What does EU taxonomy mean for fund managers?

What does EU taxonomy mean for fund managers?

Published: 18 Jan 2023 · Last updated: 18 Jan 2023

What is the EU Taxonomy?

The EU Taxonomy underpins the current shift towards transparent and measurable financial and non-financial environmental, social, and governance (ESG) reporting. It aims to reinforce corporate disclosures and mitigate the risk of greenwashing. The EU Taxonomy is a detailed piece of legislation that defines both what is - and, crucially, what isn’t - sustainable. It does this by outlining the minimum criteria for sustainable activities across six different goals.

These goals relate to:

• Climate change mitigation.
• Climate change adaptation.
• Circular economy transition.
• Pollution prevention.
• Biodiversity and ecosystems.
• Sustainable use and protection of water and marine resources.

The detail required to comply with the taxonomy is known as the technical screening criteria (TSC). TSC have been published for the first two goals: climate change mitigation and adaptation. As such, taxonomy eligibility and alignment can only be established for these two goals. Details for the last four goals were supposed to be provided at the beginning of 2023, but the TSC remain unknown.

Who does EU Taxonomy affect and when?

EU-based listed companies with more than 500 employees (i.e., companies under the Non-Financial Reporting Directive, or NFRD), and financial market participants (FMPs) operating in the EU, had to report on their taxonomy eligibility in 2022. The listed companies will have to report on their taxonomy alignment by 2023, and the FMPs will need to do this by 2024.

For full details on who is regulated under the taxonomy and when they will be regulated, the European Securities and Markets Authority (ESMA) have created a useful PDF. However, it's worth noting that this is subject to change.

How should I approach taxonomy compliance as a fund manager?

The EU Taxonomy is constructed so that companies assessing their alignment can follow a series of steps to abide by these new regulations. Fund managers must take extra steps to aggregate the company-level alignment data to fund level.

The steps are as follows for each portfolio company:

Step 1: Assessing eligibility with the taxonomy objectives

Assessing eligibility is the process of checking whether the activities of the company in question are considered in the current taxonomy regulation. The two taxonomy objectives for which there are technical screening criteria do not cover all possible company activities. In fact, most company activities are not covered. In this case, no further steps are required to be taken. The activities that are covered tend to be emission-intensive, as the current version of the taxonomy covers sectors that emit around 93% of European scope 1 GHG emissions.

It is important to note that activities not currently covered by the taxonomy do not reflect positively or negatively on the activity in question. As the regulation is updated, we expect the number of eligible activities to increase. This means it's important that companies and fund managers need to stay up to date with the latest updates on taxonomy regulation.

Step 2: Assessing whether eligible activities meet substantial contribution criteria

For the activities identified as eligible in Step 1, companies need to establish whether or not the activity “substantially contributes” to the taxonomy objective in question. This could relate to either climate change mitigation or climate change adaptation.

Detailed quantitative and measurable information is provided by EU regulators as to what constitutes a "substantial" contribution for each objective under each activity. This could involve measuring the intensity of relevant emissions, for example, by including scope 1, 2, and 3 emissions.

Step 3: Assessing whether eligible activities “do no significant harm” (DNSH) to any other taxonomy objectives

Beyond establishing that the eligible activity contributes to one of the taxonomy objectives, companies must determine whether the activity might negatively impact the other five objectives. This may mean that certain eligible activities fall short of taxonomy alignment because they significantly harm one of the other objectives, such as biodiversity. The regulators have provided DNSH detail for each activity across all six taxonomy objectives, but these are subject to change.

Step 4: Ensuring that eligible activities comply with minimum social safeguards

This final step is a case of due diligence. This step ensures that any activities that have passed Steps 1-3 do not negatively impact the social safeguards detailed in the regulation. These safeguards are based on existing regulations from the UN, OECD, and ILO. Beyond due diligence, companies will also have to publish governance policies related to human rights and anti-corruption in order to be considered fully transparent.

How is fund-level taxonomy alignment calculated?

If each company within the fund carries out these four steps, calculating fund-level taxonomy alignment becomes relatively easy. For example, if 50% of the fund’s activities are eligible (i.e., they pass Step 1), and 20% of these eligible activities are aligned (i.e., they pass Steps 2-4), the fund has 10% taxonomy alignment.

Alignment needs to be expressed in terms of turnover, capital expenditures, and operational expenditures, which leads to different alignment values. It is likely that, in early rounds of reporting, taxonomy alignment will be low due to a lack of available data. We will see significant improvements in alignment scores in the subsequent years of reporting.

How does this relate back to the Sustainable Finance Disclosure Regulations (SFDR)?

The relationship between SFDR and the taxonomy is complex because both regulations are continuing to evolve. In simple terms, fund managers classifying funds under Article 9 SFDR (“dark green” funds) need to report the alignment of all their underlying assets. Article 8 SFDR funds (i.e., “light green” funds) do not require taxonomy alignment disclosures. However, taxonomy disclosures can provide a way of demonstrating the environmental characteristics of the fund, justifying its Article 8 status.

How KEY ESG can help:

Most individual assets do not currently report on their EU taxonomy alignment. These disclosures can therefore be a big ask for fund managers. This is where KEY ESG can help.

Our intuitive software is updated in line with new legislation and new guidance, ensuring fund managers are always up to date. By following the simple steps and inputting the relevant data, you can ensure that your portfolio is compliant. The metrics gathered can then be used to improve your ESG and track your progress.

If you have any questions at all about EU taxonomy, contact our team. Why not request a free demo of our software too?

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