Patricia Diogo Patricia Diogo

The European Taxonomy: Redirecting Investment Towards Green Objectives

The European Taxonomy, launched by the EU in 2018, provides a framework for classifying sustainable economic activities to guide investments toward climate and environmental goals. It defines which activities are 'green' based on their contribution to six objectives, including climate change mitigation and pollution prevention. The regulation aims to boost transparency, shift capital flows to sustainable investments, and incorporate sustainability into financial risk management. By 2026, both financial and non-financial companies must fully report on their alignment with all six objectives.

The European Union Green Taxonomy categorizes environmentally friendly economic activities. It is considered an environmental compass for identifying private investments aligned with the EU climate and environmental objectives.

The regulation establishes reporting requirements for financial and non-financial companies concerning the proportion of their green investments. This document is a powerful tool for the transition of economic activities, as it enables to:

  • Improve the transparency of the private sector in terms of sustainable investments;

  • Redirect capital flows towards sustainable investments;

  • Facilitate the integration of sustainability issues into risk management.

HISTORICAL SUMMARY

Launched in 2018 by the European Commission, the primary aim of this text was to guide and mobilize private investment to achieve climate neutrality by 2050.

As a first step, a group of scientific experts was brought together to establish criteria and gauge the environment of economic activities to achieve carbon neutrality ambitions by 2050 and 2030.

The result was a set of criteria for analyzing whether an economic activity qualifies for a ‘green’ label, stipulating that it makes a substantial contribution to at least one of the European Union’s six environmental and climate objectives.

THE EUROPEAN TAXONOMY APPROACH

The six objectives of the European Taxonomy are as follows:

  1. Climate change mitigation (Climate Delegated Act);

  2. Climate change adaptation (Climate Delegated Act);

  3. Sustainable use and protection of water and maritime resources (Delegated Environmental Act);

  4. Transition to a circular economy (Environmental Delegated Act);

  5. Pollution prevention and control (Environmental Delegated Act);

  6. Protection and restoration of biodiversity and ecosystems (Delegated Environmental Act).

More than a hundred economic activities are listed as contributing to the six climate and environmental objectives.

The Taxonomy also distinguishes two categories of activities:

  • ‘Enabling’ activities – activities that enable other activities to contribute to one of the objectives, thereby promoting the development of sustainable sectors;

  • ‘Transitional’ activities – activities for which there are no low-carbon alternatives, but their greenhouse gas emissions correspond to the best performance in the field.

➠ In this context, gas and nuclear energy are considered ‘transitional’ activities.

To determine whether an economic activity is ‘green’ within the meaning of the Taxonomy, three steps must be followed:

  • Eligibility: an activity is considered ‘eligible’ if it is included in the evolving list of activities appearing in the delegated acts of the Taxonomy regulation. It is likely to contribute to at least one of the six objectives.

  • Alignment: an ‘eligible’ activity is considered ‘aligned’ if it meets the following criteria:

    • It meets the technical alignment criteria defined for the activity;

    • It does not harm any of the other five objectives (DNSH - Do No Significant Harm);

    • It complies with minimum guarantees such as the OECD and UN guidelines.

A company can have eligible but non-aligned activities. However, it is important to report these elements to demonstrate transparency.

This shows that the company has green activities, but does not yet fully meet the alignment criteria.

  • The third fundamental step of the Taxonomy consists of indicating the proportion of investments covered by these green activities.

    • The green share of turnover;

    • The green share of investment spending (CapEx);

    • The green share of operating expenses (OpEx).

THE APPLICATION FRAMEWORK

The companies subject to the reporting obligation under the Green Taxonomy are the following:

  • Non-financial companies, mainly large listed and unlisted companies with more than 250 employees.

  • Financial companies, such as credit institutions, insurance companies, and investment companies.

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Patricia Diogo Patricia Diogo

Overview of ESG Criteria: Challenges & Opportunities

ESG criteria cover environmental, social, and governance aspects of sustainable finance. They help investors align investments with sustainability goals, guided by regulations and ESG scores from rating agencies. Adopting ESG criteria can enhance reputation and attract investors, despite challenges like data quality, and greenwashing.

WHAT DOES ESG MEAN?

ESG criteria bring together all environmental, social, and governance considerations. It is a character, a notion related to one of these three components: environment, social, and governance. Each of these three categories of criteria has its distinct parameters.

The environmental criterion concerns everything related to natural resources, greenhouse gas emissions, biodiversity, or climate change. In short, it concerns the environment, from a scientific point of view, fauna and flora, climate, and energy. It is the “green” footprint of ESG criteria.

The social criterion takes on a human dimension, referring to the population as a whole: employees, customers, and the community. In short, it's all about human society and the challenges it faces to evolve in a sustainable way. These challenges include gender equality, well-being, diversity, inclusion, and working conditions.

The governance criterion concerns how a company directs and controls. In short, it is the process by which an entity makes decisions to meet the needs of its stakeholders or to demonstrate compliance with the law. The latter covers all aspects of a company’s transparency and accountability, the independence of its board of directors, its business ethics, its fight against corruption, and the rights of its shareholders.

Brief background: Under France’s 2015 Energy Transition law (Article 173), companies and institutional investors are required to disclose information on how they integrate ESG criteria into their investments.

WHAT ROLES DO ESG CRITERIA PLAY?

Today, ESG criteria are becoming increasingly important for investors. They enable them to choose investments aligned with their values and sustainable objectives. While financial aspects have always been at the heart of analysis, extra-financial analysis is gaining importance as the challenges of global warming and new regulations take center stage.

There are many reasons why investors want to take a more significant account of ESG criteria:

  • To direct their capital towards activities that respond to global challenges;

  • To generate long-term value since sustainable practices are more able to withstand the risks and changes of an economy in transition;

  • Exert influence to encourage better practices;

  • Achieve better sustainability performance from their portfolios;

  • Benefit from innovation influenced by sustainability concepts.

HOW TO ANALYZE ESG CRITERIA?

An ESG criterion has a score that can be calculated: the ESG score. It is a quantitative measure of a company’s sustainability performance.

There are several ESG rating agencies, such as Sustainalytics and Refinitiv. Each applies its methodology, which includes data on all three pillars − environment, social, and governance − and bases its results on public reports or company surveys.

A good ESG rating sends out clear signals: the company is doing its best to manage the risks and opportunities associated with the three criteria. It also suggests that it is demonstrating long-term resilience and responsible corporate governance.

Therefore, an investor can use his ESG scores in his decision-making. A poor score would signal “beware of potential risks.” A good score would signal a company that is permanent in terms of sustainability. It means “better risk management,” hence a greater likelihood of long-term success.

OPPORTUNITIES

Adopting and improving ESG criteria can open a wide range of opportunities for a company.

These include:

  • Enhanced reputation and credibility: a company with a good ESG approach will be better perceived by investors, along with consumers, and talents;

  • Attract institutional and individual investors with important ESG objectives: improves access to financing and capital;

  • Better risk management due to changes in regulations, markets, and disasters linked to climate change;

  • Aligning with new regulations: companies will increasingly be required to report on their ESG performance, as is the case with the Corporate Sustainability Reporting Directive (CSRD) in Europe;

  • More subtly, ESG criteria integration reinforces thinking about innovative products and services that may have a long-term financial interest;

  • Improve corporate performance through better control of energy consumption and resource management;

  • Retaining stakeholder commitment: employees, customers, investors, and the community are increasingly aware of sustainability issues and will be more inclined to associate with a company that shares the same concerns.

CHALLENGES

The challenges of ESG criteria differ according to the size of the company (SME or large corporation). From a global perspective, here are the main ones:

  • ESG standards are not yet uniform: benchmarking ESG criteria can still be very tough due to the large number of ESG standards and frameworks, making harmonization sometimes wearisome. The CSRD should enable greater harmonization over time in Europe;

  • Data quality: can be compromised by different, incomplete, or inconsistent sources, making the sustainability performance assessment unreliable;

  • Greenwashing: ESG criteria can be used as a marketing tool, giving the impression of a strong commitment without convincing results or actions;

  • Quantifying ESG impact: practices and efforts in terms of ESG criteria do not always make it possible to assess the tangible outcomes of these efforts;

  • ESG ratings from different rating agencies can vary significantly due to the contrasting methodologies used by each of them making analysis very complex for the investor.

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Patricia Diogo Patricia Diogo

A Brief History Of Sustainable Finance

WHAT DID IT USE TO BE LIKE?

In the 18th century, an Anglo-Saxon religious community, the Quakers, refused to invest in the arms and slave trades…

WHAT DID IT USE TO BE LIKE?

In the 18th century, an Anglo-Saxon religious community, the Quakers, refused to invest in the arms and slave trades. Without realizing it, a new era of finance was born: sustainable finance. The first financial strategies were based on excluding sectors that did not correspond to certain values.

Over time, and especially from the 1970s onwards, the phenomenon gained momentum. Numerous movements, notably the economic boycott of Apartheid in South Africa proposed to the United Nations in 1962, created an approach to sustainable and responsible investment. Since then, awareness of the challenges of climate change has mingled with these new investment principles. In 1972, the Meadows report “The Limits to Growth” presented the ecological consequences of economic growth. It was not until 2000 that the term “sustainable finance” was explicitly used, a concept in full bloom that laid the foundations for a more respectful financial system. As history shows, sustainable finance has always been in tune with the times and seeks to take into account all aspects of society in addition to financial issues.

It responds to all of society’s concerns and is characterized by what we call ESG (environmental, social, and governance) criteria. This acronym first appeared in 2004 in the United Nations’ “Who Cares Wins” report, under Kofi Annan’s mandate. In 2015, the UN’s 17 Sustainable Development Goals for 2030 marked a significant step forward, setting precise targets for sustainability. That same year, COP21 resulted in the Paris Agreement aimed at containing “the increase in global average temperature well below 2°C above pre-industrial levels,” and making the necessary efforts to limit it to 1.5°C by 2100. All these initiatives are aimed more broadly at the various financial companies, to promote changes in practices that are more in tune with the current challenges facing our world.

OUR TODAY

Sustainable finance refers to all financial practices that promote the common good over the long term. Numerous ambitious initiatives are currently providing a framework for this fast-growing field. Various labels, benchmarks, and standards provide definitions and certifications. For example, the Label ISR, created in France in 2016, guarantees that ISR-labeled funds take ESG criteria into account in their investment process. Innovative new financial tools, such as green bonds, have a fast-growing market. Last but not least, recent regulations are defining a framework and standards for many companies and financial institutions. The European taxonomy provides a clear classification of an economic company’s green activities. The CSRD (Corporate Sustainability Reporting Directive) aims to strengthen and harmonize sustainability reporting standards for companies in the European market.

WHAT WILL TOMORROW BRING?

Sustainable finance is still a work in progress. The future is just around the corner and, as time goes by, we can see that the efforts and demands are becoming ever greater. Many challenges remain. The absence of uniform and universal standards, the problems of greenwashing, and the difficulty and complexity of measuring the impact of companies are all issues that need to be addressed. COP28 in Dubai proved that climate debates have become a highlight of international meetings. While new directives, notably the CSRD, are gradually being applied, they will concern more and more companies, and reporting requirements and, more broadly, alignment with the principles of sustainable finance will be a mandatory pillar for all tomorrow’s stakeholders. Awareness-raising and the quest for knowledge will be essential to support the fight against global warming. Implementing clear strategies and objectives can only be beneficial to every entity.

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