- Category: European Union Carbon Market Glossary
Taxonomy Regulation in the EU carbon market legal framework stands for the Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088.
The Regulation was published in the Official Journal on 22 June 2020 and entered into force 20 days later. There is also a more general term in use: "taxonomy framework”, which is taken (see Transition finance report, Platform on Sustainable Finance, March 2021, p. 15) to include:
- the Taxonomy Regulation itself,
- the Delegated Acts containing technical screening criteria for substantial contribution to climate change mitigation and climate change adaptation,
- the Delegated Act providing details of undertakings’ taxonomy disclosures (Article 8 of the Taxonomy Regulation),
- the forthcoming EU Green Bond Standard, and sometimes
- the relevant elements of the Non-Financial Reporting Directive (NFRD).
The Taxonomy Regulation applies to:
(a) measures adopted by the EU Member States or by the European Union that set out requirements for financial market participants or issuers in respect of financial products or corporate bonds that are made available as environmentally sustainable;
(b) financial market participants that make available financial products;
(c) undertakings which are subject to the obligation to publish a non-financial statement or a consolidated non-financial statement pursuant to Article 19a or Article 29a of Directive 2013/34/EU of the European Parliament and of the Council of 26 June 2013 (on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings), respectively.
The Taxonomy Regulation establishes the world’s first-ever “green list” – an EU classification system (the "taxonomy") to facilitate sustainable finance (or green investments - although the Regulation itself does not refer to such a term).
More specifically, the Taxonomy Regulation establishes the criteria for environmentally sustainable economic activities - under the EU taxonomy, most economic activities are screened and criteria are determined (on the level of emissions, recycling rates, water management requirements, etc.) per activity area to determine whether it can be labelled as sustainable by investors and asset managers.
The relevant legal wording can be found in Article 1 of the Taxonomy Regulation, according to which the Regulation "establishes the criteria for determining whether an economic activity qualifies as environmentally sustainable for the purposes of establishing the degree to which an investment is environmentally sustainable".
The technical screening criteria (TSC) under the taxonomy legal framework are laid down by Commission Delegated Regulations.
The first TSC delegated regulation has been published in the EU Official Journal on 9 December 2021. On 2 February 2022 European Commission presented and passed to the European Parliament and the EU Member States the Taxonomy Complementary Climate Delegated Act.
Further delegated regulations will cover other environmental objectives of the taxonomy: water, circular economy, pollution prevention and biodiversity.
In principle, the Taxonomy Regulation lays out three types of activities:
1. low-carbon (Article 10(1));
2. transitional activities (Article 10(2));
3. enabling activities (Article 16).
The framework is based on six taxonomy environmental objectives.
The taxonomy uses
As the Council of the EU underlines, the taxonomy will enable investors to re-orient their investments towards more sustainable technologies and businesses. Hence, the taxonomy is first and foremost a tool for investors, however it introduces disclosure requirements, rather than telling investors in what to invest. It needs to be stressed, there is no obligation to invest only into taxonomy-compliant economic activities. However, if a financial product is marketed and/or sold to investors as ‘environmentally sustainable’, then the extent to which it is green (the ‘greenness’) must be disclosed to investors by reference to the taxonomy. This allows for many different investment strategies to co-exist, while avoiding a straightjacket approach (FAQs, Commission Technical Expert Group on Sustainable Finance).
It will be instrumental for the EU to become climate neutral by 2050 and achieve the Paris Agreement's 2030 targets. These include a 40% cut in greenhouse gas emissions for which the Commission estimates that the EU has to fill an investment gap of about 180 billion EUR per year.
Before the Taxonomy Regulation, there was no common classification system at EU or global level which defined environmentally sustainable economic activity. The document titled: “FAQs, Commission Technical Expert Group on Sustainable Finance", published on the European Commission’s website, explains that the taxonomy will have to be used by:
- the EU Member States for the purposes of any measures setting out requirements on market actors in respect of financial products or corporate bonds that are marketed or deemed as environmentally sustainable,
- financial market participants offering financial products as environmentally sustainable investments or investments having similar characteristics (they would have to disclose information on how the criteria for environmentally sustainable economic activities are used to determine the environmental sustainability of the investment).
The taxonomy is not and will not be a mandatory list of activities in which to invest. Market-led labels can continue to exist and funds targeting environmental objectives are not limited to investing in taxonomy-compliant activities – they just need to be clear on whether and to what extent their green products finance activities that qualify under the taxonomy. In addition, the taxonomy can also be used on a voluntary basis by any financial institution. For example, banks could potentially use it as a basis for their lending activities.
The taxonomy should moreover encourage companies to raise funds for projects that meet the criteria of the taxonomy, or to show the percentage of revenue or turnover from green activities with reference to the taxonomy, in order to raise green funding.
The specific uses of the taxonomy have been explained in the FAQ document (p. 9) as follows:
1. as regards financial assets (loans, bonds, equity):
- assets that are used to finance only the environmentally sustainable activities of the company (e.g. "green bonds" with transparent use of proceeds for environmentally beneficial purposes) could be considered environmentally sustainable, while other assets that only partially finance green activities may have various degrees of environmental sustainability;
- the degree of environmental sustainability can similarly be determined for investment portfolios consisting of several companies, which will incentivise investments into environmentally sustainable economic activities, without penalising or creating disincentives for investments into other economic activities;
2. as regards financial products (i.e. funds) and investment strategies:
- as the taxonomy provides a tool to assess the degree to which financial assets or companies contribute substantially to environmental objectives, it also allows financial market participants to use the taxonomy as a factor for selecting their investments;
- what’s important, it does not prescribe such strategy and allows for different degrees of ‘greenness’ and for different investment strategies currently existing in the market, such as those purely based on exclusion criteria.
The said FAQ document also mentions that the European Commission is looking into the development of an EU Ecolabel for financial products, which will consider the issue of how the taxonomy links to financial products, and therefore indirectly how it links to financial assets and companies. In this vein, on 21 December 2022 ESMA has published the document "TRV Risk Analysis, EU Ecolabel: Calibrating green criteria for retail funds” (ESMA document number: 50-165-2329).
The European Commission has also launched an online tool (the taxonomy compass) designed to facilitate the use of the taxonomy.
Platform on Sustainable Finance
The Taxonomy Regulation foresees the establishment of a Platform on Sustainable Finance (Article 20). Among the tasks of this platform will be to review the thresholds by taking into account technological changes and to advise the European Commission on the need to update the taxonomy by including or excluding certain activities. However, as the said FAQ document explains (p.7), this process should not lead to uncertainty or liability risks for investors.
Financial market participants who feel that a certain activity should be considered as environmentally sustainable for investment purposes should inform the Commission by submitting scientific evidence for their suggestion. This feedback will help the Commission and the Sustainable Finance Platform to evaluate the appropriateness of complementing or updating the taxonomy. It is also stressed that some of the technical criteria proposed may take the form of dynamic thresholds that are tightened over time in order to meet the increasingly ambitious objectives in a gradual way. This is intended to be an approach that allows for dynamism but also provides for certainty upfront as the path of tightening can be determined when establishing the thresholds.
Article 8 of the Taxonomy Regulation obliges undertakings covered by Directive 2014/95/EU (the Non-Financial Reporting Directive, NFRD) to publish information on how and to what extent their activities are associated with economic activities that qualify as environmentally sustainable under the Taxonomy Regulation. For this purpose, Article 8(2) requires non-financial undertakings to use three taxonomy key performance indicators (KPIs) related to environmentally sustainable activities, i.e. the proportion of their turnover, their capital expenditure (‘CapEx’) and their operating expenditure (‘OpEx’).
Following the review of the NFRD by the Corporate Sustainability Reporting Directive (CSRD), the scope of undertakings covered by Article 8 of the Taxonomy Regulation would be enlarged (in particular, to include listed small and medium size enterprises - SMEs). Moreover, Article 8(4) of the Taxonomy Regulation requires the European Commission to adopt a delegated act to supplement the above obligations by specifying the content, presentation and methodology of the information to be disclosed by both financial and non-financial undertakings subject to the Non-Financial Reporting Directive.
The delegated act under Article 8(4) is to set out when and how relevant turnover and expenditures associated with activities included in the Delegated Regulation count as taxonomy-aligned.
This delegation has been exercised by the Commission Delegated Regulation (EU) 2021/2178 of 6 July 2021 supplementing Regulation (EU) 2020/852 of the European Parliament and of the Council by specifying the content and presentation of information to be disclosed by undertakings subject to Articles 19a or 29a of Directive 2013/34/EU concerning environmentally sustainable economic activities, and specifying the methodology to comply with that disclosure obligation.
Qualitative disclosures for asset managers, credit institutions, investment firms and insurance and reinsurance undertakings
Under the Commission Delegated Regulation of 6 July 2021 the main KPIs for financial undertakings (banks, investment firms, asset managers, insurers) relate to the proportion of environmentally sustainable economic activities in their financial activities, such as lending, investment and insurance.
According to the Annex XI of the Commission Delegated Regulation of 6 July 2021 the disclosure of quantitative KPIs must be accompanied by the following qualitative information to support the financial undertakings’ explanations and markets’ understanding of these KPIs:
– contextual information in support of the quantitative indicators including the scope of assets and activities covered by the KPIs, information on data sources and limitation;
– explanations of the nature and objectives of taxonomy-aligned economic activities and the evolution of the taxonomy-aligned economic activities over time, starting from the second year of implementation, distinguishing between business-related and methodological and data-related elements;
– description of the compliance with the Taxonomy Regulation in the financial undertaking’s business strategy, product design processes and engagement with clients and counterparties;
– for credit institutions that are not required to disclose quantitative information for trading exposures, qualitative information on the alignment of trading portfolios with the Taxonomy Regulation, including overall composition, trends observed, objectives and policy;
– additional or complementary information in support of the financial undertaking’s strategies and the weight of the financing of taxonomy-aligned economic activities in their overall activity.
It is also noteworthy that the Complementary Climate Delegated Act presented by the European Commission on 2 February 2022 (subject to the scrutiny of the European Parliament and the Member States) provides for specific disclosure requirements associated with natural gas and nuclear energy activities included in the act, by amending the aforementioned Commission Delegated Regulation (EU) 2021/2178 of 6 July 2021.
The amendment will introduce requirements for large listed non-financial and financial companies to disclose the proportion of their activities linked to natural gas and nuclear energy (more specifically, financial and non-financial companies should present specific disclosure requirements that would show to what degree gas and nuclear energy activities, complying with the technical screening criteria, is in the numerator and denominator of the key performance indicators of those undertakings).
With the help of this specific disclosure requirement, investors that are not willing to invest in nuclear and gas activities under the conditions in the Complementary Climate Delegated Act would be able to identify and invest in activities and financial products that have no exposures to economic activities in the nuclear and gas sectors - see below Recital 15 of the Complementary Climate Delegated Act presented by the European Commission on 2 February 2022.
Complementary Climate Delegated Act presented by the European Commission on 2 February 2022, Recital 15
It is necessary that non-financial and financial undertakings provide investors with a high degree of transparency concerning their investments in fossil gas and nuclear energy generation activities for which technical screening criteria should be laid down. To provide that transparency, specific disclosure requirements for non-financial and financial undertakings should be laid down. In order to ensure comparability of the information disclosed to investors, that information should be presented in the form of a template that indicates clearly the proportion of fossil gas and nuclear energy activities in the denominator and, where appropriate, the numerator of key performance indicators of those undertakings. In order to provide a high degree of transparency to investors in financial products referred to in Article 5 and Article 6 of Regulation (EU) 2020/852 concerning exposures to fossil gas and nuclear energy activities, for which technical screening criteria are laid down, the Commission will amend or propose to amend the disclosure framework pertaining to those financial products as appropriate to provide for full transparency over the whole life of those financial products. To ensure that such information is clearly identified by end- investors, the Commission will consider amending the requirements on the financial and insurance advice given by distributors.
Timelines for the disclosures implementation
The disclosure requirements are to be implemented stepwise. In particular, from 1 January 2022 until 31 December 2022, non-financial undertakings are only required to disclose the proportion of taxonomy-eligible and taxonomy non-eligible economic activities in their total turnover, capital and operational expenditure and the respective qualitative information.