EU Taxonomy Explained: Breaking Down the 4 Criteria for Sustainability & ESG

European Union Taxonomy – A New Driver for Sustainability and ESG

While the concept of Environmental, Social, and Governance (ESG) value has been discussed in the financial community for several decades, the last 12-18 months has seen an explosive growth in interest. Driven primarily by the rapidly escalating climate crisis, but also underpinned by concerns around biodiversity, social inclusion and equality, and sustainable resource use, ESG has moved from niche to mainstream. This interest has given birth to an ecosystem of government decrees, service providers, professional committees, and reporting frameworks, as the financial community strives for a reliable and consistent method to factor ESG into company valuations.

The European Commission has recently released the Taxonomy Climate Delegated Act and Amendments to Delegated Acts on fiduciary duties, investment, and insurance advice (Yes, the EU has a talent for snappy titles). This provides a framework for the evaluation of ESG performance and for consistent labeling of green investment products. Users of the taxonomy can screen and evaluate organizations based on the activities they undertake and establishes minimum standards that must be met in order to be considered sustainable, or in the jargon, taxonomy-aligned. It will apply for financial institutions from 1-January 2022 and will be applicable for corporates from October 2022.

Disclosure obligations of the EU Taxonomy explained apply to entities subject to the scope of the EU Non-Financial Reporting Directive (essentially medium and large companies publicly listed in the EU) and to all their activities regardless of their location. The Taxonomy will create international influence despite there being no intention to bind third countries on their own sustainability or sustainable finance activities. The U.S. Securities and Exchange Commission (SEC) recommended a similar approach and recommendations, and the U.S. Department of Labor is considering options.

Reporting of alignment is done on a legal basis, meaning legal entities can assess and report the percentage of activities that are Taxonomy-aligned, expressed as the share of their turnover or expenditures (capital and operational).

EU Taxonomy Explained

In order to be recognized as taxonomy-aligned for the EU Taxonomy Regulation, an activity must meet four conditions:

1. Make a substantial contribution to at least one of the six environmental objectives:

   climate change mitigation, climate change adaptation, sustainable use of water and marine sources, circular economy, pollution prevention, and healthy ecosystems and biodiversity;

2. Do no significant harm to any of the other environmental objectives;

3. Comply with minimum social safeguards; and

4. Comply with the technical screening criteria.

What does this mean for the corporate world?  The EU Taxonomy is not a new compliance standard, the only obligation is disclosure. No corporation will be obliged to “comply” with the taxonomy, only to indicate the degree of alignment. It does however provide a clear signal of the criteria investors will be used to guide investment decisions and will provide a very visible and transparent measure of a company’s ESG performance. It will become the lens through which investors and asset managers, and the broader community, evaluate ESG performance.

Any company seeking investment or looking to maintain a strong sustainability performance for other reasons (such as competitive position, positioning for the transition to low carbon, resource efficiency, reputation, marketing, etc., see Figure 1 below) should seek the greatest alignment possible with the taxonomy.

The good news is that companies that are already collecting data, monitoring performance and reporting on sustainability are probably well progressed towards meeting the ESG disclosure requirements of the Taxonomy. It’s unlikely that the Taxonomy will introduce new aspects of sustainability that a good program was not already addressing. The challenge will most likely come from data quality. The quantified analysis undertaken by the investment community assumes a standard of data accuracy, reliability, and materiality that has not previously been demanded of the sustainability profession. Figure 2 shows the very poor level of satisfaction with ESG data in the investment community currently.

Companies will need to develop more robust human and technology resources to meet the standards required for the investment-grade data reporting that the Taxonomy requires.

Benchmark ESG™ supports this requirement in a number of ways:

• A structured framework for materiality assessment, ensuring that the reporting program addresses issues that are important to the organization, and to its host community;
• Clear, consistent, and auditable processes for data collection and processing, across the enterprise;
• Specialized tools for Sustainability and ESG-specific aspects, such as carbon accounting, management of sustainability project portfolios, and management of financial instruments (eg. Renewable Energy Certificates);
• Integrated edge-technologies such as Bluetooth beacons, smart glasses and sensors to automate data collection, and manage large data volumes;
• Real-time visibility of data quality, gaps, and inconsistencies; and
• AI, Machine Learning, and Analytical capabilities, to derive real insight from data and ensure focus on material issues that warrant investment.

The Benchmark ESG platform allows subscribers to manage their own operational and performance objectives, while also meeting the stringent disclosure standards being driven by the Taxonomy and other ESG disclosure drivers.