Recent regulatory developments and EU Member States governmental decisions show that we need more investments in sustainable development and more strategic actions in transforming the economic activities to environmentally-friendly businesses. In order to make progress in this we need to understand what the sustainable finance actually is and how it affects the business world.

Athina Moustaki, Head of Environmental, Social, Governance, Risk and Compliance Services (ESGRC), explains what the EU taxonomy is all about and how it aims to reduce greenwashing and drive investments in achieving the EU 2050 Climate Goals.

By passing the Green Deal in 2019, the European Union (EU) set the course for more sustainable investments, for example in areas like renewable energy, biodiversity or circular economy. The goal is to reach a climate-neutral economy in the EU by 2050, with a reduction of 55% already implemented in 2030. To achieve these climate goals, the Green Deal includes an investment plan of 1 trillion euros over the next 10 years. Despite this huge investment, the EU depends also on the support of the private sector to achieve the Paris climate agreement.

The EU is driving positive change to establish a framework for what sustainable finance truly means. Greenwashing is a common practice where products, investments or corporate bonds are branded as sustainable, but without the credentials to back it up. This isn’t necessarily deceptive. The trouble is that without a standard set of definitions and rules for what these terms mean, it's difficult for companies and investors to define what is and isn't 'green'.

The Regulation (EU) 2020/852 on EU Sustainable Finance Taxonomy came into force last summer, with criteria and disclosure requirements to demonstrate sustainability and give investors more confidence. This new taxonomy is part of a wave of activity from industry bodies and regulators to build trust in sustainable finance, and give investors confidence that sustainable finance is more than just a buzzword. The EU Taxonomy regulation promotes equal competition and legal certainty for all companies operating within the EU and aiming to the:

Reorientation of capital flows with a focus on sustainable investments
Establishing sustainability as a component of risk management
Promoting/encouraging long-term investment and economic activity

Let’s take a look at the EU taxonomy, and review key requirements for firms.

The EU taxonomy: six environmental objectives

The EU Taxonomy Regulation introduced environmental disclosure requirements for companies and financial market participants. The taxonomy aims to create consistent standards for activities that are described as ‘environmentally sustainable’. A key tenet of this regulation is the recognition that not all environmentally-friendly activities have a tangible impact on environmental goals.

The EU Taxonomy Regulation includes six environmental 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
protection and restoration of biodiversity and ecosystems

In addition to minimum safeguards, the EU expects companies to substantially contribute to at least one of these six objectives and have a neutral or minimal impact on the other five. The taxonomy also outlines two main types of activities that substantially contribute to these goals:

Economic activities that make a substantial contribution in their own right, for example an environmentally sustainable activity
Economic activities that support other sustainable activities, for example investing in a component that supports a sustainable project

Who it affects

The taxonomy implements new disclosure requirements for all companies already obliged to provide a non-financial statement under the Non-Financial Reporting Directive. For the most part, this includes three different groups of users for whom it will be mandatory to comply with the taxonomy regulation:

Large and public-interest companies with over 500 employees that are already required to report non-financial information under the scope of the Non-Financial Reporting Directive (NFRD)
The EU and Member States when setting public measures, standards or labels for green financial products or green bonds
Financial market participants that offer financial products in the EU

Katerina Katsouli, Director ESG & Sustainability at Grant Thornton, explains the reason why the EU taxonomy regulation introduced environmental disclosure requirements for both companies and financial market participants: "The taxonomy aims to set specific standards for activities described as environmentally sustainable. And the main reason for creating this regulation is the fact that not all environmentally friendly activities have a tangible impact on the environmental objectives that we have set ourselves. There was a very important gap, which the EU Taxonomy is coming to fill."

Disclosures obligations

From January 2022 companies must report on climate change mitigation and adaptation, and on all six environmental objectives by January 2023.

These requirements are supported by the Sustainable Finance Disclosure Regulation (SFDR), which aims to improve transparency, reduce greenwashing and promote sustainable growth.

All companies concerned must disclose how and to what extent their economic activity considers or includes sustainability based on the taxonomy regulation. More specific, Companies must disclose the following:

EU taxonomy-compliant share of turnover
Capital expenditure (CapEx) aligned with the EU taxonomy
Operating expenses (OpEx) aligned with the EU taxonomy

Disclosure should be part of non-financial reporting, probably in the annual report or an explicit sustainability report. Disclosures are expected to form part of companies’ periodic disclosures to their Regulator as well as on their websites. External verification on EU taxonomy disclosures is one more item of the upcoming regulatory developments.

It is worth noting that the disclosures based on the taxonomy regulation are within the top 3 priorities set by ESMA (the European Securities and Markets Authority) for 2022 to the participants in the European capital markets, which reinforces the pressure for the taxonomy immediate implementation by the Companies of public interest.

Financial market participants

Financials market participants are also required to make disclosures in line with the EU Taxonomy Regulation. This EU requirement will have an impact on companies because it applies to all products manufactured and distributed in the EU. The disclosure requirements are mandatory for certain products and the comply-or-explain principle applies to the rest.

For each product, companies will have to disclose:

how they have used the EU taxonomy in determining the sustainability of the underlying investments
to what environmental objective(s) the investments contribute
the proportion of underlying investments aligned to the taxonomy

The regulation highlights the need for a clear narrative to explain the disclosures and the supporting thought process. This is to help investors, who are encouraged to explain their strategies and direction of travel, particularly if their underlying investments demonstrate a low degree of alignment to the taxonomy.

How to asses if an economic activity is sustainable

In order to be classified as a sustainable economic activity according to the EU taxonomy regulation, a company must not only contribute to at least one environmental objective but also must not violate the remaining five objectives. The classification of an economic activity in terms of sustainability is based on the following four criteria, which base on the previously mentioned environmental objectives:

The economic activity contributes substantially to one or more of the six environmental objectives
The economic activity does not significantly harm any of the six environmental objectives
The economic activity complies with the minimum safeguards (set out in Article 18 of the Taxonomy Regulation)
The economic activity complies with the Technical Screening Criteria (“TSC”)

For example, an activity aiming to mitigate the climate but at the same time also negatively affecting biodiversity cannot be classified as sustainable.

The Technical Screening Criteria (the “TSC”) are uniform criteria which will be used to determine whether economic activities “contribute substantially” to each environmental objective, and therefore can be considered sustainable. The TSC will also determine whether any of those economic activities cause significant harm to any of the other environmental objectives.

The draft TSC cover the following 13 sectors:

Agriculture and forestry
Environmental protection and restoration activities
Manufacturing
Energy
Water supply, sewerage, waste management and remediation activities
Transport (including maritime)
Construction and real estate
Information and communication
Professional scientific and technical activities
Financial and insurance activities
Education
Human health and social work activities
Arts, entertainment and recreation

Authors key message

As the EU Taxonomy is still on a voluntary basis and has not yet turned into a Greek legislation, we encourage and support Companies to early adopt the EU regulation and to gain benefits upfront. Compared to their competitors, these companies stand out positively and thus should benefit from higher investments. The transition to the EU Taxonomy rules is not an easy exercise since it affects the financial and many operations of an organization. But an early adoption is definitely a successful factor for a smoothly transition and compliance journey to the EU taxonomy rules starting with the Financial Statements disclosures of the year 2021.

The message is clear – companies should look beyond the financial implications of climate change and take a more holistic approach. Acting now to reduce environmental change, while managing the risks is critical for both sustainable finance and a sustainable future.

Contact Athina Moustaki and Katerina Katsouli for further information.