The Role of Finance and EU Taxonomy for Sustainable Activities
Financial markets, through the deployment and reallocation of capital, can play a significant role in addressing today’s environmental challenges. Many market participants now acknowledge that environmental risks are financial risks. Using the theory of efficient allocation of resources, this should lead to significant inflows into sustainability-focused businesses in the years ahead.
Yet, the capital required — both from public and private sources — to holistically address the environmental challenges that we face is immense. According to the OECD, an amount as high as USD 6.9 trillion per year is going to be needed to meet the Paris Agreement goals by 2030. A large share of this investment will come from sustainability-themed investment vehicles. Such investment vehicles, according to recent estimates from Morningstar, achieved record inflows in 2020, totalling USD 1.65 trillion, an increase of nearly 65% versus 2019 figures.
Accounting for nearly 80% of that, Europe is a clear leader in sustainable investing. So much so, that the European Union, on 22 June 2020, rolled out a new regulatory framework for encouraging and facilitating environmentally-sustainable investments and to implement the European Green Deal (the “EU Taxonomy for Sustainable Activities” or “EU Taxonomy”). By providing appropriate definitions to companies, investors and policymakers on which economic activities can be considered environmentally sustainable, it is expected that the new EU Taxonomy will create security for investors, protect private investors from greenwashing, help companies to plan the transition, mitigate market fragmentation and eventually help shift investments where they are most needed.
What is the EU Taxonomy for Sustainable Activities?
The EU Taxonomy is the unified classification system for sustainable activities at the core of the EU action plan on financing sustainable growth. The regulation requires asset managers to gather reliable, consistent, and comparable sustainability-related indicators from in-scope investee companies and incorporate this data into their investment decisions and risk management processes to fulfil disclosure duties under the SFDR.
In March 2021, the EU followed up with the implementation of the Sustainable Finance Disclosure Regulation which imposes a series of sustainability disclosure obligations for manufacturers of financial products and financial advisers toward end-investors (the “SFDR”).
We believe that both the EU Taxonomy and the SFDR are positive for the financial services sector. Combined, these two regulations will accelerate our transition towards a low-carbon economy by promoting transparency and accountability, boosting green investment, and reducing ‘greenwashing’.
What are the objectives of the EU Taxonomy for Sustainable Activities?
The EU Taxonomy sets out an EU-wide classification system that establishes a list of environmentally sustainable economic activities. The EU Taxonomy is an important enabler of the European Green Deal. By providing appropriate definitions to companies, investors, and policymakers alike, the taxonomy is expected to (a) reorient capital flows towards sustainable investment to achieve sustainable and inclusive growth; (b) manage financial risks stemming from climate change, environmental degradation, and social issues; and (c) foster transparency and long-termism in financial and economic activity.
The EU Taxonomy lays out the types of economic activities that can be considered environmentally sustainable.
The six environmental objectives identified for the purposes of the EU Taxonomy are:
- Climate change mitigation
- Climate change adaptation
- The sustainable use and protection of water and marine resources
- The transition to a circular economy
- Pollution prevention and control
- The protection and restoration of biodiversity and ecosystems
For an economic activity to be considered EU Taxonomy-compliant, it must:
- contribute substantially to one or more of the six environmental objectives above;
- do no significant harm to any of the other environmental objectives;
- comply with minimum social safeguards including the OECD Guidelines for Multinational Enterprises, the UN Guiding Principles on Business and Human Rights, the International Labour Organisation’s (ILO) declaration on Fundamental Rights and Principles at Work, the eight ILO core conventions, and the International Bill of Human Rights; and
- comply with certain technical screening criteria developed by the EU Commission’s Technical Expert Group (TEG) in the form of delegated acts, applicable from 1 January 2022 for climate-related objectives and from 1 January 2023 for the other environmental objectives.
Sustainable Market Strategies, “SMS Environmental Impact Opportunities Thematic Classification”, Pages 6,7 and 8. Available at: https://rizeetf.com/wp-content/uploads/2021/07/SMS-Environmental-Impact-Opportunities-Thematic-Classification.pdf