The EU Taxonomy Regulation and its implementation

13 minutes8/16/2022

The time of greenwashing is nearing its end. Companies and financial institutions are now obligated to place a clear focus on genuine sustainability. Consequently, sustainable business has become far more than an ethical, normative concept and must instead be supported with hard facts and figures. The requirements of non-financial reporting have increased accordingly. A central element in this shift towards qualitatively measurable sustainability is the EU Taxonomy Regulation. But what does it mean for you and your company? In this article, we discuss the most important facts and explore the background of the EU Taxonomy. Learn the circumstances under which the regulation applies to you, and the requirements that business activities must fulfill to become Taxonomy-aligned. You will also receive a checklist with specific steps to guide you on your journey to Taxonomy alignment, as well as a practical example to help clarify matters. Click on the subpoints below to navigate through the article:

• EU Taxonomy: In brief 

  • Sustainability criteria in the EU Taxonomy Regulation

  • The EU Taxonomy’s 6 environmental objectives

• Technical screening criteria and performance requirements 
  • Limits and thresholds 
• 7 steps to implement the EU Taxonomy Regulation 
  • 1. Preparing for sustainability reporting 
  • 2. Preliminary study 
  • 3. Identifying business activities aligned with the Taxonomy 
  • 4. Taxonomy screening to identify substantial contributions 
  • 5. DNSH (Do No Significant Harm) assessment 
  • 6. Due diligence assessment for minimum social standards 
  • 7. Calculating financial KPIs 
• Example assessment of Taxonomy alignment (based on Weidner 2020) 
  • Example company’s situation
  • Assessment of Taxonomy-alignment 
  • Summary
  • Next steps for the example company
• Outlook 

EU Taxonomy in brief

On April 21, the European Commission adopted the Sustainable Finance Package – an ambitious, comprehensive package of measures that aims to help guide capital flows into sustainable activities across the European Union. An elementary part of this package is the EU Taxonomy, more precisely known as the EU Taxonomy Regulation (Regulation (EU) 2020/852). This is a set of screening criteria that aims to facilitate assessments as to whether a business activity makes significant contributions to sustainability – particularly towards climate change mitigation and adaptation. Beyond making a significant objective to one or more environmental objectives, none of the other environmental objectives must be harmed. In addition, the EU Taxonomy also requires alignment with minimum social standards. The Taxonomy has created, for the first time, a framework of regulations that set out what constitutes environmentally sustainable business.

Sustainability criteria in the EU Taxonomy Regulation

 The Taxonomy Regulation states that a business activity is “environmentally sustainable” if

• … it makes a significant contribution to achieving one or more environmental objectives
• … it does not have a negative impact on any other environmental objectives
• … minimum social standards are upheld (e.g. OECD Principles, UN Guiding Principles on Business and Human Rights, ILO Labor Standards)

Technical evaluation criteria and performance requirements

The contributions to environmental goals are supported with criteria in further delegated acts, and with reference to the other EU regulations and EU guidelines. Companies must demonstrate that business activities correspond to technical screening criteria that determine performance requirements for certain business activities. Although the performance criteria relate to each of the six environmental objectives, they have only been explicitly spelled out for the first two: climate change mitigation and adaptation. These performance criteria can be used to determine under what circumstances and to what extent an activity positively influences environmental objectives without compromising the other objectives.

A distinction is also made between environmentally sustainable (“green”) business activities, enabling activities and transitional activities. These activities either make a direct, significant contribution or are indirect, and have an enabling effect and support the transition to a climate-neutral economy. This would be the case, for example, if a company’s products help to reduce GHG emissions in their use phase for end customers or other companies. Enabling activities must therefore have a positive impact over the course of their life cycle. Transitional activities contribute to a climate-neutral economic system in cases where there are no climate-friendly alternatives available for technical or economic reasons. However, these transitional activities must be the most environmentally friendly in their sector, and must not exacerbate lock-in effects.

Good to know: The lock-in effect

A lock-in effect is based on a path dependence and obstructs the progress of better alternatives despite its inferiority.

One relevant lock-in effect in this context is carbon lock-in. This path dependence relates to fossil fuels and is industrial and technological in nature. The carbon lock-in is a persistent state in which market barriers and political barriers massively hamper the spread of low-carbon alternatives despite their environmental and economic advantages.

Limits and thresholds

The performance requirements either consider activities generally sustainable or take the form of limits and thresholds. 

The EU Taxonomy only regards plastics as generally sustainable if they were produced entirely through mechanical recycling of used plastics. Chemical recycling is only considered insofar as there is no mechanical method available or if mechanical methods are not economical. Life cycle assessments for chemical recycling must demonstrate that the GHG emissions across the entire life cycle are lower than of for conventional, fossil-based plastics. Such assessments must not take into account any credits, such as for decoupling from fossil fuels, or substitution effects. Bio-based plastics produced using renewable materials, i.e. biomass, industrial bio waste and municipal solid waste, are considered sustainable if it can be demonstrated that they produce lower GHG emissions than conventional, fossil-based manufacturing methods. In addition, biomass cultivation must comply with sustainability criteria as set out in Directive (EU) 2018/2001.

The limits and thresholds are set down in regulations on the allocation of free emissions certificates as part of the European Union Emissions Trading Scheme or correspond to an energy efficiency benchmark. In each case, the best 10% of European manufacturing figures are taken as the benchmark. More precisely, the benchmark is determined by figures from the top 10% most efficient installations in 2016 and 2017, in accordance with the Annex to Implementing Regulation (EU) 2021/447). 

7 steps to implement the EU Taxonomy Regulation

To comply with the EU Taxonomy, companies must carefully analyze their business activities and identify the extent to which they make a substantial contribution to the six environmental objectives. They must also demonstrate than certain activities do not have a negative impact on other environmental objectives, and that minimum social standards are upheld.

It is important to establish and adapt data collection, controlling and reporting processes to facilitate the subsequent reporting of financial and non-financial KPIs. Companies should therefore integrate the relevant departments and other key stakeholders at an early stage. Use the following steps to guide your journey to Taxonomy alignment:

1. Preparing for sustainability reporting

Systematic preparation is an advisable first step before the legal requirements take effect. This involves clarifying your company’s objectives and reaching a shared understanding about your level of ambition. Do you want to achieve alignment quickly, focus on strategic sustainability innovation, or implement long-term sustainability management based on continuous improvement? When making decisions in the preparation phase, it is important to take into account perspectives that reflect your industry context as well as contributions for different parts of your company (e.g. Sustainability, Controlling, Finance, Alignment, Sales and Production departments, etc.).

2. Preliminary study

You should establish the data you need and any information gaps at an early stage, ideally in a preliminary study. Until the final version of the CSRD is released, we also recommend gaining initial experience with standards in use to date.

3. Identifying business activities aligned with the Taxonomy

The EU Taxonomy Compass is an Excel spreadsheet containing basic information about “green” business activities. It allows companies to check whether they perform one of the listed activities or make a direct contribution to other companies’ GHG emission reductions. It also enables companies to identify transitional activities for which no climate-friendly alternatives currently exist. Financial indicators must be recorded for such activities.

4. Taxonomy screening to identify substantial contributions

Technical screening criteria and defined thresholds make it possible to examine alignment with the minimum requirements of the Taxonomy. So far, requirements have been published for two objectives: climate change mitigation and climate change adaptation. Further delegated acts will set out criteria for the other environmental objectives.

5. DNSH (Do No Significant Harm) assessment

Using a set of control questions, this assessment involves checking that each selected activity is not expected to have a significant negative impact on the environmental objectives.

6. Due diligence assessment for minimum social standards

This step involves examining individual business activities and upstream steps in the value chain for adherence to minimum social standards (e.g. OECD Principles, UN Guiding Principles on Business and Human Rights and the ILO Labor Standards)

7. Calculating financial KPIs

In this step, the task is to analyze the proportion of turnover, CapEx and OpEx from business activities that the previous steps have shown to be Taxonomy-aligned. This final step also includes collecting supporting documents and data, e.g. carbon footprints and life cycle analyses.

Example assessment of Taxonomy alignment (based on Weidner 2020)

Example of a company’s situation

A cement producer with five sites in Germany must demonstrate its alignment with the EU Taxonomy to an investor and outline the extent to which the company’s activities contribute to sustainability. Producing cements is highly carbon intensive due to the direct (i.e. process-related) CO2 emissions in clinker production and the high-temperature processes. The process-related CO2 emissions in calcination account for around 65% of total emissions. As it stands, these emissions cannot be yet avoided.

Assessment of Taxonomy-alignment

All five of the example company’s sites exclusively produce cement, with each factory contributing 20% of the company’s overall turnover. Only two factories are able to comply with the EU Taxonomy threshold by producing cement with average emissions of less than 0.722 t CO2e/t. Consequently, only the business activities at these two sites could be designated as environmentally sustainable in accordance with the EU Taxonomy Regulation. Note the phrasing: “could be designated”. Before the company can declare that these sites conform to EU Taxonomy requirements, it must demonstrate that these activities adhere to the DNSH principle and do not have a negative impact on any of the other five environmental targets. First, the company is able to demonstrate that all of its sites meet all minimum requirements set out in the OECD Guidelines for Multinational Enterprises. However, one of the two cement factories is in an area that has experienced repeated water shortages over recent summers. So, the cement productionoperations have a negative impact on the environmental objective of sustainable use of water resources.

Summary

Given that only two locations comply with the threshold, and one of these two has a negative impact on an environmental objective, the company can only designate 20% of its turnover as aligned with the EU Taxonomy.

Next steps for the example company

As only two of the company’s five factories comply with the threshold set down in technical screening criteria (0.722 t CO2e/t), the company should invest in energy efficiency measures, process improvements and negative emissions technologies.

From the current perspective, the use of carbon capture and storage (CCS) and potentially carbon capture and utilization (CCU) technologies appears inescapable, if the cement sector is to be climate-neutral. Electrification and fuel switching are potential ways to reduce the indirect emissions generated in the provision of process heat. The example company will invest €25 million to implement initial measures over the next few years, thereby making a contribution to the environmental objective of climate change mitigation. In a smaller-scale project with a budget of €2.5 million, the company will invest in drainage systems at one of its sites, which will contribute to flood protection and thereby support the environmental objective of climate change adaptation. The company aims to secure outside capital of €27.5 million to finance these measures. The investments in these measures can be described as fully aligned with the EU Taxonomy.

Outlook

Companies must inform themselves about the scope of the Taxonomy Regulation and develop implementation strategies. Due to the Taxonomy’s aims to channel cash flows into sustainable business opportunities, there is growing pressure to optimize sustainability performance and produce transparent reporting. Only through strategic sustainability management and by following the 7 steps to implement the EU Taxonomy Regulation will you be able to secure access to the capital market over the long term.

However, the shift towards sustainability pervading society as a whole is a strong argument in favor of voluntary Taxonomy reporting. Your company will benefit from higher demand on the capital market as well as more favorable financing terms for public funding and investment programs. Sustainability management within the content of the EU Taxonomy is a continuous improvement process in which investments can usually be designated as fully Taxonomy-aligned. You should view the EU Taxonomy Regulation as an opportunity to drive forward economic progress and for your company to make a genuine contribution to achievement of the UN Sustainable Development Goals.