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This special Think ESG episode of the Better Finance podcast features Brian Tomlinson from Ernst & Young LLP, and Nathan Fabian, Chief Responsible Investment Officer at the Principles for Responsible Investment.
The discussion sheds light on the EU taxonomy: a system for reporting on sustainable activities. The taxonomy is expected to be a lasting reform, with significant implications for companies with operations in the EU.
The EU has placed sustainable finance and the transition to a sustainable net-zero economy at the core of its growth strategy. Efforts were directed toward development of a taxonomy with standardized environmental performance criteria aligned with the Corporate Sustainability Reporting Directive, and the Sustainable Finance Disclosure Regulation. Communication and disclosure of progress toward alignment of companies’ economic activities with the taxonomy’s sustainability performance criteria was a priority.
The EU taxonomy creates the concept of “green by law” and provides an objective set of largely science-based criteria by which activities are measured in order to be labeled and marketed as “sustainable.” The taxonomy structure indicates when an activity makes a substantial contribution to one of six environmental objectives (climate change mitigation, climate change adaptation, water, circular economy, pollution and biodiversity) with no significant harm done to the other five.
A recent EY study examines the first-year results of the application of the taxonomy and the disclosure practices adopted by EU companies in the first wave of reporting.
Key takeaways:
“Green” implies making a contribution to a sustainable environment by measuring activities against a set of objective benchmarks developed by the EU.
The taxonomy may operate as a “forcing function”— as companies will do significant work to map activities agains the taxonomy criteria.
Companies initially should not expect high alignment with the taxonomy. The first round of reporting by EU companies showed low alignment numbers but high strategy commitment. Numbers are expected to increase over the next few years.
Many investors will look at data (such as alignment of capex to taxonomy) to understand the seriousness of companies’ transition plans.
For your convenience, full text transcript of this podcast is also available.
“These reforms around taxonomy are really requiring an objective assessment of, am I making the environment better or worse? This is really part of the future of corporate activity and financial markets. It’s actually being able to tell objectively of what the environmental performance is. That’s the key idea. That’s why it is going to be a lasting reform.”
Myles Corson
That was Nathan Fabian, Chief Responsible Investment Officer at The Principles for Responsible Investment (UNPRI), and Chairperson at European Platform on Sustainable Finance.
I’m Myles Corson from Ernst & Young, host of the Better Finance podcast. I’m delighted to share this special episode as part of our ongoing ESG reporting series.
The EU taxonomy is a unified classification system for sustainable activities. The taxonomy, along with the Corporate Sustainability Reporting Directive (CSRD) are in a package of measures intended to help the EU enhance sustainable investment.
In this episode, Brian Tomlinson, an Ernst & Young Managing Director focused on ESG reporting, and Nathan discuss the context surrounding the taxonomy and its structure, plus its implications for both EU and US companies.
I’m excited to share their discussion with our listeners. So, let’s get started by handing over to Brian.
Brian Tomlinson
Hello everyone. My name is Brian Tomlinson and today, we’re going to talk about the EU taxonomy. As many of you will have noticed, we’re in an unprecedented period of regulatory engagement on ESG across geography and across themes. Nowhere is that more true than in the EU. Though, of course, we’ve seen significant regulatory developments in the US, in addition to regulatory developments in other major countries, such as the UK, China and Canada, among others.
But the EU has really placed sustainable finance and the transition to a sustainable net-zero economy at the core of its growth strategy, and that’s all underpinned by the objectives of the green deal. Just briefly, the scope of the EU’s regulatory effort is really extremely broad, and it covers, among other things in this non-exhaustive list, fiduciary duty, investment advice, ratings agencies, supply chain due diligence — in among that, are these signature pieces of disclosure regulation. The Sustainable Finance Disclosure Regulation, which we’ll refer to as SFDR, and Corporate Sustainability Reporting Directive, which we’ll refer to as CSRD. Now, the significant thing about this, and many of you will have heard of the “Brussels effect,” is that this regulatory effort across CSRD, SFDR and the taxonomy has significant implications for US companies.
Even if you expand the disclosure ecosystems, some conceptual problems remain with sustainability and how you talk about sustainability. Some of those issues around sustainability in the ESG disclosure are transparency, comparability, and context, and overlying all of those is this problem of greenwash.
How do you get companies to talk more fully about the impact of their business on the broader environment and the broader environment on their business? How do you kind of compare apples to apples between companies? And then, how do you think about the way in which corporate performance addresses the broader social environment? What’s the context for that performance? Because many corporate targets are, essentially, based upon incrementally moving down and lowering their impacts from where they are, but what does that really tell us about the context in which companies exist and the dependencies underlying their business models?
So, this brings us to the concept of the taxonomy which I’m going to frame, essentially, an anti-greenwash device. One of the things that the taxonomy does is it creates this idea of green by law. So, something is not green because a company says it’s green, it’s green because it meets an objective set of criteria, which are largely science based. So that gets you a number of things. It gets you transparency, it gets you comparability and it gets you context.
One of the things about this taxonomy structure is that it has the opportunity to potentially impact lots of ways in which investors and corporates do their jobs. It can influence strategy development, capital flows, investment evaluation and procurement; the list of implications for the taxonomy is very broad.
We often hear concerns about the alphabet soup of acronyms in the ESG space. What the taxonomy is trying to do is to be potentially, one standard to rule them all. And also, to really pick up this notion of disclosure as a forcing function, which is that in order to talk to the market about new things, you have to do new things, and it may change the way in which you do business. This is an important area for companies, particularly in the US, to engage with.
Who better to talk to about the EU taxonomy than Nathan Fabian. Nathan chairs the EU Platform on Sustainable Finance. He is the Chief Responsible Investment Officer at UNPRI and prior to that, he was the CEO of the Investor Group on Climate Change. He’s a real innovator and maven in the ESG, sustainability and policy space, and he’s been absolutely central in the development of the taxonomy. So, with that introduction, Nathan, delighted to have you with us. I wanted to ask you to give us a little bit of a background on your role at the Platform for Sustainable Finance, and perhaps a little bit of the origin story of the taxonomy and the context of that broader EU regulatory effort connected to the underlying green deal.
Nathan Fabian
Hi Brian. It’s good to talk to you. In my role as the Chair of the Platform, we are responsible for developing environmental performance criteria to go into the taxonomy. The Platform works as a group of experts from finance, academia, industry, and from the environmental and social think tanks in Europe, all contributing their expertise, mostly on a voluntary basis, working alongside the EU officials to have this multi-stakeholder expert process for developing the taxonomy. I chair that group and we have 67 members, and we have dozens of EU officials supporting the work. It’s a large technical effort. That platform has been operating for around two years and it follows a couple of years of proprietary technical work that’s been going on in the taxonomy in Europe.
The origins of the taxonomy were, as you rightly identified, recognition that we’ve got a lot of finance flowing in capital markets toward companies and investments that are supposedly green. And the truth is, who knows? Who’s deciding what’s green? That’s really the question we’re facing now. What’s green? What’s environmentally friendly? What’s environmentally sustainable?
When you think about financial market supervision, you want your investment products to have integrity, so that they do what they say on the tin. This is a very simple principle on which financial markets rely. If I sell you a product, and your investment is contributing to a better environment, I need to be able to back that up. And if I can’t refer to some objective benchmark to do that, you may not have confidence or I might inadvertently overstate the contribution that your investment is making. Literally, hundreds of billions of euros and dollars now flowing in these markets. There was a need to address this performance standard aspect.
The other dimension, which is quite important for the origins of the taxonomy, is that Europe has been very specific about what private and public investment is required to meet climate and environmental goals. This can be modeled. It’s not that difficult. When you know you’re reducing your emissions across Europe by minus 55% by 2030, as the European target is, you can work out how many clean zero-emissions cars do I need on the road? How many net-zero emissions buildings do I need? My energy supply, what should the mix look like of energy sources? And when you are able to model that, you can tell what the investment gap is. This is really the second pillar of purpose of the origin of the taxonomy, and that is to encourage financial close, mainly in the private sector, toward these areas of green growth.
With those two efforts in mind, you can focus very clearly on what you need a taxonomy to do, and that is it’s a performance measure for whether or not there is a substantial contribution being made to an environmental objective. And that becomes the benchmark, a performance benchmark and these set up as the basis of the metrics that we use in the taxonomy today.
Tomlinson
That’s incredibly helpful framing to get us into the conversation about how the taxonomy works. We’re all aware that there are these concerns around greenwash and lack of context, and concerns around the integrity of products in the ESG space, but also, that we have this broader kind of existential set of objectives which is to realign our economies with what our planet can tolerate. Ultimately, what our complex intermediated financial markets need are a set of tools to help them on the way to applying capital to align to those objectives. It’s a complex role that the taxonomy is seeking to play. So, Nathan, can you give us a flow of how the taxonomy is structured?
Fabian
There are six environmental objectives and the idea is that you would demonstrate a substantial contribution to one of the six environmental objectives. And those are issues, like climate change mitigation, climate change adaptation, water, circular economy, pollution and biodiversity. All of these objectives are now important in our modern economies. You must substantially contribute to one of those and do no significant harm to the other five, and that’s the key part of the framework structure.
There are some additional elements. You must observe some minimum safeguards, which are the Organization for Economic Co-operation and Development (OECD) guidelines and the UN guiding principles that relate to human and workplace rights, and these are, essentially, due diligence requirements. The idea is this is a sustainability taxonomy. You’ve got to think of the multiple environmental objectives and minimum performance standards on the social side. That’s how it works.
Within that framework, we developed performance criteria. For example, energy generation, electricity generation shouldn’t emit more than 100 grams of CO2 emissions per kilowatt hour. If you can be less than that, you can be called green and sustainable. If you emit more than that, there’s a question of how bad it is, how high the emissions are, and if you’re worse than 250 grams, you’re doing significant harm to our climate goals. Similarly, on road vehicles, if you’re a zero-emissions vehicle either through battery use or hydrogen or biofuel, and you’re zero emissions, then you get to be called green and sustainable. This is a what technical screening criteria is. It just says what you have to do in order to be considered objectively green and environmentally friendly.
Tomlinson
That’s great and very clarifying. What you’re saying is you have an environmental objective. In pursing that environmental objective, you can’t harm the other environmental objectives. In pursuing the environmental objective, you can’t treat your workers badly and so on. You then have to hit the science-based technical screening criteria which can be, as you said, just the way you’re doing the activity. That feels like a very logical and thoughtful flow. What we could try to do is use a couple of high-level illustrative examples. And I wanted to test one with you and you can tell me if you agree. So, let’s say that someone was wanting to pursue the objective in relation to forestry. They said they were going to pursue an afforestation project, planting forests in areas where there was not forest before. That would seem to be absolutely a taxonomy-aligned activity. Potentially. (Laughs) However, your proposed afforestation project is going to be located on a historic carbon sink peat bog and you’re proposing to plant the trees using child labor. That shows that you can have an economic activity, which is clearly eligible for taxonomy, but doesn’t get through to being taxonomy aligned. Do you agree that is a fair-ish high-level working of the taxonomy? And can you use that as an opportunity to explain this difference between eligibility for the taxonomy and alignment for the taxonomy? Which is something that’s important at this stage of the regulation.
Fabian
It’s a good example. This is one of the strengths of the taxonomy. It provides you an explicit benchmark that you can compare any question with and see how it would apply. In this specific example, the criteria on forestry actually describe the net improvement of emission production, if you want to claim that you’re making a substantial contribution to climate change mitigation. And so, you have to demonstrate the net improvement. Under your example, the net improvement is questionable and you couldn’t demonstrate it for decades potentially. That’s not going to pass the criteria on the climate mitigation substantial contribution side. And on the use of child labor, there is a requirement to identify, disclose, and redress or mitigate that practice. The guidelines on this are explicitly clear. You would not be able to claim that you were aligned with or meeting the screening criteria.
In order to help the market use the taxonomy, the first disclosed step is to say, do you have activities in these economic activities at all? If I’m a corporation and 50% of my revenue comes from forestry, then I’m required under the disclosure obligation is to say, yes, 50% of my revenue comes from forestry activities.
The next question with disclosure starting in subsequent year is, what proportion of your forestry activities meet the technical screening criteria? The forestry on the peat bog example, that doesn’t meet the criteria. I’ve got afforestation activities in suitable land, and I can demonstrate a net improvement in climate change mitigation through sequestration and here’s my reporting framework around that. Let’s say half of my forestry activities meet the criteria, then that company can disclose to the market and say a quarter of my revenue comes from green forestry. And then I can sell a financial product, an investment in that company to say, well, you’re going to have exposure to a company with this level of green revenue. It starts to become really clear, both for the company, for the sale of the financial product, for the investor, and of course, for the market supervisors who are trying to make that this whole thing maintains its integrity.
Tomlinson
That’s incredibly helpful. It indicates that there’s a flow to this, you can follow it through the structure and then you’re aligning how your activities relate to the taxonomy. Stepping back, how much of the EU economy does the taxonomy bind upon? I believe it’s 13 sectors that are technically covered within the taxonomy. I just wanted to understand if the plan is to then extend the taxonomy to the full scope of EU economic activities.
Fabian
When we started developing criteria, we started with the heart of the industrial economy: manufacturing, energy, buildings and built environment, transport, and agriculture. There is significant majority coverage of the economic output of Europe has some coverage in the taxonomy or will be able to identify their activity in the taxonomy. The things that are not really included at all are services. So, education, health, consulting — these types of services are not really taken up, because they don’t have a high direct exposure on, say, climate change mitigation. With climate, we went to where the impact was and that’s why we’ve covered those particular sectors. So, our estimate is that around about 60% of the EU economy is covered with activities, but up to about 40% can’t find itself in the taxonomy at all at this stage. But that will eventually grow.
Tomlinson
If you take an apportionment of GDP, let’s say 60%, which is in the taxonomy, but then given the way you’ve allocated the taxonomy to those sectors, you’re catching a much higher percentage of overall GHG emissions.
Fabian
That’s exactly right. We’ve covered sectors that already are responsible for more than 80% of Europe’s emissions. We’re developing new criteria all the time, so that number will creep up. Emissions is quite different, say, by diversity impacts, where we expect to have a much smaller proportion of the EU economy that actually has a high environmental impact. So, you’re going to get smaller coverage numbers than some of the other sectors. That’s important to know. We’re trying to find ways for sectors that are not covered to, basically say, there’s nothing for me to report here, it’s not relevant to me. The largest portion of the economy is covered. And we expect that to grow as more activities are added.
Tomlinson
We’ve had, essentially, a first round of taxonomy reporting by EU companies. The first round, it was mandatory for companies to report on the eligibility of their activities to the taxonomy, provided they’re in one of the 13 sectors that the taxonomy binds. But some companies that want to lead in the ESG and sustainability space went a little further and have reported on the alignment aspects of their activities to the taxonomy. And speaking to some investment managers who had kind of looked at some of the first rounds of those disclosures, really interesting to see how some companies, if you say, the auto sector, who have currently low levels of alignment to the taxonomy in terms of their activity in single figures potentially.
Then if you look at their future CapEx plans, it’s a very different, much higher number. This is one of the things the taxonomy is trying to do. This business has really low alignment now, but they’re actually deeply committed to a strategy. That means they’re increasingly aligned and accelerating alignment over time. As someone who is deeply implicated in the design and rollout of the taxonomy, I wanted some thoughts from you on that first round of disclosure and where that could potentially take us.
Fabian
I think that companies are learning. The first round of disclosure, sometimes it will be hard to get data. We expect it to take a couple of years for this really to get in, that’s normal and I think the European market supervisors know that they need to have some leniency in the first couple of years.
You’ve hit on a key point because companies are interested in transitioning. That’s ultimately what they want to do. Having a low taxonomy alignment number today is not a problem, as long as you’ve got a good CapEx or transition story. If a company can say we get it, we understand that our business affects climate change mitigation through emissions, and pollution, and we have some targets, a long-term strategy that will see us operating in a sustainable way, the investor is logically going to say, demonstrate it, tell me what that looks like in practice. CapEx is really the gold mine of information here for investors and for the market. So, if you can demonstrate that you’re allocating your future spending to meeting targets in future, you can claim that CapEx is taxonomy aligned and sustainable. That’s the really good news story here. Whatever the number is today of our taxonomy alignment, if you’ve made a thoughtful and accurate disclosure, the market is already going to appreciate it. Then if you can demonstrate a good transition plan through your CapEx spend, you’re going to attract investors.
We encourage more transparency than companies are used to having. I’d put it to the companies listening that this is what, to raise capital in future and keep customers loyal in future, you need to be demonstrating in some way how you’re grading your business. This is a great way to do it for the markets. And it’s why low-alignment numbers today are not necessarily a problem.
We estimate that the typical investment portfolio is going to be somewhere between 5% and 10% taxonomy aligned. That’s common across the market. So, no one’s going out there and saying, apart from very specialist companies and investors saying, look, we’re 80%–90% green. That’s just not what’s happening here. These are low-alignment numbers today with really good CapEx and transition stories. That’s how to think about.
Tomlinson
And for investors, looking at those alignment numbers and those future CapEx plans, that can really help them work out which part of their investment strategies particular companies go into in their portfolio. Is it going to be those funds which have the higher ambition in terms of sustainability or is it going to be those funds that are just associated with ESG? Then there’s companies that aren’t aligned to transitions that could go into non-ESG screened funds. Although, those are unfashionable right now looking at funds flows. This is a great place to talk specifically about some of the implications for US companies through the taxonomy. We’ve been talking about the SEC’s climate proposal and the broader rulemaking ambition of the Securities and Exchange Commission (SEC) in the US, but in the EU, we have the Corporate Sustainability Reporting Directive, which builds off the Non-Financial Reporting Directive. One of the things the CSRD does is that it scopes in a much greater number of companies on the basis of being located in the EU and whether you meet two out of three qualifying criteria to report under the CSRD. And that’s basically based on your balance sheet, your revenues and your average employees in the relevant year.
For US-headquartered companies with significant footprint in the EU, high likelihood that a significant number of your EU-incorporated subsidiaries are going to be scoped into CSRD. That gets you reporting against, depending on the size of the entity, whichever is the relevant set of the European Sustainability Reporting Standards.
One of the requirements in CSRD is that companies scoped in, also report on taxonomy alignment. Your EU-located companies are going to have to have taxonomy disclosures. Those are going to be not just about eligibility for the taxonomy, but also alignment of the taxonomy. Nathan, I just wanted to get your reflections on what the EU is trying to do by scoping in such a larger group of companies and some of the broader implications of that.
Fabian
The real reason here is, I think, that you don’t want to exclude medium-size enterprise and smaller enterprises from attracting capital. We all know there’s going to be a reporting burden, but the truth is we can’t just target large companies on this. You’re not going to get the dynamism you want in your economy by attracting flows to greener businesses. That’s the main reason. The additional factor to be mindful of here is that EU domicile companies, who have large supply relationships with US companies, are also going to be asking those US companies to give them data that they can take up in their disclosures. They’re obligated by law to do this — to get the data to disclose it and it must be true and fair. Even if you’re not domiciled, but if you have customers in the EU, you’re going to be asked for data. The Brussels effect on this one is actually quite far reaching, in addition to the 45,000 European-domiciled companies that are likely to be required to have disclosures.
Tomlinson
That’s great. This reflects the way in which the way we think about ESG is changing, which is for many years, we talked about ESG at the issuer level, at the level of the company. Let’s get a company disclosing about its operations. An exception to that rule perhaps Scope 3 in the GHG protocol which is obviously a value chain construct. What the EU is doing, and also in the EU Corporate Sustainability Due Diligence Directive, is that the focus is now on the value chain. And if you look at studies, the same concept would apply to the US economy as to the EU, 80% of value chain impacts of EU economic activity, they sit outside the EU potentially in the broader value chain across a whole range of sectors. This is what the EU is trying to get at. And this is the issue about context, placing sustainability in context, and having an objective set of science-based criteria about what’s green and what isn’t green.
I’ve found this conversation extremely helpful, Nathan any kind of parting thoughts about how you expect the taxonomy to impact behavior in the future. And on what the future for your work in the EU Sustainable Finance Platform looks like.
Fabian
Thanks, Brian, it’s been great to talk to you today. The really interesting thing about this reform is that it requires an objective assessment of environmental performance. In business we used to say, well, what’s the regulation requirement to do, or if there was some kind of pricing or tax, what are the limits of that and how is it going to affect my financial position? These reforms around taxonomy are really requiring an objective assessment of, am I making the environment better or worse? I have to tell that story in an objective way. This is a new part of how the market is working and it’s important to see this is a more substantial lasting reform. Because the regulatory environment changes, and the pricing schemes and taxes change, but the environment and performance limits and requirements, they just continue to get more acute. This is really part of the future of corporate activity and financial markets. It’s actually being able to tell objectively what the environmental performance is. That’s the key idea. That’s why it is going to be a lasting reform.
What we expect to be doing is further embedding the taxonomy in all of Europe’s other financial reporting obligations, so that the linkages are explicit, but also that they’re more usable. The concepts around, say, significant harm are the same in the taxonomy as they are in the Sustainable Finance Disclosure Regulation and people know what to do with that — not to report the same thing two different ways. That’s what we’re really going to be focusing on next, is improving the usability and the embedding of this kind of reporting in the other tools. Corporate disclosure, disclosure standards, corporate reporting, financial product disclosures, investment advice by advisors, even the market supervisors are saying they’re going to use this performance information for potentially banking, capital requirements. This is what’s going on next. It’s the embedding of this kind of approach. Because ultimately, the policymakers in Europe realize that you need markets to be good at this. You need them to be able to work out these objective environmental performance standards and make judgements on that basis. We know it’s going to be a couple of years of implementing this to get it right, but the resolve seems to be clear and the influence is obviously going to be great.
Tomlinson
We’ve often talked about ESG as being a whole firm concept, cross-functional collaboration, everyone has to be involved in order for it to work. And there are challenges for that inside every issuer. At the regulatory level, sustainable finance is a whole system concept because it implicates everything. It implicates fiduciary duty, corporate governance. And in terms of the way the EU regulation is constructed, there are these necessary ways in which information flows together. The CSRD is providing information which is necessary for investors to report against the SFDR, and the taxonomy provides key links in terms of how you establish whether or not that activity is green or not. It’s quite a seamless system, but as with any new regulatory development, you have a couple of complex system change years to implement these new regulations, but the information it creates, the forcing function to change, and then the long-term benefits are of more sustainable practice, will inure to the benefit of many corporates and many investors, and broader society too.
Nathan, thank you so much for being with us.
Fabian
Good to be with you, Brian.
Corson
The EU taxonomy will have an impact on companies and their stakeholders throughout the reporting chain, and the taxonomy is proving to be a catalyst for further harmonization of standards throughout companies’ investment cycles in and beyond reporting.
Thank you, Nathan and Brian for sharing your perspectives on this important ESG reporting topic. If you’ve enjoyed this episode or any other episodes, please subscribe or leave a rating or review, and watch out for more episodes from our special ESG reporting series. You’ll find relevant related links at ey.com/betterfinance.
Thank you to all our listeners for your ongoing support. I look forward to speaking with you on the next episode of the Better Finance podcast, a series that explores the changing dynamics of the business world, and what it means for the finance leaders of today and tomorrow.
