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Green finance

The EU is developing criteria to help investors who want to choose sustainable investments. But what is the EU taxonomy and how will it work?

Investors in Europe are increasingly interested in sustainable investment opportunities. Companies that have a green story to tell want to communicate with these investors. Across the world, countless initiatives are encouraging a move to ‘think green’ and steer capital towards sustainability objectives. If a genuine shift towards sustainable investments is to happen, however, a shared understanding of what ‘sustainable’ actually means is needed. Currently, no such common understanding exists. This stands in the way of efforts to finance economic activities that can truly make a positive impact on society and the environment and consequently contribute to reaching internationally agreed sustainability targets, such as the United Nations’ Sustainable Development Goals and Paris Agreement.

Solid framework

The EU is taking the lead internationally on sustainable finance and, in March 2018, the European Commission adopted an action plan on financing sustainable growth. At the heart of this plan is a proposal to create a solid framework − an EU taxonomy for sustainable economic activities − to help investors inject capital into these activities so that Europe can become the first climate-neutral continent by 2050. This decision was solidified on 16 December 2019, when the European Parliament and Council of the European Union reached a political agreement on the creation of such a taxonomy, following a legislative proposal put forward by the Commission in May 2018.

But more concretely, why is a taxonomy necessary? A classification system will be crucial to: (i) provide a common language to determine which economic activities can be unambiguously regarded as sustainable; (ii) move towards a financial system that supports the EU's climate and sustainable development agenda; (iii) reorient capital flows towards sustainability; (iv) protect private investors and consumers against ‘green-washing’ (i.e., promoting the perception that an organisation's products, aims or policies are environmentally friendly, when in fact they are not); and (v) facilitate cross-border investments, avoiding market fragmentation.

Environmental objectives

The taxonomy regulation that was agreed in December 2019 is centred around six environmental objectives. These 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; and finally, protection and restoration of biodiversity and ecosystems.

In order to qualify for inclusion in the EU taxonomy, economic activities will need to: provide a substantial contribution to at least one of the six environmental objectives; do no significant harm to the remaining environmental objectives; comply with robust and science-based technical screening criteria; and respect minimum social safeguards.

The technical screening criteria will be developed in two batches. The first on the two climate-related objectives should be adopted by the Commission in December 2020, while the remaining four environmental objectives will be adopted a year later. Following this, companies and market players will be required to disclose their alignment with the EU taxonomy one year later: for the climate change objectives from 1 January 2022 and for the other environmental objectives form 1 January 2023. This lapse of time between the development/publication of the full EU taxonomy and requirement to report on it is intended to allow time to become familiar with the criteria underpinning the classification.

Which economic activities?

The taxonomy regulation recognises three different types of environmentally sustainable economic activities:

• Economic activities that in and of themselves contribute substantially to one of the six environmental objectives.

• Transition activities: these are activities for which there are no technologically and economically feasible low-carbon alternatives, but that support the transition to a climate-neutral economy in a manner that is consistent with a pathway to limit the temperature increase to 1.5 degrees Celsius above pre-industrial levels (for example, by phasing out greenhouse gas emissions).

• Enabling activities: activities that enable other activities to make a substantial contribution to at least one of the environmental objectives and at the same time: (i) do not lead to greenhouse gas emissions from long-term assets, thus undermining long-term environmental goals; and (ii) have a substantial positive environmental impact on the basis of asset lifetime.

Which users?

Once fully developed, the EU taxonomy will have to be used by:

  • The European Union and its Member States, in so far as they adopt measures, standards or labels concerning financial products or corporate bonds that are being presented as environmentally sustainable.
  • Financial market participants offering sustainable financial products. They will be required to disclose information on how and to what extent the investments that underlie such products support sustainable economic activities, as defined by the taxonomy regulation.
  • Financial market participants who do not offer sustainable financial products. They will need to issue a statement stating that the relevant products do not take into account the EU taxonomy.
  • Financial and non-financial companies that fall under the scope of the non-financial reporting directive. These will have to disclose information on how and to what extent their activities are environmentally sustainable.

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