The EU Sustainable Finance Taxonomy: more than meets the eye

As the call for more transparency on the sustainability risks of business operations is rising in Europe and worldwide, the European Commission identified the private sector as a key investor in the green transition. To enable it, the Commission stated that “long-term signals are needed to direct financial and capital flows to green investment”. In this context, the Sustainable Finance Taxonomy is one key instrument the Commission will use to reorient financial and capital investments towards more sustainable activities.

The Sustainable Finance Taxonomy

So, what about the Sustainable Finance Taxonomy? In a nutshell, it aims at steering private investors towards environmentally sustainable companies. It plans to do so by defining how and which economic activities can be considered “environmentally sustainable”. In this way, the Commission believes the Taxonomy will provide a harmonised set of definitions to help investors in investing in sustainable activities.

More precisely, to be included in the EU taxonomy, a business activity must “substantially contribute” to one or more environmental objectives: climate change mitigation and adaptation; water and marine resources; transition to a circular economy; pollution prevention and control; biodiversity and ecosystems. At the same time, a business must “do no significant harm” against any of said objectives. Whether an economic activity fulfils these criteria or not will be decided through the so-called “screening criteria”. These criteria will be used by financial market actors (e.g., private banks, public institutions) to thoroughly analyse the sustainability profile of the economic activities they finance and invest in.

The Taxonomy will also identify two other categories of economic activities: “transitional activities”, that is activities whose GHG emissions are substantially lower than the sector average and at the same time do not hamper the development of low-carbon alternative and do not create dependency from assets incompatible with the climate-neutrality objectives; and “enabling activities”, directly enabling other activities substantially contributing to the objectives, as long as they do not create dependency from assets undermining the environmental goals and have a positive environmental impact on the basis of their life-cycle considerations.

A troubled process

The complexity of the matter is exemplified by the number of discording voices around the deployment of the Taxonomy. Strong frictions between the EU member states and the European Commission dragged since the adoption of the regulation: a decision on gas and nuclear energy in the Taxonomy had to be delayed, and the adoption of the first set of screening criteria had to be postponed to April 2021. The European Parliament, only able to present objections to the criteria after their adoption, expressed on several occasions the dissatisfaction for how the procedure is being handled.

Industry stakeholders, or at least some of them, are not entirely satisfied either, lamenting the lack of transparency in the definition of the screening criteria and the prominent role that the Sustainable Finance Platform, formally an advisory body of the European Commission, has gained over time in the development process. Business associations have also pointed out that the short time window until the entry into force of the new rules (applicable as of 2022) poses a serious obstacle for the business community to adapt and comply, considering the absence of clear rules on the reporting obligations, expected by June 2021. Even NGOs expressed their disapproval of the screening criteria for climate change mitigation and adaptation presented in April, with some of them walking away from the Platform, a formal act of protest against what was defined being “at odds with environmental science” and creating “a disastrous precedent”.

What should businesses expect?

If anything, these reactions leave no doubt about how everybody involved (or so wishing) understands that the Sustainable Finance framework will have a redefining impact for many industrial sectors in the years to come. In fact, the Taxonomy will have extensive ramifications across the board in most sectors. This is espcially true when put in the context of the renewed Sustainable Finance Strategy, including for instance the EU Regulation on sustainability-related disclosures in the financial services sector adopted in 2019 (Disclosure Regulation) and the recent proposal for a revision of the Non-Financial Reporting Directive (NFRD).

These new rules are meant to improve the transparency and accountability of companies large and small alike, and drive them towards greener production patterns. Financial market actors will try to increase the sustainability of their investment portfolios and will use the Taxonomy as a standardised compass for that purpose, against the current fragmentation of definitions and assessment methodologies. This will have a direct impact on the way the sustainability of business’ operations is defined and how and what type of information companies will have to disclose about their operations, leaving them with much less room for interpretation. The Taxonomy might as well soon become a form of conditionality to access member states and EU funding.

As a result of the Taxonomy, individual economic activities may end up being labelled as environmentally sustainable, transitional, enabling or being left out entirely from the Taxonomy, with the risk of being denied access to advantageous source of investments and making raising capital more expensive. What is more, in absence of major alignment and standardisation at global level, it is very much likely that these rules may influence the conduct and practices of extra-EU actors as well, if they want to benefit from such a large market.

For these reasons, keeping track of the development and deployment of the Taxonomy should become a key policy priority for most industrial sectors: making sure that the nuances and best practices in the operations of a sector of activity are clearly reflected in the screening criteria will become essential for individual companies to enjoy competitive access to finance and capital investments.

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