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The impact of the EU taxonomy on the financing of sustainable development 11 May 2022 163

Since the beginning of the year, financial institutions have been reporting "Green Asset Ratios", the interpretation of which is likely to generate a lot of confusion. The concepts of eligibility and alignment with the EU taxonomy for sustainable activities need to be clarified.

In its Sustainable Finance Action Plan published in 2018, the European Commission affirms the need to redirect capital flows to sustainable projects in order to drive its 2030 climate commitments made under the Paris Agreement, and its desire to become the first net-zero region by 2050. The investment required to achieve this transition makes the use of private capital essential and places financial institutions at the heart of the European sustainable finance strategy. To this end, the EU has developed regulatory tools [1] to ensure the proper identification of sustainable projects, including an EU classification system for sustainable activities, known as the EU taxonomy. It now takes the form of a set of regulations, defining a common language for classifying green activities and disclosure obligations for enterprises.

The EU taxonomy is a methodology for assessing an undertaking's activities in relation to environmental objectives, and more specifically in its current version, to climate change mitigation and adaptation. It is laid out in several successive steps, which, once all the criteria have been met, make it possible to identify "aligned" activities, which either demonstrate a low-carbon performance, or already contribute significantly to the net zero transition, or are "enabling" by allowing the reduction of greenhouse gas emissions. 

The first step is to identify "eligible" activities, i.e. products or services that can contribute a priori to climate change mitigation or adaptation. The second step consists of comparing the performance of these eligible activities with technical criteria defined according to a scientific approach by the group of European experts mandated by the European Commission. These criteria, determined by grouping activities according to NACE classification, are quantitative criteria, most often expressed as a threshold of greenhouse gas emissions per unit of production. Finally, in order to be considered aligned, these activities must be demonstrated to have no harmful impact on other EU environmental objectives – sustainable use and protection of marine resources, transition to a circular economy, protection and restoration of biodiversity and ecosystems, prevention and reduction of pollution – and that they are carried out in compliance with international minimum social safeguards in terms of human rights and labor laws.

In addition to this process, according to the delegated act adopted in July 2021, undertakings subject to the disclosure of an energy performance statement must disclose the proportion of their turnover, capital expenditure and operating expenditure associated with eligible activities as of 2022; then with aligned activities as of 2023 for non-financial undertakings, 2024 for financial undertakings. These disclosure requirements meet the Commission's action plan's objective of transparency and the fight against greenwashing.

Banks, asset managers and insurers are stakeholders in this transparency effort through the disclosure of "Green Asset Ratios" from the first quarter of 2022. These ratios are defined in the appendices to Article 8 of the Taxonomy Regulation as the eligible and aligned portion of the assets that they hold or finance themselves, or that they manage on behalf of their clients.

This classification and transparency system set up by the taxonomy meets the primary objective of providing investors with a compass of activities. However, in order to meet the expectations of civil society, clients, investors and regulators themselves regarding the involvement of private financial institutions in financing the transition, it must be extended and take into account the trajectory of this transition in its entirety, in order to guarantee more complete and dynamic transparency on the final use of capital. The European Commission's Platform on Sustainable Finance has moreover published in July 2021 a proposal for a dynamic taxonomy to establish different levels of performance and contribution of activities to environmental objectives.

There is a strong risk of diverting financing away from the parts of the economy that actually need investment to achieve the transformation of their activities. Financial resources could get stuck in existing green asset bubbles without a "Greening Asset Ratio"!

 

[1] Sustainable finance: Commission's Action Plan  Main elements of the Action Plan: a classification system implemented as EU Taxonomy Regulation in 2021; a system of EU labels for green financial products, e.g. the EUGBS (European Green Bonds Standards) introduced in March 2020; the obligation for investors and insurers to integrate sustainability criteria in their processes, formalized in the 2019 Sustainable Finance Disclosure Regulation, and the obligation to inform their customers of the integration of ESG in MiFID and DDA.

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