In December 2019, the EU Green Deal, a plan to make the European Union more sustainable through investments in areas such as clean energy, biodiversity and circular economy, was announced(1). Part of this plan is a legally binding commitment to achieve net zero neutrality by 2050, with a proposed interim goal of at least a 55% reduction in emissions by 2030(2).
The EU also launched the Green Deal Investment Plan, mobilising at least €1 trillion of sustainable investments over the next decade in order to get on the emission reduction trajectory needed to meet the goals of the Paris Agreement as well as the other environmental objectives described in the Green Deal(3). However, the scale of the challenge is beyond the capabilities of the public sector alone: the mobilisation of contributions from the financial sector will also be key. The OECD (Organisation for Economic Co-operation and Development) estimates that € 6.35 trillion a year will be required to meet the goals of the Paris Agreement by 2030 in the EU and around the world(1).
To this end, two important pieces of legislature, the EU Taxonomy Regulation and the Sustainable Finance Disclosure Regulation (SFDR), as well as regulations on low carbon benchmarks, were implemented following the EU Action Plan on Financing Sustainable Growth (2018), which has three key goals(4):
This article covers the EU taxonomy and its impact on sustainable finance. The next article in this series will explain the SFDR in detail.
The EU taxonomy is a framework which classifies ‘green’ economic activities in order to foster and accelerate investments that are truly sustainable. Until the establishment of this framework, investment products and economic activities could be classified as ‘green’ or ‘environmentally sustainable’ without a clear and common definition of what ‘green’ or ‘sustainable’ meant. The taxonomy’s goal is to solve this issue by providing clear rules on what can be classified as ‘green’ or ‘environmentally sustainable’, in order to mobilise financing for those economic activities that make a contribution to the EU’s environmental objectives. In short, the goal of the taxonomy is to accelerate green investments by providing transparency to investors, companies and financial institutions.
The Taxonomy Regulation, published in June 2020, sets out four overarching criteria that an economic activity has to meet in order to qualify as environmentally sustainable.
The economic activity contributes to one of the following six environmental objectives:
The economic activity does ‘no significant harm’ to any of these six environmental objectives (i.e. does not have a negative environmental impact).
The economic activity meets ‘minimum safeguards’ such as the UN Guiding Principles on Business and Human Rights (i.e. does not have a negative social impact)
The economic activity complies with the technical screening criteria developed by the EU Technical Expert Group.
An important requirement of economic activities classified as sustainable by the taxonomy is that they not only need to contribute to one of the environmental objectives, but they also must not negatively impact the other specified objectives. For example, an activity that helps mitigate climate change but negatively impacts biodiversity cannot be included.
Based on the Taxonomy Regulation, in 2020, the EU’s Technical expert group (TEG) published a report outlining a draft of technical screening criteria for economic activities that make a substantial contribution to climate change mitigation or adaptation. In 2021, further guidance directly related to the remaining four environmental objectives will be released.
The taxonomy will be reviewed and updated regularly to cover emerging low carbon solutions and technologies. Moreover, in the future, a fully realised taxonomy may include not only criteria for ‘green’ activities (activities that make a substantial contribution to environmental objectives), but also for ‘brown’ or ‘red’ activities (activities that are detrimental to environmental objectives) and neutral activities, in order to clearly indicate the impact of financial products(1).
The Taxonomy Regulation also describes disclosure requirements and the categories of financial market participants and companies they apply to(1).
According to these requirements, Japanese financial market participants that offer financial products within the EU, as well as large Japanese companies which are subject to the EU’s NFRD (i.e. companies with more than 500 employees), will be required to follow the EU Taxonomy Regulation.
As the need for sustainable business increases, the EU taxonomy, as a ground-breaking green finance framework, is expected to influence ESG (environmental, social and governance) financial standards and regulations all over the world. Therefore, even Japanese companies that do not fall into either of the categories above are advised to pay close attention to this regulation, for example by testing the alignment of their investment products or economic operations.
Over 40 investment managers and asset owners who are signatories to the Principles for Responsible Investment (PRI) tested the alignment of selected investment products with the EU taxonomy(5). The examples below show the results of tests conducted on funds from two different financial institutions. As shown by the results, the taxonomy makes it possible to identify and compare different investment products and portfolios based on their degree of contribution to the environmental objectives(6)(7).
Overall, preliminary alignment tests conducted by leading financial institutions suggest that even sustainability-focused investment products have a low degree of alignment with the taxonomy, which sets the bar high in terms of the environmental criteria for sustainable investments. While it is challenging to align every investment product completely with the taxonomy, it is argued that meeting the criteria for doing ‘no significant harm’ and for meeting the minimum safeguards will be especially important.
Financial institutions that have carried out the initial testing of their portfolios have highlighted data challenges, along with the significant effort and time required for the analysis, as some of the biggest issues they faced. In fact, while the EU taxonomy criteria are very detailed, the data available is not always granular enough to carry out the analysis, especially regarding the criterium for doing no significant harm. In preparation for the introduction of compulsory disclosure in 2021, the necessity of engaging data providers as well as portfolio companies as early as possible for the preparation and provision of required data is emphasized(8).
In 2020, accelerated progress was made towards the mainstreaming of sustainable finance, not only through the EU taxonomy but also through many other sustainable finance regulations and disclosure standards. For example, the International Financial Reporting Standards (IFRS) Foundation published a consultation paper on sustainability reporting in September 2020, following growing demands for the standardisation of sustainability reporting by the capital market. This illustrates the ever-increasing importance of non-financial information for investment decisions(9). Additionally, in Japan, the Stewardship Code was revised in 2020 to require that institutional investors engage in constructive dialogue regarding sustainability(10). These trends show that, in the EU and throughout the world, ESG is becoming more and more integrated into traditional finance and investing, rather than being seen as a form of alternative investment.
Although we expect that initial compliance with the EU Taxonomy Regulation will be challenging, it will also accelerate momentum for sustainable investment, providing business opportunities for financial institutions that offer green products and attracting investment in companies developing green business models. Although the taxonomy does not apply to Japanese companies unless they fall into specific categories, it is likely to have an impact beyond the EU. First, the taxonomy could potentially influence the development of a similar model localized to the national market, or of an international standard. In fact, Japan’s Transition Finance Study Group has proposed a taxonomy focused on transitional or ‘brown’ activities, and other countries such as Canada, Colombia, China and Malaysia are developing their own taxonomies. Second, financial institutions that are in alignment with the taxonomy might rethink their investments in Japanese companies that are not. On the other hand, Japanese companies offering taxonomy-aligned products and carrying out voluntary disclosure could more easily attract investments from the EU(11).
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