The EU’s new Taxonomy Regulation is designed to support the transformation of the EU economy to meet its European Green Deal objectives, including the 2050 climate-neutrality target. As a classification tool, it seeks to provide clarity for companies, capital markets, and policy makers on which economic activities are sustainable. As a screening tool, it seeks to support investment flows into those activities. This article will explore what the Taxonomy is, how it works, and what its impact could be.

What is the EU Taxonomy?

At over 550 pages (with more to come), the EU Taxonomy can be daunting – even to the initiated. Let’s start with the basics. 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.

How are sustainable economic activities defined?

At the core of the Taxonomy Regulation is the definition of a sustainable economic activity. This definition is based on two criteria. An activity must:

1. Contribute to at least one of six environmental objectives listed in the Taxonomy; and
2. Do no significant harm to any of the other objectives, while respecting basic human rights and labour standards.

What are the six Taxonomy objectives?

The six environmental objectives of the Taxonomy are: (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, and (6) protection and restoration of biodiversity and ecosystems.

Technical Screening Criteria (TSC) define the specific requirements and thresholds for an activity to be considered as significantly contributing to a sustainability objective. These TSCs are being elaborated in secondary legislation called Delegated Acts (DAs).

‘Do No Significant Harm’(DNSH)

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.

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; and
• The activity does not lead to carbon lock-in or hamper the development and deployment of low-carbon alternatives.

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:

1. The proportion of turnover derived from the Taxonomy activities; and
2. 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.

What is the timeline for the Taxonomy?

The Taxonomy entered into force on 12 July 2020. However, most of the detail to define the TSCs remains a work in progress. The Regulation foresees future development, with the European Commission required to come forward with a report by end 2021 to explore potential expansion. The expansion could mean additional classification of:

• Economic activities do not have a significant environmentally sustainable impact;
• Economic activities significantly harm;
• Social objectives.

Here is the current timetable for completing the Taxonomy:

• 21 April 2021: TSC for substantial contribution/DNSH to climate mitigation and climate adaptation objectives adopted.
• 31 December 2021: Deadline to adopt TSC for substantial contribution / DNSH to remaining four environmental objectives. Deadline for Commission to report on potential expansion of scope of the Taxonomy.
• 01 June 2021: Commission deadline to adopt delegated act specifying content, presentation and methodology for Article 8 disclosures
• 01 January 2022: Taxonomy’s Climate mitigation and climate adaptation requirements apply
• 13 July 2022: Deadline for first review of the Taxonomy (required every three years).
• 01 January 2023: Water & marine resources use and protection, circular economy transition, pollution prevention & control and biodiversity & ecosystems protection & restoration requirements apply

Future Uses of the Taxonomy

As the Taxonomy takes shape, it may be applied in new ways. For example, the forthcoming EU proposal for an EU Green Bond Standard is expected to use the Taxonomy as the benchmark for eligibility. Linking the Taxonomy to the Green Bond Standard would create a more direct link with EU – and potentially global – capital markets.

Indeed, the latest draft report for an EU Ecolabel for retail financial products already includes Taxonomy defined thresholds for minimum investment in environmentally sustainable economic activities. The Ecolabel is expected to be finalised by the end of 2021.

Whether further EU policy measures may be tied to the Taxonomy remains to be seen. Watch this space.