The EU Taxonomy Regulation - Part 2
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We left off last week having taken care of financial materiality; it is now time to have a look at how impact materiality works too. In fact, the EU Taxonomy regulation is built on the underlying principle of double materiality: when assessing the sustainability of an undertaking, it is important to carry out an analysis - both quantitatively (financial materiality) and qualitatively (impact materiality) - from the outside in and from the inside out.
REPORTING OBLIGATIONS FOR IMPACT MATERIALITY
The Taxonomy Regulation and the Corporate Sustainability Reporting Directive (CSRD) broadly define which information must be disclosed by undertakings:
The business model and its strategy regarding sustainability;
Time-bound objectives regarding sustainability milestones: it is in fact of crucial importance that undertakings are transparent and give clearly-defined goals, for example cutting scope 1 GHG emissions by a certain quantity before a certain deadline. By defining such objectives, it is then straightforward to assess whether the firm has stuck to its promises (or, in case of failure, to which degree it accomplished its goals).
The role of its administrative, managerial, and supervisory bodies in the accomplishment of its sustainability strategy, and their relevant expertise in this field.
Policies already in place or being designed and to be enacted in the foreseeable future to achieve the set milestones and make the undertaking generally more sustainable.
Incentive schemes, once again already in place or to be enacted shortly, to adopt more sustainable behaviours.
The due diligence process throughout the transition towards more sustainable business and the pursuit of the objectives.
The potential or actual adverse impacts that the undertaking’s operations and value chain (both upstream and downstream) have on the external environment.
The actions taken to reduce and contain such adverse impacts.
The risks to which the undertaking is exposed; for example, a manufacturing firm or a firm downstream in the value chain with respect to a manufacturing firm, could run the risk of having a critical piece of its supply chain disrupted due to extreme climate phenomena.
It is important to note that, although we are used to thinking about sustainability in environmental terms, each of the points above also refers to goals, impacts, and actions to be achieved, monitored, and taken in the context of social sustainability and governance (the S and G of ESG).
How exactly the undertaking is supposed to report about the points above is defined in the European Sustainability Reporting Standards (ESRS). The ESRS standards have been expressly developed by the European Financial Reporting Advisory Group (EFRAG), a private entity established under Belgian law with the encouragement of the European Commission to serve public interest. EFRAG has then been appointed by the European Commission itself as its technical adviser to draft the ESRS.
Lastly, the CSRD establishes that the undertakings will have to integrate their sustainability reports with their financial reports, to obtain one that is all-encompassing. This one report will then have to be subject to an external audit by certified professionals, just as financial reports are already treated today.
THE ESRS STANDARDS
The ESRS standards regulate how the information above must be disclosed by undertakings; they also contain quantitative indicators that are relevant to assess a firm’s situation, such as, for example, how many employees satisfy certain conditions.
The ESRS have a two-tier structure: on the first tier, there are two cross-cutting standards, called ESRS 1 (General Requirements) and ESRS 2 (General Disclosures); they are defined as “cross-cutting” because they set the rules for the disclosures of information that is relevant to both environmental, social, and governmental sustainability.
On the second tier there are instead ten sector-specific standards, divided in the following way:
Environmental standards (ESRS E): in this category we can find five different standards; each one of them covers one of the objectives set out by the EU Taxonomy, with the exception of ESRS E1 which covers climate change from the point of view of mitigation and adaptation as well (mentioned in the first two objectives).
Social standards (ESRS S): in this category we can find four different standards. Each one of them has been developed having a particular set of people in mind: ESRS S1 covers the undertaking’s own workforce, S2 workers in the value chain, S3 other communities affected by the undertaking’s activities and, finally, S4 consumers and end-users.
Governance standards (ESRS G1): in this category we can find only one standard, about business conduct.
EFRAG has published various drafts of these standards, starting in November 2022; the final version, a result of much deliberation between the European Commission and key stakeholders from major EU industries, has been accepted in July 2023. At the moment, EFRAG is working on new sector-specific standards, standards for SMEs and standards for non-EU companies operating in EU-regulated markets; they are expected to be adopted by the Commission in June 2024.
SOME TAXONOMY CRITIQUES
Both the European Taxonomy and the ESRS have been subject to much discontent, though not all of the same nature: interestingly enough, while some major undertakings complain about what they consider an excessive reporting burden, others do not think that the disclosure requirements are harsh enough. Many of these opinions are actually available to the public, as anyone could leave a comment to the EU Commission during the public consultation period (which ended last June).
These latter opinions are entirely due to the materiality assessment: most reporting points are in fact not really obligations, but rather to be disclosed only if, following the materiality assessment procedure, they are found to be material for the undertaking. There are of course some exceptions: all the General Disclosures (ESRS 2) and the climate standards (ESRS E1) are compulsory, while the own workforce standard (ESRS S1) is compulsory only for firms with more than 250 employees. This final resolution of the EU Commission is the result of opposing forces: those claiming the Taxonomy to be too heavy, and those claiming it to be too soft. In particular, the latter judgement comes from parties which are afraid that undertakings will avoid reporting adverse impacts (which would for sure damage their reputation) by essentially lying on their materiality assessment, claiming that the activities associated with negative indicators are not material, when in reality they are. It is important though to recognise that the Regulation does in fact address this risk: by incorporating the sustainability and financial reports and having them subject to external audit, lies and misconduct become rather difficult. To sum things up, the majority of disclosure requirements cannot be considered either compulsory or voluntary, but only conditional to the outcome of the materiality assessment.
Originally, the number of compulsory disclosure requirements was much higher; the Commission has in fact reduced it by 40% with respect to the draft it had initially received from EFRAG. Furthermore, both EFRAG and the Commission have focused on revising the ESRS to make them more compatible with already existing standards, such as GRI and IFRS, as an aid to firms which already have sustainability accounting procedures in place and now need to make the transition, but also to lower the international “transaction” costs that come with comparing reports written using different standards.
Moreover, to address the concerns of companies whose majority of activities does not fall in the taxonomy-aligned section, commissioner for Financial Stability, Financial Services and Capital Markets Union Mairead McGuinness has remarked the importance of all KPIs, not just turnover: if an undertaking’s turnover is not that “green”, devoting a large portion of capital expenditures to taxonomy-aligned activities would be a strong and credible signal of the undertaking’s transition towards a more sustainable business, that could reassure its current and potential investors.
Another concern regarding the EU Taxonomy has to do with how, from a legislative standpoint, it has been adopted: as Article 290 (TFEU) states: “A legislative act may delegate to the Commission the power to adopt non-legislative acts of general application to supplement or amend certain non-essential elements of the legislative act”. The issue rises with the role played by the delegated acts within the Taxonomy framework: on one hand, it is true that the two central acts are, respectively, a regulation and a directive, but it cannot be argued that without the Climate Delegated Act (and its complement) it would simply be impossible for the whole Taxonomy framework to be applied. Therefore, given this role played by the delegated acts, they can’t simply be considered to “supplement or amend certain non-essential elements”, and their adoption would be a breach of the European legislative procedure. Furthermore, as already stated above, although EFRAG is technically independent, as an entity separate from the European Union, its very establishment was encouraged by the Commission, which then appointed it as one of its technical advisers for the Taxonomy. It is then clear why stakeholders would be concerned with whether EFRAG opposed potentially problematic decisions as much as they would have had they been given the possibility of being technical advisers.
SOME FINAL REGARDS
To draw conclusions, once again, when it comes to European legislation undertakings are afraid that the new rules will constitute an additional burden that could put them at a competitive disadvantage with respect to other non-EU firms. It is also true though, as it has been observed for instance by Columbia law professor Anu Bradford, that oftentimes the European Union is able to unilaterally influence other countries’ legislation by adopting innovative rules on its own territory alone (a phenomenon which she calls the "Brussels Effect”). Usually, big multinationals need to upgrade their lines of production and their products’ safety to comply with European law; once they have incurred the cost of compliance, which is a sunk cost, it makes more sense for them to convert all of their production capacity, as it would be more expensive to keep two different procedures in place. In order not to be at a disadvantage with companies which do not operate on the EU market, they then lobby in their respective countries to pass legislation and standards similar to European ones, whose success can also be shown as a precedent of feasibility. As a result, the EU legislative initiative spreads to third countries, protects other non-EU consumers and is able to make an impact that goes well beyond its original reach.
If these premises hold, it may then be worth taking and sticking to some bold decisions.
