Reality check: 8 years after the first EU Taxonomy conversation

For the past eight years, we have been involved up-close-and-personal in the EU Taxonomy that aims to direct green capital flows by defining sustainable activities^[1]. This includes the High-Level Expert Group (HLEG) that in 2016 recommended the creation of an EU Taxonomy, the Technical Expert Group (TEG) that shaped it and eventually the Platform on Sustainable Finance (PSF) which has been guiding implementation and concludes its mandate this year. It feels like it’s time to take stock of one of the most consequential regulations in sustainable finance.

First, we have a robust classification system to define sustainable economic activities. Based on three delegated acts between 2021 and 2023^[2], the EU Taxonomy established over 500 Technical Screening Criteria (TSCs)^[3] identifying 152 unique economic activities^[4] which make a Substantial Contribution, Do No Significant Harm (DNSH) to the environment and have Social Safeguards.

An activity is considered eligible if it’s in the EU Taxonomy activity list and aligned if it meets all the criteria (i.e. provides a credible low carbon climate or environmental solution). Other countries, such as the UK, China and Singapore, have leveraged the EU Taxonomy to establish their own classification systems.

Second, the European Commission developed comprehensive disclosure regimes to increase transparency on sustainable activities.  As part of the NFRD (and now CSRD)^[5] regulations, about 1,900 companies were mandated to disclose information^[6] against the EU Taxonomy from 2023, and eventually, around 50,000 companies will be in scope by 2029. In addition, SFDR^[7] sets requirements on disclosing financial products that are aligned with the EU Taxonomy for financial institutions.

However, the market is struggling with the implementation and large gaps remain in corporate disclosure. Our data shows that of the c.1,900 companies in scope for mandatory disclosure in 2023,^[8] less than 50% of companies fully report the EU Taxonomy data in line with the regulated template.^[9] Another 150 companies partially disclose their eligibility or alignment, while the remaining companies not yet meet their regulatory requirements.

Reporting against the EU Taxonomy is a considerable undertaking, which perhaps explains the large gap in corporate disclosure. The regulation itself is complex with over 500 unique TSCs, which can be difficult to apply as different economic activities are subject to various criteria. Furthermore, 50% of DNSH TSCs face usability challenges, such as a lack of clarity on definitions and vague languages that require significant interpretation, according to the EU Platform on Sustainable Finance (PSF).^[10]

With these usability challenges, it seems companies are applying the EU Taxonomy differently, resulting in inconsistent data. Some companies report zero alignment pending further guidance from regulators, while some disclose partial validation on DNSH criteria. Our data shows that this produces a wide range of eligible or aligned revenue and capex that in many cases reflects differences in disclosure practices, rather than in the greenness of products and business models. Figure 2 illustrates this based on reported data across auto companies.

For investors, robust estimates can play a role in complementing disclosed EU Taxonomy data, especially for portfolio analysis with a global investment universe. Globally, less than 10% of the c.4,000 large and mid-cap companies in the FTSE All World Index for example fully disclose EU Taxonomy data.^[11]

Holistic estimation methods can make resulting dataset more consistent and robust, for example, by helping to assess whether a company is likely to be more stringent or lenient on applying TSCs. Nonetheless, they offer no panacea, as they are likely to significantly underestimate alignment (they typically assume no alignment rather than alignment where data is patchy in line with the precautionary principle promoted by the PSF and the European Commission^[12]). According to LSEG EU Taxonomy estimate data, the FTSE All World for example, has 8% eligible revenue that broadly represents the green industries, but only 02% aligned revenue based on the EU Taxonomy (Figure 3).

In any case, the investible EU Taxonomy-aligned universe is likely to be very small. It will be challenging for investors to meaningfully allocate assets to sustainable economic activities. Indeed, even where they report, most companies have reported alignment of less than 5%. A recent survey by Deutsches Aktieninstitut reveals that 76% of the respondents consider that they cannot use the EU Taxonomy to make business investment decisions.^[13]

But are we limiting ourselves by only looking at the EU Taxonomy for green investment?

Eight years on from the first conversation, the EU Taxonomy is in place, giving companies across Europe and globally a standard to coalesce around. However, with complex and ambiguous criteria, disclosure regimes and data challenges, rather than facilitating green capital flows, the EU Taxonomy risks becoming a ”boilerplate” regulatory compliance exercise.  

Meanwhile, US$32-81 trillion must be deployed by 2030 to deliver green solutions and enable emissions levels to fall in line with the Paris Agreement climate targets, based on LSEG research.[14] This is a challenge that even an improved EU Taxonomy alone cannot solve. Other tools for investors, such as broader green revenues[15], transition plans and green bonds, as well as public policies and funding, have to play an important role in directing capitals towards the green transition.

[1] We still remember one debate at the EU HLEG (High Level Expert Group) in the early days: shall we use relative emission reduction or absolute carbon intensity as the threshold for electricity generation? We discussed for months and decided to use 100gCO₂e/kWh as a threshold which was adopted later by other countries.

[2] Including Climate Delegated Act in 2021, Complementary Climate Delegated Act in 2022 and Environmental Delegated Act in 2023.

[3] Over 300 TSC for Substantial Contribution requirement and over 200 TSC for DNSH requirement.

[4] Removed overlaps in economic activities under different environmental objectives.

[5] Non-Financial Reporting Directive (NFRD) was replaced by Corporate Sustainability Reporting Directive (CSRD) in 2024. Corporate sustainability reporting - European Commission (europa.eu)

[6] KPIs for non-financial corporates include turnover, capex (capital expenditures) and opex (operational expenditures); those for financial corporates include Green Asset Ratio and Green Investment Ratio.

[7] Sustainable Finance Disclosure Regulation, which requires financial market participants to disclose sustainability information, covering over 60 indicators. Sustainability-related disclosure in the financial services sector - European Commission (europa.eu)

[8] There were about 1,900 companies in the scope of NFRD for financial year 2022 reporting. These are companies defined by the Member States as: a large undertaking and a public-interest entity with more than 500 employees. (https://www.accountancyeurope.eu/wp-content/uploads/2022/12/NFR-Publication-3-May-revision.pdf)

[9] Annex II of the EU Taxonomy Regulation Disclosure Delegated Act.

[10] EU Platform on Sustainable Finance (2022). Platform Recommendations on Data and Usability of the EU Taxonomy

[11] We take FTSE All World Index as a proxy for the universe of large and mid-cap companies.

[12] Platform on Sustainable Finance's recommendations on data and usability of the EU taxonomy (europa.eu) p.49; and EU Taxonomy regulation art (19(1)(f).

[13] https://www.dai.de/en/detail/companies-esg-transformation-or-just-reporting

[14] LSEG (2022). Green equity exposure in a 1.5°C scenario

[15] Complementary to EU Taxonomy data with less restrictions in application scope