THE TAXONOMY REGULATION AND ITS OBJECTIVES
Regulation (EU) 2020/852 of the European Parliament and EU Council (the ‘Taxonomy Regulation’)¹ came into force on 12 July 2020, although it will not start applying until 1 January 2022 at the earliest. It represents a key step towards the EU’s objective of achieving a climate neutral union by 2050.
"The taxonomy is likely to be a key tool in assessing any green supporting factors under banks' prudential rules (e.g. capital adequacy treatment)."
The Taxonomy Regulation provides uniform criteria for companies and investors to determine whether an economic activity is “environmentally sustainable”. It is a classification system (known as a “taxonomy”) which will help investors identify what is, or is not, sustainable. Its aims include²:
- To re-direct capital flows to sustainable investment and to companies engaged in or transitioning to more sustainable activities;
- To limit market fragmentation in the classification of green activities and investment projects, which will in turn facilitate cross-border sustainable investment in the EU;
- To increase transparency thereby enhancing investor confidence and awareness of the environmental impact of financial products/corporate bonds; and
- To create visibility and address concerns about “greenwashing” (that is, the practice of gaining an unfair competitive advantage by marketing a financial product as environmentally friendly, when in fact, basic environmental standards have not been met).
Further, the taxonomy is likely to be a key tool in assessing any green supporting factors under banks’ prudential rules (e.g. capital adequacy treatment). For example, the European Banking Authority has a mandate to assess the need for a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives, which will use the new EU taxonomy³.
SCOPE OF THE TAXONOMY REGULATION
The Taxonomy Regulation applies to:
- measures adopted by Member States or by the EU that set out requirements for financial market participants (“FMPs”) or issuers in respect of financial products (which includes investment funds, pensions and UCITS) or corporate bonds that are made available as environmentally sustainable, for example Green Bonds (FMPs include insurance undertakings, investment firms, pension providers and fund managers);
- FMPs that make available financial products; and
- undertakings which are subject to the obligation to publish a non-financial statement or a consolidated non-financial statement pursuant to the Non-Financial Reporting Directive (see below).
"The TSC are uniform criteria which will be used to determine whether economic activities "contribute substantially" to each environmental objective, and therefore can be considered sustainable."
THE DEFINITION OF “ENVIRONMENTALLY SUSTAINABLE” UNDER THE TAXONOMY
There are four criteria under the Taxonomy Regulation which an economic activity must meet in order to qualify as “environmentally sustainable⁴”:
As mentioned above, the Taxonomy Regulation sets out six environmental objectives⁵:
- 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.
Each of the objectives is defined in the Taxonomy Regulation.
TECHNICAL SCREENING CRITERIA: OVERVIEW
"This first delegated act was expected to be adopted by 31 December 2020 with the intention that the taxonomy would apply from 1 January 2022."
The Technical Screening Criteria (the “TSC”) are uniform criteria which will be used to determine whether economic activities “contribute substantially” to each environmental objective, and therefore can be considered sustainable⁶. The TSC will also determine whether any of those economic activities cause significant harm to any of the other environmental objectives (in accordance with criteria (2) above). The TSC will therefore be used as a basis for establishing an actual list of environmentally sustainable activities and will be implemented pursuant to the Taxonomy Regulation through delegated acts which are to be adopted in two sequences⁷.
The draft TSC covers the following 13 sectors:
1) Agriculture and forestry; 2) Environmental protection and restoration activities; 3) Manufacturing; 4) Energy; 5) Water supply, sewerage, waste management and remediation activities; 6) Transport (including maritime); 7) Construction and real estate; 8) Information and communication; 9) Professional scientific and technical activities; 10) Financial and insurance activities; 11) Education; 12) Human health and social work activities; and 13) Arts, entertainment and recreation.
Work has commenced on elaborating the TSC for the first two environmental objectives (climate change mitigation and climate change adaptation). This first delegated act was expected to be adopted by 31 December 2020 with the intention that the taxonomy would apply from 1 January 2022⁸. However, the regulation is still in draft form and will be adopted as soon as possible after the evaluation of the stakeholder feedback. The feedback period closed on 18 December 2020, so we expect more information from the EU on the timetable for implementation in due course.
For the four other environmental objectives (water; circular economy; pollution control and biodiversity), the taxonomy is intended to be established by the end of 2021 so that the taxonomy can start to apply to those objectives from 1 January 2023⁹. This gives those affected by the Taxonomy Regulation a year to familiarise themselves with the TSC and to prepare for their application¹⁰.
"MINING: THIS IS AN IMPORTANT SECTOR...IN TERMS OF AVOIDING BOTTLENECKS IN THE DEPLOYMENT OF LOW-CARBON TECHNOLOGIES."
The annexes to the delegated acts are where the TSC are set out in detail, together with very technical industry specific tests for various sectors and economic activities. Investors will need to use these annexes when determining whether or not the economic activity is sustainable.
The Technical Expert Group (the “TEG”) was set up by the Commission to provide technical input and establish the TSC for each environmental objective. The TEG has now been replaced by the Platform on Sustainable Finance (the “Platform”), comprising of a broad range of experts from both the public and private sectors, who will be responsible for establishing and updating the TSC going forward¹¹. The Platform will therefore develop the TSC for the remaining four environmental objectives.
The Commission will review the TSC, based on the advice it receives from the Platform in line with scientific and technological developments, and where appropriate amend the delegated acts¹². This means that, in the case of tightening criteria for certain economic activities, it is possible that some activities that were previously considered taxonomy-aligned would lose their eligibility¹³. It is also envisaged that the scope of the taxonomy is extended beyond environmentally sustainable economic activities so that it covers other sustainability objectives, including social objectives¹⁴, and criteria for a “brown” taxonomy¹⁵.
TECHNICAL SCREENING CRITERIA: MINING, METALS & MINERALS
The EU aims to be climate-neutral by 2050¹⁶. Given the fundamental role mining has in most low-carbon and renewable energy technologies, it is interesting that the Taxonomy Regulation does not specifically address the mining, metals and minerals sector in the draft TSC.
"Mining is also key to climate change mitigation generally, as metals and minerals are essential for manufacturing renewable energy supply technologies."
The TEG published a Taxonomy Technical Report¹⁷ in June 2019 which stated: “Mining: this is an important sector both in terms of avoiding bottlenecks in the deployment of low-carbon technologies by providing the critical materials needed for low-carbon technologies, as well as the value chain link with energy-intensive manufacturing sectors…. The TEG recommends that the platform analyse the role the sector plays in terms of enhancing availability of the critical materials needed for current and future technologies to create a climate neutral, circular and resource efficient economy, while sourcing raw materials in a sustainable and responsible way, with a view to consider the ‘greening by’ potential of the sector. However, the extractive industry can also be considered a ‘greening of’ activity: minimising its impacts could make a significant contribution to climate change mitigation. The TEG was not able to complete work for this sector due to time constraints and the complexity of the issues”.
TSC have therefore not yet been established for the mining, metals and minerals sector; however, we set out below examples of how the sector would meet certain environmental objectives set out in the Taxonomy Regulation (see the list of six environmental objectives above):
- Climate change mitigation: measures are already being taken throughout the sector to reduce mining-related emissions by, for example, investment in alternative electricity generation and supply and electrification. Mining is also key to climate change mitigation generally, as metals and minerals are essential for manufacturing renewable energy supply technologies. For example, low carbon technologies require significant amounts of steel, iron, copper, aluminium, zinc and nickel¹⁸;
- Transition to a circular economy: improving efficiency, reducing waste and improving recyclability of raw materials is key to this objective. The mining sector contributes various metals and minerals to other sectors which can facilitate light-weighting and extending the lifetimes and recyclability of products and materials¹⁹. For example, every kilogram of aluminium replacing steel in car manufacturing reduces the overall weight of the vehicle by a further kilogram²⁰, and 50% of the EU’s copper demand comes from recycled material because the life span of the copper can be decades²¹; and
- Pollution prevention and control: a key area for the mining sector in relation to pollution prevention and control is the transition to electric vehicles (“EVs”). It is estimated that by 2025 an additional 350kt of copper will be required to meet energy infrastructure, charging and storage needs and an additional 950kt of copper will be consumed by the auto sector to meet EV requirements²². Nickel and lithium are both important to lithium-ion battery technology that has widespread application in EVs, as well as portable tools and electronic equipment. Many renewable energy forms also rely on minerals; for example, solar PV panels and thermal systems use a combination of up to 22 non-ferrous metals, silicon, chemicals (e.g. organic electrolytes) and a specific type of flat glass²³.
"Given that mining is a bedrock for most other industry sectors, and despite its complexities, the exclusion of mining from the TSC is a surprising decision, and one that does not assist the sector in proving sustainability going forward."
The role of mining in the transition to a more climate aware future and in meeting the EU’s carbon emission objectives is therefore a crucial one. Conversely, we cannot overlook the environmental effects an industry that consumes up to 11% of global energy use, while 70% of mining projects from the six largest mining companies operate in water-stressed regions²⁴. Increasing demand for metals and minerals would only push these figures higher unless a radically different approach is taken²⁵. For an industry generally perceived as “dirty”, this creates an obvious opportunity to rebuild trust with society as suppliers of critical minerals produced in a sustainable and ethical way²⁶.
Given that mining is a bedrock for most other industry sectors, and despite its complexities, the exclusion of mining from the TSC is a surprising decision, and one that does not assist the sector in proving sustainability going forward. Environmental, social and corporate governance scrutiny is becoming increasingly important to investors and sustainable finance is a growing discipline. The Taxonomy Regulation and TSC would have been a perfect place to encourage and assist mining to play a more immediate and greater role in that more sustainable future.
That said, the indirect effect of the draft TSC’s application to other sectors is likely to be of relevance also to the mining industry. For instance, as indicated in our EU Taxonomy for Sustainable Investments – Energy article, the energy sector will have to consider its supply chain and procurement processes very carefully as it moves forward and that will undoubtedly have a flow-through impact.
Given this indirect effect, and also in the hope and expectation that mining will be more directly covered sooner rather than later, the remainder of this article focusses on some of the more detailed reporting and disclosure requirements of the Taxonomy Regulation.
The Taxonomy Regulation is closely linked with the Disclosure Regulation (defined below) and the Non-Financial Reporting Directive (the “NFRD“) and introduces new disclosure obligations for a range of entities. We set out what this will mean for both reporting companies and FMPs below.
Article 8 of the Taxonomy Regulation requires financial and non-financial organisations covered by the NFRD to include information in their non-financial information statements on how, and to what extent, their business activities (turnover, CapEx and OpEx) align with the Taxonomy Regulation²⁷. They will have to start disclosing against the first two climate objectives (climate change mitigation and climate change adaptation) in the course of 2022 (covering the financial year 2021) and all six environmental objectives in the course of 2023 (covering the financial year 2022²⁸).
Currently the NFRD applies only to EU-incorporated large public interest entities (PIEs), which can include organisations in the financial and non-financial sectors with securities traded on a regulated market, in each case if they have more than 500 employees. However, the Commission has announced a review of the NFRD and one issue being considered is whether it is amended to include all listed companies (including SMEs) and/or set the bar precisely at SMEs level (i.e. above 250 employees)²⁹.If the scope of the NFRD was extended, this would in turn have a knock-on effect on which organisations need to comply with the disclosure requirements in Article 8 of the Taxonomy Regulation.
"Another important point to note is that that companies within the scope of the NFRD will have to disclose even if there are no specific criteria (yet) available to their activities/sector."
Another important point to note is that that companies within the scope of the NFRD will have to disclose even if there are no specific criteria (yet) available to their activities/sector³⁰. The content and presentation of the information to be disclosed under Article 8 will be further specified by the Commission by 1 June 2021 through a delegated act³¹.
FINANCIAL MARKET PARTICIPANTS
Articles 5-7 of the Taxonomy Regulation introduce new disclosure requirements for entities covered by EU Regulation 2019/2088 (the “Disclosure Regulation”), which includes insurance undertakings, investment firms, pension providers and fund managers³². Such entities will need to disclose how and to what extent their portfolios align with taxonomy objectives. More specifically:
- Sustainable products (as defined by Disclosure Regulation): entities will need to set out the percentage of their portfolio that is EU Taxonomy-aligned³³;
- Products with ESG characteristics (as defined by Disclosure Regulation): as above, entities must set out the percentage of their portfolio that is EU Taxonomy-aligned; and include a statement that the “do no significant harm principle” only applies for the investments underlying the product that consider the EU taxonomy³⁴; and
- Mandatory statement products with no ESG characteristics: the following statement must be included in their disclosures: the “product does not consider the EU Taxonomy³⁵”.
These disclosures will need to be made in a company’s pre-contractual documents, websites and periodic reports³⁶. The first set of disclosures against the taxonomy, covering activities that substantially contribute to climate change mitigation and adaption, need to be made from 1 January 2022. Disclosures in relation to all six environmental objectives will need to be made from 1 January 2023³⁷.
"How the roadmap will align with any UK taxonomy and implementation of the EU taxonomy has yet to be seen and will no doubt impact on, and add complexity to, the disclosure which FMPs are required to make."
EXTRA TERRITORIAL EFFECT
The disclosure obligations for FMPs in the Taxonomy Regulation (as set out above) apply to anyone offering financial products in the EU regardless of where the manufacturer of such products is based. In addition, the disclosure obligations pursuant to Article 8 of the Taxonomy Regulation (as set out above) apply to entities subject to the NFRD and to all their activities regardless of their location³⁸.
Furthermore, the TEG has suggested that investors in third countries could use the taxonomy criteria to benchmark or compare the environmental performance of local economic activities in those countries. In cases where a locally relevant threshold has been used to assess the environmental performance of an economic activity, it is also suggested by the TEG that companies and investors may wish to provide an additional second disclosure setting out the details and rationale for variation from the TEG standard³⁹.
The UK’s approach with respect to taxonomy-related disclosures post-Brexit is not yet clear. In June 2020, it was confirmed that the UK would retain the taxonomy framework, including the six environmental objectives. However, as the details are to be set out in the future delegated acts which are not yet finalised, the UK government could not confirm at that stage the extent to which UK law will align with EU law here. In November 2020, the UK announced that a UK taxonomy will take the metrics and thresholds in the EU taxonomy as its basis and then a new UK Green Technical Advisory Group, an equivalent to the TEG, will be established to review these metrics “to ensure they are right for the UK market⁴⁰”. In addition, the UK has published a roadmap towards mandatory climate-related disclosures across the UK economy aligned with the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD)⁴¹. How the roadmap will align with any UK taxonomy and implementation of the EU taxonomy has yet to be seen and will no doubt impact on, and add complexity to, the disclosure which FMPs are required to make.
VERIFICATION AND ASSESSMENT OF TAXONOMY ALIGNMENT
The Taxonomy Regulation does not explicitly require any formal verification of whether activities comply with the TSC. However, as set out above, compliance with the taxonomy disclosure obligations will be monitored. In addition, as good practice, FMPs are encouraged to seek external assurance on their taxonomy-related disclosures.
"It is clear that the Commission intends the Taxonomy Regulation to become a benchmark for measuring sustainable investment in a number of ways."
Disclosures made under the NFRD do not, as a baseline, require verification (although this may vary based on the transposition by Member States). However, this may be subject to change depending on the outcome of the currently on-going review of the NFRD⁴².
The Taxonomy Regulation is likely to have a significant impact on reporting obligations for FMPs and a broad range of other companies, although understanding the level of additional work required will depend on the detailed criteria set out in the TSC. It is clear that the Commission intends the Taxonomy Regulation to become a benchmark for measuring sustainable investment in a number of ways. We therefore suggest that FMPs and other entities follow its evolution closely, and in particular:
- identify any disclosure and data requirements and establish reporting procedures;
- consider the impact of the Taxonomy Regulation on investment and access to financing, particularly as this may enable investors to better target “green” investments; and
- consider their existing compliance with the criteria, and whether/how to take it into account in their future financing decisions.