THE EU TAXONOMY: THE PROS, THE CONTRAS AND EVERYTHING IN BETWEEN

ARTICLE

THE EU TAXONOMY: THE PROS, THE CONTRAS AND EVERYTHING IN BETWEEN

by Gerrit Dubois,
Responsible Investment Specialist at DPAM

- The EU has released a draft of the remaining four Taxonomy criteria.

- These four points expand on the first two criteria by adding extra depth and breadth.

- It is a promising tool for change, but increased focus across the board will be needed.
- The Taxonomy’s content is at risk of being overly technical and restrictive.

With COP26 approaching and the latest Intergovernmental Panel on Climate Change (IPCC) report stirring the talks on global warming, it might be interesting to look at the upcoming regulatory plans pf the EU. As discussed in our previous articles, the EU is developing a set of regulatory actions to provide transparency to the market and guide investors towards investments with truly green credentials. One of the building blocks of the EU Green Deal is the so-called ‘EU taxonomy for sustainable economic activities’. Let’s put this new regulation in the spotlight, discuss the contents of the Taxonomy and assess the impact.

The taxonomy can be broadly summarised as a classification system that focuses on the 6 environmental objectives shown in the figure below:

EU Taxonomy: Environmental Objectives

Source: European Commission (2019)

To make a direct link with the corporate community and increase transparency and tangibility towards all stakeholders, the objectives are linked to a list of economic activities. These are, in turn, linked to scientifically backed technical-screening criteria. But how advanced is the EU in defining these activities and screening criteria?

The screening criteria on ‘climate change mitigation’ [1] and ‘climate change adaptation’ [2] objectives have already been formally adopted. However, this August, the working group behind the taxonomy proposal (i.e. the Platform on Sustainable Finance [PSF]), published a first proposal on the eligibility criteria for the 4 remaining Taxonomy objectives (i.e. Sustainable use of water and marine resources [3], circular economy [4], pollution prevention [5], healthy ecosystem [6]). With the formal adoption only to be expected in 2022, investors and the wider financial stakeholder community are already given the opportunity to provide feedback on the first draft.

LIMITED INCREASE IN SCOPE, BUT A LENGTHY LIST OF TECHNICAL CRITERIA

Although the European Commission (EC) proposed to prioritise a set of key economic activities for each of the 4 remaining objectives, the Annex to the 100 page-report (i.e. the list of Technical Screening Criteria) contains a staggering 993 pages with detailed criteria by economic activity. As a first remark, we can state that, although the first two objectives only cover a limited amount of listed companies, the scope of the regulation increases by adding the 4 remaining objectives (although not significantly). However, the PSF working group clearly details its reasoning on the prioritisation of activities. Consistent with the selection for the first two objectives (mainly based on sectors’ respective share of global greenhouse gas emissions as well as the improvement potential of certain macro-sectors), the selection for the remaining four objectives was driven by several impact/pressure indicators and the improvement potential at the level of economic activities.

Some new activities, especially in terms of market capitalisation, include the manufacturing of pharmaceuticals, chemicals, food & beverages and electronic equipment, as well as animal production, crop production and fishing. Bearing in mind the significant investment gap of EUR 350 billion/year to meet the climate and energy targets for 2030 (i.e. 55% GHG reduction vs. preindustrial levels), and additional investments of EUR 100-150 billion/year to meet broader environmental objectives, the challenge is still huge.

However, rather than significantly extending the scope of activities, the proposed criteria also focus on the initially covered activities such as electricity generation, transport and buildings. Consequently, this makes them more restrictive and requires much more data collection. For those activities added to the list (e.g. the pharmaceutical industry, crop production or the food and beverage industry), the eligibility criteria are not only very technical, but also quite restrictive. Furthermore, the list does not cover all relevant sub activities within the industries in question. Let’s take a look at some concrete examples below:

FASHION: A LONG LIST OF TECHNICAL, RESTRICTIVE ELIGIBILITY CRITERIA

the EU’s Circular Economy Action Plan clearly describes the necessary steps and requirements for the textile industry (including textile finishing, manufacturing, repair, refurbishment, etc.). The Action Plan seeks to achieve a sustainable and fully circular economy by 2050. To do so, it pushes for tighter rules and targets by 2030. However, its technical screening criteria are long and detailed. Although the resulting data gathering will be a massive burden to the textile industry, the proposed criteria do outline a credible pathway to guide investments towards more sustainable economic activities and a greener future.

FISHING: WHAT ABOUT AQUACULTURE?

For some activities, not all relevant sub-activities are properly covered. For example, in the fishing industry, the taxonomy does not scope in aquaculture. This is a questionable decision, since this sub-sector has faced a lot of environmental criticism. The PSF argues that issues in aquaculture are different from those in fishing, hence making it difficult to carry over criteria from fishing to aquaculture. Although the PSF ‘strongly recommends that aquaculture is prioritised in the next round’, this might have been a missed opportunity.

ELECTRICITY GENERATION: FINALLY ENDING THE EVERLASTING CRITIQUE OF FOSSIL FUEL LOBBY AND EXTREME ENVIRONMENTALISTS?

The criteria also focus on activities covered in the first Delegated Acts, (e.g. electricity generation, transport and buildings), making them more restrictive and requiring them to provide more data. In these first Acts, electricity generation only had limited technical requirements (apart from the carbon emissions focus). With the new proposal, the PSF also looks at different types of electricity generation. However, it seems the expert group is only sticking to a broad description without setting stringent criteria or thresholds. Another missed opportunity?

WHEN CAN WE EXPECT A FORMAL ADOPTION?

The consultation period runs until the end of September and the working group intends to submit its final Taxonomy Report to the EC by November. Formal adoption (via Delegated Act) is expected sometime in 2022. With the IPCC’s latest report increasing the pressure and COP 26 approaching, potentially significant changes to the scope and the technical screening criteria might still be expected in the final draft. As stressed by the IPCC report, unprecedented action is required to limit global warming to 1.5°C and limit physical risks. The global carbon budget is shrinking, and this means reduction efforts should be pursued in every industry, as quickly and efficiently as possible.

For the moment, we sincerely applaud the developments and are eagerly waiting for next steps. Indeed, more transparency and accountability from both the corporate and the financial industry is needed to channel investments towards credible green activities. According to a leaked version of the third working group of the IPCC assessment report (for which the report is only to be released next year), annual spending needs to increase by five-fold in order to meet the required targets, with GHG emissions peaking by 2025, coal and gas power to be phased-out by 2030 and an immediate stop to all new oil and gas developments (in line with IEA findings). But we should stress that the Taxonomy will not be sufficient as a sole tool to drive change¹. The EU’s climate flagship project, the Emissions Trading Scheme, needs to assist the channelling of capital and investment streams towards taxonomy-aligned activities. With a multi-year trial-and-error phase behind us and financial materiality lacking so far (although this is gradually changing), the announced revisions of the system need to champion change in all relevant sectors and align their activities with the taxonomy criteria, as it is in fact ‘code red for humanity’.

The EU Taxonomy timeline

Source: DPAM

One might question if the social side is not left behind? the environmental taxonomy includes ‘social safeguards’ linked to the economic activities to ensure minimum criteria are met. But secondly, to push for an additional positive impact on the social side, the EC is also working on a Social Taxonomy based on international norms, treaties and goals, such as the UN Declaration on Human Rights and the UN Sustainable Development Goals.

Interestingly, the first draft published earlier in July highlights the focus on two dimensions. On the one hand, the working group suggests a horizontal dimension by considering good governance and operational metrics across the entire value chain (i.e. all stakeholders), hence resulting in a combination of entity- and activity-level criteria. On the other hand, a vertical dimension is proposed, where focus is put on products and services for basic human needs and basic infrastructure. This means economic activities that make such products and services more accessible, without harming efforts to achieve other social objectives, could be considered social. Stay tuned for new updates on this proposal.

Have you got some spare time on Sunday morning? You can find the draft proposal on the remaining 4 taxonomy objectives here, and the Technical Annex here.

¹Note that the Taxonomy regulation is directly integrated and linked to the revision of the Non-Financial Reporting Directive (for corporate/industry disclosures) and the Sustainable Finance Disclosure Regulation (for financial institutions).

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THE EU TAXONOMY: THE PROS, THE CONTRAS AND EVERYTHING IN BETWEEN