EU taxonomy is a tool for climate transition

But it comes with both risk and opportunities for business

By Antigoni Pafitis

In the past few years there has been a great deal of interest in the concept of ‘sustainable finance’ and the belief that it should be fundamental to the way the economy works. However, the unimaginable hardship of the Covid-19 pandemic has created pressure on countries, governments and each one of us, to set aside our efforts to fight climate change and adopt a greener way of life, in favour of a swift restoration of economic growth. But are the two concepts necessarily incompatible?

In March 2019, the European Commission (EC) demonstrated its resolve to become a global sustainable finance leader by unveiling its Sustainable Finance Action Plan. The plan anticipates firm sustainability standard actions and proposes major regulatory changes. Both are necessary to satisfy the political ambition and urgent timetable set for achieving the European Green Deal.

On this front, in June 2020, the European Parliament adopted the EU Taxonomy Regulation. The regulation is intended to boost private sector investment in green and sustainable projects. The regulation proposes the establishment of a taxonomy for sustainable investments and products which would gradually create a unified classification system. Once implemented this would allow investors to recognise which projects truly are ‘green’ and ‘sustainable’ rather than just claiming to be so.

Over the past few months, the regulation has faced criticism from many stakeholders, policymakers and some EU member states. They argue that it will shut out entire industries from capital markets, and also severely undermine the competitiveness of the European economy per se.

But what is the EU Taxonomy Regulation, to whom does it apply, and what are the challenges and opportunities arising from it?

In simple words, the EU taxonomy is a legislative framework setting out a classification system seeking to identify economic activities deemed ‘environmentally sustainable’ based on a scientific assessment. It sets six different environmental objectives in order to recognise environmentally sustainable economic activities which are aligned with the objectives of the Paris Agreement on climate change and the EU Green Deal. A key objective of the Green Deal is for the EU to achieve carbon neutrality by 2050.

The regulation imposes an obligation on large companies with more than 500 employees to report the level of the alignment of their business with the EU taxonomy. The financial metrics to be disclosed may relate to turnover, capital expenditure or operating expenditure. In addition, financial firms offering investment products will also have to disclose the degree of alignment of their portfolio with the EU Taxonomy. Finally, the EU and EU member states proposing measures to label financial products as sustainable will also be obliged to base these measures around the EU Taxonomy.

It should be clear that the intention of the regulation in identifying ‘sustainable’ economic activities, that are compatible with climate objectives based on scientific evidence, is to help guide investors towards these types of investments. This does not mean that those activities not ‘aligned’ are automatically identified as “polluting” or “unsustainable”. It mainly sets targets for sectors, but it certainly does not mandate ‘how’ a particular sector or company needs to transition between now and 2050.

The introduction of the regulation should present a number of opportunities for businesses and investors alike. However, it also presents a number of challenges for governments, regulators, the financial sector, and the business world. In order to achieve the EU Taxonomy’s ultimate goal of facilitating the transition of our economy into a carbon neutral one, multiple adjustments and amendments linked to market need may prove necessary.

In terms of challenges, one of the main points that stakeholders raise is that, since the regulation will require corporate disclosure, policymakers should be able to ensure that the right data, at the right level, is available in order to achieve smooth transition. Moreover, investors anticipate a need for significant practical and interpretive guidance, since the EU Taxonomy is complicated and technical. Last but not least, stakeholders have raised an alarm in respect of the potential complexities involved in having also to comply with competing international taxonomy frameworks. China, Australia and other significant markets all over the world are increasingly turning their attention to taxonomies. It is therefore vitally important that the EU framework should continue to develop based on international cooperation and in agreement with international standards. Businesses and potential investors should not have to grapple with conflicting definitions and systems.

The EC’s Action Plan on Financing Sustainable Growth, through its associated policies such as EU Taxonomy, is an important step in setting up a regulatory framework in which banks, firms and other stakeholders can facilitate the decarbonisation of the economy. The EC has made tremendous efforts to deliver on the Action Plan and this has had a profound impact on the acceleration of the sustainability agenda across Europe and the whole world. It is working hard to show that sustainable investment results in economic growth and prosperity. To achieve its goal of carbon neutrality the development of sustainable activities must take place throughout all sectors of the economy and the financial markets must have an incentive to contribute to the provision of capital for sustainable investments.

Antigoni Pafitis is a lawyer at Elias Neocleous & Co LLC, Brussels office