Based on research provided by ECOFACT
Our previous Client Alert of 10 March 2021 discussed the Sustainable
Finance Disclosure Regulation (SFDR) and its implications for
the real economy.
This Client Alert reviews how
EU Regulation 2020/852 on the establishment of a framework to
facilitate sustainable investment (the Taxonomy) impacts companies
in their capacities as investees, borrowers, and issuers.
KEY TAKEAWAYS
- The Taxonomy seeks market harmonization by creating legal
criteria to classify economic activities as environmentally
sustainable. While the Taxonomy is a technical document
with only a few disclosure obligations for companies, it requires
robust preparatory work, including thorough data collection and
analysis. - Companies subject to the non-financial reporting
obligations in Articles 19a and 29a of
Directive 2013/34 on annual and consolidated financial
statements and related reports (as transposed into national law)
(the Accounting Directive) must report the extent of their
alignment with the Taxonomy. However, smaller companies may also
benefit from reporting on a voluntary basis. - While the Taxonomy currently focuses on environmental
objectives, companies must also respect minimum social and
governance requirements within the scope of environmentally
sustainable economic activities (ESEAs).
BACKGROUND
Sustainable development (economic, social, and environmental) is
an objective of the internal market reflected in the Treaty on
European Union. The Taxonomy, adopted in June 2020, is a
significant step towards achieving climate neutrality by 2050, and
is part of the EU’s wider effort to promote sustainability that
includes the adoption of the SFDR and launch of the European Green
Deal in November and December 2019, respectively.
While many market participants/players currently do not disclose
environmental, social, and governance (ESG) information related to
their activities, others disclose such information using
non-uniform criteria. This leads to a lack of comparability for
capital providers, who are then disincentivised to allocate funds
based on ESG information. Sustainable finance and investments are
critical to meeting regional and international environmental goals,
including the UN Paris Agreement and the Sustainable Development
Goals. With this in mind, the Taxonomy introduces a standard
classification to enhance investor confidence in sustainable
finance, mitigate the risk of greenwashing1, reduce transaction
costs, and optimize the ability of sustainability-minded companies
to raise capital.
THE CAPITAL PROVIDER’S PERSPECTIVE
The Taxonomy supplements the requirements of the SFDR that are
applicable to capital providers, i.e. financial market participants
and financial advisers. In particular, it specifies certain
disclosure obligations concerning periodic reports and
pre-contractual disclosures. Another relevant link between the
Taxonomy and SFDR pertains to the definition of “sustainable
investment” in Article 2(17) of the SFDR, which includes
investments in ESEAs as described in Article 3 of the Taxonomy.
As discussed in our previous Client Alert, companies that are ready to
provide ESG information to their capital providers at an early
stage, as required by the SFDR and the Taxonomy, could gain a
competitive advantage in the corporate finance market.
THE COMPANY’S PERSPECTIVE
The Taxonomy also supplements non-financial reporting
obligations in Articles 19a and 29a of the
Accounting Directive on annual and consolidated financial
statements and related reports (as transposed into national law).
Specifically, Article 8 of the Taxonomy requires companies to
publish a non-financial statement with information on:
(i) how and to what extent their
activities are associated with ESEAs;
(ii) the proportion of their turnover
derived from products and services associated with ESEAs; and
(iii) the proportion of their capital
and operating expenditures related to assets or processes
associated with ESEAs.
These disclosure obligations apply to companies with an average
number of employees exceeding 500 in a fiscal year and that have a
balance sheet total of EUR 20 million or a net turnover of EUR 40
million. However, smaller companies can make such disclosures
voluntarily.2
The Taxonomy also serves as a key component to the proposed EU
Green Bond Standard (EU GBS). Companies seeking to issue green
bonds in accordance with the EU GBS will be required to ensure that
proceeds from green bond issuances fund projects that are aligned
with the Taxonomy.
According to Article 3 of the Taxonomy, ESEAs are those that
meet four conditions:
1. Make a substantial contribution to one or
more of the following environmental objectives:
(a) climate change mitigation;
(b) climate change adaptation;
(c) the sustainable use and
protection of water and marine resources;
(d) the transition to a circular
economy;
(e) pollution prevention and control;
and
(f) the protection and restoration of
biodiversity and ecosystems, each as specified in Articles 10 to
15.
The recitals of the Taxonomy refer to several documents such as
the Treaty of the European Union, Sustainable Development Goals and
the Paris Agreement issued by the EU and by the United Nations,
which companies can use to comprehend and interpret the framework
of each environmental objective.3
An economic activity that directly enables activities that make
a substantial contribution to one of the six objectives listed
above may also qualify as an ESEA. However, it must also meet the
other three ESEA conditions, not lead to lock-in effects, and have
a substantial positive environmental impact.
2. Do not significantly harm any other
environmental objective.
A company’s economic activity that makes a substantial
contribution to climate change mitigation must avoid significant
harm to the other five objectives. Article 17 of the Taxonomy
explains how each of the six environmental objectives can be
significantly harmed by a given economic activity. When assessing
the risk of harm, a company must look at the potential long-term
environmental impacts of the whole life cycle of the economic
activity and its related products and services.4
3. Comply with minimum social safeguards.
Companies pursuing ESEAs must also implement procedures to
ensure respect of social rights, including the recommendations in
the OECD Guidelines for Multinational Enterprises, the UN Guiding
Principles on Business and Human Rights, the principles and rights
set out in the eight fundamental conventions identified in the
Declaration of the International Labour Organisation on Fundamental
Principles and Rights at Work, and the International Bill of Human
Rights, as per Article 18 of the Taxonomy. Moreover, they must
adhere to the “do no significant harm” principle stated
in Article 2(17) of the SFRD.
4. Comply with technical screening criteria
(TSC).
While the EU continues to develop and refine TSCs, the EU has
set out TSC for certain economic activities for the first two
environmental objectives, (1) Climate Change Mitigation and (2)
Climate Change Adaptation in the March 2020 Taxonomy Report:
Technical Annex.5 TSCs provide thresholds and other
criteria for categorising the environmental sustainability of
specific economic activities.
What’s next?
The Taxonomy was adopted in June 2020 and companies’
obligations under Article 8 become applicable on different
dates:
- January 2022 (climate change mitigation and adaptation);
and - January 2023 (the other environmental objectives).
Under the Taxonomy, the EU Commission has the mandate to adopt
delegated acts, including those related to Article 8(4)6 and
the TSC regarding each of the six environmental objectives, as well
as to update concepts like “significant harm” and
“substantial contribution” as technology and scientific
understanding evolves.
For the environmental objectives other than climate change and
climate change adaption, the EU Commission is expected to adopt TSC
by December 2021, with application from January 2023.7
What can companies do?
As first steps to comply with the Taxonomy’s requirements,
companies are encouraged to start by collecting
data to assess whether their economic
activities:
- contribute to an environmental objective
and/or directly enable such contribution within
their value chains; - harm any of the Taxonomy’s environmental
objectives; and - fulfill the minimum social safeguards stated
in Article 18 of the Taxonomy (and consider the
adherence to such international guidelines,
principles, and standards).
Based on this assessment, companies may define future
targets for maintaining or increasing their contribution
to an environmental objective.
Moreover, companies may engage finance, risk management, and
sustainability staff to:
The next alert of the Sustainable Finance Series will
focus on selected standards for ESG-linked loans from a
borrower’s perspective.
Footnotes
1.
Recital 11 of the Taxonomy defines “greenwashing” as
“the practice of gaining an unfair competitive advantage by
marketing a financial product as environmentally friendly, when in
fact basic environmental standards have not been met”. In
practice, the concept applies to the marketing of any economic
activity as environmentally friendly, where minimum standards have
not been respected.
2.
Directive 2013/34 is under review as part of the EU sustainable
corporate governance initiative. As a result of this review,
non-financial reporting may become required for smaller and
non-listed companies.
3. The
Taxonomy currently covers only environmental objectives, but it is
expected to be extended to social objectives in the
future.
4.
According to recital 40 of the Taxonomy , “where scientific
evaluation does not allow for a risk to be determined with
sufficient certainty, the precautionary principle should apply in
accordance with Article 191 Treaty on the Functioning of the
European Union”.
5. The
draft TSC for climate change mitigation and adaptation are
available on the EU Commission’s
website.
6. A
consultation paper regarding Article 8 of the Taxonomy is available
on the European Securities and Markets Authority’s website.
7.
According to recital 44 of the Taxonomy, the TSC should promote
appropriate governance frameworks integrating environmental,
social, and governance factors as referred to in the United
Nations-supported Principles for Responsible Investment at all
stages of a project’s life cycle. This statement recognizes the
relevance of social and governance aspects within
ESEAs.
Because of the generality of this update, the information
provided herein may not be applicable in all situations and should
not be acted upon without specific legal advice based on particular
situations.
© Morrison & Foerster LLP. All rights reserved