What does EU taxonomy alignment really mean?

With the start of the first reporting period in January 2022, there has been a lot of attention surrounding the EU taxonomy. One of the main topics of discussion is how businesses will report on taxonomy eligibility and alignment and benefits of a high taxonomy score. But to understand this, it is key to first understand what taxonomy alignment really means.

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The EU taxonomy is a classification system that sets out a list of environmentally sustainable economic activities. The taxonomy forms part of the EU’s plan to scale up sustainable investment and implement the European green deal. 

The EU taxonomy is set out in an EU Regulation with several delegated acts and will apply to all EU Member States. It has not yet been integrated for EEA countries, but this process has been started. The taxonomy regulation and delegated acts set out technical criteria that must be complied with for an economic activity to be considered sustainable. Companies will be required to assess how their activities perform against the taxonomy criteria and disclose these results publicly.

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Taxonomy alignment can be broken down into simple steps:

1.  A company must have an eligible activity. An eligible economic activity is an economic activity that is described and has technical screening criteria set out in the taxonomy. All revenue, CAPEX and OPEX for this eligible economic activity is therefore taxonomy eligible. For example, electricity generation from wind power is an eligible activity, while electricity generation from coal is not eligible.

2.  The eligible activity should be assessed against technical screening criteria set out in the taxonomy’s delegated acts.

3.  The activity must make a substantial contribution to one or more of the climate and environmental objectives relevant to that activity.‍ This means that, based on the technical screening criteria, the economic activity either has a substantial positive environmental impact or substantially reduces negative impacts of the activity on the environment. 

For example, manufacturing of batteries can make a substantial contribution to climate change mitigation if the batteries manufactured result in substantial greenhouse gas emissions reductions.

4.  The activity should not do significant harm to the other remaining objectives.

The taxonomy criteria are based on the idea that an economic activity should not qualify as environmentally sustainable if it causes harm to any of the environmental and climate objectives. In the taxonomy, criteria are set out for each economic activity to ensure that as well as making a substantial contribution to one or more of the objectives, the activity does not cause harm to any of the other objectives.

5.  The activity should fulfil the minimum social safeguard standards based on OECD and UN guidelines.

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To be sustainable, an economic activity should be carried out “in alignment with the OECD Guidelines for Multinational Enterprises and UN Guiding Principles on Business and Human Rights, including the International Labour Organisation’s (‘ILO’) declaration on Fundamental Rights and Principles at Work, the eight ILO core conventions and the International Bill of Human Rights”. This means that any business will be required to demonstrate compliance with minimum standards on human rights, social responsibility, labour rights, and anti-corruption procedures. 

Taxonomy alignment therefore refers to an eligible economic activity that is making a substantial contribution to at least one of the climate and environmental objectives, while also doing no significant harm to the remaining objectives and meeting minimum standards on human rights and labour standards. The revenue, CAPEX and OPEX for such an activity is aligned or in alignment. An economic activity that is eligible and does not meet the technical screening criteria and minimum social safeguards is not aligned.

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What is a climate risk assessment and why is it key for sustainability reporting?

Climate risk is the risk that affects your business caused by climate change. It could be risks that impact your own operations or activities or activities related to your value chain that indirectly impact your business activities. There has been an increased focus on climate risk assessment in the past years, with the WEF Global Risks Report 2022  identifying climate based risks as the most significant risks facing us  in the next decade. The EU taxonomy requires climate risks assessments as a part of its technical screening criteria.

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A climate risk assessment (CRA) involves the identification of risks to development activities that are arising because of climate change, and identification of opportunities to address climate change. A climate risk assessment should be performed when investing in a new development, or when upgrading or altering existing assets, operational activities, or processes.

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CRAs are important to ensure that climate change does not undermine goals, objectives and outcomes of projects or programmes. A CRA is also important to ensure that projects are not inadvertently increasing risks, vulnerability, or driving maladaptation. This type of assessment is key to ensuring that opportunities to make development climate resilient are identified and exploited where possible, and to make sure that any development is appropriate, viable and sustainable going forwards.

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An example of a climate risk assessment and climate adaptation solutions can be seen in Slovakia’s railway modernization project. Here an analysis was carried out using local data on past trends and future projections.  Risks identified included temperature increases, increased variability of climate, and extreme rainfall events leading to a risk of local flooding. Projections and data identified weather extremes as one of the biggest climate risks for the transportation sector and for rail transport in particular, as it has potential to cause damage to the railway infrastructure.

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On the basis of the risks assessment, adaptation solutions implemented included technical solutions such as increasing resilience of the railway infrastructure by wind-proofing the catenary system, increasing capacity of the drainage system, increased railway alignment above the limit of potential flooding, reducing slope incline as prevention against landslides, resistant bridge structures and deep bridge pillars, use of highly water resistant building materials for railway subgrade and other components, installation of structural protection systems (e.g. windbreaks, retaining walls, embankments). They also included management solutions to provide solutions when extreme weather events occur and infrastructure disruption takes place. These solutions include increased maintenance and control of sections at risks, e.g. equipping switches, rails and catenaries with detectors monitoring temperature (for overheating and freezing), icing, snow precipitation or wind speed, provision of substitute bus service in the event of temporary interruption of rail transport, ensuring alternative railway routes and efficient emergency transport management.

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CRAs play an important role in the EU’s taxonomy rules. For activities to be qualified as green, an analysis should be carried out to ensure that economic activities are appropriate, viable and use opportunities to become more climate resilient where feasible.

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A CRA should contain information on:

1.      Climate-related risks to the successful realisation of the project’s intended outputs and outcomes;

2.      Risks that the project will increase the vulnerability of human populations and/or natural systems to climate change and variability;

3.      Risks that the project will contribute to maladaptation; measures to reduce climate-related risks and to adapt to climate change, to be described in a Climate Risk Management Plan (CRMP);

4.      Opportunities for promoting wider resilience and adaptation to climate change and encouraging low-carbon development.

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In practice, this requires the acquisition of appropriate, context-based climate projections and data to assess what changes to the climate may occur over the lifetime of the new development. This includes information on current and emerging hazards, emerging trends, extrapolations, and projected changes and climate scenarios based on climate data for the area and industry. Based on the projections, there should be a consideration which climate risks may be material, and a plan should be made with measures to reduce the physical climate risk to the activity.

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The EU taxonomy requires that CRAs are carried out at a scale proportionate to the scale of the activity and its expected lifespan. For activities with an expected lifespan of less than 10 years, this means the assessment should be performed by using climate projections at the smallest appropriate scale. For other activities with a greater lifetime, the assessment should be performed using the “highest available resolution, state-of-the-art climate projections” across the existing range of future scenarios consistent with the “expected lifetime of the activity, including, at least, 10 to 30 year climate projections scenarios for major investments”.

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The taxonomy also requires that climate projections and assessment of impacts are based on best practice and available guidance, taking into account the state-of-the-art science for vulnerability and risk analysis and related methodologies in line with the most recent Intergovernmental Panel on Climate Change reports, scientific peer-reviewed publications, and open source or paying models.

Measures implemented should not negatively affect the level of resilience to climate risks of other people, nature or businesses and should be in line with local, sectoral, regional and national adaptation measures.

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