The Connection of EU Taxonomy, SFDR and CSRD
In July 2021, the European Commission delivered the European Green Deal, with the goal of Europe becoming the first climate neutral continent by 2050. It aims to ensure:
- no net emissions of greenhouse gases by 2050
- economic growth decoupled from resource use
- no person and no place left behind”
To reach the target of reducing emissions by at least 55% by 2030, – which all 27 EU Member States are committed to - the implementation of the EU Taxonomy, the Sustainable Finance Disclosure Regulation (SFDR), and the Corporate Sustainability Reporting Directive (CSRD) (currently called NFRD = Non-financial Reporting Directive) will support the European Green Deal. These being central elements of the EU Green Deal, will help reaching the transformational change.
Understanding the complexity of these disclosure requirements can be a challenging process. Due to this complexity, we have created this paper to provide more clarity for large companies, financial market participants, and SMEs regarding the interconnection of these requirements, implementation timelines, and benefits businesses can gain.
What is the EU Taxonomy?
The European Commission has published the EU Taxonomy Regulation and Delegated Acts in June 2020, which has entered into force in July 2020. The Taxonomy is a classification system and transparency tool to support reaching the objectives of the European Green Deal, by providing a common language for investment purposes regarding what counts as an environmentally sustainable economic activity. Therefore, companies can monitor and communicate their sustainable activities more concretely, which will help investors to direct investments towards sustainable activities and projects. The Taxonomy regulation will also enable comparability among companies and investment portfolios. Furthermore, the taxonomy can advance the SFDR and NFRD’s regulations, by requiring companies under NFRD and SFDR to comply with the disclosure requirements.
Three main criteria were developed to determine environmentally sustainable economic activities:
- Substantial contribution to one or more of the environmental objectives
- ‘Do no significant harm’ to any of the environmental objectives
- Compliance with minimum safeguards
An activity can be disclosed as taxonomy aligned when it meets all three criteria.
Information regarding the activities and the specific criteria applicable for them can be found on the European Commission’s website: European Commission – EU Taxonomy Compass
#1. Substantial contribution
The first criterion for taxonomy-alignment is that an activity needs to contribute to at least one objective, to reach the condition of substantial contribution. Each activity has specific criteria for substantial contribution. The taxonomy defines 6 environmental objectives. These are:
- Climate change mitigation
- Climate change adaptation
- The sustainable use and protection of water and marine resources
- The transition to a circular economy
- Pollution prevention and control
- The protection and restoration of biodiversity and ecosystems
The first two objectives (climate change mitigation and climate change adaptation) are included in a first delegated act approved in 2021, while the remaining 4 objectives are to be published in 2022.
Each objective has a specific set of criteria defined for an activity regarding how to substantially contribute to an objective.
If we take the activity “Renovation of existing buildings” as an example, within the “Construction and real estate activities” sector, the following substantial contribution criteria is applicable to this activity within the “Climate change mitigation” environmental objective:
“The building renovation complies with the applicable requirements for major renovations.
Alternatively, it leads to a reduction of primary energy demand (PED) of at least 30 %).”
#2. Do no significant harm (DNSH)
The second criterion for taxonomy-alignment is that an activity does not significantly harm any of the 6 environmental objectives. Each activity has specific criteria for DNSH.
DNSH includes three types of criteria:
- Qualitative: information through due diligence process
- Quantitative: requires verification
- Process-based: verification is more difficult, due to lack of provided information
By considering the same activity “Renovation of existing buildings”, one example for DNSH towards the objective “The sustainable use and protection of water and marine resources”, is the following:
“Where installed as part of the renovation works, except for renovation works in residential building units, the specified water use for the following water appliances is attested by product datasheets, a building certification or an existing product label in the Union, in accordance with the technical specifications laid down in Appendix E to this Annex:
- wash hand basin taps and kitchen taps have a maximum water flow of 6 litres/min;
- showers have a maximum water flow of 8 litres/min;
- WCs, including suites, bowls and flushing cisterns, have a full flush volume of a maximum of 6 litres and a maximum average flush volume of 3,5 litres;
- urinals use a maximum of 2 litres/bowl/hour. Flushing urinals have a maximum full flush volume of 1 litre.”
#3. Minimum safeguards
The third criterion for taxonomy-alignment is that an economic activity needs to be in alignment with the following minimum safeguards:
- OECD Guidelines for Multinational Enterprises
- UN Guiding Principles on Business and Human Rights
- Declaration of the International Labour Organization on Fundamental Principles and Rights at Work
- International Bill of Human Rights.
Enabling and transitional activities
Those environmentally sustainable economic activities, that contribute substantially to an environmental objective can be either enabling or transitional activities.
Enabling activities allow other activities to substantially contribute to an environmental objective by directly enabling them – as its name suggests. Enabling activities can be for example to install energy efficient equipment in buildings.
Transitional activities must contribute to the objective: climate change mitigation. Activities can be categorized as transitional, if there are no other low-carbon alternatives developed, and if their level of greenhouse has emission matches to the sector or industry’s best performance. Transitional activities can be for example best-in-class cement manufacturing.
The EU Taxonomy Compass also defines these activities.
Activities can be either taxonomy-aligned or taxonomy-eligible activities. While taxonomy-aligned activities meet all three main criteria, taxonomy-eligible activities only meet the criteria of “substantial contribution”, and not the DNSH and/or minimum safeguards.
Affected companies by the EU Taxonomy
The following companies are subject to mandatory disclosure requirements:
- Large financial companies (under the NFRD)
- Credit institutions
- Investment firms
- Asset managers
- Large non-financial companies (under the NFRD)
- Financial market participants
- EU Member States – “Setting public measures, standards/labels for green financial products/green bonds”
General disclosure requirements:
- Large financial and non-financial companies affected by the EU taxonomy are subject to disclosure regarding to what extent the implemented activities meet the set criteria. Furthermore, companies’ revenue deriving from sustainable activities should also be disclosed in %. The mandatory information should be disclosed annually in either a sustainability report, or the non-financial statement of the annual report. However, it is important to note that companies are not required to live up to a certain environmental performance under the EU taxonomy.
- Financial market participants must provide information regarding to what extent the activities funded by their financial products meet the criteria set out in the EU taxonomy. They must disclose information in all the following: periodic reports, pre-contractual disclosures, and on websites. However, it is important to note, that it is not mandatory for investors to invest in those economic activities listed in the EU taxonomy, nor are their financial products required to live up to a certain environmental performance. They can, however, use it as a guide, when aiming to invest in sustainable activities.
The following companies can choose to disclose voluntarily:
- Non-EU Companies
- Companies not covered by the taxonomy
Companies under voluntary disclosure can’t be forced by other companies to do so.
Timeline – EU Taxonomy
What is the Sustainable Finance Disclosure Regulation?
SFDR aims to increase transparency and reduce greenwashing among financial market participants, including financial products and advisors, by providing the possibility to compare disclosed information towards end investors. SFDR sets out different disclosure requirements for Article 6, Article 8, and Article 9 Funds. The level of sustainability disclosure requirements increases from Article 6 to Article 9 Funds.
Article 6 Funds
Article 6 Funds are required to provide transparency regarding how they integrate sustainability risks. They need to report in pre-contractual disclosures about sustainability risks in their investment decisions.
Article 8 Funds
Article 8 Funds (also called as ‘Light green’ funds) are required to provide transparency regarding “the promotion of environmental or social characteristics in pre-contractual disclosures”, “or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices”. Article 8 fund investments only consider ESG characteristics, without having a sustainable investment objective.
Article 9 Funds
Article 9 Funds (also called as ‘Dark green’ funds) are required to provide transparency (regarding “sustainable investments in pre-contractual disclosures”, “where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark”. Article 9 fund investments consider both ESG strategies and sustainable investment objectives.
Commonalities of Article 8 and 9 Funds
- There are three main platforms, where Article 8 and 9 funds need to disclose information: periodic disclosures, pre-contractual disclosures, and website disclosures.
- Website disclosures should be updated on an ongoing basis and should provide clear, concise, and accurate data.
Affected companies under SFDR
Financial market participants where they manufacture financial products:
- an insurance undertaking which makes available an insurance‐based investment product (IBIP)
- an investment firm which provides portfolio management
- an institution for occupational retirement provision (IORP)
- a manufacturer of a pension product
- an alternative investment fund manager (AIFM)
- a pan‐European personal pension product (PEPP) provider
- a manager of a qualifying venture capital fund registered in accordance with Article 14 of Regulation (EU) No 345/2013
- a manager of a qualifying social entrepreneurship fund registered in accordance with Article 15 of Regulation (EU) No 346/2013
- a management company of an undertaking for collective investment in transferable securities (UCITS management company)
- a credit institution which provides portfolio management
Financial advisers where they provide investment advice or insurance advice
- an insurance intermediary which provides insurance advice with regard to IBIPs
- an insurance undertaking which provides insurance advice with regard to IBIPs
- a credit institution which provides investment advice
- an investment firm which provides investment advice
- an AIFM which provides investment advice in accordance with point (b)(i) of Article 6(4) of Directive 2011/61/EU
- a UCITS management company which provides investment advice in accordance with point (b)(i) of Article 6(3) of Directive 2009/65/EC;
Financial advisers which employ fewer than three persons à although they are required to consider and factor in sustainability risks in their advisory processes.
Timeline – SFDR
What is the Corporate Sustainability Reporting Directive?
CSRD will replace the Non-Financial Reporting Directive (NFRD) with additional reporting requirements, due to the evaluated shortcomings of NFRD. Currently, NFRD is applicable to listed and large companies with an average balance sheet total EUR 20M or net revenue EUR 40M projected on a financial year, employing more than 500 employees (covering ~ 11,700 companies). These companies under NFRD are required to disclose how they impact and how they are impacted by social and environmental sustainability issues. However, NFRD is rather flexible in a way, that it allows non-disclosure of information, due to its nature.
To support the European Green Deal, the European Commission proposed to tighten these requirements by replacing the Non-Financial Reporting Directive with the Corporate Sustainability Reporting Directive. This means, that the requirements set out in NFRD will also be part of CSRD, including additional reporting requirements, such as machine-readable reports and third-party audits. The tighter requirements will also broaden the scope of the new reporting directive, covering ~ 49,000 companies. This will be achieved by including SMEs besides listed and large companies and lowering the amount of the previously mentioned balance sheet total and net revenue by exceeding the 2/3 of that amount, as well as lowering the required number of employees to 250. (The decrease in numbers is only applicable to listed and large companies, not SMEs).
Timeline – CSRD
Relation of the EU Taxonomy, SFDR and CSRD
The EU Taxonomy, together with the SFDR and CSRD are tools to support directing investments towards Taxonomy-aligned activities, by enabling investors to identify these activities. Companies under the NFRD (later CSRD), are required to disclose information under the EU Taxonomy. Financial market participants and advisors are therefore not only required to disclose such information, but also to collect such information from companies within their portfolio for example and disclose further information under SFDR towards end investors. (SFDR incorporates ‘environmentally sustainable economic activities’ that have been specified in the EU Taxonomy). Another link between the SFDR and the EU Taxonomy, is that specifications of the SFDR’s sustainable investments are outlined based on the EU Taxonomy’s DNSH criterion. This ensures that sustainable investments avoid significantly harming sustainable investment objectives. Financial market participants under the SFDR also have to disclose taxonomy-aligned investments.
Market participants can only make thoughtful investment decisions, if they consider both the disclosures under the EU Taxonomy and CSRD. This will ensure that market participants are well informed about how companies’ implementation of environmental activities takes place. Disclosures under the CSRD will provide more comprehensive information, complementing the EU Taxonomy’s classification system.
Benefits of implementing the EU Taxonomy in businesses
By implementing the EU Taxonomy, companies can:
- Identify sustainable environmental economic activities
- Increase environmental performance
- SMEs can increase obtaining investment opportunities
- Investors can recognize investment opportunities
- Institutional investors can fund taxonomy-aligned activities by tailoring their financial products
- Have the possibility to get better interest rate on loans regarding taxonomy-aligned activities (planned or ongoing) – will depend on banks, however
- Companies not covered by the taxonomy can still implement it --> “could use it for some of their expenditures into output of other activities that are Taxonomy-aligned” (e.g.: buying solar panels from manufacturers, whose activity regarding solar panels complies with the EU Taxonomy)
- Inform investors and stakeholders about planned or ongoing taxonomy-aligned activities.
Using the criteria defined in the EU taxonomy can help companies to define strategies towards sustainable transition.
At the moment, there are no known legislative sanctions regarding non-compliance with the EU Taxonomy, which can be due to the fact that its development is still ongoing.
Investors require more and more sustainability information and consider more to invest in sustainable companies. Therefore, companies can gain competitive advantage by applying the criteria laid out in the taxonomy, as it is suggested to provide as much information as possible. Furthermore, its application can lead to avoiding potential negative effects on PR activities, that might happen in the future by not complying.
With regard to the development of the EU Taxonomy, there are discussions within the European Commission about developing a social taxonomy as well. It might have the same requirement framework as the environmental taxonomy with adjustments to social aspects. The EU Taxonomy in general is a dynamic regulation being regularly assessed. Therefore, businesses affected by the regulation need to keep an eye on its development.
In an ideal situation, financial market participants and financial advisors could easily gather the information they need from other companies, such as companies’ share of taxonomy-aligned activities. Furthermore, disclosing such information can help authorities with future policy development, by monitoring the situation.
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