Part II – Key Taxonomy-related takeaways
Read part 1 of this 2-part series about sustainable finance, or continue reading for part 2, in which I discuss taxonomy.
What does the proposed EU Taxonomy mean? And more importantly, what might it mean for the sector in which you are doing business? What about its implications for investment portfolios?
Regardless of your sector, it is important to recognize that the Taxonomy and its implications concern not only the financial sector, but will have broad effects across various sectors. So far, the Taxonomy discussion has focused on key sectors with regard to climate change mitigation and adaptation, but the list will be complemented as we go. The Taxonomy is also linked to the other regulatory initiatives regarding sustainable finance, including an EU Green Bond Standard, low-carbon benchmarks and corporate disclosures.
In this new blog series, "EU Sustainable Finance Explained", we will analyze the forthcoming EU regulation and will present the key takeaways. This blog (Part II) is about Taxonomy, whereas Part I provided an overview of the European Commission's sustainable finance initiatives.
The EU Technical Expert Group on Sustainable Finance (EU TEG) is currently finalizing its work on selected actions of the EU Action Plan on Sustainable Finance. The Taxonomy is one of these, and is linked to the other actions that the EU TEG has been working with. The EU Parliament has already formulated its position on the legislative proposal with respect to Taxonomy, and the next step will be to reach an agreement with the Commission and the Council. The resulting Directive will be implemented in future national-level regulations.
An EU Taxonomy is indispensable in making the EU climate targets implementable in practice. It is a classification system that enables categorization of economic activities/sectors that play key roles in climate change mitigation and adaptation. To be included in the proposed EU Taxonomy, an economic activity must contribute substantially to at least one environmental objective, and do "no significant harm" to the other five environmental objectives set out in the legislative proposal. The classification works through technical screening criteria, methodology and guidance described in the EU report on taxonomy which the EU TEG has been busy designing, together with extensive stakeholder consultations, involving numerous experts from sectors covered by the taxonomy.
An EU Taxonomy is indispensable in making the EU climate targets implementable in practice. It is a classification system that enables categorization of economic activities/sectors that play key roles in climate change mitigation and adaptation.
Legislative proposal – linking actors from finance across sectors
The regulation on disclosures relating to sustainable investments and sustainability risks (adopted by the European Parliament and Council in April 2019) states that financial market actors must disclose sustainability risks and impacts. Given that such actors provide finance for and invest in various sectors, the sustainability risks and impacts emerging from those investments need to be analysed in order to deliver the disclosure required by the regulation.
It can be expected that financial market actors will look much more closely at the activities they are financing and investing in. Prior to this new regulation, it was easier to hide investments that were non-favourable from the climate point of view. This is no longer an option, and the need to disclose massive stranded assets and carbon-heavy indicators, for example, will hardly make non-sustainable investments very tempting.
This is likely to mean that financial sector actors, supported by the Taxonomy, will closely analyse the sectors in which they invest. These sectors currently cover:
- Agriculture, forestry and fishing
- Electricity, gas, steam and air conditioning supply
- Water, sewerage, waste and the related remediation
- Transportation and storage
- Information and Communication Technologies (ICT)
- Buildings (construction and real estate activities, with application to other sectors where appropriate)
The company perspective is that it is worthwhile to look into sector-specific screening criteria within the Taxonomy. Who wants to be an outlier in a negative sense, in the eyes of financiers and investors?
Financial sector actors will likely be motivated to develop their analyses of their investment and financing targets, and to aggregate them in order to define their organization's risks and impacts, as well as to further develop them into a report. The key takeaway questions for financial market actors include:
- To what extent do our financing/investment objects mitigate climate change and/or promote adaptation to it? How do our indices and funds compare with other similar products and to what degree do they exceed the reference benchmarks? Are there any emerging risks for our business resulting from these, and what are they? How should we define and analyze these risks?
- What are the impacts of our financing/investments? What can we disclose about these impacts and the underlying risks? Do we have a common understanding of what we mean by "impact"? What kind of indicators should we use?
- Have we prepared targets and a methodology for risk and impact assessment, measurement and monitoring? Are we clear on what our processes for these are?
Given that the Taxonomy thresholds in many cases make use of sector-specific best practices, the expectation is that their role will be stronger. Thus, it will be worthwhile for companies to investigate what the sector-specific best practices are, as it is likely that financiers and investors will seek benchmarks relating to them. For companies, the key takeaway questions include:
- Does our business support climate mitigation or adaptation, and to what extent?
- Are we aware of the sustainability criteria with a specific focus on climate that our financiers and investors use? How is our business positioned with respect to peers?
- Is the needed information easily available for financiers and investors? Do we report on it in a manner that is relevant to financiers and investors?
The goal of ensuring good "financiability" and "investability" at reasonable cost will only be met if sufficient efforts are devoted to it.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.