The EU created the Sustainable Finance Action Plan to direct financial flows toward sustainable investments, and the EU Taxonomy is the bedrock of the Sustainable Finance Framework. The EU Taxonomy is a classification system for determining which economic activities are environmentally sustainable or Taxonomy eligible. The objective of the Taxonomy is to prevent “greenwashing” and to reduce information asymmetry between the reporters and the users of the reports.
While the EU Taxonomy only describes “environmentally sustainable” activities, an “Extended Environmental Taxonomy” (which supports a sustainable transition to a low carbon economy) and a “Social Taxonomy” (which focuses on “socially sustainable” economic activities) are currently being drafted and will become effective over the next 2-3 years.
In our previous article on the EU Taxonomy(read here), we looked at the background of this regulation, the six climate objectives, the concept of “DNSH – Do No Significant Harm”, and the Technical Screening Criteria (TSC) . This article explores the difference between “Taxonomy Eligible” and “Taxonomy Aligned” economic activities.
Background
As discussed earlier, the EU Taxonomy defines what a “sustainable” economic activity is. It is the basis for reporting under the EU’s Corporate Sustainability Reporting Directive (CSRD), Sustainable Finance Disclosure Regulation (SFDR), Markets in Financial Instruments Directive II, and Insurance Distribution Directive (MiFID II & IDD). The image below shows how the information on the performance of the relevant “sustainable economic activities” flows from the corporates to the end investor and how the capital flows are directed based on this information.
Taxonomy KPIs
The performance of an entity’s “sustainable economic activities” is presented as Taxonomy Key Performance Indicators (KPIs) and is differentiated between financial and non-financial entities. The Taxonomy KPI for a financial undertaking is the Green Asset Ratio (GAR), and the Taxonomy KPIs for non-financial undertakings are Turnover, Capital Expenditure (CapEx) and Operational Expenditure (OpEx). For more details on these KPIs, please refer to our article here.
The Taxonomy KPIs are calculated by aggregating the contributions of all the taxonomy-aligned economic activities of an entity. To do this, one has first to identify the economic activities that are taxonomy-eligible. So, what is the difference between eligibility and alignment? The former is a necessary condition, and the latter is a sufficient condition per the Taxonomy Regulation (access here). Before getting into the eligibility vs alignment question, let us look at the classification of the economic activities considered for Taxonomy alignment.
Types of activities included in the Taxonomy
The EU Taxonomy is a complex and work-in-progress regulation. It is essential to understand the different concepts like the environmental objectives and types of taxonomy-eligible activities. As discussed in our previous article (read here), there are six environmental objectives of the Taxonomy, which are
- Mitigation of climate change
- Adaptation to climate change
- Sustainable use and protection of water and marine resources
- Transition to the circular economy
- Pollution prevention and control
- Protection and restoration of biodiversity and ecosystems
Then there are three types of activities that can be included in the Taxonomy
- Primary activities, which directly contribute substantially to one of the six environmental objectives above (link to the regulation).
- Transitional activities which support the transition to a climate-neutral economy (as referred to in Article 10(2) of Regulation (EU) 2020/852).
- Enabling activities, which facilitate the primary activities indirectly (as referred to in Article 10(1), point (i), of Regulation (EU) 2020/852).
Taxonomy Eligible vs Taxonomy Aligned
Eligibility
To be eligible or to qualify as a sustainable activity, an economic activity should substantially contribute to at least one of the six abovementioned environmental objectives of the Taxonomy, from any one of the three types of activities highlighted above. However, only activities that contribute to the first two environmental objectives – Climate Change Mitigation and Adaptation – have been formally adopted so far.
Just because an activity qualifies as a sustainable activity does not mean that it is aligned with the EU Taxonomy Regulation because this activity could have attributes that nullify its positive contribution. To ascertain if these eligible or qualified activities are Taxonomy aligned, an activity has to satisfy two additional conditions.
Alignment
An eligible activity becomes taxonomy-aligned when it meets all of the following three criteria.
- Substantially contribute to one of the six economic activities in line with the Technical Screening Criteria (TSC).
- Do-no-significant-harm (DNSH) in relation to the other environmental objectives.
- Comply with Minimum social safeguards (MSS) as described in the Taxonomy Regulation.
As per the EU Taxonomy Compass, there are 88 activities in Climate Change Mitigation and 95 activities in Climate Change Adaptation, which an entity can choose from for reporting on Taxonomy alignment (as of July 2022).
Conclusion
For Taxonomy reporting, an entity has to
- Identify activities that are taxonomy-eligible
- Whittle down the activities and arrive at the taxonomy-aligned activities
- Map the performance of these activities to the Taxonomy KPIs
- Report the Taxonomy KPIs
Our next article on Taxonomy proposes a 3-step process on the Taxonomy KPI reporting and can be accessed here.
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