By Dennis Koudigkelis, Law Student at the University of Warwick
A quick recap…
EU taxonomy regulations form part of the EU Commission’s response to the Paris Agreement and the European Green Deal by introducing criteria that companies and investors can use to assess whether their activities are taxonomy-aligned or else “green”. taxonomy-aligned economic activities are expected to “make a substantial contribution to at least one environmental objective”, “to not do significant harm to any of the objectives” and “to meet minimum social safeguards”. Based on the criteria set in Delegated Acts, businesses and investors will be required to report their taxonomy-aligned activities, which will enable transparency in the market and eliminate greenwashing. More specifically, under Article 8(1) of the Taxonomy Regulation, undertakings within the Non-Financial Reporting Directive’s (NFRD) scope will be called to disclose the extent of their activities’ alignment.
The Good…
Taking into account the importance of sustainability in the modern world, one would be oblivious to deny the reputational effects the taxonomy would have on businesses and investments. Indeed, back in 2015, Nielsen’s Global Corporate Sustainability Report noted that 66% of consumers would invest more on a ‘sustainable brand’. Therefore, having a transparent science-based system that ‘labels’ activities as sustainable, in conjunction with the growing market predilection for such activities, it is only to be expected that the reputation of those taxonomy-aligned companies and investment portfolios will be eventually boosted or at least enhanced.
Although taxonomy disclosures are thus far not required for SMEs, which could have a limiting effect on the initiative as is described later in the article, they will likely choose to voluntarily make said disclosures. Similarly to how peer-pressure operates, the companies under the scope of the NFRD that SMEs are in business with will require such data from them, as their business partners or clients, to meet their own mandatory disclosure obligations. It is, therefore, only a matter of time for those activities not identified by the Delegated Acts to comply with taxonomy rules and to be potentially incentivised to go ‘green-er’ seeing a preference for such activities in the market.
In addition to this, having a set of transparent, scientific criteria for ‘green’ activities, responds to the pressing issue of greenwashing. Greenwashing is a phenomenon that has been closely tied with the overall trend towards sustainable business ventures and it concerns misleading marketing practices to lure customers into purchasing their ‘green’ products, distracting the consumers from other truly eco-friendly options. Therefore, EU taxonomy, by requiring mandatory disclosures of alignment, will help to distinguish the honest from the dishonest.
The Ugly…
However, there is an Achilles heel (in this case several) that one familiarising themselves with the taxonomy should bear in mind. Under the current system, companies cannot include in their taxonomy key performance indicators (KPIs) the alignment of non-EU companies and those companies out of NFRD’s scope, such as but not limited to SMEs. It is obvious, therefore, that those companies, whose clients are within either of the aforementioned groups and cannot include them in their KPIs, would see low taxonomy alignment for their activities – a false representation, however, of their true sustainability status. This poses a question of the effectiveness of the taxonomy itself, as its main focus, to guide companies and investors in a transparent matter to assess if their activities comply with sustainability criteria, cannot be performed properly. This point is illustrated in the Sustainable Finance Survey, where more than 40% of Public Financial Institutions acknowledged that their links with SMEs and non-EU partners will very likely affect their taxonomy disclosure obligations. Although it has been suggested that such data could be included from January 2025 and many SMEs could be prompted to voluntarily disclose their taxonomy alignment, at present time this ambiguity will affect many financial institutions’ obligations.
A broader issue surrounding the taxonomy could be its own limits. As noted, the Taxonomy neither requires companies to be taxonomy-aligned, nor is it “a list of activities that investors have to invest in.” In distinguishing between taxonomy-aligned and unaligned activities, it could be argued that the taxonomy creates a favourable green asset bubble for the purposes of both the Paris Agreement and the European Green Deal. This, however, is a far-fetched conclusion that bears no understanding on the reality of the financial market. As Tariq Fancy (former BlackRock executive) noted, “the system is built to extract profits” and “as long as there is money to be made” in environmentally damaging activities, this system will survive. Even if there was an ideal case-scenario of a common consensus towards sustainable investments, some obstacles would arise; only a small percentage of activities are truly taxonomy-aligned, as is indicated by the 2% of taxonomy-aligned revenue in EURO STOXX 50 and as such it would be unreasonable to expect investors to prefer non-profitable and small in amount taxonomy-aligned activities at the expense of profitable unaligned opportunities.
Some Conclusions
Even though more radical changes may need to be made to incentivise investors into taxonomy-aligned investments, the taxonomy sets the scene for undeniable change, no matter how small that change may be; having a science-based system that evaluates the sustainability of economic activities based on the extent of their taxonomy-alignment takes the matter of ‘greenness’ away from misleading marketing strategies and places it into more substantial assessment methods. And while the taxonomy does not address any impact on unaligned activities, one hopes that the focus on taxonomy-alignment and the systems in place such as the European Green Deal Investment Plan (EGDIP), which primarily aims at directing capital to sustainable investments, will ultimately lead the market into a more sustainable future. As far as the practical issues of the Taxonomy itself are concerned, one has to wait for future Delegated Acts to ease any surrounding uncertainties.