The regulatory recap
Creating a carbon-free economy
The EU Taxonomy Regulation, which is part of the wider EU sustainable finance initiative, set out a classification system, the EU Taxonomy, for economic activity according to EU climate action goals. The EU aims to be an economy with net-zero greenhouse gas emissions by 2050. This objective is in line with the EU’s commitment to global climate action under the 2015 Paris Agreement.1 Other countries are also developing taxonomies to encourage green investment, including China, Malaysia, and Singapore.
The EU Taxonomy sets a series of performance thresholds for economic activities that contribute to one of six environmental objectives (and in doing so do not harm the other five, where relevant), and meet minimum safety standards on business and human rights.
The six objectives are:
- climate change mitigation
- climate change adaptation
- sustainable use and protection of water and marine resources
- transition to a circular economy
- pollution prevention and control
- protection and restoration of biodiversity and ecosystems.
The performance thresholds are designed to help companies, project promoters and issuers to access green financing to improve their environmental performance, as well as helping to identify which activities are already environmentally friendly.2 The EU hopes to encourage the growth of low-carbon sectors and decarbonise high-carbon emission sectors.
Scope, scale and structure
A complex landscape of regulations and directives
On 18 June 2020, the Taxonomy Regulation for climate change mitigation and adaptation was published in the Official Journal3. The technical specifications for the two are complex, running to 400 pages. While financial market participants will have to complete their first set of Taxonomy disclosures by 31 December 2021, companies only need to begin making disclosures during 2022. This timing presents a challenge as the accuracy and completeness of financial institutions’ disclosures are dependent to some extent on company disclosures.
The specifications concerning the other environmental objectives (sustainable use and protection of water and marine resources, circular economy, pollution prevention and control and protection and restoration of biodiversity and ecosystems) are planned to be adopted by the end of 2021.
The performance thresholds specified by the Taxonomy Regulation apply to three types of users:
- financial market participants offering financial products in the EU, including occupational pension providers (this includes entities based outside the EU that are offering products to EU residents)
- large companies that are required to provide a non-financial statement under the Non-Financial Reporting Directive4 (large public-interest companies with more than 500 employees, including listed companies, banks and insurance companies)
- the EU and Member States, when setting public measures, standards or labels for green financial products or green (corporate) bonds.
Economic activity covered by the Taxonomy Regulation includes projects, assets and financial products. Companies will be required to report how these activities align with the Taxonomy. Corporates are being asked to disclose the percentage of their revenues that are aligned to the Taxonomy while financial institutions are required to give a figure on the proportion of their assets that are aligned.
The main aim of the Taxonomy Regulation is to establish a common language that can be used by investors, financial institutions, companies and issuers to identify activities and financial instruments that can be classified as environmentally sustainable. This common language is designed to tackle ‘greenwashing’ and a lack of comparability between the sustainability credentials of different financial institutions and products.
Building the blueprint for your firm
Act now to stay ahead of the curve
To comply with the Taxonomy Regulation a number of questions should be asked:
- Does the regulation apply to my firm?
- What is my investment strategy?
- What types of products do I want to offer?
- Who are my investors and investees?
- What is my risk appetite for disclosure?
- Do I rely on European capital flows?
Many firms already have sophisticated environmental, social and corporate governance (ESG) approaches, integrating these factors into investment decision making. These companies should study the details of the Taxonomy, determine the additional information requirements from investee companies and to what extent they are capturing these via ESG integration and mainstream due diligence activities. This will highlight where more work might need to be done.
If a firm is not yet interested in pursuing an ESG agenda, it may decide to take a low-risk and low-effort approach, reporting 0% alignment with the Taxonomy Regulation. However, it is worth noting that the promotion of green finance is the direction of travel of governments and regulators worldwide. In some countries the movement is being pushed by regulators, while in others the catalyst is the investor community.
The EU is reviewing its sustainable finance strategy, examining how to integrate sustainability considerations into its financial policy framework in order to mobilise finance for sustainable growth. For example, the EU Benchmarks Regulation is being reviewed with an aim to further support comparability between products, as well as regulations around disclosure of information to be made available to investors. It is likely that companies will be assessed on how readily available ESG data is and how it compares with other organisations. This will have an impact on operations and companies should assess the tools or proxies they use to gather relevant information.
At a policy level, companies should be making decisions now about how they will comply with the Taxonomy Regulation, bearing in mind that further regulation is in the pipeline. The Taxonomy Regulation should not be viewed as an ESG ‘side project’; it is a part of wider regulation and is one of the levers the EU is pulling in its commitment to a net zero carbon economy by 2050.
Building the blueprint for the industry
An opportunity for industry collaboration
The European Commission describes the Taxonomy as one of the most significant developments in sustainable finance and one that will have wide-ranging implications for investors and issuers working in the EU, and beyond. Given its complexity and scope, industry groups are collaborating to share best practices.
The European Banking Federation (EBF) and the United Nations Environment Programme Finance Initiative (UNEP FI) are assessing the extent to which the Taxonomy Regulation can be applied to core banking products.5 The objective of the project is to:
- provide a high-level feasibility assessment of the EU Taxonomy Regulation to core banking products
- share best practices
- develop use cases where appropriate
- issue recommendations based on the project findings.
A working group of 23 banks, five banking associations and four observers is developing guidelines. Recommendations are expected around Q4 2020.
Institutional investor industry body Principles for Responsible Investment (PRI) has established a practitioners’ group, which includes member institutions from the US and Japan. The group is developing case studies on Taxonomy implementation and will share best practice later in 2020.6
Championing change with Standard Chartered
Partnering for Taxonomy alignment
Many financial market participants are not traditional ‘green’ companies and will need education on how to comply with the requirements of the EU Taxonomy Regulation. With a strong global footprint, Standard Chartered Securities Services is well-placed to help companies diversify their revenue streams to more environmentally friendly sectors.
As a bank, we have also put ESG front and centre, committing to supporting clients to have less than 10% revenue from thermal coal by 2030, consistent with the goals of the Paris Agreement. We are also a member of the EBF/UNEP FI working group.
As a complex set of requirements, the Taxonomy Regulation requires a quantum of disclosure and we are able to collaborate with customers, exchanging ideas and ensuring compliance can be bespoke to individual companies.
Compliance with sustainable finance regulations will soon become a differentiator for issuers and financial institutions. During the past five years there has been a significant shift towards sustainable finance, and this will continue. Financial market participants must act now to keep on top of the significant amount of work that compliance will require.
1 2050 long-term strategy, European Commission Energy, Climate change, Environment, https://ec.europa.eu/clima/policies/strategies/2050_en
2 Taxonomy: Final report of the Technical Expert Group on Sustainable Finance, EU Technical Expert Group on Sustainable Finance, March 2020 https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/200309-sustainable-finance-teg-final-report-taxonomy_en.pdf
3 Regulation (EU) 2020/852 of the European Parliament and of the Council, European Commission (18 June 2020) https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32020R0852