EU Taxonomy in practice: What companies should know

published on 21 February 2023

The EU taxonomy is currently the talk of the town, especially among companies, banks, and investors. As a classification system for “green” activities, it is an important instrument of the “Sustainable Finance” action plan adopted within the European Green Deal. The aim of the taxonomy is to steer future investments into sustainable economic activities and thus make an important contribution on the way to climate neutrality in 2050. At the same time, the taxonomy poses reporting challenges for companies, as the implementation effort was underestimated for a long time.

Climate neutrality by 2050 - the European Union has set itself this ambitious goal as part of the European Green Deal and has launched a series of measures to this end in recent years. Accordingly, extensive capital flows are to be channeled into ecologically sustainable economic activities in the future in order to decouple the EU's economic growth from resource use and thus finance the transformation to a green, climate-neutral economy. But what exactly is an “environmentally sustainable economic activity”? This is where the EU Taxonomy comes in, a set of rules developed by EU bodies since 2018 that sets uniform standards for green business. This is intended to encourage companies to increasingly incorporate environmental, social, and governance (ESG) aspects into their risk management. The taxonomy has been fine-tuned for a long time and has been in force, at least in part, since the beginning of 2022 – and sometimes poses major challenges for companies in terms of interpretation and implementation.

THe Goals at a glance »
Who does the taxonomy affect? »
Conclusion»

The goals at a glance

The overall objective of the regulation is to redirect future capital flows towards “green” investments in order to create sustainable and inclusive growth. The EU taxonomy is a standardized and transparent classification system that enables investors to directly compare companies with regard to their sustainability performance and to direct their financial resources to green companies. In this context, the taxonomy does not represent a commitment to sustainable investments or economic activities, but primarily serves to identify “green” activities. Exactly which activities contribute to the restructuring of the economy and thus count as “green” is determined by the six climate and environmental targets defined by the EU:

Climate change mitigation
Adaptation to climate change
Sustainable use and protection of water and marine resources
Transition to a circular economy
Pollution prevention and control; and
Protection and restoration of biodiversity and ecosystems.

Whether or not an economic activity is considered sustainable is determined by the technical evaluation criteria, which set performance thresholds to be achieved for each activity and environmental objective. However, it is not sufficient for an economic activity to make a significant contribution, as defined by the technical evaluation criteria, to achieving one or more of the designated environmental objectives. In addition, it must not compromise any of the other environmental objectives and must be carried out in compliance with the minimum level of protection (e.g. OECD Guidelines for Multinational Enterprises; UN Guiding Principles on Business and Human Rights).

Who does the taxonomy affect?

In principle, all companies covered by the Non-Financial Reporting Directive (NFRD) and its German implementation in the German Commercial Code (HGB) (cf. sections 289b, 315b HGB) are also required to disclose information on the conformity of their business activities with the EU taxonomy. Accordingly, the EU taxonomy currently affects those capital market-oriented companies that have already been required to publish non-financial disclosures in Germany since 2017 under the CSR-RUG. On 05.01.2023, the new Corporate Sustainability Reporting Directive (CSRD) has been published, whereby the circle of companies subject to reporting requirements and thus affected by the EU taxonomy is successively expanding considerably. Medium-sized companies in particular are often unaware that, according to the current timetable, they too could be affected by the reporting obligation for fiscal years beginning on or after January 1, 2025. It is therefore important to deal with the requirements and the implementation of the EU taxonomy at an early stage.

In summary, the following deadlines are currently foreseen for implementation by companies:

2024 for all large companies already required to report under NFRD (reporting in 2025 for fiscal year 2024)
2025 for all large companies (reporting in 2026 for fiscal year 2025)
2026 for all capital market-oriented small and medium-sized enterprises with the exception of micro enterprises (reporting in 2027 for the financial year 2026).

What content must be disclosed?

Basically, the regulation provides for the disclosure of the share of “green” sales revenues, capital expenditures (CapEx) and operating expenditures (OpEx) in terms of the taxonomy for each individual taxonomy-capable or -compliant economic activity and for each of the environmental targets. Using these metrics, the taxonomy is intended to provide a basis for investment decisions and to increase the informative value of reporting, for example, by outlining what percentage of a company's revenue comes from sustainable economic activities.

Although the EU taxonomy has already been applicable since the 2021 reporting year, the two previous reporting periods were still subject to a number of simplifications for the companies concerned. For example, companies previously only had to provide information on the two environmental objectives “climate protection” and “adaptation to climate change”. The requirements for the other four environmental objectives of the EU taxonomy have not yet been published in final form and their content and publication date remain to be seen.

What are the challenges for companies?

In practice, the EU taxonomy is currently causing headaches for many companies, not least because of its diverse scope for interpretation. The taxonomy makes it mandatory to increasingly link sustainability reporting with financial reporting. However, the high number and the required level of detail of the indicators make the disclosure very complex and the associated effort should not be underestimated under any circumstances. Many of the required data will probably not be available to companies at the push of a button, and internal processes, IT systems and control mechanisms will have to be adapted to the new requirements accordingly. For this very reason, it is advisable to collect, process and analyze taxonomy-relevant data and key figures internally at an early stage, even if the company is not yet obliged to do so at the present time.

Another effort that should not be underestimated is the evaluation of taxonomy conformity. Within the framework of the EU taxonomy, all those activities that have been identified as taxonomy-compliant must subsequently be checked for taxonomy conformity. The conformity assessment is a triad of technical requirements, the so-called “Do No Significant Harm” (DNSH) criteria, and minimum social protection requirements together. In particular, the procedure and scope for testing the minimum social requirements and the climate risk analysis to be carried out as part of the technical assessment criteria are currently still subject to considerable design uncertainties. It is therefore advisable for companies to address these issues as early as possible.

Even companies that do not generate taxonomy-relevant sales must deal with the EU taxonomy, since companies must analyze CapEx and OpEx in addition to sales.

With regard to the expansion of the user group as well as the contents of the EU taxonomy, a rapidly increasing demand for qualification and personnel is to be expected in the next few years. From the company's point of view, it is therefore worthwhile to create sufficient personnel resources and capacities now, to establish further training programs and to recruit qualified specialists.

Conclusion

The scope and effort of reporting on EU taxonomy is currently still underestimated by many companies. Due to the depth of detail of the individual assessment criteria within the framework of EU taxonomy and the strong interdisciplinary nature of the topic, it is necessary for companies to deal with the topic at an early stage.

As a company, it is important to be aware of the scope of reporting under the Taxonomy Regulation. As a result of the desired orientation of future capital flows towards sustainability, companies must adapt to this change in order to secure their financing in the long term. However, changing stakeholder expectations and the social interest in sustainability also speak in favor of a voluntary report on the Taxonomy Regulation, even if the company is not yet affected by the taxonomy. Companies with a high proportion of taxonomy-compliant activities can then benefit from better financing conditions, but also access to public funding and investment programs.