TEG it easy : The landmark EU Sustainable Taxonomy takes shape

On 12 March 2020, the European Commission released the final reports of the Technical Expert Group (TEG) on Sustainable Finance, including the final reports on the EU Sustainable Taxonomy. The OECD has been supporting this process as an observer since the inception of the group in June 2018. For a wide range of stakeholders and policymakers, the final EU Taxonomy reports represent an important milestone. But what exactly do they address? What is at stake? How does the OECD add value to the process? What are the next steps, and how is the EU Sustainable Finance Taxonomy relevant in the Covid-19 situation? In order to answer these questions, let’s start with the basics.

In December 2019, European co-legislators adopted the so-called “Taxonomy” regulation. It defines the framework under which an economic activity can be considered environmentally sustainable under European financial legislation.

The regulation defines six environmental objectives:

1. climate change mitigation
2. climate change adaptation
3. sustainable use and protection of water and marine resources
4. transition to a circular economy, waste prevention and recycling
5. pollution prevention and control
6. protection of healthy ecosystems.

In order for an economic activity to be considered eligible under the Taxonomy, it needs to “substantially contribute” to at least one of the six environmental objectives. It also must “do no significant harm” to any of the other objectives. In addition, any taxonomy-eligible activity must comply with minimum social standards, including the OECD Guidelines for Multinational Enterprises, the UN Guiding Principles on Business and Human Rights, and the International Labour Organisation Conventions.

The Technical Expert Group is a group of scientific and market experts appointed by the European Commission to develop detailed assessment criteria for “substantial contribution” to the first two objectives, climate change mitigation and adaptation, and corresponding “do no significant harm” criteria for all other objectives. About 70 economic activities are covered ranging from agriculture to information and communication technologies. The final report and the technical report released in March 2020 by the TEG were developed based on consultation with over 200 industry specialists and scientists, as well as the public.

These reports represent an important milestone but do not yet constitute the final word on the regulation. Based on the technical report, the Commission will develop the next stage of the Taxonomy regulation, the so called “L2 stage” version containing the final criteria. These criteria, covering climate change mitigation and adaptation, will be implemented by December 31, 2021. The “substantial contribution” criteria for the other four environmental objectives (circular economy, water, pollution and healthy ecosystems) will be developed by a domestic platform that will be set up by the European Commission (EC). The entire set of criteria for the six environmental objectives will come into force by the end of 2022.

The taxonomy creates a framework for the financial industry, with a common definition of what the European Union considers to be environmentally sustainable. The purpose is to limit the scope for greenwashing and false claims of climate compatibility, alignment with the Paris Agreement or other environmental virtues. Importantly, the definition is not limited to activities that already meet the criteria, which can be called “green activities”. The definition also includes:

• activities “in transition” to becoming fully compatible with a net zero economy by 2050 (including precise conditions, for instance the emissions threshold declining over time)
• activities “enabling” other activities to become green, such as the manufacturing of wind turbines (again, within a specified threshold).

As it stands, the fully developed EU Taxonomy, which will be available in 2022, will cover all activities contributing to a net-zero economy in the EU by 2050. The EC has also signalled an intention to develop a “brown” taxonomy in the years to come to establish criteria for activities not compatible with such an economy.

The EC’s precise definitions of environmentally sustainable activities are a potential game changer for the financial industry and its emerging “sustainable finance” activities. A clear identification of what is sustainable could help to attract more retail, as well as institutional, savings into sustainable investment. The EC is currently developing other forms of legislation that will incorporate the taxonomy into the definition of sustainable finance products. This would include a new ecolabel for investment funds and disclosures regulation for investment products sold in the EU (including those developed by financial firms with headquarters located outside of the EU).

Use of the taxonomy will be mandatory only for those investment firms that wish to market their product(s) as “sustainable as per EU legislation”. It will also help firms explain their sustainability strategies in a way that is consistent, coherent, and easily comparable for their clients. For the corporate sector, the taxonomy provides a clear indication of what can be showcased as sustainable, and enables disclosure and reporting of sustainability achievements.

The OECD was able to enrich the work of the Technical Expert Group, drawing on its extensive work on green finance and climate mitigation, in particular to help ensure that the approach took full account of the need for diverse transition pathways. The OECD also emphasised the importance of taking a systems approach in the assessment of environmental performance and consideration of the co-benefits and trade-offs. The OECD contributions benefitted from extended interaction with the various financial actors around the TEG table.

As stated by the TEG in a public statement released on April 27, the Sustainable Taxonomy can also provide a  framework for future recovery measures, as it shows the environmental performance standards that new investments should achieve to enable the achievement of climate and environmental goals.

Due to the nature of globally integrated capital markets, financial market participants selling products into the EU, and the products themselves, will fall in  the scope of the EU Taxonomy. In light of the international implications of the taxonomy and other EU sustainable finance developments, the EC set up an International Platform on Sustainable Finance and has invited the OECD to join the Platform as an observer. Several non-EU jurisdictions have already joined the initiative. The Platform will act as a forum to discuss the international coordination of sustainable finance definitions.

To contribute to this dialogue, a forthcoming OECD report will present a stocktake of efforts to develop  sustainable finance definitions and taxonomies, mapping existing and emerging sustainable finance definitions and taxonomies in five jurisdictions: the EU, China, Japan, France and the Netherlands. It will identify common features of those taxonomies and definitions, as well as any differences and gaps, i.e. areas that are not currently covered by those frameworks. The report, to be published later this year, will also provide initial considerations on good practices for taxonomy design.

For more information on OECD work related to green finance and investment, visit: https://www.oecd.org/cgfi/