What are the implications of the Sustainable Finance Package for the Taxonomy Regulation?
With the Sustainable Finance Package, the European Commission (EC) adopts two Taxonomy Delegated Acts: (i) the Environmental Delegated Act and (ii) the delegated act amending the existing Climate Delegated Act. Together, the new delegated acts establish and further develop, respectively, the technical screening criteria defining whether certain economic activities align with the environmental objectives of the Taxonomy Regulation.
The new Environmental Delegated Act is the first regulation to define the technical screening criteria for the four remaining environmental objectives of the Taxonomy Regulation, in addition to climate change mitigation and adaptation:
- the sustainable use and protection of water and marine resources;
- the transition to a circular economy;
- pollution prevention and control; and
- the protection and restoration of biodiversity and ecosystems.
Following the adoption of the two Delegated Acts, the Taxonomy Regulation becomes relevant for a whole suite of new economic sectors and economic activities. Companies in scope of the Taxonomy Regulation that are active in any of these economic activities shall be required to assess and report their Taxonomy alignment from 1 January 2024 onward. Similarly, financial market participants must evaluate their Taxonomy alignment reports on their investments to include the new economic activities and environmental objectives to be recognized as environmentally sustainable, including activities and associated criteria for all six environmental objectives of the Taxonomy Regulation. As a result of the two new Delegated Acts, companies within scope of the Corporate Sustainability Reporting Directive (CSRD) will now also need to report on their eligibility for and alignment with the expanded Taxonomy Regulation in their annual reports.
What was the Taxonomy Regulation about again?
The Taxonomy Regulation is the dictionary defining the conditions under which an economic activity may be deemed environmentally sustainable. Certain large undertakings and financial market participants must disclose the degree to which their activities are Taxonomy aligned. By setting strict requirements on a classification as an environmentally sustainable economic activity, the Taxonomy Regulation aims to promote investments in these types of activities and mitigate the risk of ‘greenwashing’.
The Taxonomy Regulation sets out four overarching conditions that an economic activity must meet in order to qualify as environmentally sustainable:
- substantially contribute to at least one environmental objective of the following list:
- climate change mitigation;
- climate change adaption;
- sustainable use and protection of water and marine recourses;
- transition to a circular economy;
- pollution prevention and control; and
- protection and restoration of biodiversity and ecosystems.
- do no significant harm (DNSH) to any of the other environmental objectives;
- comply with minimum social safeguards, such as human rights and labour standards; and
- comply with the technical screening criteria set out in the delegated acts.
What changes have been made under the Taxonomy Regulation?
Amendments to the existing Climate Delegated Act
The Climate Delegated Act was already adopted and has now been updated as a result of the Sustainable Finance Package. The amendments to the Climate Delegated Act add more criteria for the two climate objectives that were already covered by the Taxonomy Regulation, i.e. climate change mitigation and climate change adaptation. Climate change mitigation refers to the reduction or prevention of greenhouse gas emissions, while climate change adaptation refers to the reduction of the negative effects of climate change or the exploitation of positive effects.
The amendments concern the technical screening criteria for maritime transport, which will be updated based on international standards and upcoming EU regulation. The updated technical screening criteria should ensure that the economic activity concerned has a positive impact on climate change mitigation or adaption. A review clause has also been included allowing for the revision of some technical criteria in light of technological developments and scientific evidence. For instance, the criteria for aircraft manufacturing will be reviewed by 2032 to ensure that they reflect the latest innovations and best practices in that sector.
The new Environmental Delegated Act
The new Environmental Delegated Act establishes the technical screening criteria for the four remaining environmental objectives mentioned above that were not yet covered in the Climate Delegated Act. For each activity, the regulation specifies the conditions under which it can be considered as substantially contributing to one of the four environmental objectives, as well as the criteria for ensuring that it does not cause significant harm (DNSH) to any of the other environmental objectives, i.e.:
- the sustainable use and protection of water and marine resources;
The delegated acts set ambitious standards for water transport, air transport, and the manufacture of components for low-carbon transport modes. In particular, “protecting human health from the adverse impact of any contamination of water intended for human consumption” as well as “increasing people’s access to clean drinking water” have been addressed in the new rules. Activities covered within this amendment are, among others, water supply, urban wastewater treatment and Sustainable Urban Drainage systems (SUDS).
- the transition to a circular economy;
The criteria for the transition to a circular economy require activities to improve resource efficiency, reduce waste, and enable circular business models, such as reuse, repair, remanufacturing and recycling
- pollution prevention and control;
The criteria for pollution prevention and control require activities to eliminate pollution in air, water, soil and food resources, as defined in relevant EU legislation and standards.
- the protection and restoration of biodiversity and ecosystems;
The criteria for the protection and restoration of biodiversity and ecosystems require activities to protect, conserve and restore biodiversity and ecosystems, as defined in the EU Biodiversity Strategy and Nature Directives.
In addition, the new rules determine whether an economic activity causes no significant harm to any of the other environmental objectives of the Taxonomy Regulation to ensure coherence between the activities mentioned in all Taxonomy Delegated Acts.
The updated Disclosures Delegated Act
With the new Environmental Delegated Act, companies will need to collect, report and analyse a significant amount of additional data to assess eligibility and alignment of their activities with the Taxonomy Regulation. To guide companies in this process, the new Environmental Delegated Act also amends the Disclosures Delegated Act by specifying the content, methodology and presentation of information to be disclosed by financial and non-financial undertakings concerning the proportion of environmentally sustainable economic activities in their business, investments or lending activities in their annual reports. Both reporting obligations and timelines for undertakings under the amended Disclosures Delegated Act are set out that apply to companies with respect to the new economic activities covered by the new Environmental Delegated Act.
How are ESG rating providers impacted?
ESG ratings are assessments of the sustainability performance and impact of companies, sectors or products, based on various indicators and methodologies. They are increasingly used by investors and financial institutions to inform their decisions and strategies, as well as by companies to benchmark and improve their sustainability practices. However, the ESG ratings market suffers from practices that can undermine the reliability and comparability of ESG ratings and create confusion and mistrust among users and providers of ESG ratings alike.
To address these challenges, the European Commission has proposed a regulation on the transparency and integrity of ESG rating activities,
which will require ESG rating providers to be authorised and supervised by the European Securities and Markets Authority (ESMA). The proposed regulation will also impose disclosure requirements on the methodologies, objectives, characteristics and data sources of ESG ratings, as well as organisational requirements to prevent and mitigate potential conflicts of interest. The regulation aims to increase the quality and consistency of ESG ratings, as well as to foster accessibility and innovation in the market, especially for smaller ESG rating providers.
What recommendations does the EC have for transitional finance?
The European Commission acknowledges that companies face significant challenges and costs when transitioning to a sustainable economy, such as identifying solutions, setting targets, complying with standards and accessing finance. To help overcome these challenges, the EC has issued recommendations to facilitate finance for the transition to a sustainable economy. This provides guidance to market participants on how to use existing EU sustainable finance tools to raise and provide financing for projects and activities that contribute to the transition to a climate-neutral and environmentally sustainable economy by 2050. The recommendations define ‘transition finance’ as the financing of climate and environmental performance improvements that are compatible with and contribute to the EU’s climate and environmental objectives, and that avoid lock-in effects.
Companies are encouraged, among other things, to use (i) green, sustainable, sustainability-linked and “other specific purpose” loans or bonds and (ii) the EU green bond standard. . Financial institutions and investors are encouraged to engage on the transition to sustainability on the basis of (i) lending strategies, (ii) engagement policies, (iii) the review of transition plans and sustainability reporting (e.g. under the CSRD) and ESG disclosure in prospectuses, and (iv) restricting new investments in or loans to potentially stranded assets.
How is SFDR impacted?
With the Sustainable Finance Package, the EC also aims to clarify some concepts that apply pursuant to the SFDR and Taxonomy Regulation to enhance the usability of these regulations.
The EC clarified how the ‘minimum safeguards’ that are a condition for Taxonomy alignment must be interpreted. Firstly, the minimum safeguards refer to international business conduct standards (e.g. OECD Guidelines). Secondly, an economic activity must be understood to adhere to the minimum safeguards requirement when it complies with the principal adverse impact factors that apply pursuant to the SFDR. A product that complies both with the applicable international guidelines and these principal adverse impact factors included in the SFDR, is deemed to comply with the minimum safeguards within the meaning of the Taxonomy Regulation.
In addition, the EC stated that investments that are Taxonomy aligned also qualify as a sustainable investment within the meaning of Article 9 of the SFDR. This means that Taxonomy aligned investments automatically fall in the “dark green bucket” of the SFDR.
How about (the risk of) greenwashing?
The Sustainable Finance Package of measures adopted by the European Commission expands and further develops and refines the rules applicable to companies transitioning to a sustainable economy. It is clear that the European Commission will continue to work on further improving and implementing the EU sustainable finance framework with a view to reducing (the risk of) ‘greenwashing’ across all economic activities and sectors.
Please do not hesitate to contact Stibbe’s Financial Markets team if you have any questions on the Sustainable Finance Package or other finance matters.
