The sustainable investing market has witnessed remarkable growth. At the same time, the field has been challenged by a lack of consistency in identifying what, exactly, makes an investment “sustainable”.  Sustainability taxonomies (or classification systems) have been developed by governments, international bodies and non-governmental organizations to help identify specific assets, activities or projects that meet defined thresholds and metrics that quantify sustainability.  Many of these taxonomies refer to or emulate the EU Taxonomy, widely regarded as the most developed system for sustainable finance investment classification and measurement.

What is the EU Taxonomy?

Formally adopted by the European Parliament in 2020, the EU Taxonomy already informs related EU regulation like the Sustainable Finance Disclosure Regulation (SFDR), which requires covered entities to disclose whether certain financial products align with the EU Taxonomy. Under the EU Taxonomy framework, an economic activity is environmentally sustainable if it contributes to one of the six environmental objectives such as climate change mitigation and adaptation, transition to a circular economy and pollution prevention and control; does not significantly harm the other objectives; and meets certain human rights-related “minimum safeguards”. Delegated Acts (a set of non-legislative acts adopted by the European Commission) under the EU Taxonomy set out additional “Technical Screening Criteria” (TSC), or the specific thresholds and metrics used to assess whether individual economic activities are sustainable.

The EU Taxonomy has been an ambitious endeavor, as it serves not just as a metric and benchmark for sustainable reporting and products, but it also acts as a measure of the EU’s policy progress towards a sustainable financial and economic system. Bryan Pascoe, the chief executive officer the International Capital Market Association (ICMA), recently said “the EU Taxonomy is an important and ground-breaking project designed to help inform the market and policy makers on their progress towards sustainability.” Its comprehensive design, which established 6 environmental objectives to pursue through listed activities, also lends uniqueness to the EU Taxonomy. From January 2022, both financial and non-financial entities are subject to certain reporting requirements under the EU Taxonomy.[1]

Usability Challenges of the EU Taxonomy

While there has been an increasing adoption of the principles underpinning the EU Taxonomy to help deliver on the European Green Deal, there remain some usability concerns regarding its implementation. ICMA recently published a paper, Ensuring the usability of the EU Taxonomy, that highlights certain of these issues as they relate to regulatory developments and emerging market practices. Echoing the challenges we identified in Leveraging Taxonomies: How Asset Managers Are Using New Sustainability Classification Systems, and based on existing research and market feedback, ICMA identified the following challenges which could hinder the implementation of the EU Taxonomy:

  1. Requiring highly granular data for TSC purposes
  2. Relying on EU legislation and criteria in a global market
  3. Inconsistency in the use of estimates and third-party data
  4. No proportional arrangements for smaller companies and projects
  5. Certain criteria create the need for grandfathering to smooth the energy transition over time
  6. Using economic activity based classification system (NACE) for complex projects

Navigating these challenges will be important for current and future reporting under the SFDR, the Corporate Sustainability Reporting Directive (CSRD) and the upcoming EU Green Bond regulation.

ICMA Recommendations

To address the broad usability concerns for both product alignment and sustainable reporting, ICMA recommended the following:

  1. Allowing flexibility when aligning with the Do No Significant Harm (DNSH) and Minimum Safeguard standards
  2. Adapting TSC for usability in non-EU jurisdictions
  3. Allowing use of estimates and third-party sourced data when EU Taxonomy assessments cannot otherwise by produced/obtained

To address specific issues arising from aligning green and sustainability bonds to EU Taxonomy, ICMA recommends the following:

  1. Simplifying methodology for complex projects funded by green and sustainability bonds under NACE classifications
  2. Finding a way to grandfather existing green and sustainability bond market for Green Assist Ratio (GAR)/ Green Investment Ratio (GIR) and the SFDR disclosures

The ICMA paper is not meant to address questions relating to what should be classified as sustainable. Rather, it raises important questions and recommends practical solutions to enhance the usability of all concerned parties to better align with the EU Taxonomy.

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The authors would like to thank Nupur Agrawal for her support and assistance in preparing this article.

 

[1] Since January 2022, a Delegated Act supplementing Article 8 of the Taxonomy Regulation is applicable in relation to the EU Taxonomy. In February 2022, the European Commission approved in principle the Complementary Climate Delegated Act. Disclosures relating to Corporate Sustainability Reporting Directive and the EU Green Bond Standard are also under discussion.

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