Funds that took due account of environmental, social and governance (ESG) factors in their investment strategies generally outperformed their conventional counterparts during the COVID-19 pandemic. At the same time there is an omnipresent call to align the economic recovery in Europe with the ‘green transition’. In sharp contrast to this emphasis on the importance for investors to take ESG factors on board when making investment decisions stands the uncertainty about the requirements an investment must meet to be actually sustainable.

On 18 June 2020 the European Parliament decided to remedy the lack of clarity by adopting the Taxonomy Regulation (TR) which defines the concept of ‘an environmentally sustainable economic activity’. More specifically, it sets out the broader framework within which the European Commission will set the technical criteria an economic activity must adhere to in order to be considered environmentally sustainable. 

The definition of what makes an economic activity sustainable will lie at the center of an emerging legal framework for sustainable finance. Creating such a legal framework pioneered as a priority in the Action Plan on Building a Capital Markets Union of 2015 and was translated into more concrete policy in the Action Plan: Financing Sustainable Growth of 2018 based on a blueprint designed by the High-Level Expert Group on Sustainable Finance. In particular the latter Action Plan’s goal to reorient capital flows towards sustainable investments justified the adoption of a detailed EU classification system—or taxonomy—to make it clear for investors which activities qualify as ‘green’ or ‘sustainable’.

Leaving it to the market or member states to define ESG was deemed to lead to different and incomparable concepts which could diminish confidence in sustainable finance and hamper the functioning of the internal market. Numerous examples of borderline cases seemed to provoke some controversy about where to draw the line between being sustainable and gaining an unfair competitive advantage by marketing a financial product as environmentally friendly, when in fact basic environmental standards have not been met (greenwashing). This was recently the case for a ‘green’ bond issued for purchasing fuel-efficient tankers for the transport of oil from offshore drilling sites. 

This lack of confidence in sustainable finance is especially problematic for the European Union in upholding its commitments under the Paris Agreement to keep global average temperature well below 2°C above pre-industrial levels and under the UN Sustainable Development Goals. With the adoption of the EU Green Deal and the proposal for an EU Climate Law, the commitment to become climate neutral by 2050 is likely to become a legally binding obligation. The financial markets’ role in reallocating ownership of capital is an essential enabler in attaining these climate goals by ensuring that sufficient capital is available to economic activities that fit in or evolve towards a climate neutral Europe in a science-based way. 

The definition of an environmentally sustainable economic activity under the Taxonomy Regulation consists of three requirements that will be specified in so-called technical screening criteria developed by the European Commission in delegated acts within the boundaries set by the Regulation. In order to be environmentally sustainable, an economic activity must (i) substantially contribute to one or more of the environmental objectives (ii) without significantly harming any of the environmental objectives while (iii) being carried out in compliance with minimum human rights safeguards (Article 3 TR). 

The environmental objectives referred to above focus on climate change and other environmental challenges (Article 9 TR), as opposed to social and governance factors. A ‘review clause’ in Article 26(2)(b) TR would nevertheless allow for an extension to social objectives or even a ‘blacklist’ of particularly unsustainable economic activities. In its current form, the taxonomy does indeed leave the qualification of all other activities intact, no matter how harmful they may be. In practice, however, the ‘do no significant harm’ element of the definition could serve as a minimum standard in assessing the particularly unsustainable nature of certain activities. 

 The Taxonomy Regulation gives a broad interpretation of the ‘substantial contribution to one or more of the environmental objectives’ first requirement by also including economic activities directly enabling other activities to contribute so (‘enabling activities’) (Article 16 TR). For the objective of climate change mitigation it also includes so-called transitional activities which support the transition to a climate neutral economy by being consistent with a predetermined pathway (Article 10(2) TR). The latter makes the taxonomy a transition tool that companies can use as a guide to follow a credible, science-based pathway to becoming climate neutral by 2050 even if there are no alternative climate neutral ways to perform an economic activity yet. 

The Taxonomy Regulation also amends the so-called ESG Disclosure Regulation applicable to ‘financial market participants’ being collective investment funds, insurance undertakings making insurance‐based investment products available, credit institutions and investment firms providing portfolio management, and manufacturers and providers of certain pension products (Article 2(1) ESG Disclosure Regulation). When these financial market participants offer a financial product with ‘sustainable investment’ as its objective, they will have to inform investors about the alignment of these financial products with the Taxonomy Regulation. Their precontractual disclosures and periodic reports must include a description of how and to what extent the investments underlying the financial product qualify as environmentally sustainable under the Taxonomy Regulation and which environmental objective(s) set out under the Taxonomy Regulation they contribute to (Article 5 TR). 

The same information must be provided for sustainable financial products that do not meet the threshold of ‘sustainable investment’ as set out under the ESG Disclosure Regulation but nevertheless promote environmental characteristics. For this catch-all category of financial products that are less ambitious regarding sustainability, the above-mentioned information must be complemented with a disclaimer that the taxonomy is only used for a portion of the underlying investments (Article 6 TR). All other financial products must add a disclaimer to their precontractual disclosures and periodic reports that the taxonomy is not used (Article 7 TR).

The second category of mandatory users are undertakings that are required to publish (consolidated) non-financial statements (Article 19a or 29a Non-Financial Reporting Directive). These statements will have to contain information on how and to what extent the undertaking’s activities are associated with economic activities that qualify as environmentally sustainable under the Taxonomy Regulation (Article 8 TR). Lastly, Member States and the EU must use the definition of the Taxonomy Regulation when setting out requirements for bonds and financial products that are environmentally ‘green’ (Article 4 TR). 

Next to these three categories of mandatory users, there are already several other voluntary applications of the taxonomy like its use in the European Commission’s €750 billion Covid-19-recovery instrument, Next Generation EU.

It took the European legislator over two years to adopt the Taxonomy Regulation since its proposal in May 2018. In the meantime a Technical Expert Group has been developing possible technical screening criteria to support the European Commission in adopting its delegated acts (final reporttechnical annex and excel tool). Currently a Platform on Sustainable Finance is being established which will take over the advisory role of the Technical Expert Group and monitor the taxonomy (Article 20 TR).

The adoption of the general framework for a taxonomy is an important step in clarifying to investors the meaning of sustainability in a language that is useable in a financial markets context. This is of course only the beginning of a process which tends to become more political when more technical issues need to be resolved, as previous tensions over nuclear energy have shown (EURACTIVE.com, 6 December 2019). The European Commission is also conducting a public consultation until 15 July 2020 to serve as the basis for a renewed sustainable finance strategy as part of the EU Green Deal which will be adopted in September 2020. The extension of taxonomies defining sustainable economic activities will most likely play a key role in this renewed strategy as well.

Arnaud Van Caenegem is a Doctoral researcher at the Jan Ronse Institute for Company and Financial Law, KU Leuven.