The European Commission in April adopted a comprehensive package of measures aimed at directing more investments toward sustainable activities across the European Union. As part of the European Green Deal strategy, the initiative is intended to improve the overall health of EU citizens and achieve climate neutrality by 2050. The EU Sustainable Finance Taxonomy is one of the most impactful tools in the package.
The classification system defines which economic activities contribute towards six essential environmental objectives:
- Climate change mitigation,
- Climate change adaptation,
- Sustainable use and protection of water and marine resources,
- Pollution prevention and control,
- Transition to a circular economy, and
- Protection and restoration of biodiversity and ecosystems.
Essentially, the taxonomy provides a list of sustainability benchmarks for both investors and companies. Implementation of this tool is expected to make businesses more environmentally aware and, most importantly, re-orient investments toward a low-carbon and climate-resilient economy.
It’s critical to note that this legislation concerns not only companies that are based in the EU, but also those who have investors, partners or clients in the region.
Complying With the Taxonomy
One of the mandatory applications of the taxonomy is disclosure, which aims to provide transparency on how one’s economic activity aligns with the EU's criteria. Large companies (with more than 500 employees) that are subject to the non-financial reporting directive (NFRD) and all financial companies will have to disclose the percentage of investments that alight with the taxonomy, as well as the precise environmental objectives to which those investments contribute. Other companies must disclose whether they comply with the social safeguards, and confirm that their activities do no significant harm to the aforementioned environmental objectives.
This obligation comes into force for the reports published after January, 2022. At that point, companies will have to provide data on the first two environmental objectives, climate change mitigation and adaptation.
In essence, the EU Commission has decided to target industries that operate in sectors with the highest contribution to CO2 emissions, such as energy, manufacturing and transport. Given that these sectors are responsible for a significant majority of greenhouse gas emissions, this immediate initiative seems justifiable. Interestingly enough, the EU Commission estimates that a maximum of 5% of companies’ activities align with taxonomy criteria.
As is often the case with the new regulations, preparation is crucial. For example, while it might seem that the taxonomy is irrelevant for the majority of small to medium-sized businesses, the pace at which the EU Commission changes the legal landscape suggests that this might affect them soon as well. Organizations need to start examining their business models and economic activities as soon as possible.
Investors will begin systematically requiring these disclosures as a basis for making their investment decisions, so strategizing in accordance with the taxonomy becomes a matter of one’s business resilience. To comply with the incoming legislative requirements, the following methodology is suggested:
- Determine whether your company is considered “large” in the EU's context, and check against the NFRD.
- Check against substantial contributions. Depending on the industry and environmental objectives, a substantial contribution can mean different things. For example, in regard to climate-change mitigation, it means a company’s activities should align with efforts to limit the global increase in temperature to 1.5 degrees Celsius. Currently, the legislation is plagued with intricacies which determine whether a company can be considered a substantial contributor or not. This further suggests that a thorough examination of the report is paramount to the long-term success of every company.
- Check if your company complies with the social safeguards defined in the taxonomy.
- If needed, establish a systematic data collection to calculate the proportion of turnover, capital expenditures and operating expenditures.
Apart from mandatory compliance, the taxonomy also has less tangible but much more important points of impact.
Given that it will make transparent exactly how companies are contributing to the environment, the taxonomy could substantially change investors’ decision making. This is especially relevant for large companies that have public image and reputation at the top of their agenda. It will also have a chain-like effect on the economy overall.
For example, financial institutions that want to increase their share of taxonomy-aligned investments will also be looking to invest in companies with high taxonomy “scores.” Therefore, even those companies for which compliance isn’t yet mandatory will still have a strong incentive to engage in “green” activities. In general, companies that start aligning their strategies with sustainable finance early on will have an upper hand in regard to clients, investors and shareholders.
While the taxonomy will now be high on the agenda of many companies, it’s crucial to understand that the real value goes way beyond compliance. The regulations reenforce a growing, global trend toward greener business. With devastating statistics on climate change and the environment, adoption of the new sustainable financial system is inevitable. For companies in the years ahead, becoming a sustainability leader will likely become synonymous with business success.
Andrey Koptelov is a technology observer with Itransition.