Agreement reached on the final text of the EU taxonomy regulation

Summary

In December 2019, the European Council and the European Parliament reached political agreement on the text of a proposed Regulation on the Establishment of a Framework to Facilitate Sustainable Investment - the so-called "Taxonomy Regulation". The Taxonomy Regulation will establish an EU-wide classification system (or taxonomy) intended to provide firms and investors with a common framework for identifying to what degree economic activities can be considered to be "environmentally sustainable". Together with the Disclosure Regulation¹, the Taxonomy Regulation will require firms to disclose the degree of environmental sustainability of mainstream funds and pension products that are promoted as environmentally friendly, or to include disclaimers where they do not, as well as require firms which are subject to the Non-Financial Reporting Directive² to provide certain information in relation to the Taxonomy Regulation in their related filings. In addition, individual Member States will need to abide by the criteria of the Taxonomy Regulation in relation to public measures, standards or labels concerning financial products or corporate bonds offered by issuers and other financial market participants which are to be labelled as environmentally sustainable. The requirements relating to the climate-related objectives of the Taxonomy Regulation are due to apply from December 2021, with other requirements due to apply at the end of the following year.

Background

In March 2018, the European Commission (the "Commission") published its Action Plan on Financing Sustainable Growth ("Action Plan").

A key objective of the Action Plan is to reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth. The most important and urgent action envisaged by the Action Plan is the establishment of a unified classification system on activities qualifying as contributing to environmentally sustainable objectives. The Commission anticipates that an EU-wide taxonomy will have the benefits of both preventing the fragmentation of different Member States' systems and avoiding the practice of "greenwashing" – where a firm gains an unfair competitive advantage by marketing a financial product as environmentally friendly when in fact it does not meet basic environmental standards. Further, standardising the concept of environmentally sustainable investment across the EU and between Member States should facilitate investment in environmentally sustainable economic activities.

Following publication of the Action Plan, the Commission established the Technical Expert Group on Sustainable Finance (TEG) to help carry out its goals, including the development of the EU-wide taxonomy system of environmentally sustainably activities. The TEG published its report on the EU Taxonomy for sustainable activities in July 2019. The report contains (i) technical screening criteria for 67 activities that can make a substantial contribution to climate change mitigation, (ii) a methodology and worked examples for evaluating substantial contribution to climate change adaptation, and (iii) guidance and case studies for investors preparing to use the taxonomy. The TEG is expected to finalise its recommendations by February 2020³.

In addition to the Taxonomy Regulation, the Action Plan has instigated a number of other initiatives including the closely-related Regulation on the disclosures relating to sustainable investments and sustainability risks (the "Disclosure Regulation") and a Regulation amending the Benchmarks Regulation on low carbon and positive carbon impact benchmarks (the "Low Carbon Benchmarks Regulation")⁴.

Taxonomy Regulation

What does it cover?

The Taxonomy Regulation provides for a general framework for the development of an EU-wide classification system for environmentally sustainable economic activities. The Regulation does not itself establish a label for sustainable financial products. Instead, it creates a framework that sets out the criteria to be considered for a product or activity to be considered environmentally sustainable. The detail of what constitutes an environmentally sustainable activity or product will be built up gradually over time through complex delegated legislation.

The Taxonomy Regulation does not invalidate existing environmental labelling schemes of individual EU Member States or prevent new ones from developing; however, such schemes will need to be consistent with the criteria in the Taxonomy Regulation as to what constitutes environmentally sustainable economic activities.⁵

To whom does the Taxonomy Regulation apply?

The Taxonomy Regulation applies to:

• "Financial market participants" who offer "financial products": financial market participants (as defined in the Disclosure Regulation, and including most insurance, pension and portfolio management providers) will be required to provide in pre-contractual disclosures and periodic reports information on how and to what extent the investments that underlie their "financial products" support economic activities that meet the criteria for environmental sustainability under the Taxonomy Regulation. As defined in the Disclosure Regulation, "financial products" essentially includes: (a) a portfolio managed in accordance with mandates given by clients on a discretionary client-by-client basis where such portfolios include one or more financial instruments (b) an alternative investment fund (AIF); (c) an IBIP (being an insurance‐based investment product meeting certain criteria); (d) a pension product; (e) a pension scheme; (f) UCITS; or (g) a 'pan‐European Personal Pension Product' or 'PEPP'. For those financial products that do not invest in environmentally friendly activities, a disclaimer will need to be included by the financial market participant stating that the relevant investments "…do not take into account the EU criteria for environmentally sustainable investments."
• Financial and non-financial companies falling under the scope of the Non-Financial Reporting Directive: firms in scope of the Non-Financial Reporting Directive will need to disclose information on how and to what extent the undertaking's activities are associated with environmentally sustainable economic activities. The Commission will publish the detailed reporting requirements by 1 June 2021.
• Individual Member States and the EU with regard to existing or potentially new eco-labelling or other legislative measures: individual Member States and the EU must apply the criteria specified in the Taxonomy Regulation for determining environmentally sustainable economic activities for the purposes of any legislative or other measures setting out the requirements of issuers or other financial market participants in respect of corporate bonds or other financial products to label such products as 'environmentally sustainable'.

What types of activities qualify as environmentally sustainable activities?

The Regulation recognises six different types of economic activities which qualify as environmentally sustainable activities for the purposes of the taxonomy:

• climate change mitigation: the activity contributes to greenhouse gas stabilisation consistent with the goals of the Paris Agreement⁶, through certain prescribed means including, for example, the generation of renewable energy. The Regulation also accommodates activities for which there is no technologically and economically feasible low carbon alternative but which nevertheless support the transition to a climate-neutral economy in a manner consistent with a pathway to achieving the Paris Agreement goal of limiting the global temperature increase to 1.5 degrees Celsius above pre-industrial levels (for example, by phasing out greenhouse gas emissions), provided that certain criteria are satisfied;
• climate change adaptation: the activity includes adaptation solutions that substantially reduce the adverse impact (or the risk thereof) of the current and expected future climate on either (i) other people, nature or assets or (ii) the economic activity itself, in each case without increasing the risk of an adverse impact on other people, nature and assets;
• sustainable use and protection of water and marine resources: the activity substantially contributes to achieving the good status of water bodies or marine resources, or to preventing their deterioration when they are already in good status, through certain prescribed means, including, for example, through waste water management;
• transition to a circular economy: the economic activity contributes substantially to waste prevention, re-use and recycling, through certain prescribed means, including, for example, by improving the recyclability of certain products;
• pollution prevention and control: the activity contributes substantially to pollution prevention and control through certain prescribed means, including, for example, by preventing or (where that is not practicable) reducing pollutant emissions into air, water or land (other than greenhouse gasses);
• protection and restoration of biodiversity and ecosystems: the activity contributes substantially to protecting, conserving or restoring biodiversity and to achieving the good condition of ecosystems, or to protecting ecosystems that are already in good condition, through certain prescribed means, including, for example, sustainable land use and management.

What about "enabling" activities?

Other economic activities which directly enable any of the above six objectives (for example, building wind turbines) shall also qualify as environmentally sustainable activities, provided that any such activity (i) does not lead to a "lock-in" of carbon intensive or other types of assets that undermine long-term environmental goals and (ii) has a substantial positive environmental impact on the basis of lifecycle considerations.

What are the other requirements for an activity to qualify as 'environmentally sustainable'?

In addition to substantially contributing to one of the six objectives described above, in order to qualify as an environmentally sustainable economic activity under the taxonomy, the activity must also comply with each of the following criteria:

• no significant harm: the activity must not significantly harm any of the environmental objectives above. For example, an activity that leads to significant greenhouse gas emissions harms the climate change mitigation objective;
• comply with technical screening criteria: the activity must comply with technical screening criteria for each of the six objectives that will be specified by the Commission on the basis of the technical input of a multi-stakeholder Platform on Sustainable Finance (described below). The detailed screening criteria are meant to be updated regularly in recognition of the fast-changing nature of both science and technology, and will set out in specific detail the conditions to be met for an activity to constitute a substantial contribution towards one of the six objectives or that the particular activity is not resulting in significant harm; and
• minimum social and governance safeguards: the activity must be carried out in compliance with a number of minimum social and governance safeguards as referred to in the Regulation.

What about nuclear energy and natural gas, and activities which cause significant harm to environmental objectives?

Nuclear energy and natural gas are not explicitly excluded or included in the list of eligible environmentally sustainable economic activities. The Taxonomy Regulation leaves it to the delegated acts – to be based on the input of the stakeholders comprising the Platform for Sustainable Finance - to determine the role for nuclear energy and/or natural gas, if any, in the taxonomy. As described below, The Taxonomy Regulation incudes a review clause by which the Commission may extend the Regulation to cover other activities which cause significant harm to environmental objectives.

How will the technical details be progressed?

The TEG recommendations are the first input to the Commission's work on developing the future delegated acts. The TEG is expected to finalise its recommendations by February 2020.

However, the technical screening criteria and other elements of the delegated acts will be made by the Commission on the basis of the input of a new body to be established under the Taxonomy Regulation: the Platform on sustainable finance (the "Platform"). The Platform will be composed of public sector experts from the European Environmental Agency, the European Supervisory Authorities and the European Investment Bank and the European Union Agency for Fundamental Rights, together with private sector experts including financial and non-financial market and business actors and experts representing civil society, including those with expertise in the field of environmental, social, labour and governance issues.

What about social and other objectives?

The Taxonomy Regulation is expected to develop over time, both in terms of the detail of the technical requirements, but also in terms of the scope of its coverage. For example, by December 2021, the Commission is obliged to publish a report describing the potential for the further development of the current taxonomy and expansion of its scope beyond environmentally sustainable economic activities, in order to cover activities that significantly harm environmental sustainability, as well as other sustainability objectives, including social objectives.

Next Steps

The Taxonomy Regulation will come into force 20 days after its publication in the Official Journal. However, effectively the timeframe will be substantially longer as the requirements of the Regulation will apply only after the adoption of the delegated acts establishing the technical screening criteria for each environmental objective. These will be developed in two phases:

• The delegated act on the first two climate-related objectives (i.e. "Climate Change Mitigation" and "Climate Change Adaptation") should be adopted by the Commission by 31 December 2020 and will therefore apply from 31 December 2021.
• The delegated act on the remaining four environmental objectives should be adopted by the Commission by 31 December 2021 and will therefore apply from 31 December 2022.

Co-author: Catherine Lillycrop

1. Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector.
2. Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups, as amended.
3. https://www.icmagroup.org/assets/documents/Regulatory/Green-Bonds/EU-Taxonomy-Political-Agreement-ICMA-December-2019final-191219.pdf
4. See our briefing here: https://www.ashurst.com/en/news-and-insights/legal-updates/teg-releases-final-report-on-climate-benchmarks-and-benchmarks-esg-disclosures/
5. 'Hot topics: Regulating sustainable finance', Practical Law (https://uk.practicallaw.thomsonreuters.com/w-018-9850?originationContext=document&transitionType=DocumentItem&contextData=%28sc.Default%29&comp=pluk)
6. https://unfccc.int/process-and-meetings/the-paris-agreement/the-paris-agreement