The EU Taxonomy: A Framework for Sustainable Finance

The European Union Taxonomy is a pioneering framework introduced in June 2020, designed to categorize economic activities and investments as either sustainable or not, thus providing a universal language for measuring and assessing sustainability progress. It represents a pivotal component of the European Green Deal, which aims to expedite the transition to a sustainable economy. The EU Taxonomy is instrumental in helping financial and non-financial entities align their operations with environmental objectives and goals outlined in the European Green Deal.

What Does EU Taxonomy Eligibility Entail?

The foundation of EU Taxonomy eligibility lies in the Statistical Classification of Economic Activities in the European Community, commonly referred to as “NACE codes.” 

Currently, the EU Taxonomy focuses predominantly on two categories of economic activities: those with high carbon emissions and those facilitating the transition to a sustainable economy. The framework outlines six crucial environmental objectives that determine the eligibility of NACE codes and economic activities:

1. Climate Change Mitigation: Activities that contribute significantly to reducing greenhouse gas emissions and combating climate change.
2. Climate Change Adaptation: Activities that enhance resilience to climate change and mitigate its adverse impacts.
3. Sustainable Use and Protection of Water and Marine Sources: Activities aimed at conserving and protecting aquatic ecosystems.
4. Transition to a Circular Economy: Activities promoting resource efficiency and a circular approach to economic processes.
5. Pollution Prevention and Control: Activities focused on reducing pollution and its detrimental effects.
6. Protection and Restoration of Biodiversity and Ecosystems: Activities dedicated to preserving and rehabilitating natural ecosystems.

Assessing EU Taxonomy Eligibility for Non-Financial Corporates

For non-financial corporations, evaluating their EU Taxonomy eligibility involves a systematic process:

Identifying Activities

The first step is identifying which of their activities fall under EU Taxonomy eligibility. Companies already utilizing NACE codes find this process relatively straightforward. Others must cross-reference their activities with the EU Taxonomy-eligible activities list, potentially necessitating a classification system transition.

Aligning Financials

Once eligible activities are identified, companies must determine the financial metrics associated with each, including turnover, capital expenses (CapEx), and operating expenses (OpEx). These metrics form the basis for calculating the total EU Taxonomy eligibility.

Calculating Eligibility

With eligible activities and corresponding financial metrics established, companies can compute their overall EU Taxonomy eligibility. This process is crucial for understanding the alignment of their operations with the EU Taxonomy.

The Green Asset Ratio (GAR)

Starting in January 2024, EU banks must disclose their Green Asset Ratio (GAR) for the financial year 2023. The GAR provides quantifiable evidence of the extent to which a bank’s financed activities align with the EU Taxonomy’s sustainability criteria. Banks have traditionally focused on redirecting capital toward green investments and reducing fossil fuel exposure, but the GAR introduces a new level of transparency.

The GAR is defined as the proportion of a credit institution’s assets financing EU Taxonomy-aligned economic activities compared to its total covered assets. Calculating the GAR involves some complexities:

Understanding Assets

Banks must differentiate financial assets from on-balance and off-balance sheet assets. Exclusions include exposures to central governments, central banks, and supranational issuers, along with assets held for trading. Assets like derivatives, interbank loans, and certain others may be considered entirely non-eligible.

Data Availability

Data availability can be a hurdle, as only entities under the Non-Financial Reporting Directive (NFRD) need to disclose their EU Taxonomy alignment publicly. Additionally, many corporates may not be prepared to calculate their alignment due to various constraints. For loans like mortgages or car loans, banks may need to assess alignment themselves, which can be time-consuming, especially when criteria vary by country.

Implications for Banks

The GAR’s impact extends beyond disclosure requirements. It can influence banks’ balance sheets, their business strategy, and their financial resilience. Stakeholders, including investors, may use GARs as a key indicator of a bank’s environmental, social, and governance (ESG) characteristics. Banks may set GAR targets and align their balance sheets accordingly.

The evolving EU Taxonomy and the inclusion of more activities over time will affect banks’ balance sheet optimization decisions and product strategies. Banks must also incorporate ESG factors into loan origination and pricing processes, ensuring compliance with regulatory guidelines.

The EU Taxonomy and the GAR represent critical steps toward a sustainable economy. They encourage businesses to assess their environmental impact, drive transparency in the financial sector, and facilitate investments in sustainable activities, ultimately contributing to the goals of the European Green Deal and a greener future.