November 4, 2020

The European Union has emerged as a global leader in the fight against climate change. After beating the emission reduction, renewable energy usage, and energy efficiency targets it set in 2008, the EU has continually upped the ante. In 2019 it ratified its goal to be carbon neutral by 2050. To meet this objective, the bloc endorsed the Green Deal, which intends to achieve carbon neutrality in a manner that is both cost-effective and socially just. To better direct the billions of euros from public and private funds that the Green Deal hopes to solicit, Brussels is putting in place a number of laws including the non-financial reporting directive (NFRD) and the EU Taxonomy. The EU is erecting several pillars to fulfill the Climate Law. In addition to enacting the Taxonomy and the NFRD, the EU will codify new emissions, renewable energy, and energy efficiency targets. The 2050 goal envisages an economy powered by renewable energy sources. More than just a means of slowing the rate at which the earth is warming, renewables are a driver of economic growth, according to the EU. The same is true of decarbonization, which the EU hopes will create enough new high-paying jobs in the circular economy, transportation, and infrastructure as well as renewable energy to offset any job losses in fossil fuels.

The Process

The Taxonomy is a framework for determining the degree of sustainability an investment offers. To define sustainability, the Taxonomy establishes six objectives. For an investment to be sustainable, it needs to comply with at least one of these objectives and do no harm to the other five. The range of objectives reflects the richness of the concept of sustainability. To comply with an objective, an investment needs to meet certain operational hurdles (read: substantial contribution) such as keeping GHG emissions below some threshold. In the course of meeting one objective, the investment cannot be detrimental to another objective (the so-called “Do no significant harm” provision). If an investment passes these two sets of hurdles, then it also has to be compliant with relevant “minimum safeguards”—labor laws that ensure social equity are as much a part of the Taxonomy as is environmental integrity. The EU Taxonomy is a comprehensive classification system that can be implemented only by following a sequential, multistep process.

Mapping Out the Entire Economy

As noted, to comply with any of the six objectives, a company must prove it has reached certain levels of operational efficiency to achieve “substantial contribution.” This approach implies that for each of the six objectives, relevant operational hurdles and technical specifications need to be set up for every economic activity. Consequently, building out the Taxonomy is an enormous task. The EU has begun by mapping the largest emitting activities and the first two objectives: climate-change mitigation and adaptation. The other objectives and sectors will be mapped over the next two years. As part of this process, the Taxonomy drills down into the revenue (or CAPEX) within the company associated with the sustainable activity (assuming this activity has met all the technical, operational, and legal hurdles). Asset owners and investment managers will be required to disclose the percentage of their portfolio—defined as the weighted average of underlying debt or equity exposure—that complies with the Taxonomy.

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