The EU’s ESG investment taxonomies are evolving. Only certain aspects of climate action are currently taken into account, but work is on-going so that the environmental taxonomy covers more areas and will be applied in a subtler fashion. The “social” taxonomy is also being prepared.
Climate change mitigation and adaptation are targeted in the taxonomy that entered into force on 12 July 2020. The goal of this classification is to provide businesses and investors with a common language with which to discuss the drive to sustainability. Yet the current text only goes so far.
New environmental classification
In July the European Commission’s broad-based expert group the Platform on Sustainable Finance (PSF) published proposals to extend this framework. Now, work on the final text is on-going at the Commission. Final texts and the implementation timeline are due by the end of November.
This will include the completion of the environmental taxonomy by adding definitions related to biodiversity and ecosystems, the circular economy, pollution prevention, and water. These aspects will sit alongside the climate-related taxonomy already in force.
Intermediate “brown” taxonomy
Greater subtlety will also be added to the achieving these goals. Dubbed the “brown taxonomy” (a name the Commission isn’t keen on by the way) there will be definitions regarding the move towards greater sustainability. Currently the taxonomy only describes activities that make a “significant contribution” to environmental objectives, while doing “no significant harm” to other objectives (such as social aspects).
There is a “high risk of misinterpretation and misunderstanding” regarding the “intermediate performance” area (that is between making a “significant contribution” and doing “significant harm”) noted the PSF report. There was recognition that the taxonomy did not necessarily encourage polluting industries to make marginal improvements towards sustainability.
For example, Luxembourg-based steel maker Arcelor Mittal emits substantial pollution and so would not qualify for green status. In July it announced plans to invest €1bn to create the world’s first net zero steel plant in Gijón, Spain, which would be powered by hydrogen, yet still this would not alter the company’s green credentials as per the existing taxonomy. The PSF proposals seek a way to reward these efforts.
Hence the brown taxonomy will detail efforts which make an “intermediate contribution” to sit between the two poles of significant contribution and significant harm. The PSF proposals suggest using a traffic light system to highlight this progression.
New social taxonomy
As for the social taxonomy, the PSF draft report does not make this midway distinction, keeping with the definition of projects that deliver a “substantial contribution” or those that cause “significant harm” to social objectives. They also called for the classification to feature existing international authoritative standards, linked to businesses rather than the activities they pursue.
They suggest horizontal and vertical dimensions. The vertical would classify the type of firms that make products and services available while doing no harm to other social objectives. The horizontal factors also lean towards the G for governance of ESG, with reference to corporate governance standards, impacts on a range of stakeholder groups affected by economic activities, tax matters, bribery, lobbying practice and more.
Governance also a factor
Vertical objectives include improving accessibility to products and services for basic human needs (water, waste water treatment, food, housing, health and general care, education etc) and basic economic infrastructure (transport, telecoms, electricity, financial inclusion, waste management etc). Horizontal objectives capture CSR ideas, such as ensuring work practices respect staff, that consumer interests are promoted, helping to build sustainable communities, promoting good governance standards, and following transparent and “non-aggressive” tax planning practices.
Industry bodies had some criticism for these proposals. European fund industry group Efama said only “indisputably” harmful activities incapable of transitional change should be marked as being significantly harmful. They called for these to have a different category from those areas where a significantly harmful performance is a choice by the company. They called for a label to be made available for investments that aim to move activities away from harmful practices.
Similarly, AFME, which represents global banks, called for a dedicated significantly harmful taxonomy focused on activities which could not be improved. “We are concerned that classifying under a significantly harmful taxonomy activities which do have the capability to improve their environmental performance away from significant harmful levels risks stigmatising such activities and deterring investments into companies that wish to transition those activities,” they said.
Efama was also concerned that intermediate performance levels added complexity, so they suggested setting clear thresholds for transformational activity. There were also worries that some aspects of the social taxonomy could become politically contentious.