A practical guide on main steps and cases study results on how to comply with the EU Taxonomy

The EU Taxonomy is one of the most significant developments in sustainable finance and will have wide-ranging implications for investors and issuers working in the EU and beyond. This tool helps investors navigate the transition to a low carbon, resilient and resource-efficient economy by assessing to what degree investment portfolios (both equity and fixed income) are aligned with the European environmental objectives:

  1. Climate change mitigation
  2. Climate change adaptation
  3. Sustainable use and protection of water and marine resources
  4. Transition to a circular economy
  5. Pollution prevention and control
  6. Protection and restoration of biodiversity and ecosystems

As with all other regulations, nothing comes easy. Applying the taxonomy requires a five steps approach that in reality becomes seven or eight steps depending on the data availability, internal ESG readiness and the disclosure level of the invested companies.

One of the key disclosures that investors need to make is the definition of the proportion of underlying investments that are Taxonomy-aligned, expressed as a percentage of the investment, fund, or portfolio - including details on the respective proportions of enabling and transition activities.

Source: Cardo AI analysis

To do that, investors need to go through the following steps:

Step 0 – Translate every sector/industry classification system to NACE economic activity code

To determine eligible economic activities in the Taxonomy, investors need to map the current classification system in use: e.g. NAICS or BICS (already mapped by the Taxonomy), GICS, ICB, SIC, TRBC, etc. with the European industry classification system (NACE).

Step 1 – Break-down invested company’s sectors by turnover or capex, and if relevant opex to determine if these activities are listed in the Taxonomy

Starting from the turnover, investors need to be able to break down the sectors of activity in which the company’s funds are allocated (both equity and fixed income). Successively, map these sectors to the list of taxonomy and flag those sectors that are present.

Step 2 – Validate if the companies meet the substantial contribution criteria

Every company in the portfolio is required to validate whether or not each economic activity meets substantial contribution criteria to climate mitigation and/or adaptation objectives. Substantial contribution is assessed through different screening tests carried out based on a collection of thresholds by sector.

To do that, investors need to have ready the data reported from the companies. In case data is not available – due to lack of reporting – an estimation of the data point or an approximation of the threshold could be a solution to determine the significant contribution.

Step 3 – Validate if the companies meet the “do no significant harm” criteria

The third step requires investors to conduct a due diligence-type process to verify the company’s activities meet the “do no significant harm” to the other environmental objectives using a set of qualitative and quantitative tests. They are typically applied at the company level looking at the production process or in the use phase and end of life treatment of the products produced.

Step 4 – Control if there are any violations of the social minimum safeguards

Investors need to conduct due diligence to control any negative impacts on the minimum safeguards related to UNGP (United Nations Guiding Principles on Business and Human Rights), OECD (Organisation for Economic Co-operation and Development), and ILO (International Labour Organization) conventions. OECD guidelines for MNES (Multinational Enterprises) ensure compliance with qualitative DNSH and minimum safeguards are recommended to be followed for the due diligence process.

Step 5 – Calculate the alignment of investment with the Taxonomy and prepare disclosure at the investment product level

Once the previous steps have been completed and the aligned portions of the companies in the portfolio have been identified, investors can calculate the alignment of their funds with the taxonomy (as an example, if 10% of a fund is invested in a company that makes 10% of its revenue from Taxonomy-aligned activities, the fund is 1% taxonomy-aligned for that investment, and so on).

Assessing a portfolio for Taxonomy alignment

Source: Taxonomy: Final report of the Technical Expert Group on Sustainable Finance (March 2020)

A great initiative has been the case studies around how to use the EU Taxonomy shared by PRI’s (Principle for Responsible Investment: The PRI is an investor initiative in partnership with UNEP Finance Initiative and UN Global Compact). Starting in late 2019, over 40 investment managers and asset owners worked to implement the Taxonomy on a voluntary basis in anticipation of upcoming European regulation.

Here is a summary of some of the cases studies:

For more details on these case studies and practical EU taxonomy implementation recommendations click here!