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ESG Impact Month: The EU Taxonomy - what investors need to know

26 September 2022

The green transition is in progress. Everyone from investors to regulators and the wider society expects firms to change, improve, better define and be transparent about how environmentally sustainable their activities are. The EU Taxonomy provides a definition for what it means to be a sustainable activity and is a huge step in the right direction to prevent greenwashing and unlock green finance.

What is The EU Taxonomy and who does it apply to?

The EU Taxonomy Regulation for Sustainable Activities (Regulation (EU) 2020/852) is a classification system for 'green' business activities. The regulation has identified six key environmental objectives:

  • Climate change mitigation
  • Climate change adaptation
  • Water protection
  • Circular economy
  • Pollution prevention
  • Biodiversity and ecosystems

Each sustainable activity outlined in the EU Taxonomy (“the Taxonomy”) is considered to substantially contribute to one of the environmental objectives. The activity must be administered in such a way that it does not do significant harm to any of the other five objectives. Additionally, the activity must meet the minimum social safeguards, which consider human rights, fair competition and anti-bribery, among other key social topics.

The regulation is targeted at financial market participants with financial products that make environmental claims. SFDR Article 9 funds, i.e., financial products that cite sustainability as a key objective must report against the Taxonomy.

SFDR Article 8 and Article 6 funds, which do and do not include sustainability considerations in the investment process respectively, may wish to make a disclosure.

Why is the EU Taxonomy important for every company and investor looking to have a positive impact?

Businesses and investors will reap significant benefits from aligning to the EU Taxonomy.

Companies have access to a new tool that makes it easier for them to demonstrate their involvement in low-carbon and climate resilient activities and thus raise funds for facilitating a green transition. Investors have more clarity on a company’s green credentials, enabling fairer comparisons and a better understanding of climate related risks and opportunities within their investment portfolios. Such and understanding helps investors manage reputational risks associated with investments that claim green credentials. Finally, the society as a whole will benefit from the alignment of companies and investments to the Taxonomy, since its objectives are a direct translation of the Paris Agreement commitments and the UN SDGs.

It accelerates the urgent green transition.

The Taxonomy comes at a critical time for climate action - at the start of a decade which will determine whether we are able to avoid catastrophic climate change. The regulation aims to direct capital flows towards a low-carbon future and ensure that the financial sector and companies are fully on board with the transition.

The scale of investment required to achieve climate neutrality by mid-century and limit global warming to 1.5oC, far exceeds what Governments can contribute. Private investment must be mobilized. The Taxonomy will stimulate such investments urging more market participants to get involved. Those that are already focused on this sustainable direction or can adapt faster will have a competitive advantage. Overall, the Taxonomy will define green finance and unlock its full potential.

It helps identify and eradicate greenwashing.

A key objective of the regulation is to drastically reduce greenwashing. It provides consistent, reliable and objective framework with robust criteria for what qualifies as sustainable. Businesses will no longer be able to make their own subjective claims, give their own definitions and hide behind their marketing. For example, firms that want to market their products or investments as sustainable and aligned with Article 9 of the SFDR, need to demonstrate their green and social credentials. The Taxonomy provides us with a widely accepted gold standard for what environmental sustainability is. It enables investors and customers to recognize and identify greenwashers, non-transparent, irresponsible or unsustainable businesses.

Other Sustainable Taxonomies Worldwide

Rather than being the definitive classification for sustainable activities, the EU Taxonomy is simply the beginning. There are 21 green taxonomies in place, in development or under discussion worldwide. Whilst they all have the same overarching objective- to identify activities that support the fight against climate change, the approach and details vary greatly.

Many countries have focused their green taxonomies on companies operating in unsustainable sectors, such as energy and construction, but the individual taxonomies consider the nuances of the country’s existing infrastructure. For example, countries that are heavily reliant on fossil fuels, such as South Korea and Canada, have included natural gas or focused on fossil fuel reduction, rather than solely identifying green activities.

This global landscape of varied green taxonomies will cause difficulties for global financial institutions and corporations and add to the already growing reporting burden. Whilst a global taxonomy would be ideal, there is a question as to whether that could feasibly be achieved, given the unique challenges facing each country in the transition to net zero.

As these frameworks develop and evolve, it will be interesting as to whether consistency is achieved in the approach to the assessment, the classified activities, and most importantly, the metrics that must be reported.

All things considered, the EU Taxonomy is largest green finance initiative and is going to be the key tool for reallocating capital towards sustainable activities in the coming years. It is a major enabler of climate action helping companies and investors to prove their claims and drive positive change.

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