future. The EU is developing taxonomy-enabling regulation to ensure that companies and investors use and report on their taxonomy-alignment through disclosure requirements and financial product labels.

High-level text on the taxonomy regulation has already found political agreement in the EU with a more detailed version of the legislative proposal coming by the end of 2020. The Platform on Sustainable Finance, made up of public and private-sector experts, will be tasked by the European Commission with expanding and updating the taxonomy on a permanent basis once it’s legally-enshrined.

How does the EU taxonomy work?

To comply with the taxonomy, a user will need to check if their economic activity is currently included as an eligible activity. If listed, the economic activity will have to meet three requirements:

  1. Substantially contribute to one or more of six environmental objectives, including:
    1. Climate change mitigation
    2. Climate change adaptation
    3. Sustainable use and protection of water and marine resources
    4. Transition to a circular economy
    5. Pollution prevention and control
    6. Protection and restoration of biodiversity and ecosystems
  2. Do no significant harm to the other objectives
  3. Comply with minimum safeguards.

The first and second requirements are the “technical screening phase” used to determine whether a “substantial contribution” to an environmental objective is made and no significant harm is done to the relevant objectives. Environmental performance thresholds are used to determine if the activity meets these requirements. Currently, the technical screening criteria has only been developed for climate mitigation and adaptation categories, which can be found in the March final report on the EU taxonomy. The other environmental objectives will be developed in the coming years

To determine if the economic activity meets the “substantial contribution” threshold, it must meet a specific environmental performance threshold by either its own activity or through an enabling activity. For example, to meet the threshold of a “substantial contribution” under the climate change mitigation objective, the economic activity of passenger cars or commercial vehicles must have a tailpipe (i.e. direct emissions from the car) emission intensity of 50 grams of carbon dioxide per kilometre or below.

In the technical screening phase, an economic activity’s own performance, or its enabling of another, is split into either a low-carbon activity or a transition activity. The low-carbon activity has very low or zero emissions profile, while the transition activities help facilitate emission reductions (even if that activity is not low carbon). Only economic activities that don’t currently have an economically feasible low-carbon alternative are eligible to be considered as a transition activity.

The third requirement is to ensure that the activities comply with social safeguards such as those defined by guidelines from the Organisation for Economic Cooperation and Development and the United Nations’ Guiding Principles of Business and Human Rights.

Going forward, if a company or investor believes they have an economic activity that is making a significant contribution, but screening criteria isn’t available, they will be able to engage the EU’s Platform on Sustainable Finance group for consideration.

The EU taxonomy falls short on managing the low-carbon transition

One area of contention is around “significantly harmful” activities. As mentioned above, to be eligible as a transition activity, an activity cannot have an economically feasible low-carbon alternative. As well, the activity must have emissions that correspond to best performance in its sector or industry, the activity cannot hamper the development and deployment of low-carbon technologies, and it cannot lock-in long-term carbon intensive assets. Essentially, the activity must still be consistent with the EU’s long-term emission-reduction goals.

The EU’s Technical Expert Group on Sustainable Finance’s final report on the EU taxonomy recommends that the EU Commission tasks it’s Platform on Sustainable Finance with developing classifications for “brown” or polluting activities that have feasible alternative technologies. A brown taxonomy would label activities as “significantly harmful to environmental objectives”, which could deter investment and financing due to fears of downside tail risks in a low-carbon transition.

Critics of the taxonomy say it omits incremental improvements from polluting activities that would contribute to emissions reductions in the short-term, such as an oil company reducing the carbon intensity of its operations. This middle ground between green and brown requires more attention. Mark Carney, former governor of the Bank of England, said that the taxonomy, in its current form, was binary and did not capture transition opportunities. “Mainstreaming sustainable investing will require a richer taxonomy – 50 shades of green,” said Carney in a speech at the UN Secretary General’s Climate Action Summit 2019.

Recommendations from Canada’s Expert Group on Sustainable Finance supported the need for a Canadian taxonomy that includes opportunities for financiers and investors to support high-emitting sectors in their low-carbon energy transition. Countries like Canada are likely to utilize the EU’s experience and learnings, but will likely require a taxonomy that supports the transition for resource-based industries. The EU will expand its taxonomy if their goal is to become the global standard.

What does the EU taxonomy mean for your business?

The taxonomy will be used by a variety of market participants and policy makers to provide clarity on economic activities which contribute to environmental objectives and support the global transition to a low-carbon economy.

New labels, standards and benchmarks to easily navigate

The EU plans to introduce the taxonomy into new labels, standards and benchmarks to help investors and companies more easily navigate the sustainable-investing landscape, including:

  • Ecolabel: introduction of an official label for retail-level sustainable financial products
  • EU Green Bond Standard: standardization to verify issuers’ green credentials
  • Low Carbon Benchmarks: to define a Paris-aligned investment universe and the creation of index-linked products.

With the growth in sustainable investment products, green bonds and low-carbon benchmarks, the EU is creating official labels to try and provide the industry with the transparency and credibility it needs for mass adoption.

The EU and its member states will also be required to use the taxonomy when setting future standards on environmentally sustainable financial products.

Changes to banking capital requirements are still being considered by the EU Commission, while Canada’s expert group asked financial stability supervisors to look at incentivizing banks through reduced capital requirements for green projects, and penalizing requirements for “significantly harmful” ones. For example, Natixis, the French banking group, has introduced a proprietary “Green Weighting Factor” as a capital allocation mechanism to positively or negatively adjust its risk-weighted assessments, with plans to eventually use the taxonomy as its classification system.

Disclosure requirements will be a burden, but present opportunities

The taxonomy will be incorporated into the EU’s Non-Financial Reporting Directive (“NFRD”), an existing company disclosure legislation for large companies (>500 employees)Companies will be asked to describe how, and to what percentage, their revenues, capital expenditures, and, if relevant, operational expenditures are aligned with the taxonomy. This will likely be a burdensome activity for many companies to break down their revenues and expenditures on an activity-level. Across the globe, companies would be wise to get a head start via a learning-by-doing approach, especially those who are keen to position themselves as low-carbon solution providers.

Company disclosure requirements will help businesses gain an understanding of what contribution they are currently making to environmental objectives, and the direction they’re heading based on future expenditures. Companies that align their activities with the taxonomy may create demand for their equity and debt financing activities from investors utilizing the taxonomy to create green portfolios and products, or by being included in low-carbon indexes and benchmarks. Alternatively, companies may be punished by capital markets if they are largely misaligned with environmental objectives.

In addition to the company disclosure requirements, companies providing financial products or services in the EU will be required to disclose against the taxonomy (via a percentage) if their products are marketed with having sustainable or ESG objectives. Financial products that do not make a specific sustainability claim will still be required to explain (through a comply-or-explain rule) whether they have chosen to disclose their alignment with the taxonomy. While these disclosures, again, represent a burdensome reporting activity for financial product providers, many will be keen to prove their green credentials using the taxonomy. As demand for sustainable investment opportunities continues to grow, financial products that can prove their environmental performance will be well positioned to take advantage of the growing market.

How can investors use the EU taxonomy?

Investors are seen as key drivers in the shift to a low-carbon economy and the taxonomy should be seen as a useful tool. While some companies may find the increased disclosure requirements a political overstep, investors can quickly change this thinking.

Under the financial disclosures regulation, asset owners and managers will need to begin with screening their sustainable investment portfolios to produce a taxonomy-alignment percentage. Portfolio company disclosures will be a key cog in this process, and as such, the taxonomy can immediately be used by all investors to engage their portfolio or issuing companies. Investors should seek to understand their disclosures against the taxonomy. Investors may join forces to convince non-compliant companies that consistent and transparent taxonomy disclosures are required, and this may be a topic for future shareholder resolutions.

Asset owners, such as pension funds, will also be key in making taxonomy-alignment a requirement for asset managers and their investment products. Asset owners who currently have mandates with sustainability claims will want their asset managers to disclose their taxonomy-alignment. This information can be used to assess how well positioned their investment portfolios are for a low-carbon future, and can be standardized for future deployment across the investment process. The taxonomy could, for example, be integrated into their RFPs, manager due diligence, selection and monitoring processes. It will provide a useful tool to compare asset managers and their various environmental products. In addition, as more beneficiaries become aware of the taxonomy, they will want to understand how their investments are helping to support the low-carbon transition and asset owners will need to report the actions they are taking.

Asset managers currently offering ESG and sustainable investment funds can assess their portfolio alignment (percentage of a fund or other investment vehicle) with the taxonomy and use it as a tool to identify green opportunities that will benefit from the transition to a low-carbon economy. For those with higher ambitions, special attention will need to be paid to the Ecolabel for investment products in order to understand what they need to do to qualify.

All investors can look to set internal targets for taxonomy-alignment, and the proposed low-carbon benchmarks could be a useful tool to defining a new investment universe to position portfolios for a low-carbon future.

With a potential brown taxonomy, investors will be able to identify what percentage of their portfolios are invested in companies whose economic activities are inconsistent with long-term emission-reduction goals, helping to highlight those investments which give investors exposure to transition risks.

More work required but the impact will be widespread.

While the EU taxonomy is a work in progress, and currently restricted to the EU and those who do business with it, global companies and investors would be wise to use the taxonomy to understand how their businesses or investment products will be impacted.

Those who are caught off guard by the taxonomy regulations or similar future taxonomy regulations in their jurisdictions could be in for an abrupt and uncomfortable change to adhere to new reporting requirements, labelling standards, and to stay level with their peers. Having standardized processes in place to gather data, engage relevant parties for information, and assess your business and/or portfolios will allow companies and investors to position themselves to thrive in a low-carbon, taxonomy-filled, future.