The EU Taxonomy Regulation is a classification system that allows investors to prove the sustainable nature of their investments. It is an optional framework that identifies criteria (more specifically, Technical Screening Criteria or ‘TSC’) to determine when an economic activity can be labelled as ‘sustainable’.
The EU Taxonomy Regulation is interconnected with other EU sustainability reporting regulations, namely, the SFDR, for financial entities, and the CSRD, for non-financial undertakings.
The goal is to provide companies, investors and policymakers with appropriate definitions for which economic activities can be considered environmentally sustainable. Subsequently, the aimed result is to create certainty for investors and protect them from greenwashing, to assist companies in increasing their environmental consideration, and to lead the shift towards a sustainable economy.
If an entity wishes to claim that its activity pursues sustainability objectives, it must prove so by complying with the TSC quantitative and qualitative thresholds and conditions. From a private equity perspective, fund managers of an Article 8 or 9 fund must prove that their portfolio companies promote or contribute to sustainability.
How to assess EU Taxonomy alignment?
In essence, fund managers must prove their alignment with at least one of the six core environmental objectives:
- Climate change mitigation
- Climate change adaptation
- Water
- Pollution
- Biodiversity
- Circularity
It must be noted that social objectives have not yet been integrated in the EU Taxonomy and, therefore, funds which exclusively promote or contribute to social objectives are left out of this framework and can reasonably decide not to disclose these figures. If you would like to know more about the development of a social taxonomy, check out this article.
Fund managers must first identify the economic activities that their portfolio companies engage in. If those activities can be found in the EU Taxonomy framework, they are considered ‘eligible’. The second step is to check the TSC that apply to each eligible activity and assess whether the portfolio company meets the requirements to be considered ‘aligned’ with sustainability standards.
The EU Taxonomy alignment assessment is a three-step process:
- Demonstrate your Technical Screening Criteria for one of the six environmental objectives.
- Prove you Do No Significant Harm to the five remaining objectives.
- Satisfy the Minimum Social Safeguards.
If your company complies with all three steps, you can market your business activity as ‘sustainable’ in conformity with the EU Taxonomy.
The definition of the first two environmental objectives (climate change mitigation and adaptation) was published back in 2021. In 2023, the Commission published the remaining four (water, pollution, biodiversity and circularity).
Disclosures under the EU Taxonomy Regulation
If determined that a specific entity’s activity is eligible under EU Taxonomy, after reviewing the applicable TSC, it will be classified as either aligned or non-aligned. Now, if determined that the activity is actually aligned, it is also important to measure the extent of that alignment through Key Performance Indicators ('KPIs').
To put it simple, TSC determine whether the activity is eligible and aligned under EU Taxonomy, that is, whether it can be considered sustainable; whereas KPIs quantify the company’s actual contribution to that Taxonomy-aligned activity. If a company is aligned with more than one Taxonomy-aligned activity, this assessment will still be only done once.
In particular, fund managers must disclose the proportion of their products investing in EU Taxonomy-aligned companies or projects. The goal is to achieve transparency for investors, promote capital redirection towards EU Taxonomy-aligned activities and hold financial entities accountable for their contribution (or lack thereof) to sustainability.
The most used metric to disclose eligibility and alignment is turnover. Nevertheless, there are many cases in which the eligible activity does not generate revenue. For this reason, we recommend measuring all three KPIs (turnover, CapEx and OpEx), to have a more accurate overview of the sustainability characteristics of the investment and higher chances to showcase your company’s efforts.
The Reporting Templates for non-financial undertakings can be found in Annex II of the Disclosures Delegated Act. Annex I contains additional reporting requirements.
The templates require aggregated summaries of the KPIs, specifying the alignment with substantial contribution to each environmental objective, with DNSH criteria and with the minimum safeguards. In addition, companies must disclose their methodology and the assessment process. The CSRD also requires third party verification of EU Taxonomy Reports.
414 can assist you in identifying and disclosing your EU Taxonomy eligibility and alignment.
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