How the EU Taxonomy impacts sustainability reporting

Brian Tomlinson, Managing Director and ESG Thought Leader at Ernst & Young LLP, explained that the EU Taxonomy’s scoping is broadly consistent with the Corporate Sustainability Reporting Directive (CSRD) (i.e., if a company is required to comply with CSRD, they will be required to comply with EU Taxonomy, although the EU Taxonomy may apply more broadly to regulations beyond the CSRD) and that disclosures will be included as part of the CSRD reporting. Companies may want to evaluate consistency between reporting under EU Taxonomy and the European Sustainability Reporting Standards (ESRS), both in terms of data points to consider and the outcomes of the double materiality assessment.

“The EU Taxonomy essentially asks companies two questions. First, are you conducting activities that can contribute to the EU’s sustainability objectives? That’s the concept of ‘eligibility.’ And second, are you doing those activities in a sustainable way? That’s the concept of ‘alignment,’” Tomlinson said. Companies will report certain KPIs related to both of these concepts (discussed further below).

As such, the EU Taxonomy is creating the notion of “green by law.” For eligibility, companies report whether they are conducting activities that make a substantial contribution to one or more of six environmental objectives:

• Climate change mitigation
• Climate change adaptation
• Sustainable use and protection of water and marine resources
• Transition to a circular economy
• Pollution prevention and reduction
• Protection and restoration of biodiversity and ecosystems

The activities that are included under each of the six objectives are specific to the relevant objective. For example, climate change mitigation activities are clustered in sectors that are heavy greenhouse gas (GHG) emitters, such as manufacturing, transport, energy and buildings.

To determine whether an eligible activity is being conducted in a sustainable way (to become an aligned activity), it must pass through a three-step assessment:

• Technical screening criteria: To have a substantial contribution to one of the six environmental objectives, the activity must be done by reference to specific environmental criteria (e.g., not emitting more than specific amount of GHG emissions per unit of output).
• Do No Significant Harm (DNSH): In contributing to one objective, it is important not to undermine the other five objectives. The EU Taxonomy provides criteria to assess this, from conducting climate risk assessments to avoiding pollution.
• Minimum social safeguards: In contributing to climate objectives, it is important to avoid social and human rights harms. The EU Taxonomy references a range of soft-law instruments, such as the Organisation for Economic Co-operation and Development’s guidelines for multinational enterprises, to assess this.

The EU Taxonomy requires companies to report on the degree of taxonomy alignment against a highly granular set of KPIs on the share of sustainable activities (both eligible and aligned) by revenue, capital expenditure and operating expenses. These disclosures provide detailed insight into the amount of green revenues that companies have today, and (through the capex disclosures) their plans for increasing green revenues.

EY presenters discussed the intricacies of assessing eligibility for the 151 economic activities outlined in the EU Taxonomy. The regulation is complex and there can be many judgment calls in assessing whether an activity is eligible (even before it has been assessed for alignment). Companies should invest time in a thorough eligibility assessment, starting with a high-level mapping exercise to identify activities engaged in by the company. Once that pool has been identified, companies can narrow the list of eligible activities to those impacting the three KPIs. This process helps companies arrive at a final, smaller subset of eligible activities, which can then be assessed in detail for alignment with the EU Taxonomy's criteria.

“Historically, companies have struggled to communicate the sustainability of their product portfolios,” said Anne Munaretto, a partner, in Climate Change and Sustainability Services at Ernst & Young LLP. That is partly a result of companies using proprietary criteria to determine the “sustainability” of their products. By providing a standard for companies to align with, the EU Taxonomy offers a comparable way to report sustainable revenue or R&D efforts. The detailed criteria help companies with diverse product portfolios make sustainability claims with a methodology that investors and customers understand.

The EU Taxonomy should also benefit companies that are in the process of a low-carbon transition by allowing them to showcase their transition plans. Companies with low green revenue but high-aligned capex can use the EU Taxonomy to demonstrate their transition toward sustainability. Leading institutional investors have begun to use EU Taxonomy disclosures to assess the speed and quality of corporate transition plans.

The EU Taxonomy also interacts with the availability of sustainability-linked finance. For example, in the EU, investment funds seeking to substantiate their claims as “sustainable” are referencing EU Taxonomy criteria. The type of activities that EU Taxonomy covers may also align to green investment tax incentives. “There continues to be significant appetite around ESG investments,” Munaretto said.