Our thinking Quick reads EU Taxonomy – Challenges and opportunities for GPs
 
ESG and sustainability
February 2022
5 min read

EU Taxonomy – Challenges and opportunities for GPs

What is the EU Taxonomy? 

The EU taxonomy was created as a classification system for sustainable economic activities. In response to our worsening climate crisis and the lack of initiative from the broader private sector, in 2019 the European Commission launched the Green Deal. The Green Deal set out an ambitious 2030 Climate Target Plan, involving a targeted 55% reduction in emissions compared with 1990s levels in the EU by 2030. This target is aligned with the Green Deal’s long-term objective of achieving net zero greenhouse gas emissions by 2050.  

To support this massive transition, there is a need for increasing sustainable investment to the tune of €350Bn more per year. As sustainability focused investors search for opportunities, accurate identification of what constitutes “sustainable” is increasingly necessary and in demand. To this end, the European Commission created the EU Taxonomy (‘Taxonomy’) as a living framework within the European Union (EU).  

The creation of the EU Taxonomy resulted in a myriad of new definitions for activities and criteria for qualification, creating much complexity for the GPs it targets. At MJ Hudson, we have found that many GPs struggle to interpret how the regulation would affect them and what they are accountable for from 1 January 2022 and going forward. This article offers our insights into the reporting requirements GPs should cover, and the opportunities and challenges they may face in the process of alignment to the framework.

What does EU Taxonomy mean for GPs? 

From the 1st of January 2022, GPs offering Article 8 (light-green) or Article 9 (dark-green) products under the SFDR are required to report on the Taxonomy alignment of their financial products.

The EU Taxonomy is separated out into ‘Delegated Acts’ which define activities and criteria for eligibility for six key climate objectives:

Currently, only the first delegated act of the Taxonomy Regulation, covering the first two out of the six environmental objectives, is applicable to GPs – the delegated acts covering the remaining objectives are scheduled for release mid-2022, for reporting from early 2023.

For each underlying portfolio company or asset, eligible activities should be identified and assessed using the Taxonomy’s Technical Screening Criteria based on the environmental objectives it relates to. The Technical Screening Criteria consist of three parts: (1) substantial contribution [to the objective], (2) Do no Significant Harm (DNSH) criteria, and (3) Minimum safeguards. The first part assesses if the activity has a substantial enough contribution to one of the climate objectives; the second ascertains that the activity is not conducted to the detriment of other objectives (e.g. if you produce solar panels for the Climate Mitigation objective, you must recycle your waste materials responsibly to not do harm to the Circular Economy objective); finally, minimum safeguards on operation must be met such as following the principles of the ILO (International Labour Organisation) core conventions and the International Bill of Human Rights.

A company’s Taxonomy alignment is the proportion of the revenue for eligible activities that meet all Technical Screening Criteria.

The second delegated act, on the remaining four objectives, is scheduled to enter into force from 1 January 2023 – although the deadline has been postponed several times. Once all the objectives are in force, GPs will be required to report on the alignment with all environmental objectives, which may provide benefits to GPs currently holding (but not being aligned to the Taxonomy on) sustainable or transitional assets related to water resources, circular economy, pollution prevention and biodiversity control. More information regarding the EU Taxonomy can be found in our Taxonomy guide.

Opportunities for GPs 

At MJ Hudson, we believe the EU Taxonomy brings transparency regarding sustainable investments, providing a logical system behind why they are defined as such and how they fit into the greater climate ambitions of the Eurozone. The EU Taxonomy regulation and its reporting may bring substantial opportunities for GPs and can be used as a tool to further enhance the value of Article 8 and Article 9 funds in particular:  

  • at the fund level, EU Taxonomy alignment allows for differentiation from competitors and has the potential to result in reputational benefits for the fund manager.
  • the transparency of the Taxonomy’s reporting provides clear guidance for investors to assess if investments are environmentally sustainable in the decision-making process.

Challenges for GPs 

  • it requires a thorough assessment at investee company level, which makes you dependent on the quality of their assessment (or the availability of data if you operate in public markets).
  • the Technical Screening Criteria are strict and yet do not always clearly apply to every economic activity that a company might undertake. Becoming Taxonomy-aligned might require expert guidance and taking timely action.
  • the regulation is still in development, so GPs will have to stay on their toes and reassess their assets as new guidance is released. The Technical Screening Criteria for the other four objectives are not yet finalised (scheduled for 2023).

Our services 

At MJ Hudson, we are at the forefront of understanding new regulation as it is released and specialise in supporting private market investors in navigating the sustainability space. We have helped many large and complex clients determine the EU Taxonomy eligibility and alignment of their portfolios, at both a company and fund-level, and understand how to plan for future reporting requirements. Utilising a proprietary MJ Hudson EU Taxonomy platform to streamline the data gathering process for investee companies, we save time and costs on data processing and allow for strategic consideration on the sustainability of your portfolio. We deliver individual Taxonomy alignment reports at company and fund levels (as required), highlighting alignment along with actionable recommendations to increase alignment in future. If you are interested in more information regarding our Taxonomy assessment or if you would like to see a demonstration of our tool, please contact us via bdm@mjhudson.com.

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