Green taxonomy: Challenges and opportunities in an uncertain regulatory framework

What is European Taxonomy?

To achieve its 2030 climate goals and reach carbon neutrality by 2050, the European Union has no choice but to rely on investors and companies to redirect capital flows toward sustainable activities. However, until recently, no standards or regulations clearly defined what constitutes a sustainable activity. To fill this gap, the European Commission created the concept of ‘green taxonomy’ as early as 2018, aiming to define “a common system for classifying sustainable economic activities”. [1]

What is meant by sustainable activity according to the taxonomy?

In June 2020, the European Parliament and the Council adopted a regulation that defines this taxonomy.

The work conducted by a group of experts, known as the Technical Expert Group (TEG), has established the rules: for a company to be aligned with the European taxonomy (and thus be considered sustainable), it must meet several criteria.

It must fulfill at least one of the following six objectives without significantly negatively impacting the other five (the principle of “do no significant harm” [2]):

  1. Mitigating climate change.
  2. Adapting to climate change.
  3. Sustainable use and protection of aquatic and marine resources.
  4. Transition to a circular economy.
  5. Pollution prevention and reduction.
  6. Protection and restoration of biodiversity and ecosystems.

It must adhere to what are called minimum safeguards, particularly regarding human rights, social rights, and labor rights.

In addition to the so-called “sustainable” activities, the taxonomy defines two other categories of activities that are equally essential for the necessary transition.

First, “enabling activities”: activities considered non-sustainable under the taxonomy but that enable the development of sustainable sectors that, in turn, contribute to one of the six objectives. For example, components or fuels necessary for these sectors.

Lastly, “transitional activities” for which there is no viable low-carbon alternative, but they commit to using the best available techniques to limit their impact. For example, the production of recycled aluminum. [3]

Where is the regulatory process currently standing?

The regulatory process was initiated several months ago. Following the publication of the recommendations from the Technical Expert Group (TEG) on the selection criteria for activities contributing to the first two climate-related objectives, two acts have been adopted so far, in June and July 2021.

The first act defines the list of eligible activities, and the second clarifies climate-related reporting requirements. [4]

Currently, nearly 80 activities have their alignment criteria fully defined. The ongoing process will gradually expand the regulation and criteria.

The most recent publication is that of an additional delegated act, which includes gas and nuclear energy as transitional energy sources. The next step is the framing of activities related to agriculture, expected to be released in 2022.

Therefore, financial actors and non-financial companies need to prepare for publishing information for the 2021 reporting cycle within this evolving regulatory framework.

What obligations do companies have?

All companies subject to the NFRD (Non-Financial Reporting Directive) must disclose, within their Non-Financial Performance Statement (DPEF – France), the share of sustainable activities as a percentage of 1) their revenue, 2) their CAPEX [5], and 3) their OPEX [6].

For this first year of publication, the reporting for 2022 on 2021 has been simplified. It only covers the first two objectives of the taxonomy, those related to climate change. It focuses on the proportion of activities eligible for the taxonomy, not necessarily those already aligned. In general, regulators have emphasized the importance of narrative elements, through which companies will need to detail the assumptions made to identify eligible activities and calculate various KPIs.

In 2023, only the first two objectives related to climate change will remain relevant, but the reporting will be on activities aligned with the taxonomy. In addition to identifying their eligible activities on the predefined list, companies must ensure that these activities meet the criteria for substantial contribution to one of the objectives, the “do no significant harm” principle, and the minimum safeguards. For this second exercise, companies will be required to use the reporting template established by the Commission.

Starting in 2024, the next four taxonomy objectives will be gradually integrated into the scope of the exercise.

Concretely, how should one organize?

For businesses, the exercise involves identifying which of their activities are eligible, meaning they appear on the list published by the Commission, and among these, which ones align with the taxonomy, meaning they meet the objectives mentioned earlier.

Concretely, a transport company whose activity is eligible under the green taxonomy will logically have a significant portion of its revenue subject to the reporting requirement on eligibility. However, to determine if its activity aligns with the taxonomy, it will need to define if the modes of transport used meet the criteria established for that activity, such as for transport, meeting the CO2 emissions threshold, set at 50 g/km.

Once the scope of aligned activities is identified, the next step is to gather the associated accounting data.

There’s one important point to note: in the absence of revenue eligible for the taxonomy, a company is not necessarily exempt from all reporting requirements. It may still have eligible CAPEX or OPEX. In fact, a company can have activities that are not considered sustainable but invest in or have expenses related to sustainable activities (CAPEX for thermal renovation of its buildings, OPEX for research and development).

The difficulties faced by businesses

They are largely related to the framework of the exercise, where the rules are not entirely set and still leave room for uncertainty. There is uncertainty about the timetable, as already mentioned, and also about the implementation details, for which requests for clarification are expected.

Regarding financial indicators, the definitions of revenue and CAPEX align with those of Directive 2013/34/EU and IFRS standards, which are already regularly reported by companies. However, with respect to OPEX, the definition is less clear and poses difficulties; several stakeholders have even criticized a lack of consistency.

In calculating the percentage of green revenue or green CAPEX/OPEX, after determining the denominators, the main difficulty faced by companies is calculating the numerator, which initially involves identifying these activities eligible for the taxonomy. To do this, the EU proposes using an equivalence table of activities based on NACE codes, but these codes may not always be sufficient to identify eligibility: they are not detailed enough, too macro, and companies struggle to make sense of them.

The analysis of each activity, its compliance or non-compliance with alignment criteria, which can be complex or poorly documented, will also require a considerable amount of time, at least in the initial reporting.

The next step, which involves realigning environmental criteria and accounting language, also presents some obstacles. It essentially requires close internal dialogue between management controllers, accountants, and CSR teams, a dialogue that is not yet always established in companies.

Finally, for entities involved in more than one activity, the volume of data will be significant, and sources of information will be multiple. Such data processing will likely require the use of suitable data collection, consolidation, and reporting tools. This digitalization and industrialization of information collection and processing processes will be even more necessary, especially since, from 2024, there will be a demand to analyze the evolution of KPIs over time. While no verification is required for this 2022 reporting, it is highly likely that future requirements will become more stringent, resulting in an increased need for the auditability of practices and published data. The lack of data and their lack of robustness can also be a hindrance to alignment.

Opportunities for Businesses

More than just a constraint, the European Green Taxonomy should be seen as a new framework that enables companies to (re)think their strategies in a sustainability context and make themselves more appealing to investors.

There are co-benefits to seize, such as gaining a better understanding of their business details and bridging the gap between financial and CSR teams, which is increasingly necessary as integrated reporting becomes more widespread. It also helps with better allocation of resources and investments, identification of cost-saving opportunities (such as investing in less energy-consuming technologies), and even exploring new markets for more environmentally friendly products.

Beyond the regulatory imperative and even if it’s not directly involved, a company enhances its attractiveness when it incorporates the taxonomy framework. By displaying a significant share of sustainable activities or investments, it demonstrates its commitment. This opens the door to accessing financing at more favorable rates, like green loans, and sets it apart in procurement processes. Moreover, thanks to the influence of the European Taxonomy, it strengthens its status as a pioneering European company to attract foreign investments.

Conclusion

It is in an evolving regulatory context that companies will commence their 2021 Taxonomy reporting. They will need to make significant investments, even though the rules for this year have been simplified. In the long run, they will also need to equip themselves and invest in tools if they want to meet the increasing requirements, such as the integration of the four other environmental objectives of the taxonomy.

This process will primarily be an opportunity for them to rethink their strategy, reaffirm their commitments, and enhance their attractiveness to stakeholders. This, in turn, offers opportunities in terms of cost reductions, new markets, and financing.

[1]https://finance.ec.europa.eu/sustainable-finance/tools-and-standards/eu-taxonomy-sustainable-activities_en

[2]https://commission.europa.eu/documents_en

[3]-[FR]https://www.vie-publique.fr/questions-reponses/283166-neutralite-carbone-la-taxonomie-europeenne-en-six-questions

[4]https://eur-lex.europa.eu/legal-content/FR/TXT/?uri=CELEX%3A32021R2139&qid=1641376327393

[5]CAPEX, short for “capital expenditure,” refers to the total expenses related to both tangible and intangible investments dedicated to the purchase of professional equipment.

[6]OPEX, short for “operational expenditure,” refers to the operating expenses or routine charges incurred to operate a product, a business, or a system.

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