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EU Taxonomy – How to put the Green in Green Finance?


Tuesday, November 3, 2020

In Part 1 of the Philip Lee Green Finance Series we looked at the background to climate change crisis, the EU Green Deal, and its component parts. In Part 2 we look at the EU Green Taxonomy (the “Taxonomy”) and forthcoming disclosure and reporting requirements for companies and institutions.

The Taxonomy entered into force on 12 July 2020. It is the bedrock upon which all the building blocks of the Green Deal are based. It is the benchmark to identify to what degree an economic activity is environmentally sustainable, whether it be in terms of green bonds, green loans, or investment portfolios. It will guide disclosures that require to be made to investors and reporting on investments and financial products which are labelled as environmentally sustainable, and ultimately for the purposes of an institution’s own regulatory reporting.

Under the Taxonomy, an activity, financial product or investment may only be described as ‘environmentally sustainable’ if:

  • it substantially contributes to or enables a significant contribution (judged against technical criteria) to one of six environmental objectives.
Source: EU Technical Expert Group on Sustainable Finance, 2020

 

These objectives will be introduced on a phased basis from 1 July 2020, the first 2 being, (i) climate change mitigation and (ii) climate change adaptation; and
• must ‘do no significant harm’ (DNSH) to any of the other objectives;
• be carried out in compliance with minimum social safeguards; and
• comply with technical screening criteria (to be issued by the Commission through delegated acts).

Financial products that do not meet this sustainability criteria may not be marketed, distributed or sold as ‘environmentally sustainable’ in the EU.

Disclosure and reporting
The Financial Stability Board established the ‘Task Force on Climate-related Financial Disclosures’ (TCFD) which generated recommendations to encourage financial institutions and non-financial companies to disclose information on climate related risks and opportunities.

Investment firms and funds will be required from 10 March 2021 as part of the Sustainable Finance Disclosure Regulation (EC 2019/2088) (SFDR) to make disclosures on sustainability risk policies, and their integration into investment decisions by providing (i) precontractual information, (ii) information on their websites, and (iii) information in relation to their remuneration policies and in relation to financial products. This is a ‘comply or explain’ methodology whereby firms must disclose their level of environmental sustainability, or include an explanation as to why sustainability risks are not deemed relevant. The SFDR requires financial market participants to make disclosures in respect of their investments/financial products detailing the degree to which they are taxonomy aligned in terms of their environmental or social characteristics, sustainable investment objective, information on the methodology used to assess, measure and monitor those characteristics or objectives, and the data sources, screening criteria and sustainability indicators used. Sustainable investments under the SFDR are defined as (linked to the Taxonomy) investments in economic activity that contribute to an environmental objective, social objective or human capital or economically or socially disadvantaged communities, provided that they do not significantly harm any environmental objective; whose investee companies follow good governance practices; and adopt sound management structures.

The Non-Financial Reporting Directive (EC2013/34 and EU2014/95) (NFRD) will require large firms to include taxonomy aligned disclosures in their financial reporting and filings. This comprises disclosure of environmental, social and employee matters, respect for human rights and bribery and corruption to the extent necessary for understanding a company’s development, performance, position (i.e. value of the company) and the impact of its activities (i.e. environmental and social materiality).

The European Commission have built on these requirements in issuing its ‘Guidelines on non-financial reporting: Supplement on reporting climate-related information’ . Climate-related information should include risks of negative impacts on the company (i.e. transition risks or physical risks) and the climate (i.e. emission of GHG, use of fossil fuels in production, raw materials used may result in GHGs). Companies are instructed to consider a long term horizon and whole of supply chain approach reflecting sustainability and identifying climate-related risks to their business and where they determine there to be no material risks, to disclose how they reach that determination.

The guidance covers key reporting areas and adopts recommended disclosures incorporating further guidance for companies:

  • How climate change impacts business model and strategy, and how its activities can affect the climate;
  • Information on policies, targets and the involvement of the board and management in relation to climate change;
  • Reporting of performance against target setting and impact of policies;
  • Climate-related risk identification and management processes, such as climate adaptation or mitigation measures;
  • Identify and publish key performance indicators (KPIs) relevant to their business, for example:
    – GHG emissions (direct and indirect, and absolute emissions targets);
    – Energy consumption from renewable/non-renewable sources;
    – Turnover from products/services substantially contributing to climate change/adaptation;
    – Green Bond ratio or Green Debt ratio, ie financing derived from climate-related financial instruments;
    – Sector specific targets under TCFD supplemental guidance.

For banks and insurance companies the guidance and disclosures are intended to be assessed from the perspective of their lending, investing, underwriting or asset management activities, acknowledging that banks can both exacerbate climate-related risks and promote low-carbon transition by the manner in which they integrate climate change impact into their evaluation of loans and investments. These requirements will involve deep changes to the way banks operate, make lending decisions and manage their loan portfolios.


Author

Simon O’Neill

PARTNER


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