The European Union is rolling out a comprehensive, science-based regulatory framework for sustainability reporting and sustainable finance. In December 2019, the European Commission presented the European Green Deal: A program of actions to transform the European economy in line with the Paris Agreement climate objectives and the UN Sustainable Development Goals.
The Taxonomy Regulation was published in June 2020 and has now entered into force. It is like a dictionary that aims to classify green economic activities against 6 overarching environmental objectives based on uniform, science-based criteria.
Companies have to report which proportion of their Turnover, CapEx and OpEx can be considered green or "Taxonomy-aligned". Financial Market Participants marketing sustainable financial products have to disclose aggregated eligibility and alignment percentages for their portfolios.
Credit institutions have to compute a special KPI called the Green Asset Ratio which relies on Taxonomy data while the managers of SFDR article 9 funds ("dark green funds") have to report on the taxonomy alignment of portfolio companies.
There is a very clear goal behind the disclosure requirements imposed on both financial and non-financial businesses. The publication of Taxonomy scores (which serve as a proxy for how much different business activities contribute to the creation of a greeners Europe)
The EU institutions hope to prevent greenwashing and re-orient capital flows towards green and sustainable activities (e.g., through the InvestEU Programme, which is aimed at leveraging €279 billion of public and private investments for climate financing between 2021 and 2027).
As the foundation of the Green Deal, EU institutions defined 6 environmental objectives:
1) Climate Change Mitigation
2) Climate Change Adaptation
3) The sustainable use and protection of water and marine resources
4) The transition to a circular economy
5) Pollution prevention and control
6) The protection and restoration of biodiversity and ecosystems
In order to qualify as Taxonomy-aligned (or "environmentally sustainable), an economic activity must substantially contribute to at least one of them. The activity must also satisfy Do No Significant Harm (DNSH) criteria, to ensure that it does no significant harm to any of the other environmental objectives. It is also mandatory for the “Minimum Social Safeguards” to be respected at the company level: these safeguards are defined in the Taxonomy Regulation, and imply that a company complies with the Human and Labor Rights enshrined in the OECD Guidelines for Multinational Enterprises and in the UN Guiding Principles on Business and Human Rights.
The scope of the EU Taxonomy is currently governed by the Non-Financial Reporting Directive (NFRD) and the Sustainable Finance Disclosure Regulation (SFDR)and is applicable to both non-financial and financial undertakings. Large public-interest companies with more than 500 employees have to report on their Taxonomy Alignment as of January 1, 2022, while nearly all FMPs offering financial services and products within the Union have started reporting pursuant to SFDR Level 1.
In total, approximately 11,700 large companies across the EU have to report on the taxonomy. Additionally, thousands of article 9 funds will have to begin doing so as well.
Companies are required to use the Taxonomy framework to report the share of their Turnover, CapEx, and OpEx that can be considered “environmentally sustainable” or “Taxonomy-aligned”. The Taxonomy enables companies to find out which of the economic activities they perform are eligible for Taxonomy-alignment, and will thus be factored into the “environmentally sustainable” share of their KPIs. The Taxonomy describes every criterion that an activity has to fulfill in order to be considered environmentally sustainable. By referring to it, companies are able to compile all of the necessary information to determine their overall Taxonomy alignment (the higher, the better!).
For companies, understanding this framework is paramount to being compliant with their disclosure obligations, but also if they want to attract new green investments.
Meanwhile, all FMPs have to report some extent of aggregate Taxonomy score relying on both eligibility and alignment while product-level disclosures for asset managers focus exclusively on alignment. An important hurdle for asset managers is data availability – as only a subset of EU companies currently have to report, it is challenging to obtain Taxonomy-alignment data for a large number of portfolio companies.
Within their Taxonomy-alignment disclosures, companies will also have to differentiate between ‘enabling’ and ‘transitional’ activities. Transitional activities that substantially contribute to an environmental objective in and of themselves.
Enabling activities, in contrast, are activities that enable other economic activities (also performed by other companies) to make a substantial contribution to an environmental objective.
In the norm, all Taxonomy-related disclosures will have to be located in the company’s annual management report, pursuant to the NFRD.
In addition to that and on a voluntary basis, Taxonomy disclosures can also be mentioned in the company's Annual Report as they rely on financial KPIs.
Another option is for the company to draw a separate report dedicated to non-financial/sustainability disclosures. Once the CSRD enters into force, Taxonomy disclosure data will also have to be digitally tagged by companies, in order to be machine-readable.
The proposed directive calls for the creation of a European Single Access Point, where all company reports will be gathered and made publicly available. For FMPs, Taxonomy-disclosures are to be published in different documents depending on the level: product-level information has to be displayed on the website and in the relevant prospectuses, while firm-level KPIs have to be published in periodic reports.
Sustainability reporting for companies is currently regulated by the Non-Financial Reporting Directive (NRFD). However, European Institutions have recently reached a deal concerning the Corporate Sustainability Reporting Directive (CSRD), which will amend NFRD requirements by extending the scope of sustainability reporting obligations.
All companies listed on regulated markets, as well as a significant portion of unlisted large and midsize companies making up around 75% of the European Union’s global turnover (that is, in total, more than 55 000 companies) will be required to report on their Taxonomy alignment from January 1, 2025 on 2024 financial data.
The implementation of the CSRD for companies beyond the scope of the NFRD has been delayed in comparison to the original timeline, while this was not the case for the SFDR Level 2. This means that Article 9 fund managers have to report on portfolio taxonomy alignment while their portfolio companies do not yet face any obligations to conduct this reporting. Data availability struggles are most likely to continue for asset managers and banks for a few more financial years, as non-EU companies with 1 or more subsidiaries generating at least €150Million Turnover in the Union will only have to report against the Taxonomy from January 2026 on 2025 data, while this will likely be pushed to 2028 for listed SMEs.
The upcoming CSRD will also require all sustainability reports to be subject to an external independent audit, which is currently optional. The information disclosed will have to be digitally tagged by companies, as it will need to be machine-readable to feed the upcoming European Single Access Point (for more information on what the ESAP is, see this question).
Article 8 (“light green”) funds ‘promote environmental or social characteristics’, while Article 9 (“dark green”) funds constitute ‘environmentally sustainable investments’.
For more information, read this article on our blog.
The CSRD expands the scope of companies that are required to report on the Taxonomy: first, all companies listed on regulated markets (stock markets) will have to report on their Taxonomy alignment, except for listed SMEs. Second, and most importantly, reporting will also be required for all companies (publicly listed or not)meeting two out of three of these criteria:
1) €40million in net turnover
2) €20million on the balance sheet
3) 250 or more employees.
These criteria correspond to the European definition of a medium-sized company. In total, about 55,000 companies (representing around 75% of the EU’s global turnover) will have to compile Taxonomy-alignment data by Jan 1, 2025. Te publicly listed companies that have to disclose their Taxonomy-alignment this year under the NFRD only have to do so for 2 environmental objectives (climate change mitigation and adaptation).
When disclosure obligations will start applying to unlisted and mid-sized companies, reporting against the other four objectives will also be mandatory.
Moreover, companies looking to attract green capital by leveraging Green Bonds or by receiving low cost of capital investment from Article 9 funds have a very strong incentive to start Taxonomy-alignment reporting on a voluntary basis. Check out how companies and financial market participants can utilize Briink’s platform for their financial reporting.
Technical Screening Criteria are set forth in the Taxonomy Delegated Acts and in their Annexes, and establish the precise conditions (either qualitative and quantitative) for an activity to be considered Taxonomy-aligned (sustainable).
As of now, only the Technical Screening Criteria for substantial contribution to Climate Change Mitigation and Climate Change Adaptation have entered into force – and so have DNSH criteria for on all objectives as well as for the Minimum Social Safeguards.
The Delegated Act outlining the Technical Screening Criteria for the four remaining environmental objectives is expected to enter into force on January 1, 2023.
Once substantial contribution is proved for one of the 6 environmental objectives for an activity, companies will also have to assess whether that same activity Does No Significant Harm (DNSH) to any other of the environmental objectives.
There also exists Technical Screening Criteria that are to be applied to the DNSH requirement: these are found in the Annexes to the Climate Delegated Act of June 4th, 2021. While the compliance-assessment for DNSH also has to be conducted at the activity-level, it is currently sufficient to conduct a company-level assessment of compliance with the Minimum Social Safeguards by cross-referencing its Human and Labor Rights Protection framework with the contents of the OECD Guidelines for Multinational Enterprises and UN Guiding Principles on Business and Human Rights.
The eligibility and/or alignment of parts used to conduct eligible/aligned activities themselves (such as the manufacture of zero-emission vehicles or solar panels for example) has been a bit of a controversial/tricky topic for parts manufacturers.
What is important to keep in mind is that an activity can be eligible or aligned if and only if it fits the activity description. The best use case here is probably “Manufacture of other low-carbon technologies”: it is often the case, in the automotive industry for example, that some companies manufacture only the parts which will then be used in zero-emission vehicles by the car manufacturers.
Here, the activity description for “Manufacture of other low-carbon technologies” includes a series of NACE codes which are indicated as relevant: these span as wide as rubber and plastic products, electrical equipment and general purpose machinery. It can therefore be safely assumed that these NACE codes not only cover finished products, but also the parts that go into finished low-carbon products.