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The EU Taxonomy Regulation

The EU Taxonomy Regulation
  • United Kingdom
  • Financial services and markets regulation - ESG
  • Financial institutions

03-07-2020

Introduction

A key element of recent EU measures designed to encourage environmentally sustainable investment decision making is the Taxonomy Regulation (Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088) (the “Taxonomy”).  The Taxonomy was published in the Official Journal of the EU on 22 June, following its adoption by the European Parliament on 18 June 2020.  It enters into force 20 days after publication, on 12 July 2020.  Please see below on the timing of its application. 

The Taxonomy is a technical framework that helps to assess how sustainable (or, in crude terms, how ‘green’) an economic activity is on a scientific, comparable basis. This in turn allows for the assessment of a particular company or portfolio.

What are the broad environmental aims set out in the Taxonomy?

The Taxonomy lists six specific environmental objectives. These are:

  1. climate change mitigation (this is linked to the targets for limiting global average temperature increases agreed in the Paris Agreement);
  2. climate change adaptation (this can be differentiated from climate change mitigation in the sense that mitigation addresses the causes of climate change whereas adaptation addresses its impacts);
  3. the sustainable use and protection of water and marine resources;
  4. the transition to a circular economy (i.e. an economy in which resources are kept in use for as long as possible);
  5. pollution prevention and control; and
  6. the protection and restoration of biodiversity and ecosystems.

How is activity to be assessed by reference to the Taxonomy?

To be considered environmentally sustainable under the Taxonomy, an activity must satisfy the tests set out below:

  1. it must substantially contribute to the one or more of the environmental objectives listed above as set out in the Taxonomy;
  2. it must do no significant harm to any of the specified environmental objectives (the meaning of this for each activity will be detailed in regulatory technical standards currently being developed by the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority (the “ESAs”);
  3. it must be undertaken in compliance with minimum social safeguards; and
  4. it must comply with technical screening criteria which will be established by the Commission in delegated acts.

Practical use and application of the Taxonomy

The Taxonomy will apply directly to:

  1. EU Member States (when determining national level rules regarding financial products marketed as environmentally sustainable); and
  2. Financial market participants (“FMPs”) with products that promote environmental characteristics;
  3. FMPs with products that do not promote environmental characteristics (albeit that their obligations are limited to the making of negative statements); and
  4. Undertakings to which the non-financial reporting requirements of Directive 2013/34/EU as amended by Directive 2014/95/EU (the “NFRD”) apply.

The Taxonomy defines FMPs by reference to the definition included in Regulation (EU) 2019/2088 (the “Disclosure Regulation” or “SFDR). Broadly speaking, FMPs are asset managers and institutional investors. Financial products for these purposes includes segregated portfolios (commonly referred to as segregated mandates), funds (UCITS and AIFs), insurance products, pension schemes, pension products and pan-European personal pension (PEPP) products.

The Taxonomy will be of particular relevance to UCITS ManCos, AIFMs and MiFID investment firms with an interest in sustainable investment products, portfolios or strategies. That being said, it is also likely to inform the thinking and disclosures of non-EU managers selling such products into both the EU and other markets given that the EU is an early-mover and becoming something of a standard bearer in this area. Over time, EU rules and measures in respect of sustainable investment products may become ‘best practice’ as has been the case in other regulatory spheres, such as with the out-sized impact of the GDPR on data protection policy and standards in non-EU jurisdictions.

As mentioned at the outset above, the Taxonomy’s purpose is to serve as a tool for comparative analysis of the sustainability of economic activity. In practice, this analysis is likely to begin with the identification by FMPs (or perhaps third party data providers) of the various economic activities of a company with a view to identifying those that may be Taxonomy-eligible and against which the other tests can be applied.

Once the Taxonomy alignment of individual companies within a portfolio has been identified, the next step envisaged by the Taxonomy is the calculation and disclosure (including, for example, on websites and in prospectuses) of the percentage of the overall investment portfolio and each individual holding (i.e. at both product and investment levels) comprised of Taxonomy-eligible activities. Calculation of these Taxonomy-eligible percentages will be made in accordance with the technical screening criteria contemplated and disclosures made by managers should then include these percentages. In addition, as mentioned above, disclaimers will be required for financial products which are not held out as being environmentally sustainable (i.e. funds with no ESG strategy or element).

In tandem, the combined effect of the Taxonomy and SFDR will be to provide greater clarity to investors on the substance behind sustainability claims. SFDR will expose the extent of the FMP’s stated ESG-risk management for the product, consideration of the negative impacts of investment decisions on sustainability factors and, where relevant, key aspects of the product’s sustainability characteristics or objectives.  The Taxonomy will provide empirical evidence as to the underlying portfolio’s sustainability.

The Taxonomy will also require certain investee companies (those subject to the Non-Financial Reporting Directive) to understand, measure and provide details of Taxonomy alignment. Two clear intentions of the regime are to incentivise investee companies to improve their Taxonomy alignment so that they continue to be attractive investments and to ensure that new, Taxonomy-aligned businesses are well-positioned to attract the capital investment they require.  There are also likely to be indirect impacts for other entities such as third party data providers that will supply information about investee companies’ Taxonomy alignment.

Further uses for the Taxonomy are likely to become more apparent over time as thinking and activity in this area evolves. For example, the proposed, voluntary EU Green Bond Standard will require investments financed by products bearing the standard to be aligned with Taxonomy criteria.

Along with other related measures in this area, including SFDR (see our briefing “Introduction of disclosure obligations on the integration of ESG factors and risks”) and the Low-Carbon Benchmarks Regulation (see our briefing “Low Carbon Benchmarks Regulation”), the EU expects that the Taxonomy will help to harmonise the approach of all Member States to sustainable investments products and consequently further its goals of ending perceived “green-washing” and increasing capital flows to truly sustainable activities which accord with the climate change targets set out in the Paris Agreement.

Timing and further consultation

The transparency obligations described above in relation to the six environmental objectives will enter into force as follows:

  • from 1 January 2022 in respect of the climate change mitigation and adaptation objectives; and
  • from 1 January 2023 in respect of the remaining four objectives.

So the first related company reports and investor disclosures will fall due at the beginning of 2022.

The technical expert group advising on the Taxonomy published its final report, “Sustainable finance: TEG final report on the EU taxonomy”, on 9 March 2020. This report sets out recommendations on the overall framework of the Taxonomy and includes extensive guidance on how FMPs may use and disclose against the Taxonomy in practice. Further developments will be rolled out via a new Platform on Sustainable Finance. This platform is expected to go live in Autumn 2020.

Separately and in advance of implementation, the ESAs issued a joint consultation paper on proposed ESG disclosure standards on 23 April 2020. As well as containing a number of questions on the proposed RTS under SFDR), this consultation paper contains a number of taxonomy-related points on which the ESAs welcome feedback. Stakeholders are asked to respond by 1 September 2020.

The effect of the UK’s departure from the EU on the Taxonomy Regulation

The Taxonomy is an example of what is known as “in-flight” EU regulation, being EU regulation for which the principal instrument is in force at the time the UK on-shores EU law under the European Union (Withdrawal) Act 2018 (“EUWA”) on 31 December 2020 (known as the Implementation Period Completion Date (“IPCD”), but for which further detail of regulation, for instance in the form of RTS,  does not come into force until after IPCD. It is likely that the RTS under the SFDR will also come into force after IPCD.

In respect of such in-flight regulation, the UK government will need to make a decision as to whether to adopt, amend or reject the regulation.

In a letter dated 28 May, John Glen, the Economic Secretary to the Treasury, reported to the European Scrutiny Committee that HMT could not comment as to whether the UK would seek alignment with the unpublished aspects of the taxonomy after the implementation period.

Last week the Chancellor of the Exchequer made a written ministerial statement about such regulations, however, he did not say anything specifically about the Taxonomy or SFDR. The Chancellor’s general principle was that while the UK had helped to write much of the EU financial services regulations, “rules designed as a compromise for 28 countries cannot be expected in every respect to be the right approach for a large and complex international financial sector such as the UK” and “[w]e will … tailor our approach to implementation to ensure that it better suits the UK market outside the EU.”

While the broad aim of the Taxonomy and the SFDR are uncontroversial, the fine detail of what constitutes sustainable economic activity is a subject of (often fierce) debate and is constantly evolving. The UK government, encouraged by UK based green lobbyists and activists, wants to show global leadership on sustainable finance and so it is likely that the UK version of the Taxonomy will contain a range of differences.  Over time, those differences can be expected to grow as the UK regulators, more agile than their EU counterparts can be, are able to respond to new developments and lobbying in this area.

Just as this briefing went to press The Financial Services (Miscellaneous Amendments) (EU Exit) Regulations 2020 (the “Regulations”) became law. They make the following provisions:

  • disapplication of the provisions which empower the ESAs to prepare RTS; and
  • addition of UK Climate Transition Benchmarks and UK Paris-Aligned Benchmarks as domestic equivalents of the new EU-low carbon benchmarks.

These provisions are further discussed in the explanatory memorandum to the Regulations.

It is not clear whether policy makers see these changes as part of the onshoring process (because domestically the FCA is not asked to draft legislation) or an active decision not to onshore certain future legislative acts.

How can Eversheds Sutherland help?

Our in depth understanding of the sector means that we are well placed to advise you on the scope and implications of the Taxonomy and SFDR, as well as opportunities arising from the trend towards impact investing and sustainability more generally.

Find out more about environment, social and governance (ESG) factors >