To understand the purpose of EU taxonomy, it is important to know how it fits in the broader context of the EU Green Deal.

The European Commission presented the EU green deal as a new growth strategy to address and tackle the most significant climate issues. Its main objective is to make the EU climate neutral by 2050 and reduce greenhouse gas emissions by 55% by 2030. The EU green deal plan will mobilize €1 trillion to support sustainable investment over the next decade, and it will develop a framework for private investors to facilitate sustainable investment. In that context,  the EU taxonomy is a classification system that clarifies which activities are considered environmentally sustainable. Providing clear guidance on determining whether or not an activity is considered as sustainable, helps companies to shift their investment where it is needed and protects investors from greenwashing.

The EU taxonomy and the Sustainable Finance Disclosure Regulation (SFDR) play a key role in reaching the objectives of the European green deal.

Criteria for Environmentally Sustainable Economic Activities

According to Article 3 of the Regulation, an activity qualifies as sustainable if it substantially contributes to one or more of the six environmental objectives set out in the Regulation. Furthermore, the activity does not significantly harm (DNSH) any of the objectives and it should be carried out in compliance with minimal safeguards, e.g. The International Bill of Human Rights and OECD Guidelines for Multinational Enterprises. Lastly, the activity needs to comply with the technical screening criteria that the Commission has established.

For each of the six environmental objectives, the Commission will issue delegated Act with detailed technical screening criteria. A first delegated Act on sustainable activities for climate change adaptation and mitigation objectives was published in 2021. Therefore, it has been applicable since January 2022. We expect the second one to be published later in 2022, while for the other four objectives, delegated acts are announced to be published later on for application in 2023.

The process of determining whether an economic activity is considered sustainable can be summarized in 4 steps: identification of activities, technical screening criteria, DNSH criteria and social safeguards criteria.

What Companies Fall Under the Scope of the EU Taxonomy?

The EU Taxonomy applies to entities divided into three groups: undertakings that fall under the non-financial reporting directive (NFRD), financial market participants that offer financial products (asset managers, life insurance, occupational pension providers etc.) and lastly, the Regulation applies to EU and its member states measures, that set out requirements for FMP or issuers regarding financial product or corporate bond being labelled as environmentally sustainable.

Reporting Requirements for Financial and Non-Financial Undertakings

As of January 2022, financial market participants need to disclose the proportion of their activities that are considered “taxonomy-eligible economic activities “or “non-eligible “in their turnover, capital (‘CapEx’)  and operational expenditure (‘OpEx’) and total assets. In other words, large entities are not required to assess the Taxonomy – alignment of these activities in 2022. Furthermore, given the technical standard criteria which are at the moment only established for the first two environmental objectives, entities are required to report only on the activities contributing to those 2 objectives. Taxonomy-eligibility reporting in the first year of reporting should prepare undertakings for their alignment disclosures requirement, expected as of January 2024 for the previous calendar year.

Non-financial undertakings shall follow the same rules as for FMP for the year 2022. However, as of January 2023 non-financial entities should report the activities that are considered aligned with the EU Climate Delegated Act ( supplementing EU taxonomy regulation by establishing the technical screening criteria for determining the conditions under which economic activity is considered to substantially contribute to an environmental objective).

Impact on Companies’ Strategy and Business Model

It is important to emphasize how the EU taxonomy does not prevent FMP to finance or invest in activities that are not eligible to the Taxonomy. Likewise, not all economic activities which might contribute to mitigating climate change or support transition are mentioned by the Taxonomy at the moment.

However, EU taxonomy together with the other regulatory measures ( SFDR, NFDR, ECB guide on Climate-Related Risk, etc.) will most definitely lead to a major shift of capital into financing sustainable activities. Therefore, companies that do not change their business models to support or contribute to mentioned environmental objectives, will most probably lose their relevance in the market. Already now we have examples of large institutional investors, like Allianz and others, which have announced to shift their capital into green assets or companies that substantially contribute to a net-zero economy within the next 20 years.

Even the entities that do not fall under the scope of the Taxonomy, like SMEs, will be impacted indirectly. For example, as of 2022 and onwards, European banks will be required to disclose the so-called “Green Asset Ratio “which is the ratio of a bank’s loans and securities meeting the EU taxonomy. This will also include loans to SMEs. Therefore, corporates that are not obliged to disclose information under the EU taxonomy will need to agree on terms to exchange this information with the bank since they will be subject to the Regulation.

The EU Taxonomy will Continue to Develop

The EU Commission clarified how the Taxonomy expects to evolve. For example, technical screening criteria are still missing activities that are important to include within the Regulation. Transition activities – those for which there are no technologically and economically low carbon alternatives – must be reviewed every three years to establish whether they are still considered “transitional “ones. Clearly, the current six objectives may also change depending on the upcoming political discussions and findings.

Indeed, there are many uncertainties and questions regarding sustainable financing and the implementation of accompanying regulatory measures. All market participants need to be aware of how this sustainable transition process will affect companies at all levels. Therefore it is a priority to tackle this challenge by ensuring your company is undertaking all necessary steps to comply with the current requirements and prepare for the upcoming changes. Companies that are at the moment legally out of the reporting scope will not necessarily escape from it. The reason is that some of the financial counterparts they will have will be subject to this legislation.