What constitutes ‘sustainable activity’? What does not? And what does it take to achieve compliance with the EU Taxonomy for Sustainable Activities? These are the questions that put European and international compliance officers in the ESG weeds.
Towards the end of 2021, as world leaders, civil society and environmental activists converged in Glasgow for the 26th session of the Conference of the Parties (COP 26) to the United Nations Framework Convention on Climate Change (“UNFCCC”) to discuss and debate the increasingly dire climate outlook and what that means for the energy transition, regulators in the EU and other jurisdictions have continued the Yeoman’s task of developing frameworks and rules pursuant to which companies and financial firms will have to report on their contributions (or not) to “green” activities. As it turns out, the threshold question of defining what is and is not “green” appears easier said than done, at least depending on whom you ask.
These regulatory disclosure obligations are considered critical as they would enhance ESG disclosure obligations in certain jurisdictions and make mandatory such disclosures for many companies and financial market participants, replacing or supplanting current “voluntary” reporting frameworks such as those issued by the Task Force on Climate Related Financial Disclosures (“TCFD”), the Global Reporting Initiative (“GRI”) and the Sustainable Accounting Standards Board (“SASB”).
Perhaps the two jurisdictions being watched most closely are the United States and the European Union. The U.S.—through most notably the Securities and Exchange Commission (SEC)—is evaluating public comments on enhanced ESG disclosures. The Commission is expected to propose new disclosure rules on March 21. It also has signaled a willingness to police ESG-related disclosures, financial products and investment approaches through inspections of regulated financial advisors (through its Division of Examinations) and enforcement of suspected disclosures that are materially misleading to the market (through its Division of Enforcement).
The other key jurisdiction is the E.U., which in many ways is ahead of the U.S. on its ESG disclosure journey, having mandated some form of environmental, human rights and governance disclosures from the largest E.U. companies since 2014. In 2021, the E.U. enhanced ESG-related disclosure regulations for “financial market participants” (i.e., asset managers, financial institutions, pension funds) in the form of the Sustainable Finance Disclosure Regulation (“SFDR”), and for more large European companies, in the form of the Corporate Sustainability Reporting Directive (“CSRD”). But the subject of most discussion towards the end of 2021 was the E.U. Taxonomy for Sustainable Activities, the evolutions of which will remain closely watched in the coming year.
What Is the Taxonomy?
Fundamentally, the taxonomy is a common language intended to reflect scientific consensus on what is (and, by omission, what is not), a “sustainable activity.” It was, among other things, built out of the very legitimate concern surrounding “greenwashing” – i.e., reporting to the market that activities are sustainable or environmentally friendly, when they are in fact not, and/or misrepresenting the scope or percentage of such activities in light of their overall activities. To avoid this, it defines technical criteria across six environmental objectives:
- Climate change mitigation,
- Climate change adaptation,
- Sustainable use and protection of water and marine resources,
- Transition to a circular economy,
- Pollution prevention and control, and
- Protection and restoration of biodiversity and ecosystems.
For a company or financial market participant to describe its activities as “taxonomy-aligned,” the activities must make a “substantial contribution” to at least one of these six objectives and must “do no significant harm” to the other categories. They must also comply with the OECD Guidelines on Multinational Enterprises and the UN Guiding Principles on Human Rights. A group of experts is proposing technical screening criteria to define what constitutes a “substantial contribution” and “no significant harm” for each activity covered under each of the six objectives. Following political agreement at EU level, these technical screening criteria are adopted as Delegated Acts under the EU Taxonomy Regulation.
For the objective of climate change mitigation, for example, an activity is considered as sustainable if it “substantially contributes” to keeping the average global temperature increase from pre-industrial levels to below 2 degrees Celsius (with the ambition of keeping it to 1.5 degrees Celsius, as set out in the Paris Agreement). The EU Delegated Act establishing the technical screening criteria for climate change mitigation defines, for example, the construction of new buildings as taxonomy-aligned if the building’s primary energy demand is at least 10% lower than the national threshold set for nearly zero-energy building requirements (7.1). To cite another example from the same Delegated Act, the manufacture of cement is considered as taxonomy-aligned if the specific GHG emissions from production are lower than 469kg CO2e per ton of cement manufactured (3.7). A loan or other financial asset is considered as taxonomy-aligned if it finances an activity that fulfills the taxonomy criteria.
This classification system is viewed as a pre-requisite for taking meaningful actions while protecting investors, shareholders and the public from misleading or fraudulent information. The taxonomy allows market participants, among other things, to (1) classify assets and investments; and (2) conduct climate change and sustainability risk assessments. The taxonomy will be used to prepare pre-contractual and periodic disclosures and other representations, develop and implement internal ESG compliance programs and evaluate, audit and maybe one day litigate ESG performance.
What Is Considered “Green”?
Given the importance of being able to demonstrate that a company is involved in a higher proportion of “taxonomy-aligned” activities, it should come as little surprise that there has been significant debate as to which activities should be considered as making substantial contributions to one of the above six criteria, while doing no significant harm to the other five. Much of this debate has centered on companies involved in natural gas and/or nuclear activities. Proponents of such activities claim that they are a necessary component in the energy transition from dirtier fossil fuels, and a potential source (particularly with nuclear) of widescale “clean” energy. Opponents, however, claim that “rewarding” companies involved in such activities by allowing them to fall within the taxonomy’s scope delays the needed decrease in emissions to meet the Paris targets and (again, particularly with nuclear), ignores the harmful waste side effects of such activities.
The debate reached a head at the very end of 2021. On New Year’s Eve, the European Commission released a draft Complementary Delegated Act that included natural gas and nuclear, citing their role “…as a means to facilitate the transition towards a predominantly renewable-based future.” This prompted a forceful response from member states opposed to such activities, both on substance and for the timing of the release. Austria, which is opposed to both gas and nuclear being included, threatened to sue the European Commission, while other countries spoke out for one or the other (e.g., France in favor of nuclear; Germany in favor of gas), depending on their economic and energy mix. Despite the outcry, it is not expected that there will be sufficient opposition for the Complementary Delegated Act to be formally blocked, although changes could still result as to how gas and nuclear activities are assessed under the taxonomy and, if there is litigation, what result it has on the framework’s future.
Under Article 8 of the Taxonomy Regulation, large undertakings required to publish non-financial information pursuant to the Non-Financial Reporting Directive (NFRD) will have to disclose what portion of their turnover, capital expenditure and operational expenditure is aligned with environmentally sustainable activities.
The NFRD currently applies to large public-interest companies with more than 500 employees (and a balance sheet total exceeding €20 million or a net turnover exceeding €40 million) including listed companies, banks, insurance companies and others as designated by national authorities. As noted above, the CSRD would amend the NFRD and expand the reporting obligation under the EU Taxonomy to all large companies and all companies listed on regulated markets (except listed micro-enterprises).
The reporting obligation under Article 8 of the Taxonomy Regulation for the environmental objectives climate change mitigation and climate change adaptation will be phased in with lighter reporting in 2023 and full reporting of indicators aligned with the European Taxonomy for non-financial undertakings applicable from January 2024 (for financial year 2023) and for financial undertakings from January 2025 (for financial year 2024). The Delegated Acts for the other EU environmental activities have not yet been adopted and will therefore apply later.
Some companies have decided to start voluntarily reporting on alignment with EU Taxonomy criteria ahead of the reporting obligation, with German energy company EnBW for example making available taxonomy alignment figures for revenue, CAPEX, OPEX and EBITDA for financial years 2019 and 2020 for two of its business segments.
Why Should U.S. / Multinational Companies Care?
Even if certain large multinationals and non-E.U. organizations are not formally subject to the taxonomy, there are benefits to developing a familiarity with it and considering whether and how their activities could be potentially assessed under its framework. Among other things, the detailed nature of the assessment and rigor required to perform it can bring benefits to an organization in more thoroughly understanding the risks and opportunities of its operations and activities from a climate / sustainability perspective. The debate surrounding what should be included as “sustainable” or “green” likely presages similar debates that are all but certain to continue in the U.S. and elsewhere as part of the complex and multi-factored energy transition.
The U.N. Principles for Responsible Investment (“PRI”) – an independent body of signatories committed to responsible investing – has helpfully released a report highlighting the efforts of 40 financial market participants to implement the taxonomy within their investment activities. While focused on investment managers and asset owners, the report contains advice that would be helpful to any organization trying to better understand the sustainable nature of their activities:
- Establish a framework, including through devotion of sufficient resources and messaging from management;
- Develop a process, including starting early, starting small, and taking a step-by-step, bottoms-up approach;
- Identify challenges, including reliability of data issues; and
- Find solutions, including working with companies and data providers to try to obtain assurance regarding information.
The PRI also highlighted for policy makers some of the consistent challenges faced by the volunteers, including the need for significant guidance on how to implement the taxonomy, and requirements for companies to report—with sufficient granularity—the data that is necessary for investors to make an accurate and reliable assessment of whether their investment in a particular company is or is not taxonomy aligned. The existence and reliability of data was a consistent theme among many of the case studies, and reflects a burgeoning market for innovative ways to accurately collect and measure data at the asset level that is relevant for these taxonomy assessments.
While enforcement will likely be a necessary component of the E.U. framework as well, it has to date focused significant amounts of effort on developing and defining the taxonomy through which “sustainable” activities can be classified, measured and disclosed. Although the taxonomy remains subject to debate and refinement regarding its scope and timing of application, it is an important initiative that highlights both the challenges and opportunities for governments and organizations as they seek to assess the sustainable nature of their activities and transition to a cleaner and more renewable-focused future.