The Situation: The European Union ("EU") is on track to adopt the Taxonomy Regulation by the end of 2020, a key pillar of both the EU Action Plan on Financing Sustainable Growth and the European Green Deal.
The Result: The Taxonomy Regulation will require significant new disclosures and technical screening for covered entities in virtually all areas of the economy.
Looking Ahead: Regulations and related delegated acts will roll out over the next several years, and reporting requirements will phase in over time. The Taxonomy Regulation is one of the main pillars of the Environmental, Social, and Governance ("ESG") regulatory framework designed to achieve the EU's objective of carbon neutrality by 2050.
On April 15, 2020, the European Council, which includes the heads of state of EU countries, adopted a regulation (the "Taxonomy Regulation") containing an EU-wide classification system for environmentally sustainable economic activities. The taxonomy is designed to determine when an economic activity qualifies as "environmentally sustainable" in order to establish the degree to which an investment in that activity is "environmentally sustainable." This standardized classification system will underpin all sustainability-related disclosure obligations.
In a sign of the fast-moving pace and interconnectedness of EU regulatory change in this area, on April 23, 2020, the three European supervisory authorities launched a joint consultation on updating disclosure requirements under the sustainable finance disclosure regulation (the "Disclosure Regulation," together with the Taxonomy Regulation, the "Regulations").
The Regulations will have far-reaching effects within and outside the EU, as the EU encourages (and markets may soon expect) financial market participants around the world to observe the principles and requirements contained in the Regulations. While the Regulations and related publications, such as a recent report published by the technical expert group ("TEG") advising the European Commission on sustainable finance, provide some much-needed clarity, it is also clear that covered entities will have significant new work streams to ensure compliance and significant ongoing obligations.
The taxonomy framework will be based on six EU sustainability objectives:
- Climate change mitigation;
- Climate change adaptation;
- Sustainable use and protection of water and marine resources;
- Transition to a circular economy;
- Pollution prevention and control; and
- Protection and restoration of biodiversity and ecosystems.
The Regulations will require covered entities to determine and disclose whether their economic activities linked to financial products offered as sustainable investments qualify as environmentally sustainable, or "taxonomy-aligned," on a comparatively accelerated timetable. Such activities should (i) contribute substantially to one of the six sustainability objectives; (ii) do no significant harm to any other objective; (iii) be carried out with minimum safeguards set forth in the Taxonomy Regulation; and (iv) comply with technical screening criteria. Covered entities should begin preparing now for the Regulations' ambitious timetable and extensive disclosures aimed at promoting transparency and accountability in ESG reporting and, therefore, combating "greenwashing." However, covered entities will need to remain flexible in their preparations in order to adapt to yet unpublished details of the Regulations.
Once the European Parliament votes to adopt the Taxonomy Regulation, the European Commission will adopt initial delegated acts by the end of 2020 to provide technical screening criteria for reporting on the objectives of climate change mitigation and climate change adaption. Covered entities will need to provide their first set of disclosures under the Taxonomy Regulation from January 1, 2022 (for the 2021 reporting period). Subsequent delegated acts to be issued in 2021 relating to the four other sustainability objectives will require disclosure from January 1, 2023 (for the 2022 reporting period). The TEG, and by extension the European Commission itself, recognizes that this timetable presents a significant challenge to covered entities, who may not have the required information available in time. Ultimately, given the ongoing market trends focusing on ESG-related investments, a covered entity's failure to comply with the Regulations' disclosure and reporting requirements may impact its access to financing. The Regulations are thus a clear call for transition management:
- Large companies covered by the Non-Financial Reporting Directive 2014/95/EU (i.e., public interest entities above a specified turnover/balance sheet threshold with more than 500 employees) will be required to disclose (i) the proportion of turnover; and (ii) the amount of capital expenditure and operating expenses that are "taxonomy-aligned."
- The TEG recommends that covered entities analyze separately each economic activity for each of the six environmental objectives in the Taxonomy Regulation.
- Financial entities such as equity, debt, real estate, private equity, and venture capital funds, as well as pension schemes and insurance-based investment products, must make additional disclosures under the Disclosure Regulation, on a macro and a product level, when an investment promotes environmental or social characteristics—or be forced to include a disclaimer stating that the investment fails to account for EU sustainable finance criteria.
- Certain financial entities will also be required to disclose what percentage of their portfolio investments are taxonomy-aligned, as well as other taxonomy-related information in pre-contractual documents and on their websites.
These disclosures are likely to have a significant impact on the operations and internal organization of covered entities, including new processes to collect, analyze and present the required data and information. Entities should at a minimum: (i) identify the covered economic activities they (or their investment portfolio) engage in; (ii) verify that these activities meet the relevant screening criteria; (iii) verify that the entity (or investment) meets the "do no significant harm" test; (iv) conduct proportionate, risk-based due diligence on each covered activity based on international guidelines; and (v) calculate what portion of the covered activity meets the taxonomy screening criteria. These new requirements may seem an overwhelming new burden, and we recommend that covered entities rapidly move to establish systems and procedures to comply with the Regulations, whether on a stand-alone basis or as part of a larger compliance program with other EU-imposed disclosure requirements.
The EU intends to focus in the not-distant future on the "S" (social) and "G" (governance) aspects of ESG, which may follow the Regulations' lead on disclosure and technical screening. As stated by the TEG, future international harmonization of ESG-related taxonomies is most welcome.
Two Key Takeaways
- The Regulations will require companies to analyze and quantify their "taxonomy-aligned" activities and financial products, and provide significant disclosure relating to activities purportedly contributing to sustainable finance.
- The devil will be in the details as EU bodies pass final rules. Covered entities should begin preparing their disclosure and technical screening analysis now, but should remain flexible in order to cater to ESG-related regulatory and market developments.
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.