In a world facing unprecedented environmental challenges, the European Union (EU) has taken a significant step forward in promoting environmental accountability and sustainability through the introduction of a Digitised Taxonomy Framework. This innovative approach, which leverages digital technology and data, is poised to revolutionize how we identify and measure the environmental impact of economic activities.
In this blog, we will explore the EU’s ambitious move and its potential to shape the future of sustainable finance and environmental governance.
Introduction- The Urgency of Environmental Accountability
Environmental issues such as climate change, biodiversity loss, and pollution have become defining challenges of our time. The urgency to mitigate these crises has grown exponentially, with governments, businesses, and individuals recognizing the need for coordinated efforts to transition to a more sustainable and ecologically responsible world.
By passing the Green Deal in 2019, the European Union (EU) set the course for more sustainable investments, for example in areas like renewable energy, biodiversity or circular economy. The goal is to reach a climate-neutral economy in the EU by 2050, with a reduction of 55% already implemented in 2030. To achieve these climate goals, the Green Deal includes an investment plan of 1 trillion euros over the next 10 years. Despite this huge investment, the EU depends also on the support of the private sector to achieve the Paris climate agreement.
The EU Taxonomy regulation and the Sustainable Finance Disclosure Regulation (SFDR) are implemented to ensure equal competition and legal certainty for all companies operating within the EU.
Both regulations follow the objective of the Green Deal and have the following key goals:
- Reorientation of capital flows with a focus on sustainable investments
- Establishing sustainability as a component of risk management
- Promoting/encouraging long-term investment and economic activity
One of the key drivers of environmental degradation is the financial sector. Investments and financial decisions have a substantial impact on the environment, and as a result, there is a growing demand for transparency and accountability in the world of finance. Sustainable finance, which promotes investments in activities that contribute to environmental and social objectives, has emerged as a powerful tool in addressing these issues.
The EU’s Taxonomy Regulation
To support the transition to a more sustainable economy, the EU introduced the Taxonomy Regulation as part of the European Green Deal. The regulation, which came into force in July 2021, establishes a common framework for determining which economic activities can be considered environmentally sustainable.
What is EU taxonomy?
The Taxonomy is primarily a classification system for economic activities. Like any classification system, it has definitions and rules. The EU Taxonomy’s definitions and rules determine which economic activities are environmentally sustainable. As a classification system, the Taxonomy was created to address greenwashing by enabling market participants to identify and invest in sustainable assets with more confidence. However, the Regulation also places new Taxonomy linked disclosure obligations on companies and on financial market participants.
The EU taxonomy regulation describes a framework to classify “green” or “sustainable” economic activities executed in the EU. Previously, there was no clear definition of green, sustainable or environmentally friendly economic activity.
The EU taxonomy regulation creates a clear framework for the concept of sustainability, exactly defining when a company or enterprise is operating sustainably or environmentally friendly. Compared to their competitors, these companies stand out positively and thus should benefit from higher investments. Thereby, the legislation aims to reward and promote environmentally friendly business practices and technologies.
The focus lays on the following six environmental objectives:
- Climate change mitigation
- Climate change adaptation
- Sustainable use and protection of water and marine resources
- Transition to a circular economy
- Pollution prevention and control
- Protection and restoration of biodiversity and ecosystems
Enabling & Transitional Activities
Within the activities that substantially contribute to one or more environmental objectives, the Taxonomy also defines two classification categories, Enabling Activities and Transitional Activities. These were added to allow activities which may not otherwise have been considered sustainable to contribute to the overall objective of promoting sustainability.
Enabling activities allow other activities to make a substantial contribution to one or more of the Taxonomy’s six objectives. However, enabling activities cannot lead to a ‘lock-in’ of assets which would undermine long-term environmental goals. They must also have a substantial positive environmental impact over the activity’s lifecycle.
Transitional activities must contribute to climate change mitigation and a pathway to keeping global warming in line with Paris Agreement commitments.
Transitional activities only qualify where the following criteria are met:
- There are no technologically or economically feasible low-carbon alternatives
- Green House Gas emission levels correspond to the best performance in the sector or industry
- The activity does not lead to carbon lock-in or hamper the development and deployment of low-carbon alternatives
To be classified as a sustainable economic activity according to the EU taxonomy regulation, a company must not only contribute to at least one environmental objective but also must not violate the remaining ones. An activity aiming to mitigate the climate but at the same time also negatively affecting biodiversity cannot be classified as sustainable.
The classification of an economic activity in terms of sustainability is based on the following four criteria, which based on the previously mentioned environmental objectives:
- The economic activity contributes to one of the six environmental objectives
- The economic activity does ‘no significant harm’ (DNSH) to any of the six environmental objectives- For an activity pursuing one or more of the six objectives to qualify as sustainable it cannot cause significant harm to any of the other Taxonomy objectives. For each activity, the TSC lay out thresholds to define compliance with do no significant harm.
- The economic activity meets ‘minimum safeguards’ such as the UN Guiding Principles on Business and Human Rights to not have a negative social impact
- The economic activity complies with the technical screening criteria developed by the EU Technical Expert Group
The Digitised Taxonomy Framework
While the Taxonomy Regulation is a groundbreaking initiative, it faces challenges in terms of implementation and ensuring consistent and accurate reporting of environmental performance. To address these challenges, the EU has embarked on the journey to digitize the Taxonomy Framework.
- Enhanced Data Accessibility: By digitizing the Taxonomy Framework, the EU aims to make the criteria and data related to sustainable finance more accessible to market participants. This will enable investors, businesses, and regulators to have a clearer understanding of which activities align with sustainability goals.
- Automation and Efficiency: Automation plays a pivotal role in this framework, streamlining the process of assessing and reporting on environmental performance. By leveraging digital technology, the EU is making it easier for businesses to evaluate their environmental impact and demonstrate their commitment to sustainability.
- Real-Time Monitoring: The digitized framework allows for real-time monitoring and reporting, giving stakeholders up-to-the-minute information about the environmental impact of economic activities. This not only enhances transparency but also encourages continuous improvement.
- Global Standards: The EU’s move towards digitization also aligns with international efforts to create standardized taxonomies for sustainable finance, fostering global harmonization in the measurement of environmental sustainability.
Impact and Implications
The introduction of the Digitised Taxonomy Framework by the EU has profound implications for the financial sector and beyond:
- Informed Investment Decisions: Investors will be better equipped to make informed decisions, channeling capital into activities that have a positive environmental impact. This encourages the growth of sustainable finance.
- Enhanced Corporate Responsibility: Businesses will need to adapt to the digitized framework, improving their environmental performance and transparency, as they are held accountable for their activities’ sustainability.
- Government Leadership: The EU’s move sets a precedent for other governments to follow suit, fostering global cooperation in addressing environmental challenges.
- Fostering Innovation: The development of digital tools and platforms to support the Taxonomy Framework will stimulate innovation in the financial sector, promoting the growth of green finance and fintech.
New Taxonomy Reporting Requirements
While the Taxonomy is primarily a classification tool, it has other functions. For example, it requires certain entities to disclose information concerning the degree of alignment of their activities with the Taxonomy. This is achieved by amending the disclosure requirements in the EU’s Non-Financial Reporting Directive (NFRD) and the Sustainable Finance Disclosure Regulation (SFDR).
NFRD Taxonomy Disclosure- Any undertaking subject to the NFRD needs to disclose how, and to what extent, its activities are associated with activities that are considered as environmentally sustainable. Within that group, non-financial undertakings will need to disclose:
- The proportion of turnover derived from the Taxonomy activities; and
- The proportion of their capital expenditure and operating expenditure associated with Taxonomy activities.
This is known as Article 8 disclosure, and it will also apply to the expanded list of entities captured by the EU’s new proposal for a Corporate Sustainability Reporting Directive (CSRD).
SFDR Taxonomy Disclosure- SFDR scoped entities will need to disclose information on Taxonomy-alignment of their products. The disclosure covers products that have sustainable investment as their objective (Art. 9 SFDR products), and for those with environmental or social characteristics (Art. 8 SFDR products). This is known as Article 5 and Article 6 Taxonomy disclosure. The disclosure will cover how and to what extent the investments underlying the financial product are in economic activities that qualify as environmentally sustainable under the Taxonomy Regulation.
For financial products that do not do not consider the EU criteria for environmentally sustainable economic activities, the entity must make this statement in its disclosure. This is known as Article 7 Taxonomy disclosure.
The EU’s Digitised Taxonomy Framework represents a giant leap forward in the quest for environmental accountability and sustainability in finance. By leveraging digital technology to enhance accessibility, automation, and real-time monitoring, the EU is setting the stage for more responsible investment and business practices. As the world grapples with environmental crises, this innovative approach promises to be a cornerstone in the journey toward a greener and more sustainable future. It’s an exemplar of how the intersection of technology and policy can drive positive change for the planet and our societies.