With time running out to act on climate change, can the EU’s proposed system for identifying environmentally sustainable activities work? Barbara Davidson reports
This article was first published in the April 2020 China edition of Accounting and Business magazine.
Only 10 years remain to achieve the UN’s Sustainable Development Goals. The World Economic Forum has declared that ‘serious climate action’ is needed in order to avoid a dangerous level of global warming by limiting the planet’s average temperature to no more than 2°C higher than pre-industrial levels (in accordance with the Paris Agreement). It asked participants at its Davos 2020 summit to commit to net-zero carbon emissions by 2050. The European Union (EU) alone must invest an additional €175bn–€290bn (US$190bn–US$315bn) annually to meet its climate and emissions targets. Is the EU equipped to meet these objectives, especially in light of recent weather events?
Investing in environmentally sustainable activities is a key part of the solution. Despite this, there is currently no single, agreed way to identify such investments. Different governments and institutions use different identification criteria; this can lead to confusion, reduced confidence, higher costs and conflicting results. A reliable, consistent approach is needed. Enter the EU’s ‘unified classification system for sustainable activities’. Better known as the EU Taxonomy, it forms part of the European Commission’s (EC) 2018 Action Plan on Financing Sustainable Growth.
The Taxonomy provides a common language for identifying ‘environmentally sustainable’ economic activities and selling corresponding products. It can help increase access to financing, improve transparency and reduce opportunities for ‘greenwashing’ (providing misinformation about environmental performance). It is designed to meet current and future climate goals.
The Taxonomy is a product of political and technical processes. It will become law by means of a taxonomy regulation, the proposed text of which was agreed by the EC, the European Parliament and the EU Council in December 2019. The proposed regulation specifies that an economic activity will be considered environmentally sustainable only if it ‘substantially contributes’ to at least one of the following six environmental objectives (while doing no significant harm to the others):
- climate change mitigation
- climate change adaptation
- sustainable use and protection of water/marine resources
- transition to a circular economy
- pollution prevention and control
- protection and restoration of biodiversity and ecosystems.
The activity must also meet certain social safeguards and comply with technical screening criteria. The proposed regulation excludes power generated by solid fossil fuels, and is silent on nuclear and gas. It recognises that the Taxonomy must evolve with changes in science, technology and business, and so also requires:
- consideration of existing legislation/frameworks/standards
- technological neutrality where possible
- lifecycle assessments
- periodic reviews and updates.
Disclosures include how and to what extent environmentally sustainable products, or products with environmental characteristics, comply with the Taxonomy criteria. The dislosure requirements will apply to any ‘financial market participant’ that sells products in the EU, and to entities covered by the EU Non-Financial Reporting Directive. In addition, eligible non-financial entities will have to disclose the percentage of revenues, and investments/expenditures, associated with ‘Taxonomy-eligible’ activities. Any other EU financial product must indicate if Taxonomy criteria were not taken into account.
The EC formed the independent Technical Expert Group on Sustainable Finance (TEG) to determine how an economic activity contributes to the first two objectives (climate change mitigation and adaptation) while assessing the need to do no significant harm across the four other objectives. In 2019 the TEG issued its draft taxonomy report (the final version is expected in the first half of 2020), which includes:
- science-based recommendations
- technical screening criteria, with suggested minimum thresholds, for assessing climate mitigation for 67 activities across various sectors
- a context-driven, process-based approach for deciding if activities meet the climate adaptation criterion
- guidance and case studies
- recommendations for the Platform on Sustainable Finance, which replaces the TEG later this year.
The stringency of the proposed technical screening criteria provides a level of assurance that eligible activities will help meet ambitious emissions targets.
International convergence on environmental sustainability is crucial to meeting worldwide climate targets. Consequently, there are concerns that the Taxonomy is not a global standard. Although it can be a valuable reference for investors, an activity-based taxonomy may be of little use in some jurisdictions. Canada, a resource-based economy, is developing its own taxonomy. And while a focus on economic activities rather than companies could help with transition, obtaining good-quality data, such as revenues or carbon emissions, by activity may be difficult. This also re-opens the debate on making climate-related disclosures mandatory. Investors typically use GICS global classification to identify sectors, whereas the Taxonomy uses the European industry-based NACE system. Although the TEG recommends mapping between the two, there is concern that this is an unnecessary complication.
Meanwhile, Taxonomy-related disclosures will not be required until the Taxonomy regulation (and related technical screening criteria) comes into force (full implementation expected by 2022). Political concessions were needed to agree the proposed regulation in a timely manner, and the EC is required to consult with a member states expert group before adopting technical screening criteria into law. Political pressure, along with numerous actors, could delay the dates or dilute the Taxonomy content.
After the TEG hands its completed recommendations to the EC, the Platform on Sustainable Finance will go on to finalise the technical screening criteria, with staggered effective dates.
It will also advise on future amendments, perform cost-benefit analyses, evaluate stakeholder input, monitor sustainable investment trends, and take on any other tasks that may arise.
In the interim, investment firms should familiarise themselves with the activities and technical screening criteria needed to identify or design environmentally sustainable products – the sustainability reporting commitments made at Davos, if implemented expeditiously, could help with this. In addition, corporates could direct their future spending towards environmentally sustainable activities; investors could refine their investment requirements and increase their engagement; and stakeholders can participate in public consultations.
By providing a weapon in the battle against climate change, the EU Taxonomy for sustainable economic activities may help this decade kick off on a positive note.
Barbara Davidson formerly headed investor engagement for the IASB.
"Economic activities must ‘substantially contribute’ to at least one of six environmental objectives"