The Taxonomy Regulation: More Important Than Just as an Element of the Capital Markets Union

On 18 June 2020, the EU ‘Taxonomy Regulation’, (TR) was adopted by the European Parliament and the Council, with the objective to develop a common language and a uniform definition of what counts as environmentally ‘sustainable’ economic activity. Along with the 2019 Sustainable Finance Disclosure Regulation (SFDR) and the 2019 Low Carbon Benchmarks Regulation, it constitutes a ‘trilogy’ implementing the Capital Markets Union (CMU) Action Plan in relation to sustainable finance. The TR is viewed in the context of the climate and energy targets set by the EU for 2030 with a view to becoming climate-neutral by 2050 and substantially builds on the 2020 Report of the Technical Expert Group on Sustainable Finance (TEG), which developed an ‘EU taxonomy’ classification system to determine whether an economic activity can qualify as environmentally sustainable. My recent article, ‘The Taxonomy Regulation: More Important Than Just as an Element of the Capital Markets Union’, aims to analyse this legislative act in the context of EU financial regulation. The article’s objectives are threefold:

The first is to present the system of rules relating to the TR’s ‘core element’, namely setting out criteria according to which an economic activity will be considered environmentally sustainable. This system is anchored in the definition of six environmental objectives, namely climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, as well as protection and restoration of biodiversity and ecosystems (healthy ecosystem). These environmental objectives are the benchmark for assessing whether an economic activity qualifies as environmentally sustainable and, accordingly, for establishing the degree to which a financial investment is environmentally sustainable. The objective is to avoid that investments qualify as environmentally sustainable where the economic activities benefitting from those cause harm to the environment to an extent that outweighs their contribution to an environmental objective.

In particular, for the purposes of the TR, an economic activity qualifies as environmentally sustainable if four criteria are met cumulatively: it substantially contributes to one or more environmental objectives, does not significantly harm any other environmental objective, is carried out in compliance with specific safeguards, and complies with applicable technical screening criteria (TSC) as set out in delegated acts adopted and to be adopted by the Commission. The TSC will come into force in two stages: those on climate change mitigation and adaptation on 1 January 2022 and those on the other four objectives on 1 January 2023. It is also noted that, by 31 December 2021, the Commission must publish a Report describing the necessary provisions to extend the TR’s scope beyond environmentally sustainable economic activities and cover both economic activities that do not have a significant impact on environmental sustainability and significantly harm it, as well as social objectives.

The second objective of my article is to analyse the TR’s field of application and the disclosure requirements for environmentally sustainable investments. The TR applies to measures adopted by Member States or by the EU, setting out requirements for financial market participants or issuers in respect of financial products or corporate bonds that are made available as environmentally sustainable, to financial market participants that make available environmentally sustainable financial products, as well as to undertakings which are subject to the obligation to publish non-financial statements pursuant to the EU Non-Financial Reporting Directive and issue environmentally sustainable bonds. The TR sets out specific disclosure requirements for marketing financial products or corporate bonds as environmentally sustainable investments, which supplement the sustainability-related disclosure rules of the SFDR in pre-contractual disclosures and in periodic reports. It thus intends to alleviate the burden on investors’ own due diligence with regard to the environmental sustainability of products and to address concerns of ‘greenwashing’.

Finally, the article’s third objective is to develop on how the core element of the TR will be of primary importance even for entities which are not covered by its scope of application, namely beyond the reach of the CMU project. It is reasonably argued that the significance of its impact is not confined to firms directly covered by its scope and the disclosure requirements imposed on them. The EU taxonomy classification system laid down in the TR will be taken over in other sources of EU financial regulation. Even though this legislative act does not directly apply to the lending activities of credit institutions, its impact on the latter activity is significant indirectly through the European Central Bank (ECB) ‘Guide on climate-related and environmental risks: Supervisory expectations relating to risk management and disclosure’ of 27 November 2020 and guides to be developed by the European Banking Authority (EBA).

In this respect, on 30 October 2020, the EBA issued a discussion paper ‘On management and supervision of ESG risks for credit institutions and investment firms’, which aims at defining and developing assessment criteria for ‘ESG factors’ (namely environmental, social or governance characteristics, that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual with an impact, in turn, on the financial performance and solvency of credit institutions through their counterparties). The discussion paper further outlines EBA’s understanding of the relevance of ‘ESG risks’ for a sound functioning of the financial sector (ESG risks defined to mean the risks of any negative financial impact to an institution stemming from the current or prospective impacts of ESG factors on its counterparties). These include, but are not confined to, climate-related and environmental risks, as defined in the ECB 2020 Guide.

This discussion paper forms the basis for an EBA Report (expected in June 2021), which will elaborate on the arrangements, processes, mechanisms and strategies to be implemented by credit institutions to identify, assess and manage ESG risks, appropriately embedding them in their internal governance and risk management frameworks. Furthermore, the Report will assess, in accordance with the provisions of the so-called ‘Pillar 2’ of the framework governing the micro-prudential regulation and supervision of credit institutions, the inclusion of ESG factors and risks in the review and evaluation performed by supervisory authorities (including the ECB for significant credit institutions) within the Single Supervisory Mechanism (SSM). Given the frequency of references to the TR in this discussion paper, the taxonomy framework will be a significant benchmark in this respect.

By concluding: the TR sets out the criteria for determining whether an economic activity qualifies as environmentally sustainable for the purposes of establishing the degree to which an investment is environmentally sustainable and lays down a disclosure framework for marketing financial products or corporate bonds as environmentally sustainable investments. Even though the TR applies to EU credit institutions only to the extent that they provide portfolio management services, my article argues that the above criteria will also be taken in account by prudential supervisors when assessing the extent to which EU credit institutions are exposed to ESG risks in the course of the supervisory review and evaluation process.

Christos V. Gortsos is a Professor of Public Economic Law at the Law School of the National and Kapodistrian University of Athens and President of the Academic Board of the European Banking Institute (EBI).