The EU Taxonomy: Monstrosity or Chance of ‘Hero Role’ for the CFO? • With Commentary From Acre’s Harco Leertouwer

Commentary from Acre's Harco Leertouwer for CFO, published on 06/07/23. Orginal Source: De EU Taxonomie: gedrocht of kans op ‘heldenrol’ voor de CFO?, Authors: Jaime Donata and Jan Jaap Omvlee. Originally posted in Dutch, this is a translation of the original text.

What will the new classification system mean for the CFO and the financial organization? A tour of four experts.

The EU Taxonomy came into effect on January 1, 2022; the classification system that indicates whether an activity or investment is sustainable. The aim is to make the economy more sustainable by redirecting cash flows to demonstrably sustainable activities and making it easier for investors to opt for sustainable investments. At the moment, however, the classification is insufficiently clear to provide a proper insight into the sustainability of companies. There is a lot of room for interpretation leading to a variety of outcomes. That doesn't make the job of the CFO any easier. If only because the EU Taxonomy - an independent law - applies to all companies that fall under the Non-Financial Reporting Directive (NFRD) and soon under the Corporate Sustainability Reporting Directive (CSRD). In addition, it also applies to the financial sector - banks, insurers and asset managers - which must report under the SFDR (Sustainable Finance Disclosure Regulation).

Where is the EU Taxonomy now? And what will the new classification system mean for the CFO and the financial organization? In the latest CFO Magazine, CFOs, experts and an EU politician had their say. This week we publish these three articles about the EU Taxonomy separately on CFO.nl.

Six objectives, three criteria

Europe will meet the climate targets in 2050; that is the ultimate goal of the European Green Deal, with which Europe wants to contain the increasing warming and disruption of climate and biodiversity. The EU Taxonomy is one of the tools to achieve that goal, through investment decisions by companies and investors. The EU Taxonomy should ensure that investments can be better compared with each other but should also provide companies with a checklist with which they can shape their own sustainability agenda.

An additional goal is to prevent 'greenwashing' - misleading green marketing - and to facilitate labelling and raising capital for sustainable activities.

The EU Taxonomy assesses the sustainability of companies' economic activities. Larger companies and financial institutions must report on this and make their reports public.

There are six environmental objectives against which activities and investments are assessed:

• climate change mitigation;
• adaptation to climate change;
• the sustainable use and protection of water and marine resources;
• the transition to a circular economy;
• pollution prevention and control;
• the protection and restoration of biodiversity and ecosystems.

However, business activities are additionally assessed against three criteria: 1) the investment or activity must make a substantial contribution to one of the six objectives; 2) the investment or activity must not cause significant damage to one of the five other objectives (Do no Significant Harm or 'DNSH') 3) the activity must take place in accordance with established (social) minimum guarantees and with due observance of the OECD guidelines and UN Principles on Business and Human Rights.

One system, different interpretations

The EU Taxonomy has the ambition to describe as concretely as possible those parts of the economy where the greatest gains can be made when it comes to reducing (mitigating) climate change and adaptation. The EU Taxonomy forces companies to analyze and report activities in a different way – a task that often ends up on the plate of the CFO. Over the last two years 2021-2022, all listed companies in the EU with more than 500 employees, as part of their so-called non-financial reporting, have had to indicate what part of their turnover and investments fall under activities that have been designated by the EU Taxonomy as 'most relevant to the climate'. For 2022, companies have already indicated which of these activities will actually be carried out 'green'.

From 2025, it will also be the turn of the large European private companies. They will soon also have to report on the EU Taxonomy and thus also collect new data.

KPMG research

In 2022, consultancy firm KPMG mapped out how companies will work in 2021 when reporting according to the EU Taxonomy. The consultancy firm analyzed 34 EU Taxonomy reports from Dutch companies for 2021 - and came to the conclusion that reporting activities and revenue streams that fall within the EU Taxonomy domains is still quite complicated for some companies.

Gijs de Graaff, Director Sustainability Reporting & EU Taxonomy at KPMG, who led the research notes: “Companies interpret similar types of income in different ways to determine whether their activities are 'substantially contributing' to climate change mitigation or adaptation. In addition, we see companies explaining their own activities and revenue streams that fall within the EU Taxonomy domains in a very different degree of detail. It is therefore difficult to compare reports fairly. We also saw that the link between figures and sustainability strategy is still not explained by many,” says De Graaff.

Specific challenges per sector

De Graaff saw - and sees - quite a few companies struggling with the interpretation of the classification: “A number of sectors had specific challenges. For example, for a large part of the activities of the telecom sector - investments in the network infrastructure, cables and transmitters that enable teleworking and thus contribute to the mobility issue in a sustainable way - it was not obvious whether or not they fall within the 'green' objectives of the EU Taxonomy. This was confusing for a number of companies we spoke to.”

In the EU Taxonomy, 'ICT solutions aimed at collecting, transmitting and storing data, as well as modeling and using it' are labeled 'green' when those activities are mainly aimed at providing data and analysis to achieve greenhouse gas emission reductions. to make possible.'

The EU Taxonomy is also clear about the type of ICT solutions that qualify: “the use of decentralized technologies, the Internet of Things, 5G and artificial intelligence.” De Graaff: “But for the telecom sector it was a long time unclear whether investments in fiber and 5G could also fall within the EU Taxonomy. The European Commission has now made it clear that this is not the case. This may have consequences in the future. For example, there are now telecom providers that use Green Bonds for investments in network improvements. The question is whether such bonds will still be called Green Bonds in the future. According to the proposed European Green Bond Standard, at least 85 percent of funding would have to be used for activities that are 'green' according to the EU Taxonomy in order to meet the standard of this new standard.”

Uncertainties in definitions

There are more formulations in the classification system that are clumsily drafted. De Graaff: “Even when it comes to the activity 'production of films, video and television programmes, making sound recordings and publishing music recordings', it is difficult for companies to understand when activities may or must not be counted as potentially climate-adaptive .”

The main text of the EU Taxonomy states that video and TV productions that “meet the cultural and entertainment needs of customers” fall within the Taxonomy because they can be “potentially green”. If business activities fall within the EU Taxonomy, it means for companies that turnover, investments and operating expenses related to these activities must be reported. But later in the Taxonomy there is an additional formulation that further determines whether a potentially green activity is actually 'green'. An activity must: 'contribute to greening or be facilitating.'

De Graaff: “The formulations in the Taxonomy are so woolly that some media companies chose to only qualify their activities under the Taxonomy if they are specifically aimed at climate adaptation. Other companies consider all revenues from video and TV productions to be part of the taxonomy regulation, regardless of the subject of the video, because "creative activities, arts and entertainment" can potentially contribute to adaptation according to the rating system. These companies are right in a way, because companies must also report 'potential' green activities, even if they are not currently defined as 'green'. But companies sometimes interpret the question of which activities are 'potentially green' differently. So what we see in our research is that companies take different turns in what they report or not.”

DNSH criteria

These and other ambiguities identified by De Graaff do not make things any easier for CFOs. Michel Scholte, director of the Impact Institute and sustainability expert, also has an opinion on this: “The results of this KPMG study also reveal a deeper problem: the EU Taxonomy is currently not sufficiently refined to really do justice to the complexity of sustainability information. The Taxonomy merely classifies whether or not something is 'green', while the practice is almost always more nuanced: an electric car may have less CO2 emissions than a car with a combustion engine, but it does emit rubber particulate matter. And the battery is indeed polluting and exhausting. The binary structure of the EU Taxonomy – green or non-green – actually makes it an unsuitable classification to quantify and monetize the social damage of activities and investments. In other words: the EU Taxonomy does not provide us with a suitable language to make transparent the positive or negative impact of activities and investments. This makes it difficult to compare activities with each other and the Taxonomy is also unsuitable for reducing polluting investments.”

De Graaff would like to add some nuance to this: “It is true that the DNSH (Do No Significant Harm) criteria are used to map out the interrelationship between various sustainability domains. An activity only counts as green within climate mitigation if it does not harm the other five environmental objectives of the Green Deal.”

Paper tiger?

De Graaff foresees that it will be several years before apples can be compared with apples. “Very few companies really focus on the EU Taxonomy, so I understand very well that many parties and companies still experience the EU Taxonomy Regulation as a paper tiger.” Michel Scholte: “For the time being, the EU Taxonomy is only binding for a limited group. Only listed companies must use this in their reporting, but KPMG's research shows that a number of companies actually do not do this at all, or only to a very limited extent.”

De Graaff agrees with Scholte: “The EU Taxonomy is not a policy package, but a classification system. There is not yet a policy that rewards companies for alignment with the Taxonomy. The applicability of the EU Taxonomy will only become visible with the introduction of the CSRD, but this will take effect in one and a half years and will also apply to large unlisted companies from the 2025 reporting year. subject is estimated to increase to approximately 50,000 companies in the EU. But the intended change in the way of doing business will only change when tangible business cases emerge. This would happen, for example, if the EU Taxonomy were to become a precondition for public tenders, or if significantly cheaper financing became available for companies that provide unambiguous insight into the green and gray qualification of their activities according to the European Taxonomy rules.”

“CFO, take your hero role”

According to Scholte, the new EU Taxonomy is a great step forward as a basic idea, but in practice it is a monstrosity of all kinds of political interests and lobby parties. The impact calculations are also incorrect in terms of content. Gas-fired power stations, nuclear energy and plastic solar panels from China – they are all green according to the current EU Taxonomy. That is, of course, nonsense.”

De Graaff also mentions the DNSH and minimum guarantees here: “In activities involving solar panels and nuclear energy, it must also be determined whether they do not seriously harm other environmental objectives. For example, requirements are set for solar power plants regarding the recyclability of solar panels and that the minimum guarantees are also met in the production process. If nuclear power plants want to fall within the EU Taxonomy, they must have a sound plan about what they do with their nuclear waste. There are provisions that prescribe how you can generate nuclear energy 'greenly' and what you must do to store or process nuclear waste 'sustainably' according to guidelines of Euratom (the European Atomic Energy Community). The EU Taxonomy adheres to those standards.”

At the same time, according to both experts, the current weakness of the existing system also offers the opportunity to enter into an honest discussion, internally and externally, about sustainable choices that you can (or cannot) make as a company - and what that will cost. Scholte: “It is precisely the current multi-interpretability of the EU Taxonomy that could, in principle, offer the opportunity for true transparency instead of businesses and sectors continuing to lobby to destroy the system. I would say: CFO, take your hero role.”

But the question is which CFOs will take on the hero role. Gathering the information in particular, still proves to be a challenge for many CFOs. Some of the companies surveyed by KPMG have not disclosed their EU Taxonomy KPIs at all in their annual reports. They encountered problems with the amount of data needed to perform the suitability assessment. An example that KPMG cites is that of a Design & Consultancy company that indicated that a manual test to screen all projects for impact would simply not be feasible due to the size of its project portfolio. Other companies have problems reporting under the EU Taxonomy because data was not available or considered sufficiently reliable.

De Graaff also wants to challenge the CFO: “While companies may now use the Taxonomy Regulation as a checklist, this classification system can also be used as a transition instrument. At present, the link with company vision, mission and strategy is hardly ever made. That while the Taxonomy can also be used to support, for example, the energy transition or the route to a fully sustainable business operation. Subsequently, the transitions to sustainable business operations will also have to be in line with the ambitions of Frans Timmermans' EU Green Deal. Only then can we talk about a collective contribution towards a sustainable economy.”

EU Taxonomy part of CSRD

The CSRD applies from 1 January 2025 (reporting year 2024) to large listed companies and other major issuers of shares and bonds on a regulated market in the EU and from 2026 (reporting year 2025) to large private companies. The EU Taxonomy will then also become part of the CSRD.

In that light, Egbert Willekes, Senior Researcher & Lecturer Future Proof Control at HAN, is extremely critical of the current status of the EU Taxonomy, but also of the pace of the process: “The EU Taxonomy will soon become part of the CSRD. As a result, sector-specific standards will soon be added to the current sector-agnostic standards.”

According to Willekes, it will be quite a challenge to implement the CSRD without the EU Taxonomy and the sector-specific standards, especially in combination with the due diligence obligations in the chain, the CSDD (Corporate Sustainability Due Diligence): “My advice? Enter CSRD properly first, without requiring the Taxonomy. Then do research into the effectiveness of the CSRD: are organizations sustainable enough? Will the financing flows indeed move differently and will they accelerate the sustainable transition sufficiently? If not, then I am not in favor of imposing further reporting obligations. In that case, I think you should move to other, more mandatory regulations, such as a tax/subsidy system based on true pricing, or making certain sustainable goals mandatory in line with the Paris Agreement, for example by making Science Based Targets (SBTi).”

Don't lean back

No matter how little refined the EU Taxonomy is and how complex the CSRD may seem, it is up to the CFO to provide insight into the financial, social and sustainable performance of the company and to account for it: waiting is not an option . Sooner or later, concrete business cases will arise, for example if the EU Taxonomy becomes a precondition for tenders or if financing becomes cheaper for CSRD-compliant companies. De Graaff: “The Taxonomy is never 'finished' because it contains an ingrained mechanism of reviews and adjustments. The standards will also become stricter. What is 'green' in 2023 may no longer be green in 2040."

Whether the EU Taxonomy will soon be finished or not, the CFO cannot and does not have to sit back. The CSRD will soon be further elaborated in the European Sustainability Reporting Standards (ESRS), which provide insight into the structure and publication requirements of the sustainability report. So if the EU Taxonomy remains under construction in the coming years, the ESRS will contain sufficient guidelines for how the sustainability report should look. The European Financial Reporting Advisory Group (EFRAG) prepares the ESRS and sends it as an opinion to the European Commission, which uses this advice to adopt the ESRS as delegated acts. This concerns the elaboration of technical matters, which require specialist knowledge and which have little political significance. The Taxonomy Regulation provides that such a delegated act will enter into force only if no objections are raised by the European Parliament or the Council within a period of four months, or if both institutions have notified before the expiry of that period that they will not object.

The intention was for the European Commission to adopt the first set of ESRS by 30 June 2023. However, the timelines for the regulations have proven to be indicative on several occasions. Due to the consultation period up to and including 7 July, the deadline has now been postponed until the end of July. After that, they still have to come to a final version. It is still unclear how long this will take, but it seems to the experts who contributed to this piece that there will be a new version before August 1.

Chief Sustainability Officer

What does all this mean for the CFO - and how should they prepare for the EU Taxonomy? Harco Leertouwer, Manager Director Europe Acre, who advises organizations on the implementation of 'sustainability leadership' does have an idea about it. It is better for the CFO to take the lead and show that they are serious about creating value for all stakeholder groups: “With the introduction of the EU Taxonomy and the CSRD Directive, the EU has shown that it is serious about moving towards a more sustainable financial system. This is a good business. But it also creates additional obligations and responsibilities for the CFO and the finance department. That is why I say: let a new Chief Sustainability Officer (CSO) be the director in this transformation process and work together with the CFO to exploit the opportunities offered by CSRD.

The introduction of the CSRD creates a new situation. Many companies have to draw up or update a sustainability strategy and redesign their processes and systems based on this in order to achieve the sustainability goals. But the crux lies in collecting the right data for reporting on this and guaranteeing the quality of that data. This forces directors to intensify the dialogue with their stakeholders. And yes, along the way you may lose employees or customers, but you will also find new employees and customers. As a CFO you must have the ambition to be a pioneer in your sector and be prepared to make choices, even the difficult ones."

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