On 21 April 2021, the EU published the first of two planned sets of performance criteria for environmentally sustainable activities under the Taxonomy Regulation. The criteria published will allow businesses and investors to assess activities and determine whether they meet the EU standard for substantially contributing to the objectives of climate change mitigation or adaptation (the Climate Standards).
Taxonomy & Climate Standards
The Climate Standards are set out in a draft delegated measure under the Taxonomy Regulation. The Taxonomy is the core legislative measure under the EU’s Sustainable Finance Action Plan and sets out the EU framework for a harmonised classification system for environmentally sustainable activities. The Climate Standards are the first step towards implementation of that framework and are expected to be finalised no later than six months from the date of their adoption by the Commission on 21 April last.
Mandatory & Voluntary Use
There is no obligation on financial and non-financial firms to use the Taxonomy framework incorporating the Climate Standards. However, the Taxonomy does require companies in-scope of the Non-Financial Reporting Directive or NFRD (large listed entities, banks and insurers) as well as managers of financial products in scope of the Sustainable Finance Disclosures Regulation or SFDR, to disclose whether and, if so how, they use the Taxonomy.
The Taxonomy disclosure rules come into effect on 1 January 2022.
For NFRD entities, further legislative measures are planned for adoption by 1 June 2021 which will mandate the form, content and presentation of disclosures required under the Taxonomy including when and how relevant turnover and expenditures count as Taxonomy compliant.
As per our previous briefing (ESMA Consults on Green Fund Disclosures), fund management companies (FMCs) that market funds with an environmentally sustainable strategy (light green funds under SFDR) and/or funds which specifically target environmentally sustainable investments (dark green funds under SFDR) are in scope of the Taxonomy’s investor disclosure rules. These rules mandate disclosure of ‘how and to what extent’ underlying investments are in activities that comply with the Taxonomy and the Climate Standards or, in other words, the level of alignment of the fund’s investments with the Taxonomy. Where available, FMCs can and should leverage the Taxonomy disclosures of companies in scope of the NFRD, to comply with their own investor disclosures obligations. To the extent such disclosures are not available e.g. in the case of non-EU investments, FMCs can use the Climate Standards to assess investee entities’ activities to determine whether they are aligned with Taxonomy. When an activity under assessment complies with the Climate Standards, the assessment should be able to count either or both the investee entity’s turnover from these activities and any capital expenditure (and specific operational expenditure) as Taxonomy-aligned. The Taxonomy-alignment of the fund portfolio can then be disclosed as an aggregation of the weighted average contribution of the investments to activities which comply with the Taxonomy.
The Climate Standards incorporate detailed performance criteria for activities that make a substantial contribution to two of the six EU-agreed environmental objectives i.e. climate change mitigation and climate change adaptation. Criteria for assessing activities against the remaining four objectives are currently being developed before coming into effect on 1 January 2023.
Activities for which there are no Climate Standards are not classified as ‘unsustainable’. To qualify under the Climate Standards, the Taxonomy requires that activities make a ‘substantial contribution’ to an environmental objective but FMCs with green funds may choose to invest in companies engaged in activities which have different degrees of environmental performance, activities not covered by the Taxonomy or those which don’t comply with the ‘do no significant harm principle’ under the Taxonomy. Such investments can still be sustainable even though they are not Taxonomy-aligned. There is no obligation to invest in Taxonomy-aligned activities, only to disclose the level of Taxonomy-aligned investment.
In all, there are over 200 Climate Standards covering activities across 13 economic sectors:
- Environmental protection and restoration activities
- Water supply sewerage waste management and remediation
- Construction and real estate activities
- Information and communication
- Professional scientific and technical activities
- Financial and insurance activities
- Human health and social work activities
- Arts, entertainment and recreation
Each Climate Standard sets down performance thresholds for (i) substantially contributing to the Taxonomy’s environmental objectives of climate change mitigation and adaptation; along with (ii) criteria for complying with the Taxonomy principle of ‘do no significant harm’ i.e. that the activity which meets the threshold for (i) does not simultaneously impede the achievement of one or more of the other five environmental objectives under the Taxonomy. The ‘do no significant harm’ or DNSH principle is a core aspect of the Taxonomy included to ensure progress towards one objective is not made at the expense of another.
Transitional & Enabling Activities
The Climate Standards provide for two specific types of environmentally sustainable activities. First, for the climate change mitigation objective, it recognises ‘transitional’ activities. As outlined in EU Taxonomy supporting documents, these are activities for which low-carbon alternatives are not yet available and that have greenhouse gas emission levels that correspond to the best performance in the sector or industry. For example, this might include best-in-class cement manufacturing. Nevertheless, there are two conditions: (i) they should not hamper the development and deployment of low-carbon alternatives and (ii) they should not lead to a lock-in of carbon-intensive assets, considering the economic lifetime of those assets. The second category of activities to be recognised are those referred to as ‘enabling’ activities, being those that directly enable others to make a substantial contribution to an environmental objective. For example, this could include manufacturing of renewable energy technologies, installation of energy efficiency equipment in buildings, research into materials for stronger flood defences, or use of cover crops that reduce the risk of flooding for an area.
Performance criteria for both transitional and enabling activities are set out in the Climate Standards.
The Commission believes that ‘financial entities and companies are already using or considering using the EU Taxonomy framework’ and so ‘will be able to report voluntarily’ once the Climate Standards are finalised later this year. Mandatory reporting under the Taxonomy will apply from January 2022 for the climate change mitigation and adaptation objectives, and from January 2023 for the other four objectives. The Commission is exploring appropriate guidance and options for how companies in-scope of the NFRD (proposed to be revised and extended under the new Corporate Sustainability Reporting Directive) and financial market participants (including FMCs) can meaningfully report in the first year of their reporting obligations given the data gaps which have been accentuated by the delayed publication of the Climate Standards, originally scheduled for adoption by end-December 2020.
If you have any queries on the issues discussed in this article, please contact the Asset Management & Investment Funds team or your usual William Fry contact.