The European taxonomy is the beginning of dramatic regulatory action on sustainability

• The EU unveiled several new policies including the final taxonomy, a climate law and forward guidance on corporate sustainability disclosures
• Europe’s climate-focused taxonomy will later be complemented by other environmental, social and transition taxonomies
• Companies & financial institutions will feel an impact as investor expectations continue to rise

The European Union has announced the widely anticipated adoption of its new Taxonomy, and at the same time put its climate change objectives (an at least 55% cut compared to 1990 levels) formally into law. It has also renamed its existing ESG reporting framework as the Corporate Sustainability Reporting Directive (from the Non-Financial Reporting Directive). This major new regulation from Europe will likely have a global impact.

Although these changes are only directly legislated for companies tied to the European Union, they will have a global impact because they impact European companies, companies listed in Europe, and European investors. As an example of the expanding reach, the European Commission noted that the taxonomy would cover 40% of European listed companies, accounting for 80% of direct greenhouse gas emissions in Europe and covering energy, forestry, manufacturing, transport and buildings.

When Europe’s sustainability disclosure requirements are released in 2022 and implemented starting in 2024 they will expand the current NFRD coverage of 11,000 companies to reach almost 50,000 companies. This will be done by including all listed companies and all large companies, and by becoming a voluntary standard for non-listed SMEs.

The Taxonomy in its current form primarily covers a limited range of ‘green’ activities relating to climate change mitigation and adaptation. It doesn’t address the social or transition-related sectors which will follow, along with another four ‘green’ classifications defined by Taxonomy regulation (water, circular economy, pollution prevention & control, and protection of biodiversity and ecosystems).

All of these changes, along with stricter definitions about what is eligible for green finance in China relating to green bonds, signal a sharp amplification of expectations about the direction of responsible finance over the next few years. Both the EU and China are increasing regulatory expectations around green finance. As work progresses on the ‘Common Ground’ taxonomy through the International Platform on Sustainable Finance, the standards are likely to be stricter than they were this time last year.

These regulatory developments set the floor on what is expected from companies, and by extension financial institutions and investors. The future requirements relating to sustainability disclosure that will be unveiled in 2022 and implemented starting in 2024 will sharply increase the expectations from forward-looking investors. It will also step up the requirements of European companies down their supply chains, which other European Commission legislation on corporate due diligence requirements could accelerate.

All of these changes have been well-publicized and shouldn’t come as a surprise. They are both wide-reaching and just the tip of the iceberg. The changes that will result from implementation — beginning with the taxonomy and already adopted Sustainable Finance Disclosure Regulation (SFDR) — will have a global impact.

The challenge for companies and financial institutions operating outside the European Union won’t come from the regulations themselves. Instead, it will come from the follow-on impacts and expected future policy changes that European investors, financial institutions and others will anticipate before they become enacted. There will also be non-European changes — the U.S. regulator is also debating sustainability reporting requirements, and ASEAN is working on its own taxonomy — which will add to the complexity of different sustainability and responsible finance frameworks.

Regardless of the specific policies enacted in different regions, which will affect each financial institution or investor differently, there is a growing urgency for financial institutions and investors to know better what ESG risks they are exposed to. By doing so, they can avoid being wrong-footed by the impact of major new regulations that will affect them, even if only indirectly.

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