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EU Sustainable Finance Taxonomy: Will Categorization Bring Clarity?

The European Union Taxonomy Regulation (the “Taxonomy”) entered into force on July 12, 2020, as part of the European Commission’s (the “Commission”) broader action plan on sustainable finance initiated in March 2018.

The Taxonomy establishes a uniform classification system, akin to a glossary, to ensure that participants in financial markets have a shared language for assessing the environmental sustainability of various activities.  As a means of vetting financial products that claim to be “green” or sustainable, this classification system includes dozens of categories with specific characteristics to determine whether an economic activity provides a substantial contribution to mitigation or adaptation activities that align with the EU’s sustainability commitments. The Taxonomy also requires companies subject to the EU Non-Financial Reporting Directive to provide certain information in relation to the Taxonomy in their public filings.

The Taxonomy

The Commission estimates that for the EU to meet the Paris Agreement’s 2030 targets and the EU’s target of becoming carbon neutral by 2050, the EU needs approximately 180 billion Euros per year of additional investments from now until 2030.  To facilitate private investment into the economic activities that would help meet the EU’s goals, the Taxonomy Regulation establishes a uniform set of criteria and vocabulary to allow investors and companies to consistently describe and assess the extent to which their economic activities are aligned with the designated categories of environmentally sustainable activities.

The Taxonomy applies to:

  • measures adopted by member states and by the EU that set out requirements and standards for financial products, such as managed portfolios, alternative investment funds and pension schemes, or corporate bonds that are made available as “environmentally sustainable”;
  • financial market participants, such as investment funds, portfolio managers and occupational pension providers who are “making available financial products” to the public; and
  • large public-interest companies which are:
    • governed by the law of a member state and whose transferable securities are admitted to trading on an EU regulated market, credit institutions, insurance companies, or other entities designated by member states as public interest entities due to their nature, size or number of employees; and
    • which either (i) employ more than 500 employees and have a balance sheet of more than 20 million Euros or a net turnover of more than 40 million Euros or (ii) which act as parent to a group of companies made up of those set out in limb (i).

Under the Taxonomy, environmentally sustainable activities must:

  • contribute “substantially” to one or more of six environmental objectives: climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a “circular economy” (an economic system focused on eliminating waste and encourage reuse and recycling), pollution prevention and control, and protection and restoration of biodiversity and ecosystems;
  • not significantly harm any of the six environmental objectives;
  • be carried out in compliance with certain minimum safeguards; and
  • comply with certain performance thresholds (the “technical screening criteria”) (see below).

Disclosure Requirements

The Taxonomy also amends the existing EU Regulation on Sustainability‐Related Disclosures in the Financial Services Sector (the “Disclosure Regulation”).  The Disclosure Regulation introduced transparency and disclosure requirements for certain financial market participants and financial advisers, setting out what firms must disclose on their website, pre-contractual disclosures that must be made and information that should be reported periodically to investors.

The Taxonomy amends the Disclosure Regulation by increasing the amount of information that such financial market participants and financial advisers are required to disclose.  The specific disclosure requirements vary by financial product.

Financial products with sustainable investment objectives or carbon emission reduction objectives and financial products that promote environmental characteristics may need to make additional pre-contractual and periodic disclosures under the Taxonomy.  If a financial product does not fall into one of these two categories, the following disclosure must be made as part of the pre-contractual disclosures and as part of the periodic reporting disclosure:

The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities.

Large public interest entities are already required by the Non-Financial Reporting Regulation to publish non-financial statements.  Under the Taxonomy, such non-financial statements must now also include (a) the proportion of turnover derived from products associated with activities that qualify as environmentally sustainable under the Taxonomy and (b) the proportion of capital expenditure and operating expenditure related to assets or processes associated with economic activities that qualify as environmentally sustainable.

Member states will be responsible for monitoring financial market participants’ compliance with the enhanced disclosure requirements set out by the Taxonomy and for setting out rules and penalties for failure to comply.  Such penalties must be “effective, proportionate and dissuasive”.

Delegated Acts

While the Taxonomy provides the general framework for the classification system, the Taxonomy gives the Commission the power to adopt secondary legislation (i.e. “delegated acts”) which will define the technical screening criteria for each environmental objective.

Such delegated acts will, for each of the environmental objectives, specify the content and presentation of information that will need to be disclosed and establish technical screening criteria for determining the conditions under which each specific economic activity is considered to contribute substantially to the environmental objectives listed above.

The requirements for the technical screening criteria are set out in the Taxonomy and include the requirement to:

  • identify the relevant potential contributions to the environmental objective while respecting the principle of technological neutrality;
  • specify the minimum requirements that need to be met to avoid significant harm to any of the environmental objectives;
  • be quantitative and contain thresholds to the extent possible, and otherwise be qualitative;
  • be based on conclusive scientific evidence;
  • take into account the nature and the scale of the economic activity; and
  • take into account the potential market impact of the transition to a more sustainable economy, including the risk of certain assets becoming stranded as a result of such transition and the risk of creating inconsistent incentives for investing sustainably.

The delegated act containing the technical screening criteria on climate mitigation and adaptation is due to be adopted by the Commission by December 31, 2020, with a view to it applying from January 1, 2022. The delegated act relating to the remaining environmental objectives is due to be adopted by the Commission by December 31, 2021, with a view to it applying from January 1, 2023.

The Commission has established the EU Technical Expert Group on sustainable finance (the “TEG”) to assist the Commission in establishing the delegated acts. The TEG published its final report on the Taxonomy for sustainable activities on March 9, 2020, which provides guidance for users on the obligations of those affected by the Taxonomy, including how to make disclosures using the established taxonomy and recommendations on establishing a “Platform on Sustainable Finance” to be established under the Taxonomy, which will replace the current TEG and advise the Commission with respect to the delegated acts.

Implications for U.S. Companies

Although the Taxonomy is in effect in the EU, it has implications for companies in the U.S. as well.  Although some European investment banks have been reducing their holdings,[1] historically, European funds have heavily invested in U.S. companies.  The obligations of these funds to report under the guidelines of the taxonomy may mean that such funds will begin seeking enhanced reporting and disclosure from their U.S. company investments or ultimately shift their investment dollars to companies that provide such requested disclosures.

In addition, the TEG is currently evaluating whether natural gas projects with certain complementary technologies (for example, carbon capture and sequestration) could be included in the Taxonomy.[2]  Given the significant natural gas reserves in the U.S., whether this fuel source qualifies for inclusion as an activity aligning with the EU’s sustainability commitments would impact domestic companies with current or expected EU-based investors, and influence the future availability of credit for such companies from EU-based funding sources.

Implications for the Low-Carbon Energy Transition

By establishing a standardized concept across the EU of what qualifies as an environmentally sustainable investment, the Taxonomy reduces complexity for investors in comparing sustainable investments in a like-for-like manner. This is intended to facilitate investment in environmentally sustainable economic activities across the EU and enable financial market participants with higher standards of environmental sustainability to attract investment more easily by making such information readily available and digestible.

In turn, by being required to disclose the level of sustainability in a company’s financial products, there will be higher pressure on companies to align themselves with the aims of the Paris Agreement.

The Taxonomy further seeks to address general market and investor concerns about “greenwashing”, whereby a seller gains an unfair competitive advantage by marketing a financial product as environmentally friendly, when the consumer’s expectations of certain environmental standards have not been met. The Commission’s goal is that, by standardizing the criteria for what qualifies as an “environmentally sustainable” financial product and requiring market players to disclose additional information which can be easily compared between products and market players, not only will financial instrument providers adhere to a higher, consistent standard, but investors and consumers will regain faith that the products they are investing in adhere to their expectations, thereby attracting back capital that may otherwise have been hesitant to invest in unverifiable sustainable funds.

[1] Financial Times, European banks slash $280bn from main US businesses (November 24, 2019); available at: https://www.ft.com/content/ef651618-0b08-11ea-bb52-34c8d9dc6d84.

[2] Taxonomy Report: Technical Annex (Updated Methodology & Updated Technical Screening Criteria, at 205 – 211 (issued March 2020) (finding that “The TEG adopted a technology-neutral approach that can ensure rapid decarbonisation within the electricity sector. Adherence to the declining emissions intensity threshold is technically feasible for virtually any energy generation technology. However, it does imply that unabated fossil fuel combustion, namely coal and natural gas, will be ineligible under the Taxonomy.”)  

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.