The EU Taxonomy is a legal classification framework being introduced in stages, to help define what is (and isn’t) a sustainable economic activity. It will require companies to make new disclosures on the extent to which their activities are associated with taxonomy-aligned activities and it will require fund providers to describe the extent to which their products are also taxonomy aligned. Yawn…..yes, it is as dull as it sounds (591 pages but hey, there is a handy 67 page summary…..). However, because of the impact it could have on sectors, companies and share prices, every investor (not just the ESG guys) will need to get to grips with it. And by the way, the timing for its implementation is by the end of 2021 (assuming it gets sign-off from the European Parliament).
Two reasons, both of which required the taxonomy to be science-based. Firstly, the investment required to address the challenges of climate change is huge; the European Investment Bank (EIB) estimates that to address transport related climate issues needs Euro80bn, water and waste Euro90bn and energy Euro100bn. To close the gap, the EU needed to define ‘green’ in order to direct capital towards it. The second reason is fund green-washing. ESG is very popular right now. The taxonomy will blow a hole in some of the claims that some fund providers are making.
What does it actually mean for corporates and investment firms?
It all hinges on corporates reporting the right stuff that investors can use. For corporates, financial and non-financial companies will need to disclose, in their annual accounts (or dedicated sustainability report), any turnover and capital or operational expenditure associated with taxonomy-aligned activities. At the fund level (or other financial products), fund providers will be required to disclose the extent to which the portfolio is aligned (if they have sustainability as an explicit investment objective) or for those funds which don’t have a sustainability objective, it’s comply or explain.
Do companies even report this information?
No….nope…not even close. Or rather they may do some to regulators e.g. for purposes of the EU Emissions Trading Scheme (ETS), but certainly not currently to investors. The statement, ‘In cases where full disclosure is not made, the TEG acknowledges the hurdles involved in assessing compliance’ somewhat understates the problem.
What is defined as ‘green’?
In its first iteration, the Taxonomy is focused on climate change. In due course, it will be broadened out to address other environmental concerns e.g. ‘sustainable use and protection of water and marine resources’ and ‘transition to a circular economy, waste prevention and recycling’. In the first round, activities are classified as ‘green’ (already low-carbon), ‘transition activities’ (that contribute to net-zero emissions in 2050, but aren’t themselves there yet) and ‘enabling activities’ (that enable low-carbon performance or substantial emissions reductions). Things like low carbon transport or battery storage are included in the latter category. Manufacturing of batteries for electric vehicles is taxonomy eligible, but lithium mining isn’t. Go figure. So-called ‘brown’ activities aren’t currently included, although the taxonomy is open to considering this area in the future (think oil & gas transition).
It’s part of a whole bunch of other green regulatory stuff
The EU is at the forefront of global financial system reforms that aim to incorporate sustainability. As such, the EU taxonomy shouldn’t be viewed in isolation, but as one part of a series of actions, which it could provide a framework for, including new capital requirements for taxonomy-aligned projects, a green quantitative easing program from the European Central Bank, or a haircut for brown assets in the European Central Bank’s collateral policies.
Well done for reading this far
Will it work? We have said before that ‘perfect is the enemy of good’. There is a strong element of idealism in the very comprehensive technical recommendations made by the taxonomy, like there is only one shade of green. Given that no corporates currently report in this way, the new regulation will be both challenging and potentially burdensome. Will there be sufficient end-user (investor) demand to make companies report this stuff? Does its complexity mean it will simply get ignored? Will the easiest way to conform be to invest in pure-play climate solution providers (;0)? Time will tell.
About the author
Ryan Smith is Head of ESG Research at Kames Capital. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 19 years’ industry experience. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University. *As at 30 November 2019.