EU Parliament adopts Taxonomy Regulation

In recent years the European Union has paid increasing attention to sustainability in its policy- making particularly in the financial sector.

In March 2018 the European Commission published its Action Plan on Financing for Sustainable Growth. The Action Plan has three main objectives:

to redirect capital flows towards sustainable investment in order to achieve sustainable and inclusive growth;
to manage financial risks arising from climate change, resource depletion, environmental degradation and social issues; and
to promote transparency and long-term sustainability in financial and economic activity.

The European Commission has stressed the importance of having sufficient, reliable and comparable information on sustainability in order effectively to direct capital towards sustainable investments. The Action Plan therefore foresees, as a very first action, the establishment at EU level of a classification system (the 'taxonomy') for sustainable activities in order to provide investors with clear and transparent information on environmental sustainability. The Taxonomy Regulation, adopted on 18 June 2020, is the cornerstone of the Action Plan.

Objectives and process

The Taxonomy Regulation will help to fight greenwashing. A reliable classification of green investments will also provide investors with sufficient information to make informed decisions to increase their investments in truly sustainable activities where appropriate. The Commission's ambition is also that its taxonomy will serve as a reference model for other countries around the world.

The Taxonomy Regulation aims progressively to integrate a 'green list' into EU legislation.

In June 2019 based on more than 200 experts’ opinion, the Technical Expert Group on sustainable finance (TEG) published a report on the use of the Taxonomy and a first version of its technical report, proposing, for 67 economic activities, technical criteria to determine how each activity makes a substantial contribution to mitigating or adapting to climate change (technical screening criteria). On 9 March 2020, the TEG published the final version of its report on the use of the taxonomy.

The report is complemented by a technical annex containing an updated list of technical selection criteria for economic activities that can substantially contribute to mitigating or adapting to climate change, including an assessment of significant harm to other environmental objectives.

Sustainable Economic Activities and Sustainable Investments

The Taxonomy Regulation does not determine the sustainability of companies or assets but the sustainability of economic activities. Also, it does not provide a list of green activities. An investment is environmentally sustainable if it finances one or more activities that qualify as environmentally sustainable under the Taxonomy Regulation. The Taxonomy Regulation sets out a general framework to determine whether an activity meets the sustainability criteria set out in the Taxonomy Regulation for the purpose of establishing the degree to which an investment is environmentally sustainable. The same company may therefore have activities that are sustainable under the criteria of the Taxonomy Regulation and activities that are not. The sustainability of an investment portfolio will thus have to be determined taking into account the degree of sustainability of the activities of the companies that make up the investment portfolio.

Sustainable Economic Activities

An economic activity qualifies as environmentally sustainable if it meets four conditions :

Substantially contributing to at least one of the six environmental objectives set out in Article 9 of the Taxonomy Regulation (see below).
Not significantly harming any of the environmental objectives set out in Article 9 of the Taxonomy Regulation. This means that if an economic activity substantially contributes to one environmental objective but at the same time significantly harms another, it will not qualify as a sustainable activity. The exact scope of the “no significant harm” principle will be set out in the Technical Screening Criteria (see below).
Complying with minimum social and governance safeguards provided for in Article 18 of the Taxonomy Regulation, which refers to the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work (prohibition of forced labour, freedom of association, the right of workers to organise themselves, the right to collective bargaining, equal pay for men and women, non-discrimination and prohibition of child labour) and the International Bill of Human Rights. By this requirement, the Taxonomy Regulation aims to maintain the achievements reached under the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights rather than to promote further progress.
Complying with the scientifically based Technical Screening Criteria established by the Commission. Technical Screening Criteria are important in order to determine the conditions under which a specific economic activity is considered to contribute to or significantly to harm one or more environmental objectives. The Technical Screening Criteria will be developed over time by delegated acts supplementing the Taxonomy Regulation. The first set of Technical Screening Criteria, for activities which substantially contribute to climate change mitigation or climate change adaptation, will apply as from 1 January 2022. The second set of Technical Screening Criteria, which cover economic activities substantially contributing to the other Environmental Objectives, will apply as from 1 January 2023.

Environmental Objectives

The six environmentally sustainability objectives as detailed in Articles 9 to 15 of the Taxonomy Regulation are :

1-Substantial contribution to climate change mitigation

An economic activity is considered to contribute substantially to the mitigation of climate change where that activity contributes substantially to the stabilisation of greenhouse gas concentration in the atmosphere, in particular through process innovation or product innovation, use of renewable or climate-neutral (including carbon-neutral) energy, increasing clean or climate-neutral mobility, developing the necessary energy infrastructure to enable the decarbonisation of energy systems, or producing clean and efficient fuels from renewable or carbon-neutral sources. Climate change mitigation means to keep the increase in the global average temperature to under 2°C and pursuing efforts to limit it to 1.5°C above pre-industrial levels.

Obviously, activities that result in significant greenhouse gas emissions are to be considered as significantly harming climate change mitigation. Delegated acts to be adopted by the Commission (by 31 December 2020 with a view to ensuring their application from 1 January 2022) will establish Technical Screening Criteria to determine which activities contribute substantially to the mitigation of climate change and which significantly harm climate change mitigation.

2-Substantial contribution to climate change adaptation

An economic activity is considered to contribute significantly to climate change adaptation i) when it provides solutions that reduce the risk of the adverse impact of the current and expected future climate on that economic activity without increasing the risk of an adverse impact on people, nature or assets or ii) when it provides solutions that reduce the risk of the adverse impact of the current and expected future climate on people, nature or assets without increasing the risk on other people, nature or assets.

Delegated acts to be adopted by the Commission (by 31 December 2020 with a view to ensuring their application from 1 January 2022) will establish Technical Screening Criteria to determine which activities contribute substantially to the climate change adaptation and which significantly harm this objective.

3-Substantial contribution to the sustainable use and protection of water and marine resources

An economic activity is considered to contribute substantially to the sustainable use and protection of water and marine resources where that activity contributes substantially to achieving or preventing the deterioration of good water status or contributes to the good environmental status of marine waters or prevents the deterioration of marine waters by any of the following means : (i) protecting the aquatic environment from the adverse effects of discharges of urban and industrial waste water for example by collecting and treating such water, (ii) protecting human health from the adverse effects of any contamination of drinking water, (iii) through abstraction in compliance with good quantitative status, (iv) improving the rational use of water and facilitating the sustainable use of water through long-term protection of available resources, or (v) ensuring the sustainable use of marine ecosystem services or contributing to good environmental status of marine waters.

Delegated acts to be adopted by the Commission (by 31 December 2021 with a view to ensuring their application from 1 January 2023) will establish Technical Screening Criteria to determine which activities contribute substantially to sustainable use and protection of water and marine resources and which significantly harm this objective.

4-Substantial contribution to the transition to a circular economy

An economic activity is considered to contribute substantially to the transition to a circular economy, including waste prevention, reuse and recycling, where that activity : (i) improves the efficient use of raw materials in production, (ii) increases the durability, reparability, upgradeability or reusability of products, (iii) increases the recyclability of products, (iv) reduces the hazardous substances in materials and products, (v) prolongs the use of products, (vi) increases the use of secondary raw materials and their quality, (vii) prevents or reduces waste generation, (viii) increases preparedness for reuse and recycling of waste, (ix) minimises incineration of waste and waste disposal, (x) avoids the accumulation of litter.

Delegated acts to be adopted by the Commission (by 31 December 2021 with a view to ensuring their application from 1 January 2023) will establish Technical Screening Criteria to determine which activities which contribute substantially to sustainable use and protection of water and marine resources and which significantly harm this objective.

5-Substantial contribution to pollution prevention and control

An economic activity is considered to contribute substantially to pollution prevention and control where that activity contributes to protecting the environment against pollution by : (i) preventing or reducing pollutant emissions into air, water or soil other than greenhouse gasses, (ii) improving levels of air, water or soil quality in areas where the economic activity takes place while minimising adverse impacts on human health and the environment or the risk thereof, and (iii) preventing or minimising any adverse impact on human health and the environment from the production, use or disposal of chemicals, or (iv) cleaning up litter and other pollution.

6-Substantial contribution to the protection and restoration of biodiversity and ecosystems

An economic activity is considered to contribute substantially to the protection and restoration of biodiversity and ecosystems when it contributes substantially to the protection, conservation and restoration of biodiversity or to achieving the good condition of ecosystems or to protecting ecosystems that are already in good condition, through (i) nature and biodiversity conservation, (ii) sustainable land management, (iii) sustainable agricultural practices and (iv) sustainable forest management.

The Commission will work on the definition of activities harmful to the environment. The text of the Taxonomy Regulation provides very general guidelines and does not exclude any technology or sector from green activities, except the use of solid fossil fuels such as coal or lignite and therefore electricity generation from solid fossil fuels. Gas production and nuclear energy are still the subject of debate.

Entities impacted by the Taxonomy Regulation

1-Member States and the European Union

Member States and the European Union must comply with the Taxonomy Regulation when imposing any requirement on financial market participants or issuers in respect of sustainable financial products or corporate bonds which are marketed as environmentally sustainable. This obligation is broadly drafted and will cover the requirements set by Member States and the European Union to allow financial market participants and issuers to use standards or eco-labels.

2-Financial Market Participants

The Taxonomy Regulation does not require Financial Market Participants to invest in sustainable economic activities. The option chosen to promote sustainable investments is that of transparency. Financial Market Participants will have to disclose information on financial products that are offered as environmentally sustainable.

The Taxonomy Regulation defines 'Financial Market Participants' and 'financial products' by reference to the definitions included in Regulation 2019/2088 on sustainability disclosure in the financial services sector (SFDR).

Financial Market Participants are :

Insurance undertakings that offer insurance-based investment products
Investment firms providing portfolio management services
Institutions for occupational retirement provision (IORPs)
Pan-European personal pension products providers
Fund managers (managers of alternative investment funds and UCITS management companies, managers of a qualifying venture capital fund and managers of a qualifying social entrepreneurship fund)
Manufacturers of pension products to which SFDR applies, and
Credit institutions providing portfolio management services.

Financial Market Participants are defined based on the nature of their services. This new category comprises financial service providers that invest third party funds or that offer financial products.

The Taxonomy Regulation applies to EU-based Financial Market Participants providing financial products or services on the territory of one or more Member States. It also applies to non-EU asset managers or other financial entities marketing ‘financial products’ within the EU and indirectly also to issuers of financial products aiming to market these in the EU. Such issuers, even if located in a third country, may be required to assist Financial Market Participants with the required disclosures by providing information relating to environmental sustainability.

The financial products considered by the Taxonomy Regulation are :

Portfolios under discretionary and individualised management including one or more financial instruments within the framework of a mandate given by a client
UCITS
Alternative investment funds (AIF)
Insurance-based investment products
Pension products, and
Pension schemes or pan-European individual retirement savings products.

The Taxonomy Regulation supplements the SFDR by imposing additional sustainability-related disclosure obligations on Financial Market Participants.

Where a financial product has sustainable investment as its objective, the Taxonomy Regulation requires Financial Market Participants to disclose in the pre-contractual documentation and in periodic reports :
information on the environmental objective(s) to which the investment underlying the financial product contributes, and
how and to what extent the sustainability criteria of an investment underlying the financial product are in economic activities that qualify as environmentally sustainable pursuant to the Taxonomy Regulation. For example, a fund manager marketing a 'green' fund will have to indicate in the pre-contractual document for that fund which of the six environmental objectives are promoted by the activities in which the fund invests and ii) how and to what extent the investments made by the fund are in sustainable economic activities. The information published will have to enable investors to know the share of the investment financing sustainable activities as a percentage of total economic activities. This corresponds to the degree of environmental sustainability of the investment. It is expected that Financial Market Participants will use the Technical Screening Criteria developed by the Commission to assess a company’s economic activities and determine whether each of its activities meet the sustainability criteria of the Taxonomy Regulation.

Where a financial product promotes environmental or social characteristics or a combination of these characteristics, similar disclosure obligations as listed above apply. The product will have to be accompanied by the following statement : “The ‘do not significant harm’ principle applies only to those investments underlying the financial product that take into account the EU criteria for environmentally sustainable economic activities. The investments underlying the remaining portion of this financial product do not take into account the EU criteria for environmentally sustainable economic activities”.

Where a financial product does not promote environmental or social characteristics and does not have sustainable investment has its objective, pre-contractual disclosures and periodic reports must contain the following statement : “The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities”.

All Financial Market Participants are within the scope of the Taxonomy Regulation, because even those which do not promote sustainable financial products must disclose that the financial product is not sustainable.

3-Undertakings subject to the Non-Financial Reporting Directive (NFRD)

Public interest entities with more than 500 employees (including listed companies, credit institutions and insurance undertakings) which are subject to the NFRD will have to include in their (consolidated) non-financial statements information on how and to what extent their activities are economic activities that qualify as environmentally sustainable under the Taxonomy Regulation. The information must include:

the proportion of turnover derived from products or services associated with economic activities that qualify as environmentally sustainable; and
the proportion of capital expenditure and the proportion of operating expenditure related to assets or processes associated with economic activities that qualify as environmentally sustainable.

The Commission is to adopt a delegated act on the content and presentation of this information by 1 June 2021.

4-Others

Of course, the classification system developed in the Taxonomy Regulation could also be used on a voluntary basis by companies not covered by the SFDR or the NFRD which would, for example, wish to raise funds for sustainable activities.

Entry into force

The Taxonomy Regulation will enter into force on 12 July 2020. The operational part of the Taxonomy Regulation will enter into force gradually, on 1 January 2022 as regards the first two Environmental Objectives enshrined in the Taxonomy Regulation (climate change mitigation and climate change adaptation) and on 1 January 2023 as regards the four other Environmental Objectives listed above. The new disclosure requirements will apply from 1 January 2022 or 1 January 2023, depending on the relevant Environmental Objective.

The Taxonomy Regulation will be further implemented through delegated acts governed by Article 290 TFEU. In the preparation of those delegated acts, an International Platform on Sustainable Finance will be set up, bringing together representatives of the European Environment Agency, the European Supervisory Authorities, the European Investment Bank and the European Investment Fund, experts representing relevant private stakeholders, in particular financial market participants, and scientific experts appointed in a personal capacity with proven knowledge and experience in the areas covered by the Regulation.

The Taxonomy Regulation will enter into force before the Brexit transition period ends on 31 December 2020. However, the operational sections of the Taxonomy Regulation will only enter into force after the end of the Brexit transition period once the delegated acts have been published. The disclosure requirements imposed by the Taxonomy Regulation will therefore not constitute retained EU law in the UK. However, the UK Government made public in June 2020 its intention to retain the taxonomy framework, including the Environmental Objectives set out in the Taxonomy Regulation (but not necessarily any not yet known clarification to be set out in the future delegated acts).