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Sustainable finance: a guide to the EU taxonomy

Paul Young Paul Young

Everyone knows that we need more investment in environmentally-friendly business, but before we can make progress we need to agree what sustainable finance actually is. Paul Young explains how an EU taxonomy with standardised language can reduce greenwashing and drive investment.

While the City is full of talk of post-Brexit deregulation, sustainable finance is one area of business where we are likely to see stricter rules. The EU is driving positive change to establish a framework for what sustainable finance truly means. Greenwashing is a common practice where products are branded as sustainable, but without the credentials to back it up. This isn’t necessarily deceptive. The trouble is that without a set standard for what these terms mean, it's difficult for companies and investors to define what is and isn't 'green'. Investment in sustainable projects is integral to the cultural and financial shift needed to manage and reduce climate change, so empowering investors to make informed choices is critical to achieving our 2050 climate goals.

The EU Taxonomy Regulation came into force last summer, with criteria and disclosure requirements to demonstrate sustainability and give investors confidence. This new taxonomy is part of a wave of activity from industry bodies and regulators (such as the FCA) to build trust in sustainable finance, and give investors confidence that sustainable finance is more than just a buzzword. Other initiatives include a proposed Sustainability Standards Board from the IFRS Foundation, a sustainable finance framework from the British Standards Institution, and the development of an ISO sustainable finance standard.

We 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:

1 Economic activities that make a substantial contribution in their own right, for example an environmentally sustainable activity

2 Economic activities that support other sustainable activities, for example investing in a component that supports a sustainable project

Disclosure requirements

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 large public-interest companies with more than 500 employees, including listed companies, banks and insurance companies. 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.

Financial market participants

Financials market participants are required to make disclosures in line with the EU Taxonomy Regulation. This EU requirement will have an impact on UK 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 requirements will capture the following products in the three key FS sectors if they are manufactured in Europe:

  • In the pensions and asset management sectors' Undertakings for Collective Investment in Transferable Securities (UCITS) funds, alternative investment funds (AIFs), portfolio management (under Article 4(1) of MiFID II) and pensions will be subject to the above requirements
  • The same is applicable for all insurance-based investment products (IBIPs)
  • For corporate and investment banking products, the requirements cover securitisation funds, venture capital and private equity funds, portfolio management and index funds

Disclosures are supposed to form part of companies’ periodic disclosures to their regulator as well as on their websites.

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.

The UK and the EU taxonomy

The UK government is yet to adopt the EU taxonomy but using it as a best practice template will improve consistency and build trust in the market. Whatever direction local regulations take, comparable standards will probably emerge over the next few years. Preparing to disclose on environmental footprints will help firms stay ahead of the curve and prove more attractive to investors.

It would also support the government’s phased rollout plan for UK companies to complete mandatory disclosures aligned to the Task Force on Climate-related Financial Disclosures (TCFD) recommendations by 2025 - although it’s important to note that the EU taxonomy is broader. While TFCD-aligned disclosures look at the financial risks due to climate change, the EU taxonomy considers environmental aspects such as pollution, water, marine resources and biodiversity. 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 Paul Young for further information.

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