EU Sustainable Finance Taxonomy
The EU Sustainable Finance Taxonomy is classification system that aims to determine whether an economic activity is environmentally sustainable.
The Taxonomy is an implementation tool that can enable capital markets to identify and respond to investment opportunities that contribute to environmental policy objectives. It presents
- A list of economic activities which can make a substantial contribution to climate change mitigation and
- Criteria to do no significant harm to other environmental objectives.
- It also presents a framework for evaluating substantial contribution to climate change adaptation.
In committing to the SDGs and climate-related goals through the Paris Agreement, the EU and its Member States endorsed a direction for sustainable growth. These goals provide signals to corporations and investors about future economic trends, investment opportunities and risks, but it is only the alignment of public policies to the goals that will encourage capital markets to re-orient capital flows.
If Europe is to mobilise capital at scale for sustainable development, it needs a technically robust classification system to establish market clarity on what is ‘sustainable’. This system would cover a wide range of activities, investments and assets that can be clearly linked to the Paris Agreement and the Sustainable Development Goals (SDGs). Such a ‘sustainability Taxonomy’ would identify under which conditions or criteria any given investment or financial product will contribute to the EU’s sustainability objectives. The Taxonomy would enable market growth by re-orienting capital flows towards assets that contribute to sustainable development; by creating much needed comparability across standards, labels, products and jurisdictions; and by enabling market participants to invest in sustainability with greater confidence and ease. The HLEG proposed a detailed framework for the development of a future Taxonomy and presented a proposal for the climate change mitigation elements of this Taxonomy.
Through financing or investments and through the stewardship of investments, investors will influence the decisions taken by corporations and other entities. This chain of influence requires translation of policy goals into frameworks that the investors and managers of capital can respond to. The EU Taxonomy is one example of such a framework: a list of economic activities assessed and classified based on their contribution to EU sustainability related policy objectives.
The regulation on disclosures relating to sustainable investments and sustainability risks, which was formally adopted by the European Parliament and Council in April 2019, sets out requirements for financial market participants in relation to the disclosure of sustainability risks and impacts. Of particular relevance for the EU Taxonomy, it requires financial products targeting sustainability objectives to disclose:
- How the sustainability objectives are met and, if an index has been designated as a reference benchmark, whether and how it is consistent with the sustainability objectives.
- The extent to which sustainability objectives are attained, the overall sustainability-related impact of the financial product and, where an index has been designated as a reference benchmark, a comparison through sustainability indicators of the respective impacts of the financial product and a broad market index.
- A description of the sustainability objectives of the product and information on the methodologies used to assess, measure and monitor the sustainability objectives.
The taxonomy presents a list of economic activities which can make a substantial contribution to climate change mitigation and criteria to do no significant harm to other environmental objectives. It also presents a framework for evaluating substantial contribution to climate change adaptation.
The list of economic activities covered is not exhaustive and additional activities will be added to the Taxonomy in future.
The Taxonomy is readily useful to investors, but the benefits of widespread use of the Taxonomy as a common language and reference point for markets, requires transparency by investors and companies alike. There is an important role for practical, disclosure-based regulation to help inform financial decision making and enable market participants to respond to the EU’s goals for financing sustainable growth.
Environmental Objectives in Scope of the Taxonomy
The proposed EU regulation identifies six environmental objectives for the purposes of the Taxonomy (Article 5):
- Climate Change Mitigation
- Climate Change Adaptation
- Sustainable Use and Protection of Water and Marine Resources
- Transition to a Circular Economy, Waste Prevention and Recycling
- Pollution Prevention and Control
- Protection of Healthy Ecosystems
Mandatory Users of the Taxonomy
The proposed Taxonomy regulation envisages two main mandatory users of the Taxonomy:
- Member States or the EU when adopting measures or setting requirements on market actors in respect to financial products or corporate bonds that are marketed as environmentally sustainable.
- Financial market participants offering financial products as environmentally sustainable investments or as investments having similar characteristics.
The Taxonomy may have additional uses:
- The Taxonomy is proposed as providing a basis for establishing the environmental characteristics of green bonds using the proposed EU Green Bond Standard.
- It is also referenced in the draft InvestEU regulation as a framework to aid in monitoring the InvestEU fund’s contribution to climate targets.
Eligibility Criteria for an Economic Activity
For an economic activity to meet the definition of an ‘environmentally sustainable economic activity’ and thus be considered Taxonomy-eligible, it must:
- Contribute substantially to one or more of the environmental objectives
- Do no significant harm (DNSH) to any other environmental objective
- Comply with minimum social safeguards (under the draft regulation, these are defined as ILO core labour conventions).
- Comply with the technical screening criteria
The implication of the DNSH principle is that economic activities, even when making a substantial contribution to climate change mitigation and/or adaptation, will not be eligible for the Taxonomy if they cannot be performed in a way which avoids significant harm to other environmental objectives.
The taxonomy adopts the NACE Classification system of economic activities as it is comprehensive in its coverage of EU economic sectors, is used by EU institutions such as Eurostat and has already been implemented by some financial institutions.
Technical Screening Criteria
The technical screening criteria are specific characteristics that can be used to determine whether an economic activity provides a substantial contribution to mitigation or adaptation
Issues and Challenges
- The TEG notes that the NACE classification system does not record stocks or flows of natural resources where they are not monetised, or broader efforts to account for these, such as the System of Integrated Environmental and Economic Accounting. It can neither capture activities which have been avoided, nor individual behavioural choices
- In some areas, such as climate change adaptation, the sector framework cannot fully address location and context specific considerations
- In other areas, NACE lacks sufficient granularity to enable the full evaluation of compliance with environmental objectives, and so has been supplemented by additional categories
- Technical Expert Group on Sustainable Finance Taxonomy, Technical Report, June 2019