EU definition of green finance

A legal framework for a EU definition

Long read

27 September 2019

Given that many investment products are not clear or make false statements about what climate or environmentally sustainable activities they finance, the EU has embarked on a process to elaborate EU definitions. A framework law will allow the EU create a “taxonomy”, i.e. to categorise and impose criteria on what are environmentally sustainable economic activities. The EC is to regulate the details, first about climate-friendly activities based on the advisory report by a technical expert group with a majority of financial stakeholders. Other environmentally sustainable activities will have to be elaborated later; defining socially sustainable activities might not start before 2022 or 2023.

Standardising the definitions has been a laborious exercise and draft proposal still show shortcomings. It has met with strong opposition from the financial industry and member states, so that taxonomy law has not yet been agreed. Importantly, however, no investor will have to use the taxonomy’s definitions when marketing green finance products, except when explicitly using the EU taxonomy’s criteria and EU green bond or other (future) EU green standards and labels.

1. An EU “taxonomy” to define environmentally sustainable activities

The European Commission made a proposal for a framework law(opens in new window) to establish and regulate an officially accepted EU “taxonomy”: a uniform definition and categorisation of environmentally-friendly activities to be financed. The final legal text has not yet been agreed (see below: decision-making process) but is likely to contain the elements listed below.

The categorised EU environmentally sustainable economic activities would have to comply with the environmental objectives of:

climate change mitigation (defined in Art. 6)
climate change adaptation (defined in Art. 7)
sustainable use and protection of water and marine resources (defined in Art. 8)
transition to a circular economy (defined in Art. 9)
pollution prevention and control (defined in Art. 10)
protection of healthy ecosystems (defined in Art. 11)

Each of the six categories above will need to apply the following screening criteria:

contributing substantially to one or more of the environmental categories (mentioned above (1)-(6))
not significantly harming any of the other environmental objectives (significantly harm is defined in Art. 12)
complying with the minimum social safeguards, i.e. the eight core ILO labour rights, the International Bill of Human Rights, the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights (Art. 13)
complying with technical screening criteria and benchmarks specific to each activity identified in the taxonomy

These screening criteria and technical benchmarks for each of the “climate change mitigation” activities (see (1) above) have been elaborated by a technical expert group (TEG) consisting of different financial stakeholders(opens in new window) . The TEG draft report(opens in new window) issued in June 2019 (see below) also covered economic activities for the climate change adaptation objective (see (2) above), but not those related to the other objectives ((3) to (6) above).

The law will stipulate that the final definition and screening criteria of each of the categories and activities will need to be legally adopted through “delegated acts” or other implementation regulations by the EC and applied months later (the dates have not yet been decided). The first delegated acts will cover (1) climate change mitigation activities and (2) climate adaptation activities, based on the TEG report. Given potential technical changes and urgencies, the criteria will need to be adapted in the future under the guidance of a Platform on Sustainable Finance. That Platform will also be tasked with identifying and elaborating the screening criteria of the other four ((3)-(6)) environmentally sustainable activities, as well as potentially social or other sustainability activities. The composition of the Platform is to be defined in Art. 15. The EU Ministers of Finance want a Member States Expert Group on Sustainable Finance to monitor the Platform and provide advice for the EC’s delegated acts.

The application of the taxonomy is voluntary, i.e. no investor has to use the taxonomy. The use of the taxonomy will be compulsory for different future EU standardised investment instruments, such as the EU Green Bond Standard, an EU ecolabel for sustainable investment products, etc. The taxonomy will not (yet) apply to loans and (investment) bank activities related to investment.

Reporting would only be compulsory when an investment claims to be sustainable with an environmental objective according to the taxonomy. Discussions are still being carried out on how investors will be required to report in which way the taxonomy is applied. There are different proposals, e.g. how much of the entire investment covers an activity defined by the taxonomy, whether the reporting is compulsory according the EU Regulation on Disclosure of Sustainability Investments (DSR, 2019).

The supervision and enforcement are to be carried out by the relevant national and EU supervisory bodies. It is not yet clear whether the Taxonomy should be established before end 2021 and be fully enforceable before end 2022.

Whether or not the scope of the regulation will be extended to a taxonomy covering activities with social or other sustainability objectives will only be decided after the EC has completed an evaluation by the end of 2021 or the end of 2022.

2. The decision-making process

In March 2019, the European Parliament (EP) already finalised its text on how it plans to amend(opens in new window) the EC’s legislative proposal. The Council of Ministers of Finance (ECOFIN) only finalised its position on its amendments on 25 September 2019. The Finance Ministers of the EU member states were divided within ECOFIN on particular issues, with tactics being used to delay the implementation by groups of Finance Ministers in changing coalitions per issue of discussion, e.g. voluntary application or not, nuclear energy included or not, more say of member states in defining the criteria or not, early binding implementation or not.

The Finnish presidency of the EU would like to see an agreement between the EP and ECOFIN position before the end of its presidency (31 December 2019). The parallel EP and ECOFIN texts with amendments will have to be discussed in the trilogue in order to arrive at a compromise on the final legal text. Given that both parties have different positions, e.g. ECOFIN does not want the taxonomy to be fully applied before January 2023 (start only in 2021) and is still divided whether nuclear energy is to be considered as carbon free(opens in new window) , a compromise final legal text might not be easy(opens in new window) . However, EC Commissioner Dombrovskis, who proposed the law, appealed to all parties to make progress and undertake decisions in order “to avoid greenwashing(opens in new window) ”.

3. Criticisms of the taxonomy legislative proposal and draft amending texts

Defining what are climate change mitigating and climate adaptation activities should prevent the various and unjustified claims about the effects investments have on climate change and the environment. It might even avoid a green financial bubble that might burst when its minimal effects become clear.
There are however many concerns about the limitations of the future taxonomy law, whereby much effort might have limited effect on resolving climate change and environmental problems, let alone social problems. The criticism includes:

The taxonomy law proposal only defines environmentally sustainable activities, and currently these would only apply to around 1 to 5% of all investment products. There are proposals to add 1) transition activities and 2) enabling activities to allow financing a transition towards climate mitigation.
France’s proposal to have a “full taxonomy” of all activities, including defining what is not sustainable (“brown taxonomy”), was rejected. The requirements for those using the taxonomy will result in making green finance investment products more expensive than those that harm the environment.
The taxonomy will only apply to those who voluntarily choose to do so. Since there is no obligation on investors, a high level of green washing(opens in new window) will continue. So far, the taxonomy does not apply to banks.
The start date for the actual application of the first categories of the taxonomy (see (1) and (2) above) might be delayed up to 30 months after the law is agreed upon, as a result of delaying tactics on the part of some EU member states. The remaining four categories (see (3) to (6) above) will take much longer and be elaborated under the yet-to-be-established Platform on Sustainable Finance, whose composition and powers are still being debated.
The categorisation of socially sustainable activities and fully environmentally and socially sustainable activities is not foreseen (for initial identification) before 2022 or 2023. This is incompatible with social and human rights problems(opens in new window) , as well as those investing to achieve UN Sustainable Development Goals and applying ESG risks and ESG impact assessments (see article about DSR). Moreover, the application of labour rights and human rights as minimum safeguards have no explicit processes to adhere to (see also below: TEG report), while social abuses are often interconnected with environmentally destructive activities.
The taxonomy depends on better information from the companies in whose shares and bonds investors place their money. However, standardisation and verification of company reports on ESG issues are not yet fully in place (see overview article, paragraph on new EC guidelines for the Non-Financial Reporting Directive) and the law would not include an obligation on investors to verify company information.

4) TEG proposals(opens in new window) on taxonomy details

A technical expert group (TEG) of mostly financial stakeholders(opens in new window) was created to advise the EC on the details of the screening criteria and technical benchmarks (e.g. the amount of CO2 emissions allowed) for each environmentally sustainable activity that can make a substantial contribution to (1) climate change mitigation or (2) climate adaptation, while avoiding significant harm to the four other environmental objectives (mentioned in the legislative proposal (see above), related to (3) water, (4) circular economy, (5) pollution, (6) ecosystems).

On 18 June 2019, the TEG published its draft technical report on the EU taxonomy(opens in new window) . The public online consultation for comments was open until 13 September 2019(opens in new window) . A summary(opens in new window) of the TEG report and a supplementary report(opens in new window) on how to use the taxonomy is also available.

The report sets out:
(1) Technical screening criteria for 67 economic activities which can make a substantial contribution to climate change mitigation, categorised in eight sectors, namely agriculture, forestry and fishing, manufacturing, energy supply, water and waste, construction, transport, IT, construction and real estate (see p. 107-109 of the report(opens in new window) for the full overview);
(2) A methodology and detailed examples for evaluating activities with substantial contribution to climate change adaptation (overview p. 110; full details p. 386 onwards).

The proposed overall methodology on how to apply the taxonomy for the climate mitigation activities, such as the elaboration of definitions and screening criteria with emission limits and the application of the do-no-substantial-harm criteria, are explained on pages 19-28 and 62-65 of the TEG report. The application of the screening approach for each of the 67 identified economic activities is described on pages 111-385. The TEG report also provides guidance and case studies for investors who are preparing to use the taxonomy.

How to apply the minimum social safeguards has been restricted to addressing the eight ILO labour rights conventions as proposed by the EC (draft Art. 13). The TEG has described them in very general terms (pages 64-65, 73-74), but not in detail for each economic activity. It is not clear how the minimum social safeguards which were added by the EP and draft ECOFIN text will be elaborated, namely the International Bill of Human Rights, the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights. The remaining period of the TEG’s mandate, until the end of 2019, will only be used to complement the missing details of some identified environmentally sustainable economic activities and incorporate the feedback.

Notwithstanding the huge amount of work that was needed by the TEG to elaborate the first part of the taxonomy, there are quite a few concerns and criticisms on the draft TEG report regarding:

Scope, e.g. including in the taxonomy’s activities hydropower (dams), use of crops as biomass for bio-fuel, and (intensive) livestock;
Identification of climate mitigation activities: e.g. dependence on certifications that are not reliable, lack of definition on what is sustainable forest management; too few details about climate adaptation economic activities;
Company information, e.g. it is unclear whether enough information about company activities will be reported, including by data providers (see page 74, 77); the requirements can only be adhered to by large companies, which might result in small companies being crowded out due to a lack of financing; what kind of verification can be done to screen non-EU financial products that assert the use of the taxonomy?
Minimum social criteria, e.g. the lack of detailed due diligence processes and screening for each of the labour and human rights obligations;
Application, e.g. the entire investment will not need to be in line with the taxonomy but instead, investors will be able to identify which proportion of the underlying assets in which they invest is eligible under the taxonomy criteria (i.e. if an investment fund contains many different companies, not all companies need to have 100% environmentally sustainable activities: see page 10 of “Using the Taxonomy(opens in new window) ”)
Usefulness, e.g. the (TEG) proposes expanding the taxonomy to ensure a wider application beyond economic activities that are already contributing substantially to climate change mitigation, by also introducing the categories transition activities and enabling activities; many institutional investors are already complaining that this is too complex to be used and are lobbying against potentially high application costs.