Breaking down the EU Taxonomy

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One way or the other, navigating the EU Taxonomy Regulation is becoming essential for businesses across Europe. This regulation is designed to define what constitutes environmentally sustainable practices, helping companies and investors make informed decisions. But what does it mean for your business, and how does this system work? In this article, we’ll break down the essential steps and criteria, explaining how companies can align their activities with the EU’s green goals.

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What is the EU Taxonomy?

The EU Taxonomy is a classification system that defines what qualifies as sustainable or green economic activities. This way it promotes sustainable financing and guides investors toward environmentally friendly initiatives. The system lists activities eligible for green investments. Companies involved in these activities can be considered sustainable assets when raising funds or offering financial products in capital markets.

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By setting clear criteria, the EU Taxonomy helps prevent "greenwashing"—misleading claims about an investment’s environmental benefits. It ensures investments meet the EU's strict sustainability standards, forming a key part of the European Green Deal, which aims for a climate-neutral Europe by 2050.

Specific objectives of the EU Taxonomy Regulation:

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• Clear definitions of sustainability: The regulation sets common criteria for the sustainability of economic activities.
  
  
• Transparency for investors: By providing clear criteria, the Taxonomy helps investors assess whether their investments truly contribute to sustainability. This prevents "greenwashing," where companies or investments are falsely presented as environmentally friendly.
  
  
• Supporting the Sustainable Finance Market: The regulation supports the growth of the sustainable finance market by giving investors confidence in the "green" claims of financial products. Also, it provides guidelines for financial institutions and large companies to report on the sustainability of their activities.
  
  
• Promoting Sustainable Growth: By encouraging economic activities recognized as sustainable, the Taxonomy contributes to the broader EU agenda for sustainable growth and achieving the goals of the European Green Deal

The EU Taxonomy process: how to determine your alignment

Achieving the goals of the EU Taxonomy requires a structured and multi-step approach to evaluate and classify economic activities as environmentally sustainable. The process ensures that investments and activities contribute to at least one of the environmental objectives set by the EU while avoiding significant harm to others.

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Here’s a breakdown of six concrete steps involved in applying the EU Taxonomy:

Along with every step let’s walk through a concrete example of applying the EU Taxonomy. Let's say we want to start an offshore wind energy project, a commonly cited example of a sustainable economic activity. We'll go step by step through the eligibility, screening, and other criteria.

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Step 1. Identifying potential eligibility of activities

First, you have to map out all your companies activities that generate revenue. These activities correspond to a NACE-code (Nomenclature of Economic Activities). NACE-code is an European industry classification system used to categorize economic activities. And each eligible activity for the EU Taxonomy is linked to one of these specific NACE codes, making it easier for companies and regulators to identify which business operations fall within the scope of the taxonomy.

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This can be a challenging task for companies as they might not have all their activities categorized according to the NACE codes. Additionally, if your activity is not listed, it cannot be aligned with the EU Taxonomy.  

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Once your activities are identified you need to determine whether an economic activity is eligible under the EU Taxonomy. The taxonomy specifies a list of economic activities across various sectors that are potentially environmentally sustainable. These activities are grouped under the six key environmental objectives.

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Eligibility means the activity falls within the scope of the taxonomy. However, being eligible doesn’t automatically mean it’s considered sustainable — that’s determined in the next steps.

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Example: Let´s see how this applies to our example of the wind farm. The NACE code for wind energy production is D35.11 ("Production of electricity from renewable sources"). Wind energy production is explicitly included in the EU Taxonomy’s list of eligible economic activities under the objective of climate change mitigation. Wind energy is considered a sustainable activity because it contributes to reducing greenhouse gas (GHG) emissions by generating electricity from a renewable source.

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• Eligible Activity: Electricity production from wind power.

Step 2. Technical Screening Criteria

After we have found out that our activity falls under the scope of the taxonomy it is time for step 2. Before an eligible activity can be classified as environmentally sustainable, it must meet specific technical screening criteria. 

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The activity must substantially contribute to at least one objective. The screening criteria are designed to measure this contribution quantitatively (e.g., emission reductions) and qualitatively (e.g., adoption of best practices).

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Example: Let’s return to the example of the offshore wind energy project. For it to be classified as environmentally sustainable under the EU Taxonomy, it must meet specific technical screening criteria for climate change mitigation. These criteria require that the project significantly reduce greenhouse gas (GHG) emissions compared to conventional energy sources like coal or natural gas.

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Since wind energy produces zero direct emissions during operation, it automatically meets the criteria for contributing to climate change mitigation. By generating electricity without emitting CO₂ or other harmful gasses, the project aligns perfectly with the taxonomy’s technical requirements

Step 3. Do No Significant Harm (DNSH)

Once an activity passes the technical screening for its positive contribution to an environmental objective, it must also not significantly harm any of the other five objectives. This is the Do No Significant Harm (DNSH) requirement.

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It is the responsibility of the company to ensure that its economic activities comply with the DNSH criteria laid down in the respective delegated act. This might require a detailed assessment which can be executed by an external competent authority which subsequently grants a permit. 

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For example, an economic activity that reduces emissions but causes substantial harm to another criterium, (e.g protection biodiversity, by deforestation) would fail the DNSH criteria and is therefore not Taxonomy aligned.

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The DNSH requirements ensure a balance between environmental goals, preventing actions that might solve one problem while creating another. Each environmental objective has its own set of criteria for determining what constitutes "significant harm." Companies can take and must report about measures to prevent their actions to harm the other objectives. 

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Example: We take again our example of the offshore energy project. First the company must identify the activities in the Climate Delegated Act and the Complementary Climate Delegated Act to which the company is complying with the DNSH criteria. Then it collects the required data and assesses if the activities meet the respective criteria. Here some examples of what to expect from a certain assessment:

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• Sustainable use and protection of water and marine resources: In our case we build an offshore wind farm. Now we must avoid significant harm to marine biodiversity and habitats. This may require environmental impact assessments to ensure that the construction of wind turbines does not disrupt marine ecosystems, particularly in protected areas.
  
  
• Transition to a circular economy: The materials used in the construction of our turbines (e.g., metals, composites) should aim for reusability or recyclability. For example, if old wind turbines are decommissioned, they should not result in excessive waste.
  
  
• Pollution prevention and control: Wind energy projects must ensure that construction activities (e.g., installing wind turbines) do not generate substantial pollution (e.g., noise, water contamination).
  
  
• Protection of biodiversity and ecosystems: The project must minimize impact on bird and bat populations, which can be affected by turbine blades. Measures such as siting turbines away from migration paths or installing technology to detect and deter wildlife may be necessary.

Step 4. Minimum social safeguards

Then, the EU Taxonomy requires that companies comply with minimum social safeguards. These safeguards are based on international standards like the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.

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This step ensures that an economic activity does not violate fundamental human rights, labor rights, or governance standards, even if it meets environmental criteria.

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Example: Our wind energy company must ensure compliance with international labor and human rights standards. This involves:

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• Ensuring that workers involved in the construction and operation of the wind farm have fair working conditions.
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• Respecting local communities' rights, including ensuring that any land acquisition for onshore wind projects is conducted ethically and with appropriate compensation.

Sep 5. Reporting and disclosure

Once you've completed the screening criteria, the next step is to report and disclose how your activities align with the EU Taxonomy. Companies under the Corporate Sustainability Reporting Directive (CSRD) or Non-Financial Reporting Directive (NFRD) are required to disclose this information, while others may do so voluntarily.

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In step 5 you disclose the Key Performance Indicators (KPI) of each economic activity and the total KPI´s for all activities at the level of the company. In your disclosure, you should report the following: 

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The percentage of the company’s turnover (revenue) that is derived from taxonomy-aligned sustainable activities. This shows how much of the company’s overall business is linked to sustainable operations.

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Secondly, the company must report about the proportion of  CapEx (Capital Expenditure) that is aligned with the taxonomy. CapEX refers to the investments made in developing, upgrading, or acquiring long-term assets, such as new infrastructure or technology that supports

sustainability. This demonstrates how much the company is investing in future sustainability.

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Third, the share of OpEx (Operational Expenditures), the day-to-day costs involved in running the business that are dedicated to taxonomy-aligned activities must be reported. You can think of maintenance or operational expenses, which reflects ongoing efforts to maintain sustainable operations.

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Transparent reporting on turnover, CapEx, and OpEx is crucial for stakeholders and investors to evaluate the company’s sustainability claims. It shows how much of a company's financial activities are truly aligned with the environmental objectives.

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Example: Our wind energy company would report that 80% of its turnover comes from wind energy production, indicating that 80% of its revenue is taxonomy-aligned.

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The company would also report that a significant portion of its CapEx is directed toward building new wind turbines, fully aligned with the EU Taxonomy’s criteria for climate change mitigation.

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For OpEx, the company would disclose how much it spends on operating and maintaining the wind farm to ensure it meets sustainability standards.

Step 6. Verification

Finally, the company must ensure that its alignment with the EU Taxonomy is verified, either through internal audits or third-party verification. External auditors might review the company’s reporting on how the wind energy project meets the technical screening criteria and DNSH requirements.

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Example: An external auditor reviews the company’s environmental impact assessments for the wind farm, ensuring that it complies with biodiversity protection requirements and that the CapEx/OpEx reporting is accurate and taxonomy-aligned.

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The EU Taxonomy and the CSRD‍

Both the Taxonomy and the CSRD (Corporate Sustainability Reporting Directive) are part of the broader EU Sustainable Finance Action Plan. Together, they ensure that financial markets have the information needed to invest in sustainable and responsible activities.

Under the CSRD, companies must publish information about their social and environmental impact. The EU Taxonomy provides the framework and criteria for determining which activities can be considered sustainable. Companies will need to report how their activities align with the criteria of the EU Taxonomy.

Challenges and benefits

Certainly the EU Taxonomy comes with challenges and costs. Companies may need to invest in external experts, technology solutions, and ongoing assessments to ensure their activities align with the taxonomy. On the other hand, your company could benefit from increased access to certain types of sustainable finance, such as green bonds or other instruments. 

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Additionally, companies may find that they are able to attract more investors who are looking for sustainable investments. Also, compliance can increase your brand recognition and gives you a competitive advantage over companies that are not compliant. 

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Last but not least, climate change adaptation can bring a number of benefits for business, such as improved resilience to climate change impacts, reduced costs, and improved social and environmental outcomes.

How to prepare?

Below a few tips and tricks on how you can prepare your company for the requirements:

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• Start early: The EU Taxonomy can be complex, so begin preparing as soon as possible. Early preparation allows you to understand the criteria, gather the necessary data, and make adjustments without rushing.
  
  
• Set up a cross-functional team: Assemble a team that includes experts from finance, sustainability, legal, and operations. A diverse team ensures that all aspects of your business are considered and that compliance with the Taxonomy is managed efficiently.
  
  
• Develop a clear reporting process: Establish processes for tracking and reporting the necessary data (turnover, CapEx, OpEx). Ensure your systems can produce high-quality, accurate reports, as this will be critical for meeting regulatory requirements and building stakeholder trust.
  
  
• Stay informed: Keep track of updates to the EU Taxonomy and other related regulations. Regularly follow news from the European Commission and industry organisations to ensure you remain compliant with regulations and seize new opportunities for sustainable growth.

More info

In case you would like to know more about the EU Taxonomy don't hesitate to contact one of our experts, or take a look at the following sources:

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Taxonomy user guide by European Commission: https://ec.europa.eu/sustainable-finance-taxonomy/assets/documents/Taxonomy%20User%20Guide.pdf

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Taxonomy compass: https://ec.europa.eu/sustainable-finance-taxonomy/taxonomy-compass; 

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Reporting delegated act: https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:02021R2178-20240101#tocId13

Interpretative FAQs on activities: https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=OJ:C_202300267‍

FAQs on reporting: https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=OJ:C_202300305;

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