APPLYING TAXONOMY: DIFFICULTIES AND OPPORTUNITIES FOR BUSINESSES
What is a sustainable activity according to the taxonomy?
In order to achieve its 2030 climate goals, the European Union has no choice but to rely on investors and businesses to redirect capital flows towards sustainable activities. However, until recently, no standards or regulations clearly defined what a sustainable activity is. The European taxonomy aims to fill this gap by establishing “a common system for classifying sustainable economic activities”. This work was entrusted to a group of experts (the Technical Expert Group, or TEG), which defined that an activity is considered “sustainable” if it substantially contributes to at least one of the following six objectives:
- Climate cange mitigation;
- Climate change adaptation;
- Sustainable use and protection of water and marine resources;
- Transition to a circular economy;
- Pollution control;
- Protection and restoration of biodiversity and ecosystems.
In addition, the activity must not cause harm to the other five objectives (the “do no significant harm” principle) and must respect minimum safeguards, including human rights, to be considered aligned with the taxonomy.
There are also two categories: first, “enabling” activities, which allow other activities to contribute to one of the six objectives, for example the production of photovoltaic panels. And second, “transitional” activities that reduce the environmental impact of activities that are not considered “sustainable” but for which there is currently no alternative, for example the production of recycled aluminum. [1]
What is the status of the regulatory process?
Following the publication of the TEG sharing its recommendations for setting the selection criteria for activities contributing to the first two climate change-related objectives, a first delegated act defining these activities[2] and a second one specifying climate-related reporting obligations were adopted in June and July 2021, respectively. On December 31, 2021, the European Commission proposed an additional delegated act to include gas and nuclear as transitional energy sources. As of now, it still needs to be adopted by the Commission, the Parliament and the Council after consultation with the member states. While the regulatory framework is not yet completely set, financial actors and non-financial companies must prepare to publish information on their 2021 exercise.
What obligations are there for companies?
In March 2022, companies will have to disclose, within their Non-Financial Performance Disclosure (DPEF – Déclaration de la Performance Extra-Financière), the share of sustainable activities as a percentage of 1) their revenue, 2) their CAPEX, and 3) their OPEX.
In order to avoid / Due to risk to double counting, trading companies, suppliers, or subcontractors generally have difficulties to estimate sustainable revenue: this is the case, for example, for companies solely involved in the sale of electric vehicles, suppliers of tires for electric vehicles, or subcontractors involved in the assembly of electric vehicles.
However, it should be noted that in the absence of revenue eligible for the taxonomy, a company may still have eligible CAPEX or OPEX. Indeed, a company may have activities that are not considered sustainable but invest in the thermal renovation of its buildings (CAPEX) or have research and development expenses in this direction (OPEX).
This year, however, the 2022 reporting on 2021 will be simplified in several ways:
- It only concerns the first two taxonomy objectives related to climate change;
- Companies are not required to use the reporting template;
- The reporting will only focus on the share of activities eligible for the taxonomy. This means that companies will have to identify whether their activities are included in the taxonomy activity list, without having to verify compliance with the substantial contribution criteria to one of the objectives (technical criteria). They will also not have to ensure compliance with the “do not significant harm” principle and minimum safeguards;
- As this is the first reporting, companies will not have to make comparisons with previous years.
Finally, regulators have emphasized the importance of narrative elements, through which the company can detail the assumptions made to identify eligible activities and calculate the various KPIs.
In 2023, companies will still not be required to provide comparative information, but they will be required to use the reporting template. In addition to identifying eligible activities, they will need to verify compliance with the substantial contribution criterion to one of the objectives and the “do no significant harm” principle and minimum safeguards.
The comparison, relating only to activities contributing to the first two climate change-related objectives, will have to be carried out only from 2024 on the 2023 financial year.
It can also be expected that future reporting will include the four following objectives of the taxonomy.
The difficulties encountered by companies
While the definitions of revenue and CAPEX are based on those of Accounting Directive 2013/34/EU and IFRS standards, and are therefore already regularly reported by companies, the definition of OPEX is less clear and several stakeholders have criticized a lack of coherence between the denominator and numerator
After calculating the denominators, the main difficulty encountered by companies is the calculation of the numerator, which involves identifying activities among more than 100 activities eligible for the taxonomy. The EU has published an equivalence table with NACE codes, but these may not always be sufficient to identify an eligible activity. In addition, it is recommended to use the descriptions of each activity as well as their criteria for substantial contribution. This will therefore require a considerable amount of time and effort, at least for the first reporting cycles.
This will then be a matter of translating these environmental criteria into accounting language, requiring close dialogue between the management controlling and the CSR or sustainable development teams of a company.
Finally, for companies involved in more than one activity, the volume of data will be significant and likely cannot be managed without the use of suitable data collection, consolidation and reporting tools. This will be even more necessary as of 2024, when it will be required to show the evolution of KPIs compared to the previous year. For now, no audit is required, but it is not guaranteed that this will be the case for future reporting.
Opportunities for companies
Some elements, however, can represent opportunities for companies, such as the need for close dialogue between management controlling and CSR teams. This can be useful at a time when integrated reporting, which presents financial and non-financial information in the same document, is starting to become more widespread.
This exercise should also allow the largest and most diversified companies to better understand the details of their business and activities. This could help them identify cost reduction opportunities (for example, by investing in less energy-intensive technologies) or even new markets (for more environmentally friendly products).
Ultimately, the indicators will probably become key in defining the company’s strategy. They will also facilitate the dialogue with investors and attract them when a company can demonstrate a significant share of sustainable activities or investments. Thanks to the influence of the European taxonomy abroad, this will allow European companies to be precursors and even to attract foreign investments.
Conclusion
Companies must therefore begin this new reporting exercise in a still evolving regulatory context. Even though the rules for this year have been simplified, this will require them to invest in human resources and reporting tools. Companies also need to prepare for the following years’ exercises, which will include the other four environmental objectives of the taxonomy, and probably soon objectives of the future “social taxonomy”. However, this should also represent opportunities for cost reductions, new markets and funders’ investments.
Finally, companies should be prepared to obtain rather weak KPIs if we rely on the European Commission and the Adelphi Institute, which have estimated that only 1 to 2% of the 2020 turnover of listed companies would be eligible for the European taxonomy.[3] It will then be a question of standing out from the competition and setting ambitious objectives for the years to come in order to be able to say that a company contributes to the fight against climate change.
