The EU’s Green Capitalism Takes Shape: Taxonomy Screening Criteria and Corporate Sustainability Reporting

By Paul Mertenskötter on May 19, 2021

Posted in ESG, EU Law and Regulatory, Financial

The European Commission has presented a package of key enabling legislation on sustainable finance (the “Sustainable Finance Package”). This includes the much-awaited first technical screening criteria under the Taxonomy Regulation — outlined in the Taxonomy Climate Delegated Act (“TCDA”) — and a proposal for a Corporate Sustainability Reporting Directive (“CSRD”), which significantly revises and expands on the existing Non-Financial Reporting Directive’s remit and disclosure rules for corporates. While the former is directly aimed at financial institutions and investors, and the latter at large and listed entities, the package has broader implications for all corporates.

Sustainable Finance Package: Context and CommentThe Commission’s intention with its Sustainable Finance Package is twofold: (1) in the short term, to set a clear regulatory framework to encourage investments that will contribute to a sustainable and inclusive economic recovery from the COVID-19 pandemic; and (2) in the long term, to ensure the transition to a carbon neutral EU economy by 2050, in accordance with the 2020 European Climate Law. Following the adoption of the EU Taxonomy Regulation (explained further below), the Sustainable Finance Disclosure Regulation, and the Benchmark Regulation, which enhances the transparency of benchmark methodologies, the Commission has in this legislative package laid out the next building blocks for its envisioned sustainable finance ecosystem.

In addition to the impact on financial institutions and investors directly subject to the new laws, the Sustainable Finance Package may impact corporates in the following ways:

Corporates may be more likely to receive requests for data on their environmental and other sustainability practices as upstream capital markets participants grapple with new obligations to distinguish between green, “light green,” and other investments;
Corporates may be subject to direct requirements to report on activities relating to their environmental, social, and governance objectives;
Longer-term, the package may form the basis of a “blueprint” for wider stakeholders, meaning that corporates may need to improve performance against the standards, not just to attract capital, but also to remain competitive; and
On a global level, these EU sustainability measures have real potential to become gold standards and influence the investment market outside of the EU, a phenomenon known as the ‘Brussels Effect’.[1]

Corporates are therefore well-advised to assess both the scope of their reporting and disclosure obligations and those of their potential investors and other sources of capital, in order to remain competitive.

We will cover these developments in more detail in a series of articles. Below, we highlight the key issues that corporates should be aware of in: (1) the draft TCDA; and (2) the proposed CSRD.

Draft EU Taxonomy Climate Delegated Act

The Taxonomy Regulation introduced an EU-level taxonomy of environmentally sustainable activities, along with new disclosure requirements for financial market participants. Among other things, these include an obligation to disclose the proportion of turnover that is derived from, and the proportion of capital expenditure associated with, environmentally sustainable economic activities. The Taxonomy Regulation establishes high-level criteria and objectives to which economic activities must contribute to be deemed environmentally sustainable (or “green”), as well as harmful activities from which businesses must refrain. Its goal is to provide businesses, investors, consumers, and regulators with a common language about what is, and by extension what is not, an environmentally sustainable economic activity.

The Taxonomy Regulation also empowered the Commission to adopt Delegated Acts setting forth technical screening criteria. The draft TCDA (in its Annexes, here and here) sets forth sector-specific definitions of environmentally sustainable economic activities, ranging from manufacturing to electricity generation and transport. Notably, although the TCDA sets criteria for when hydrogen manufacture may be considered a sustainable investment (as we discussed in a recent article), it does not cover natural gas or nuclear energy, which are expected to be covered by supplementary technical screening criteria later this year. The Commission will establish a web portal where stakeholders can make suggestions on other areas in mid-2021; these suggestions will be assessed by the Commission and Platform on Sustainable Finance.

Timeline

The Taxonomy Regulation entered into force on July 12, 2020, but the core transparency and disclosure provisions will only apply from January 1, 2022 with respect to climate change mitigation and adaptation objectives. From January 1, 2023 the provisions will also apply in relation to the other environmental objectives contained in the Taxonomy Regulation.

The TCDA remains subject to scrutiny by the European Parliament and Council. They will have three months to raise any objections they may have and could in theory block the adoption of the TCDA. The TCDA is otherwise expected to apply from the Fall of 2022.

Proposal for a Corporate Sustainability Reporting Directive

The proposed CSRD is intended to fill the informational gap between asset managers that must assess which economic activities are environmentally sustainable pursuant to the Sustainable Finance Disclosure Regulation and potential corporate investment targets that may not already make this information available.

The proposed CSRD is intended to extend the scope of the existing Non-Financial Reporting Directive, which only applies to large public interest entities[2] and groups with over 500 employees. By contrast, the CSRD will apply to all large[3] EU corporates and all listed companies, including listed SMEs. In-scope entities would be required to report according to mandatory sustainability standards that include indicators that correspond to the Sustainable Finance Disclosure Regulation and Taxonomy Regulation.

The reporting would be subject to an “audit” or assurance requirement, which would move from an initial “limited” assurance requirement, to a “reasonable” requirement over time and as standards are agreed. The results would be included and published in companies’ management reports, and would also be made available to all via the envisaged European Single Access Point under the Capital Markets Union Action Plan.

Notably, the Commission’s CSRD proposal leaves the door open to an exemption for EU-based subsidiaries of parent companies based in third countries. However, the exemption will only be available if the Commission deems the third country’s sustainability reporting obligations equivalent to the EU obligations, pursuant to the Transparency Directive’s process for determining equivalence. This will likely be an important area of future regulatory activity and will be an important area for multinational companies to watch.

Timeline

The CSRD proposal will follow the EU’s ordinary legislative procedure. If the European Parliament and Member States can come to an agreement on standards — which is not a given — Member States will be required to implement the Directive by December 1, 2022. Companies that are within the scope of the Directive would have to comply from financial years starting on or after 1 January 2023, meaning they would need to publish reports from 2024, whilst SMEs would have to comply from January 1, 2026.