ESG Enterprise: SFDR, NFRD, and CSRD: Guidance on EU Taxonomy

 As part of ESG Enterprise weekly report.  This week we focus on the broader European Union Sustainable Finance Action Plan, the EU-regulated financial market participants are now mandated to make their first non-disclosure in line with the EU Taxonomy from Jan 2022 and throughout the year. Due to this, organizations across the industry are already getting set for significant investment to ensure compliance with the EU Taxonomy. This article takes a detailed look at how the EU Taxonomy fit within the broader sustainable finance framework which are the SFDR, NFRD, and CSRD.

What is the EU Taxonomy?

The EU Taxonomy can be described as a green classification system that translates the EU’s climate and environmental objectives into criteria for specific economic activities for investment purposes.

It recognizes as green, or ‘environmentally sustainable, economic activities that make a substantial contribution to at least one of the EU’s climate and environmental objectives, while at the same time not significantly harming any of these objectives and meeting minimum social safeguards.

It is a transparency tool that will introduce mandatory disclosure obligations on some companies and investors, requiring them to disclose their share of Taxonomy-aligned activities. This disclosure of the proportion of Taxonomy-aligned activities will allow for the comparison of companies and investment portfolios.

In addition, it can guide market participants in their investment decisions. Companies, if they wish, can reliably use the EU Taxonomy to plan their climate and environmental transition and raise finance for this transition. On the other hand, financial companies can use the EU Taxonomy to design credible green financial products.

Why the EU Taxonomy?

It is vital to create reliable tools to support companies in transitioning to climate neutrality and a sustainable economy. The EU Taxonomy is one such tool, translating the climate and environmental objectives into clear criteria to create a common language around green activities.

It will create a frame of reference for investors and companies. It will support companies in their efforts to plan and finance their transition, help mitigate market fragmentation, protect against greenwashing and accelerate financing of those projects that are already sustainable.

It is an important element of a much broader sustainable finance framework that will deliver a complete toolkit for financing the transition. The added value of the EU Taxonomy is that it can help scale up investment in green projects necessary to implement the European Green Deal.

How does the EU Taxonomy fit within the broader sustainable finance framework?

In the sustainable finance framework, three disclosure tools are very important. They include:

• The Non-Financial Reporting Directive (NFRD): NFRD aims to deliver a comprehensive corporate reporting framework with qualitative and quantitative information to facilitate the assessment of companies’ sustainability impacts and risks. NFRD requires large public-interest entities to disclose information in their non-financial statements concerning Environmental, Societal, and Governmental (ESG) matters. According to the EU Taxonomy, companies falling within the scope of the existing NFRD are expected to report on the extent to which their activities are sustainable. The indicators for this requirement will be specified in a separate Commission Delegated Act, in alignment with SFDR and existing EU Taxonomy requirements.

• Corporate Sustainability Reporting Directive (CSRD): Following a review of the NFRD consultation that closed in June 2020, the European Commission has issued a Corporate Sustainability Reporting Directive (CSRD) proposal on April 21st, 2021.  The European Commission’s proposal extends the scope of NFRD requirements to include all large companies, whether they are listed or not, without the previous 500-employee threshold. This change broadens the scope of entities from 11,600 to 49,000 and means that all large companies are publicly accountable for their impact on people and the environment. In addition, the Commission is proposing to extend the scope to include small and medium-sized Enterprises that have securities listed on regulated markets, except listed microenterprises.  Together with the Corporate Sustainability Reporting Directive (CSRD), the EU Taxonomy will ensure that companies falling under the scope of the CSRD disclose their environmental performance information and their Taxonomy aligned economic activities.

• Sustainable Finance Disclosure Regulation (SFDR): This law applies from March 10th, 2021, and complements corporate disclosures by creating a comprehensive reporting framework for financial products and financial entities. Different investment strategies may entail investments in economic activities with different levels of environmental performance. For this reason, the SFDR distinguishes disclosure requirements for:

• Financial products that claim to have ‘sustainable investment’ as their objective (in environmental objectives) are often referred to as ‘dark green’ financial products).

• Financial products that claim to be promoting social or environmental characteristics (often referred to as ‘light green’ financial products). 

The SFDR requirements are linked with those under the EU Taxonomy by including environmentally sustainable economic activities’ as defined by the Taxonomy Regulation in the definition of ‘sustainable investments’ in the SFDR.

How does the EU Taxonomy help companies transition towards sustainability?

The EU Taxonomy criteria provide a reference point for companies in their decision-making regarding their green transition. Companies can use the EU Taxonomy to improve their overall environmental performance and to attract investors. By covering capital expenditure linked to the transition plans, the EU Taxonomy can help attract investors searching for Taxonomy-aligned investments to finance the transition, helping both companies and investors accelerate the transition to sustainability. Businesses of any size, including small companies, can use the EU Taxonomy to explain to investors or stakeholders in general whether they carry out or plan to carry out Taxonomy-aligned green activities. Disclosures are only mandatory for large companies within the scope of the CSRD. However, small companies and businesses could find it useful to disclose the Taxonomy alignment of their activities voluntarily.