Assessing the Impact of the EU’s Taxonomy Regulation

In effect since July 2020, the European Union’s Taxonomy is a classification system that provides a common language for what is environmentally sustainable. It is intended for financial products that have environmental sustainability as their objective or that promote their environmental characteristics. To understand what effect the Taxonomy is having on those products, on issuers and others, GLG’s Jaid Longmore, Client Solutions Manager in EMEA, recently conducted a teleconference with Christopher Boyd, a renewable energy expert and a former senior civil servant at the Environment Department of the European Commission in Brussels (see below for more). Edited excerpts of the discussion follow.

Chris, please start with some background.

In general terms, there’s a sea change going on worldwide. Things that are green, environmental, and ESG are becoming something seen as positive rather than negative. For the EU, the Taxonomy is part of an effort to direct capital toward green investment and away from unsustainable activities by countering green washing, fostering long-termism and, in some sense, better managing sustainability.

The first of the two main planks of the EU’s efforts are the Sustainable Finance Disclosure Regulation (SFDR), which was published in December 2019 and is now being applied. It covers necessary disclosures in prospectuses, portfolio management agreements, annual reports, and other financial documents. The second major plank is the Taxonomy regulation, which still has lots of technical details to sort out.

At the moment, all that is covered are climate-change mitigation and adaptation. Other environmental aspects will be added later, as will social and government aspects. The Taxonomy is rules-based and very detailed, with an emphasis on doing no harm. There are several technical annexes to the rule that contain all the details. If you investigate one requirement, such as composting bio waste, you can see how complicated following all these rules will be for the companies involved and for investment managers to get company data so they can meet their own various hurdles.

Two more thoughts. First, because of Brexit, the Taxonomy regulation obviously does not apply in the UK. Nevertheless, the UK intends to look into its own Taxonomy regulation and probably will incorporate much of the EU’s Taxonomy regulation into UK law. Moreover, any UK fund sold in the EU will need to comply with the Taxonomy regulation and use the same language. I should also point out that the U.S. Congress has asked the SEC to develop similar criteria in the U.S., so there’s a risk of different criteria in North America and Europe, which poses potential for problems in translating between the two.

Second, for corporate issuers and asset managers, the Taxonomy should help bring about clarity as to what can be labeled green, but there are going to be big problems of data reliability. Do companies have all the data they need? How will they get it? Will the data be controlled? How transparent will it be? Should companies themselves provide it? Yes, but then how is that controlled? Who audits this sort of stuff? Are there going to be ESG rating agencies? These are all unresolved issues.

What would be the correct way to assess a company that enables Taxonomy-eligible activities but is not eligible itself?

The Taxonomy, in one of its annexes, addresses that issue. What it says, in effect, is that if you are a company making widgets somewhere in a way that allows other companies to reduce their carbon emissions substantially, and if your widgets are vital to this greenhouse gas reduction, then that can be considered as eligible and making a substantial contribution, and therefore can be included in your green portfolio. All this has to be done with a life cycle assessment and validated by a third party. It’s not going to be simple. But the company concerned presumably will deal with that or some kind of Standard & Poor’s of the ESG world will spring up and do that.

When will companies and financial market participants need to start making disclosures based on the Taxonomy regulation?

At the moment, the deadline for starting disclosure remains January 1, 2022 — which seems like tomorrow. Nevertheless, I wouldn’t be surprised if discussions going on in Brussels lead to some kind of postponement, but that has not been announced. I know the commission doesn’t want to postpone, but I think there will be enough smoke and fog around the whole thing that the rules won’t be too strictly applied from the start; there will be some leeway. But most managers of green funds have got to start thinking seriously about it right now.

You touched on this briefly, but what extraterritorial reach will the Taxonomy regulation have?

If it’s a green EU fund or it’s being sold into the EU and its investments are in the U.S., the fund manager will have to make sure that the U.S. company it invests in, for example, is making a substantial contribution according to the EU Taxonomy. In that sense, the rules will have an extraterritorial reach, even though the U.S. company doesn’t have to comply with the EU Taxonomy. So, the company — let’s say a bio composting company in the U.S. — will have an incentive to show that its techniques respect the EU Taxonomy to have more people buying their shares, even if it’s in the U.S.

Similarly, EU funds investing in EU companies that have operations outside the EU will want to make sure those activities are still making a substantial contribution to mitigating climate change, according to the criteria of the Taxonomy.

Is there a way to ensure global harmonization of these taxonomies?

Various bodies are trying to coordinate this, and people in Brussels speak a very similar language to the environment people in Washington. But we’re a long way apart and there will be differences, which I hope are not too large. Let’s hope that we can evolve toward something that’s vaguely usable worldwide. But this is complicated, and there’s a big danger that there will be varying standards with varying language.

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About Christopher Boyd

Christopher Boyd was a senior civil servant at the environment department of the European Commission in Brussels. He has dealt with environmental policy development, focusing on issues such as green investment criteria, renewable energy, carbon trading, sustainability, resource efficiency, and biodiversity. Prior to rejoining the European Commission in 2011, Boyd worked for over 10 years in the renewable energy sector with expertise in multicultural deal making and implementation throughout Europe. He was Chief Executive Officer Italy for Airtricity (now SSE Renewables), a leading renewable energy company developing and operating wind farms across Europe, where he negotiated and set up a joint venture with a local partner in southern Italy. Earlier, he worked several macroeconomic issues at the EU, including the creation of the euro.

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This financial industry article is adapted from the March 24, 2021, GLG teleconference “The European Union’s ESG Taxonomy: What Is Green?” If you would like access to this teleconference or would like to speak with financial industry expert Christopher Boyd, or any of our more than 900,000 industry experts, contact us.