Taxonomy and green finance: Europe’s 4 basic steps for climate

Taxonomy and green finance: four fundamental documents were recently presented referring to the European Commission’s Action Plan for a greener and cleaner economy. The project that was initiated in March 2018, aims to channel capital towards a low intensity carbon economy.

In May 2018, the European Commission began implementing the first measures contained in the Action Plan, by introducing three regulatory proposals related to:

• the taxonomy of eco-compatible activities;
• low-carbon benchmarks and positive carbon impact;
• institutional investors’ disclosure on ESG risks.

The European Commission subsequently appointed the Technical Expert Group on Sustainable Finance (TEG), comprising a multi-stakeholder group of experts brought together by the Commission to establish the guidelines for sustainable finance in Europe and to provide consulting on four specific issues referring to: taxonomy, prioritising environmental issues and more specifically, on the mitigation and adaptation to climate change; improving the guidelines on reporting information related to climate by larger-sized and public interest companies (including banks, asset managers, insurance companies); the introduction of a European Green Bond Standard, namely European quality certification for green bonds; common criteria to build low-carbon benchmarks and a positive-carbon impact.

The TEG undertook to compile four reports on each of the subject areas specified by the EU Commission. On 18 June, two final reports were presented in Brussels, relating to Taxonomy and the European stand for Green Bonds and a provisional report on Climate Benchmarks and Benchmarks’ ESG Disclosures.

At the same time, the European Commission also presented the new guidelines for reporting climate information.

These four documents mark a further acceleration by Europe to comply with the Paris Agreement climate objectives (COP21).

The guidelines on reporting information on climate change

Starting with the proposals drawn up by the TEG, the European Commission published guidelines directed at companies, so that the latter could improve reporting on their impact on climate and the impact that climate change could have on their business.

The document contains practical recommendations aimed at facilitating businesses’ task in providing this important information, in line with the requirements set out in the Directive on Non-Financial Reporting (Directive 2014/95/EU) and to integrate the guidelines from the Task Force on Climate-related Financial Disclosures (Financial Stability Board TCFD). There are around 6,000 businesses, including listed companies, banks and insurance companies that are obliged to provide non-financial information on their environmental impact.

TEG Report on sustainable finance

In addition to the guidelines, the European Commission also published three reports on sustainable finance by the TEG work group. The first and probably the most important because it provides the basis for the others (and for the guidelines), is the one on European taxonomy that aims to define the classification system for sustainable economic activity from an environmental perspective.

We will look at how these reports are structured with regard to sustainable finance.

1. The technical report on European taxonomy

A practical guide and the only one formulated at European level, for policy makers, industries and investors, which aims to identify green economic activities. For the European Commission, this forms the basis for channelling private investments towards a low-carbon economy.

The document comprises 414 pages, in which the TEG defines the criteria for an activity to be defined as being “sustainable”. Namely one that has a positive impact on at least one of the 6 environmental protection objectives identified, without causing damage to the others.

The objectives include:

• mitigation of the effects of climate change;
• adaptation to climate change;
• sustainable use and protection of water and marine resources;
• transition to a circular economy, waste prevention and recycling materials;
• containment of pollution and protection of ecosystems.

In turn, for an economic activity to be considered sustainable, it must meet these four conditions:

• contribute positively to at least one of the six environmental objectives referred to above;
• have no significant negative impact on other objectives;
• comply with minimum social standards;
• comply with specific technical criteria (qualitative or quantitative, based on scientific evidence and on current market practices). These criteria can define whether an activity contributes positively (“substantially contribute”) or does not involve negative effects (“not significantly harm”) in relation to the environmental objectives.

The macro-sectors chosen by the TEG were: agriculture, forestry and fishing, manufacturing, electricity, gas, steam supplies and air conditioning; storage and transport; construction and property.

Based on the criteria set by the TEG, every company will be able to establish and report whether the activities it is involved in comply with the European Commission’s taxonomy. In particular, it can show which portion of turnover can be considered “sustainable” based on the taxonomy definitions.

2. The report on the European Green Bonds Standard

The second report refers to the “European Green Bond Standard” and defines clear and comparable criteria for the issuing of green bonds. In particular, by referencing the taxonomy, these standards attempt to determine which activities are deserving of being financed with a green bond.

Specifically, the TEG recommends that a Green Bond, according to the EU GBS, is defined as a bond or any debt security, whether listed or not, issued by a European organisation, non-EU or international organisation that meets these three requirements:

• specific declaration of issuer’s compliance with the EU GBS;
• use of income in green projects (financing and refinancing of new or existing projects);
• a recognised External Reviewer accredited with the competent European institutions will verify compliance with the EU GBS.

Based on market best practices, the EU Green Bond Standard identifies four key elements that must be respected:

• Compliance with European taxonomy;
• Disclosure of environmental objectives and strategy implemented to achieve these;
• Mandatory reporting on the allocation of resources and in environmental impacts;
• Mandatory check by External Reviewer.

In this report, the Commission sets the objective of supporting the green bonds’ market and increasing sustainable and responsible investments. The TEG further explained how this tool with the proposed characteristics, can contribute to overcoming the obstacles limiting the development of the green bond market and to increasing financial flows to green projects.

3. The (provisional) report on European climate benchmarks

The third report refers to “European benchmarks on climate and disclosure on benchmark Esgs”. Low-carbon benchmarks imply the “decarbonisation” of traditional benchmarks, or selecting securities associated with lower CO2 emission levels. Whereas positive-carbon impacts include activities that can avoid more emissions in relation to whatever is effectively being emitted: they therefore allow investors to compare the portfolios in the securities basket that contribute to creating scenarios that correspond with the Paris Agreement objectives.

The methodology specifies the technical requirement for the reference indices (benchmarks) that assist investors to invest in an effectively sustainable manner (and thus combat greenwashing). The report also defines the reporting requirements for benchmark Esg. providers.

To qualify as reference indices for the climate transition, these benchmarks must meet specific criteria, inter alia:

• show a significant reduction in the overall intensity of greenhouse gas emissions in relation to traditional benchmarks;
• be sufficiently exposed to the relevant sector to fight climate change;
• show their ability to reduce the intensity of emissions on an annual basis.

The way forward

The TEG mandate has been extended until the end of the year. Over this time, the work group will review the additional feedback received based on the relevant consultation process that will close on 13 September (Call for feedback on TEG report on EU Taxonomy) and prepare an implementation guide on taxonomy.  In September, a final report will be published that will serve as the basis for drawing up the European Commission delegated acts.

Finally, to implement the Paris Agreement and achieve the United Nation’s Sustainable Development Goals, the European Commission proposes increasing the advancement of climate programmes throughout Europe, raising the expenditure budget to reach climate targets to 25% for the period 2017-2021.