EU Taxonomy Regulation: ESG disclosure obligations for large companies

On 22 June 2020, the Regulation on the establishment of a framework to facilitate sustainable investment (Taxonomy Regulation) was published in the Official Journal. The Taxonomy Regulation establishes a classification system (or taxonomy) which provides business with a common language to identify whether a given economic activity should be considered "environmentally sustainable". This then allows the business to determine how far an investment is environmentally sustainable. The taxonomy is intended to be used by the EU, by EU member states, by corporate issuers and by financial services firms, when assessing, and disclosing information on, environmental sustainability.

The Taxonomy Regulation is also a transparency tool. In particular, Article 8 of the Taxonomy Regulation imposes additional non- financial reporting obligations on certain entities. This insight summarises those non-financial reporting obligations.

See Overview of the Taxonomy Regulation for more information on the new disclosure requirements for asset management firms and our Taxonomy Regulation Tracker.

What's our view?

This Regulation requires large entities (explained below) and, subject to consultation, potentially others to report on the extent to which their turnover, and capital and operating expenditure relates to 'environmentally sustainable' activities, variously as from 2022 and 2023. It needs to be viewed in the context of the EU's focus on a greener, more sustainable, longer term business environment supported by better engagement between listed companies and their investors. It's likely to become a key metric for investors seeking to measure the ESG performance of listed companies and (importantly) would appear to enable a ready comparison between companies (though it won't be quite that easy).

The Taxonomy Regulation is focussed on Environmental disclosures, but with the increased focus on Social factors as a result of COVID-19, it's a further acceleration of the emphasis on ESG and the wider question of whether companies should have a purpose broader than making money.

These new reporting obligations do not, however, automatically apply in the UK and the UK has already announced that it will introduce its own ‘Green Taxonomy’ – see Government Roadmap to Sustainable Investing.

Which entities does it apply to?

It applies to large public interest entities that are required to publish non-financial information under the Accounting Directive (Directive 2013/34/EU), as amended by the Non-Financial Reporting Directive 2014 (2014/95/EU) (NRFD).

Public interest entities are ones (i) governed by the law of an EU member state and whose transferable securities are admitted to trading on an EU regulated market; (ii) credit institutions; (iii) insurance undertakings; and (iv) any designated by EU member states as public interest entities (for example, because of the nature of their business, their size, or the number of their employees).

A public interest entity is large if it has more than 500 employees (which is averaged over the financial year) and it has:

• a balance sheet of more than €20m; or
• net turnover of more than €40m.

It also applies to a parent undertaking of a large group that meets the criteria in these bullets.

The EU’s proposal for a Corporate Sustainability Reporting Directive includes an amendment to the definition of public interest entities which would result in a wider group of companies having to comply with these obligations. This would extend the scope of the NFRD to include (i) all large companies, whether listed or not, and without the 500-employee threshold; and (ii) SMEs with securities listed on regulated markets (other than listed micro-enterprises). It would not include SMEs with securities listed on SME growth markets or multilateral trading facilities. It remains to be seen whether these additional companies will be immediately subject to the full Taxonomy reporting requirements or there will be a transitional period. See EU proposal for a Corporate Sustainability Reporting Directive for more information.

What are the new reporting obligations?

Entities in scope must include, in their non-financial statement (or consolidated non-financial statement), information on how and to what extent the entity's activities are associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9 of the Taxonomy Regulation - see below (Article 8).

The Taxonomy Regulation specifies the climate-related key performance indicators (KPIs) for large non-financial companies as:

• the proportion of their turnover derived from products or services associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9; and

• the proportion of their capital expenditure and of their operating expenditure related to assets or processes associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9.

It does not however specify equivalent KPIs for financial entities (investment firms, asset managers, insurers, credit institutions).

On 10 December 2021, a Commission Delegated Regulation (the Article 8 Delegated Act) setting out Level 2 measures under the Taxonomy Regulation was published in the Official Journal and took effect on 1 January 2022. The Article 8 Delegated Regulation specifies the KPIs for financial undertakings. It also sets out the detailed rules for complying with the Article 8 disclosure obligations, with the content, methodology and presentation of the KPIs being set out in a number of Annexes.

The Article 8 Delegated Act also provides for a phased implementation, focussing first on Taxonomy eligibility rather than alignment – see 'When do these obligations come into force?' below.

On 20 December 2021, the European Commission published a set of FAQs which are designed to assist entities making disclosures in accordance with the Article 8 Delegated Act. See Taxonomy Regulation – FAQs on Article 8 Disclosure Obligation for more information.

What does "environmentally sustainable" mean?

The Taxonomy Regulation classifies an economic activity as "environmentally sustainable" provided it:

• contributes substantially to one of six defined environmental objectives - see below;
• does not significantly harm any of the environmental objectives;
• complies with a series of minimum social safeguards; and
• complies with performance thresholds (known as "technical screening criteria" (TSC)) (Article 3). These are also known as a ‘Taxonomy-aligned economic activity’.

On 9 December 2021, a Commission Delegated Regulation (2021/2139) made under Articles 10(3) and 11(3) of the Taxonomy Regulation (referred to as ‘the Climate Delegated Act’) was published in the Official Journal and took effect on 1 January 2022. The Climate Delegated Act sets out the TSC for determining:

• the conditions under which an economic activity qualifies as ‘contributing substantially’ to climate change mitigation or climate change adaptation; and
• whether that economic activity does no significant harm (DNSH) to any of the environmental objectives.

See Taxonomy Regulation – Level 2 climate change TSC published for more information.

What are the "environmental objectives"?

Environmental objectives are:

(a) climate change mitigation;

(b) climate change adaptation;

(c) the sustainable use and protection of water and marine resources;

(d) the transition to a circular economy;

(e) pollution prevention and control; and

(f) the protection and restoration of biodiversity and ecosystems. (Article 9)

Where does the information have to be published?

The new disclosures must be in the company's non-financial statement or consolidated non-financial statement, or in any separate report that it publishes.

When do these obligations come into force?

The Article 8 Delegated Act introduced a phased implementation for these disclosure obligations:

From 1 January 2022– non- financial entities need only disclose the proportion of Taxonomy-eligible and Taxonomy non-eligible economic activities in their total turnover, capital and operational expenditure together with certain qualitative information for the previous financial year.

For entities whose financial year is the calendar year, the first reporting period is therefore 1 January 2021 to 31 December 2021. For other entities, only the last annual reporting period has to be covered, so that, if the financial year starts on 1 July and ends on 30 June, the first disclosures only need to cover the period 1 July 2021 to 30 June 2022.

From 1 January 2022 and for 2023 –financial entities need only disclose (i) the proportion in their total assets of exposures to Taxonomy non-eligible and Taxonomy-eligible economic activities; (ii) the proportion in their total assets of the exposures to central governments, central banks, and supranational issuers, derivatives and undertakings that are not in-scope entities, together with certain qualitative information for the previous financial year. Credit institutions and insurers must make some additional disclosures.

From 1 January 2023 – KPIs and accompanying information to be disclosed by non-financial entities.

From 1 January 2024 - KPIs and accompanying information to be disclosed by financial entities.

1 January 2026 - credit institutions also need to report on the Taxonomy-alignment of their trading book and fees and commissions for non-banking activities.