The Alphabet Soup of EU Taxonomy

In 2015, the Paris Agreement was signed, committing the EU to be climate neutral by 2050 – the European Green Deal. Three objectives were highlighted to attain climate neutrality:

• To reorient capital flows to more sustainable projects
• To establish sustainability as a component of risk management
• To stimulate transparency and a long-term focus

In order to measure and compare economic activities across industries, the EU needed a uniform classification system, a “taxonomy”, to increase consistency and comparability of investment areas and to avoid greenwashing. This classification could then be used in several ways – to direct capital markets, to issue an EcoLabel for retail financial products, to create standards for green bonds, to classify social governance criteria and to identify activities that severely compromise environmental objectives.

The EU Taxonomy is a 500+ page document…

Alongside the EU taxonomy was the NFRD, the Non-Financial Reporting Directive, put in place in 2018. It corresponds exactly to its name, a non-financial reporting requirement to go alongside a company’s existing financial reporting requirements, for a select set of listed companies.

The NFRD applied to large, public-interest companies with over 500 employees – approximately 11,700 organisations in total. These entities were required to report on ESG areas in:

• Environmental matters
• Social matters and treatment of employees
• Respect for human rights
• Anti-corruption and bribery
• Diversity on company boards

Exactly HOW each entity fulfils the requirements of the NFRD is up to the entity itself. It can choose from any number of reporting guidelines, such as the GRI (Global Reporting Initiative), ISO 26000, SASB and other internationally accepted standards.

However an entity chooses to comply with the NFRD, it should include in its reporting the proportion of turnover, CapEx and operating expenses related to Taxonomy activities – also referred to an ARTICLE 8 disclosure.

The EU defined “taxonomy activities” or sustainable economic activities in six areas (all environmental), phased in during 2022-2024:

• Climate change mitigation (from January 2022)
• Climate change adaptation (from January 2022)
• Sustainable use and protection of water and marine resources (from January 2023)
• Transition to a circular economy (from January 2023)
• Pollution prevention and control
• Protection and restoration of biodiversity and ecosystems

In addition to reporting on each of these, entities are also required to r

The SFDR was adopted in March of 2021 to increase transparency and enhance credibility in investment products. It is an additional reporting standard covering financial products that have sustainable investment, environmental or social characteristics as their objective.

As the NFRD took effect and Taxonomy activities were reported, other additions and changes made the system even more complex. Some of the reporting was redundant, there was a lack of consistency (and transparency), and only a small subset of entities were required to report.

With these issues in mind, the EU charged the EFRAG (the European Financial Reporting Advisory Group) to assess the current issues and to create standards… the ESRSs. They also expanded the NFRD through a new directive, the CSRD,

The ESRSs are 12 draft standards that should be passed as law (a DA or Designated Act) by the end of August 2023. The ESRs create an obligation for companies subject to the NFRD/CSRD to develop and publish a holistic view of sustainability in their organisation, including:

• the role of sustainability in the corporate strategy and business model
• the material impact the company has on each of the 12 ESG topic areas (and any future sector-specific standards)
• the management of sustainability within the organisation
• the policy, objectives and action plans for each of the standards
• the company performance in each of these areas

The CSRD will replace, expand and clarify the NFRD from 2024. It will apply to any companies meeting any two of the following criteria:

• Turnover exceeding €40 million
• Balance sheet total exceeding €20 million
• More than 250 employees

The CSRD will also apply to subsidiaries of non-EU companies that meet the above criteria.

The CSRD should help to consolidate the data requirements, but will also increase the information needed, both quantitative and qualitative. It requires a short- and a long-term view, both future and backwards, and includes the value chain.

Most notably, the CSRD will will require an external auditor with “limited assurance” up to 2030 when the requirement will increase to “reasonable assurance”.

The CSRD will also require double materiality, or that reporting organisations consider sustainability from two perspectives:

• Inside-out view – the organisation’s impact on people and the environment, such as damage to natural resources or human rights violations
• Outside-in view – external, sustainability-related developments that create both risks and opportunities for the organization, such as reputation risk, taxation and/or development in new areas.

The hope of the double materiality perspective is to both give investors a way to compare risks and opportunities across entities and to encourage those entities to make positive steps in overall sustainability.

In summary, the EU Taxonomy is a first attempt at a classification system for sustainable activities. The NFRD and the SFDR are reporting requirements for large entities and financial instruments, respectively. The EU Taxonomy is being further clarified and made more consistent through the ESRSs. The NFRD is being expanded and replaced by the CSRD.