An Introduction to the EU Taxonomy

Key Takeaways

 

• The EU taxonomy is a classification system of “environmentally sustainable economic activities”
• It has been created to help investors make green investments 
• Six environmental objectives have been identified
• The taxonomy specifies how each activity can contribute to each objective
• To be taxonomy aligned, an activity must contribute to at least one objective, Do No Significant Harm (DNSH) to any of the others, and meet minimum social safeguards 
• From 2022, companies will need to report on the percentage of their overall turnover, CapEx and OpEx in FY'22 that is taxonomy eligible

 

A little background

 

Of the many developments in ESG legislation in recent years, the introduction of the EU taxonomy is arguably one of the most pivotal. But what is it exactly? What makes it so important, and who is it likely to affect? To answer all your burning questions, we’ve put together this introductory guide.   

As we already know, the EU has set itself some ambitious goals when it comes to its climate policy, including a 55% reduction in greenhouse gas emissions by 2030 and to become an entirely climate-neutral continent by 2050. 

To help achieve these goals, the European Commission released a sustainable finance plan in 2018, with the aim of bringing together economic and environmental policies and encouraging green investment. 

But for this to be a success, they first needed to establish clearer definitions of what ‘green’ consisted of. And so the EU taxonomy, first published in June 2020, was established. 

 

So…what is the EU taxonomy? 

 

In biology, taxonomy is the science of naming, describing, and classifying all living things. The European Commission has taken this approach and applied it to sustainable business.

The EU taxonomy is a classification system of environmentally sustainable economic activities. Put simply, it’s a dictionary-style tool detailing specific business activities that are considered sustainable by the EU. 

 

What makes the taxonomy unique

 

The taxonomy fills two important needs: it provides us with a common language for talking about sustainability and uses objective, quantifiable criteria for assessing businesses.  

Previously, differing sustainable finance legislations and organisations (such as Ecolabel and the Green Bond Standard) each had their own terminologies. One of the aims of the EU taxonomy is to bring everyone together with unified definitions, measurements and objectives. 

It has identified six environmental objectives: 

1. Climate change mitigation
2. Climate change adaptation 
3. Protection of water and marine resources 
4. Transition to a circular economy
5. Pollution control
6. The protection of ecosystems

While previous guidelines left room for interpretation, the taxonomy takes a more rigorous approach, looking at individual business activities in granular detail while using a science-backed approach.

 

A tool for both investors and corporates

 

The taxonomy is designed primarily to be used as a tool for sustainable investment. By putting everyone on a level playing field, it will help investors understand more clearly where companies stand in relation to one another. 

It will also play a vital role in guiding business decision-making. Due to its objective framework, the taxonomy will make it harder for companies to hide behind their marketing. 

 

Who is affected by the EU taxonomy? 

 

Taxonomy rules apply to all large European companies that fall under the NFRD (Non-Financial Reporting Directive); i.e. public interest entities with more than 500 employees. 

Financial market participants offering products in the EU that promote environmental objectives are also required to report.

 

How it’s structured

 

 

The taxonomy looks at a number of major sectors including agriculture, manufacturing, transportation, energy, construction and communications. For each sector, it provides a list of industry-relevant activities that could be considered sustainable. 

It then looks at each activity through the lens of its six environmental objectives by providing a list of ‘substantial contribution’ criteria and ‘do no significant harm’ (or DNSH) criteria for each objective. 

For an activity to be considered eligible, it only needs to meet the substantial contribution criteria for one of the six objectives. For it to be taxonomy aligned, it has to meet the substantial contribution criteria for at least one of the six, comply with the DNSH criteria for all six, and meet minimum social and governance safeguards (in accordance with the OECD, UN and ILO issued guidelines).

 

What needs to be reported, and when?

 

 

If taxonomy rules apply to you, you’ll need to disclose in your annual report how much of your overall business follows the activities outlined in the taxonomy. 

The taxonomy is currently being rolled out in two phases: 

1. In phase 1, companies need to report on the proportion of their turnover, capital expenditures (CapEx) and operational expenditures (OpEx) that is taxonomy eligible. This phase begins in 2022 (for the 2022 annual report) for financial institutions and all other sectors.
2. In phase 2, companies need to report on the proportion of their turnover, CapEx and OpEx that is taxonomy aligned. This phase will begin in 2023 or in 2024 for large companies and financial institutions respectively.   

 

What else should I know? 

 

It’s important to note that the taxonomy is still being developed. Currently, criteria for only the first two objectives—mitigation and adaptation—have been published, with the remaining four published at the start of 2023. 

Beyond this, it will be subject to continuous review, allowing for new industries and activities to be added in over time. As the first “green list” of its kind, all eyes are on the taxonomy, with scientists and business leaders keen to ensure that it is as accurate and fair as possible. 

One recent example is the addition of gas and nuclear energy. Three natural gas activities and three nuclear activities have been included, and are subject to additional requirements in order to be taxonomy aligned. This has sparked a considerable amount of debate: while providing stricter criteria for these activities can be seen as a positive, many argue that labelling them as ‘sustainable’ is misleading.

Looking further ahead, there’s talk of other similar legislations, like a “social taxonomy”, eventually being developed. This will broaden the scope significantly, applying the same level of scrutiny to the ‘S’ of ESG.    

As the taxonomy is so young, it is still in a state of flux: its contents, and how it is used, is likely to expand and evolve over time. 

 

Our recommendations

 

 

 

 

Start early: As with any new legislation, the best way to keep on top of things is by staying ahead. Understanding and reporting on the taxonomy takes time, so it’s best to get the ball rolling as early as possible.  

Stay agile: Keep in mind that the taxonomy is still growing and is likely to evolve. Adopting a process that allows for new requirements as they come along, rather than needing to be re-evaluated each year, is key. 

Be alert—don’t assume the taxonomy won’t affect you: Don’t ignore the taxonomy just because you’re a small or medium-sized organisation. Taxonomy alignment is becoming a key consideration for investors, so represents a vital opportunity for securing capital. The scope of who needs to report is also set to increase in the future—so if you aren’t impacted now, you may be later on.

Think big: The taxonomy is just one important thread in a much bigger tapestry of evolving and expanding legislations, requirements, and expectations. Don’t tackle each requirement in isolation. Instead, lay strong foundations: make sure all your data is verifiable by implementing a cohesive process across your entire organisation. 

 

To help you stay ahead of evolving legislations, Workiva helps you build data connections across your entire organisation and systems while maintaining control and mitigating risk. By empowering you to trust your data and report in a transparent and verifiable manner, you can go beyond compliance, and focus on communicating—and achieving—your company’s goals. If you'd like to find out more, check out our ESG demo video.