EU Taxonomy reporting practices in 2023 and what is coming next

Since its inception in July 2020, the EU Taxonomy Regulation has been pivotal in steering the European Union towards a sustainable future. This regulation establishes a definitive classification system that identifies environmentally sustainable economic activities, promotes transparency, and directs capital flow towards sustainable investments—critical moves that underpin the ambitious goals of the European Green Deal.

Over the past year, this framework has undergone notable developments, influencing a wide range of sectors. This article delves into the current state of EU Taxonomy reporting, exploring how it has evolved over the last two years, the challenges encountered, and the help of technological solutions like the one of Dydon AI in navigating these complexities.

The phased-in reporting approach of the EU Taxonomy

Acknowledging the complexity of the EU Taxonomy and its reporting requirements, the European Commission has implemented a phased approach, easing companies and financial institutions into compliance. Now that it’s in the second year of application, there are still challenges to be solved and new modifications to be implemented.

In the fiscal year 2021, nonfinancial undertakings were mandated to report solely on the segment, concerning turnover, CapEx, and OpEx, associated with eligible economic activities in compliance with the Climate Delegated Act. Subsequently, in the reporting year 2022, this obligation was expanded to encompass the notion of alignment. Nonfinancial undertakings have now been compelled to disclose the portion of turnover, CapEx, and OpEx linked to both taxonomy-eligible and taxonomy-aligned activities in adherence to the Climate Delegated Act.

Per Article 8 of the Taxonomy Regulation, in addition to the accounting policy, the contextual information and the assessment of compliance with Regulation, the disclosure of nonfinancial undertakings should encompass three obligatory tables—one for each Key Performance Indicator (KPI), namely CapEx, OpEx, and turnover. These tables are required to report the proportion of taxonomy-aligned activities, taxonomy-eligible yet not aligned activities, and non-taxonomy-eligible activities.

This gradual approach was applying also to financial institutions that saw a phased-in reporting period spanning two years, with alignment Key Performance Indicators (KPIs) becoming obligatory in the fiscal year 2023. This is because financial undertakings rely on data disclosed by both their nonfinancial and financial counterparts to formulate indicators mandated by the Delegated Act associated with the EU Taxonomy.

During the fiscal years 2021 and 2022, financial undertakings were only required to disclose the percentage of exposures to taxonomy-eligible and taxonomy-ineligible activities within their total assets. Additionally, they had to report the proportion of exposures to: central governments, central banks and supranational issuers, to derivative instruments, and to undertakings not subject to Articles 19a and 29a of Directive 2013/34/EU.

Moreover, credit institutions must reveal the percentage of their trading portfolio and on-demand interbank loans in relation to their total assets. Insurers, on the other hand, are mandated to disclose the proportion of nonlife insurance and reinsurance economic activities that are both eligible and ineligible for the taxonomy.

Development and expansion of the EU Taxonomy Regulation: the Taxo4

These past twelve months have been prosperous in new developments intended to improve the regulation and make it more effective.

In December 2022, the EU responded to interpretive challenges by releasing two draft Commission Notices. These documents offer clarifications to common queries regarding the disclosure mandates under Article 8, known as the Disclosures Delegated Act and the Climate Delegated Act.

The formal adoption of the Delegated Acts on June 27, 2023, marks a crucial development in this regard, introducing significant amendments to the existing regulations and expanding the scope of the EU Taxonomy.

The inclusion of the additional four environmental objectives, referred to as “Taxo4”, broadens the focus from primarily climate change mitigation and adaptation to encompassing sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems.

This expansion, which will become effective from January 1, 2024, is a pivotal step in advancing sustainable finance in the EU.

How are companies dealing with the EU Taxonomy?

The EY EU Taxonomy Barometer 2023 provides important insights about the current state of the EU Taxonomy. After two years of Taxonomy application, it appears that companies are still struggling to understand the new regulation.

The EY report reveals that the average eligibility of Key Performance Indicators (KPIs) for nonfinancial entities remains below 40%, showing a significant gap between potential and actual alignment with sustainable activities. This gap varies across countries and sectors, with some industries, such as manufacturing, demonstrating higher eligibility rates.

Looking at the 277 nonfinancial entities analyzed, 96% of those included a taxonomy disclosure in their annual report or in separate non-financial reports. Within this group, a significant majority of 89% reported on at least one of the three key performance indicators (KPIs) – turnover, CapEx, or OpEx.

Among financial entities, the banks’ contributions to the EU’s environmental goals were measured via the Green Asset Ratio (GAR), focusing on taxonomy-aligned assets, averaging 26% for eligible assets. Insurers used two metrics: “Eligible premiums,” averaging 48%, reflecting contributions to climate change adaptation, and “Eligible assets,” averaging 15%, indicating the potential contribution of the investment portfolio to the environmental objectives.

Furthermore, the EY report highlights that alignment challenges among companies disclosing EU Taxonomy information were prevalent for various reasons. Some companies could not achieve alignment due to the lack of necessary information to cover the Technical Screening Criteria (TSC). In the construction, infrastructure, and real estate sectors, many firms couldn’t trace back to the design and manufacturing phases of products used, affecting alignment. Meanwhile, health, biotechnology, chemicals, and manufacturing sectors often failed to align due to non-compliance with the ‘Do No Significant Harm’ (DNSH) criteria.

Banks’ Challenges in Integrating the EU Taxonomy

What are the main difficulties for banks in integrating the EU Taxonomy into their credit processes? There are challenges related to the integration into the banking processes, as well as regulatory challenges.

The banking integration challenges are represented by the following:

1. Organizational Classification: Aligning different banking departments with EU Taxonomy requirements.
2. Data Integration and Availability: Managing external data, including climate risks and public data.
3. Roll-out Across Banking Groups: Implementing EU Taxonomy compliance within banks and banking groups.
4. Portfolio Assessment: Initial valuation and periodic reclassification of portfolios.
5. Data Management: Integrating taxonomy data into existing systems and processes.

While the main regulatory challenges are:

1. Evolving Regulatory Landscape: Adapting to ongoing changes in the regulatory process.
2. Diverse EU Jurisdictions: Managing variations in thresholds and nomenclatures across EU states.
3. Audit Standards Interpretation: Clarifying future audit routines and standards.
4. Parallel Legislative Processes: Navigating complexities of multiple concurrent legislative processes alongside the EU Taxonomy.

Streamlining EU Taxonomy Compliance with AI

Recognizing the intricacies of the EU Taxonomy Regulation and its impact on financial institutions, Dydon AI offers European banks and companies the reporting software TAXO TOOL – an innovative AI-powered solution specifically designed to address these challenges and make the over 40,000 pages of dense regulatory text more manageable for banks and financial entities.

The TAXO TOOL leverages AI and NLP-based solutions to automatically analyze documents and extract pertinent information. Based on the acquired data, the solution can preselect the answers to the EU Taxonomy’s long list of questions, streamlining the workflow for banking personnel, and speeding up the process enormously. Integrating external data services on climate and geological risks is another feature, ensuring financial institutions access to comprehensive risk assessments, aligning with the EU Taxonomy’s evolving objectives.

With TAXO TOOL, we exemplify the need for sophisticated and exceptionally adaptable systems, offering financial institutions a robust and intelligent solution to meet the EU Taxonomy’s stringent and complex compliance demands. Discover more by getting in touch with us for a free software demo with one of our sustainability experts.