As part of the EU’s efforts to promote sustainability, financial and non-financial institutions are now required to disclose their alignment with the Taxonomy in their annual reports. The Taxonomy serves as a classification system that identifies and promotes environmentally sustainable economic activities in the region to reorient capital investments toward sustainable activities.
While it represents a significant step toward a more sustainable European market, the EU Taxonomy has been a source of considerable confusion. Many companies need help comprehending its application and the extent of its potential in promoting the green transition.
In this article, we will explore the challenges, the timeline, and the KPIs for navigating the EU Taxonomy reporting requirements.
Understanding the EU Taxonomy Reporting Timeline: Dates and Deadlines
In 2018, the European Commission introduced its Action Plan on Sustainable Finance, which initiated various legislative initiatives aimed at promoting transparency in the finance industry through ESG disclosures. The EU Taxonomy regulation is a significant component of this plan with six specific sustainability objectives:
- Climate change mitigation
- Climate change adaptation
- Sustainable use and protection of water and marine resources
- Transition to a circular economy
- Pollution prevention and control
- Protection and restoration of biodiversity and ecosystems
The Taxonomy outlines reporting criteria that serve as the basis for other sustainable finance legislation, such as the Sustainable Finance Disclosure Regulation (SFDR), under which all financial market participants must disclose the extent to which their financial products are environmentally sustainable, address sustainability-related principal adverse impacts, and the degree to which their products align with the Taxonomy objectives.
Financial and non-financial corporates that fall under the Non-Financial Reporting Directive (NFRD) scope are now expected to report both Taxonomy eligibility and alignment annually, following the timeline in the table beneath.
|January 2022||January 2023||January 2024|
|Non-financial corporates||The first climate delegated act has taken effect, setting criteria for activities that contribute to mitigating or adapting to climate change. |
Alignment reporting is not required.
|Reporting for additional technical criteria was due, but it has been delayed (the Environmental Delegated Acts is still pending finalization). Disclosure regarding the alignment of mitigation and adaptation objectives. This is limited to large non-financial corporates.||Alignment on all the six environmental objectives of the EU Taxonomy.|
|Financial corporates||Banks and other financial institutions are required to report Taxonomy eligibility for the previous year.|
Alignment reporting is not required.
|Same situation as above for the remaining four Taxonomy objectives.|
This is limited to large financial corporates.
|Same requirements as above. Financial corporates will also be expected to report on the alignment with all the six Taxonomy objectives.|
It is also to be noted that starting from 2024, European banks will be subject to new reporting responsibilities with the Green Asset Ratio (GAR) – a newly introduced key performance indicator aimed at providing a standardized and comparable measure of the percentage of banks’ assets that are invested in environmentally sustainable projects and activities.
Furthermore, starting from January 2026, following a three-year transition period, credit institutions will be required to report on the Taxonomy alignment of their trading book and fees and commissions for non-banking activities.
KPIs for Non-Financial Corporates in EU Taxonomy Reporting
For non-financial companies, there are essentially three key performance indicators (KPIs) to be taken into account for the EU Taxonomy:
Turnover: This KPI indicates the proportion of turnover derived from products or services aligned with the Taxonomy. It measures the turnover generated from products or services that meet the environmental sustainability criteria against the company’s total turnover. The KPI related to turnover is calculated as follows: Revenue or turnover derived from taxonomy-aligned products or services / Total revenue or turnover.
Capital Expenditure (CapEx): This KPI indicates the proportion of the capital expenditure of taxonomy-aligned activities. It measures the total amount of investment in tangible and intangible assets during the financial year before depreciation, amortization, and any re-measurements associated with the taxonomy-eligible activities. The KPI related to CapEx is calculated as follows: Capex of Taxonomy-aligned activities / Total CapEx.
Operating Expenditure (OpEx): This KPI indicates the proportion of the operating expenditure associated with taxonomy-aligned activities. The OpEx used in the taxonomy differs from what most companies report in their financial statements. The KPI aims to capture non-capitalized costs (i.e., those not captured by the CapEx KPI) related to investments in assets and processes. OpEx is a category of costs that “complements” CapEx in relation to investments and, together with CapEx, gives an indication of a company’s strategy for maintaining or improving environmental performance and resilience. The KPI related to OpEx is calculated as follows: OpEx of Taxonomy-aligned activities / Total OpEx.
KPIs to Unlock Success in EU Taxonomy Reporting for Financial Corporates
For European banks and other financial corporates, there are two KPIs to be taken into consideration for the EU Taxonomy:
Green Asset Ratio (GAR): This KPI applies to credit institutions or lenders and is used to indicate the proportion of exposures related to a credit institution’s taxonomy-aligned activities compared to its total assets. Its primary purpose is to establish a universal and comparable metric that indicates the proportion of a lender’s assets invested in environmentally sustainable projects and activities. The GAR is calculated differently for investment firms that deal on their own account and those that do not.
Green Investment Ratio (GIR): Asset managers should report the proportion of taxonomy-aligned investments managed in the value of all covered assets under management (AuM) from its collective and individual portfolio management activities. Covered assets under management refer to all AuM except for sovereign exposures. The weighted average of taxonomy-aligned investments should be based on the share of taxonomy-aligned economic activities of investee companies. Asset managers shall rely on the underlying investee companies’ KPIs to compute their own GIR. They shall also provide a breakdown for each environmental objective, aggregated environmentally sustainable economic activities, a subset of transitional and enabling economic activities, and the type of investments. In addition to asset managers, insurance companies are also required to report on the eligibility and alignment of their underwriting businesses.
EU Taxonomy Reporting with AI: our best practices
The complexity of the EU taxonomy and its implementation pose some concrete challenges for both banks and companies in the years onward.
Just to mention some of these challenges:
1) the current internal processes have to be adapted; 2) documentation requirements are increasing enormously and its management, this could have an impact on the time needed to complete e.g. loan applications; 3) as mentioned, the EU taxonomy defines fixed and auditable criteria for whether an economic activity is environmentally sustainable in relation to six defined environmental objectives. The associated verification process is enormously complex and sometimes very time-consuming; 4) the cost of developing IT tools, as the new processes have to be absorbed by the IT infrastructure and the existing services for ESG are no longer sufficient to assess clients on the basis of the EU taxonomy.
As the second quarter of the year is rapidly approaching, the new obligations starting in January 2024 are already not too far ahead in the future. Because of the numerous new changes concerning companies’ responsibilities and the confusion that still seems to loom over large European corporates, companies must now start appropriately preparing for what is to come.
At DYDON AI, we recognize the magnitude of the current challenges, where a turbulent and fast-evolving market environment makes things more confusing and complicated for corporates that also need to adapt to new complex regulations. But we are also well aware of how much is possible to simplify things with relevant regtech solutions that can enable greater agility and speed in dealing with regulatory requirements.
Can the assessment process be automated?
Yes, up to a certain level. This is exactly what we are trying to achieve with TAXO TOOL and offer to banks and companies. The complexity of the EU taxonomy can be simplified and accelerated through automation.
Our award-winning solution called TAXO TOOL uses AI to make this transition toward a greener economy smoother and the EU Taxonomy compliance for your company and financial institution much simpler and definitely more manageable.
Digitization of the EU taxonomy belongs to the field of RegTech, i.e. technologies that enable greater agility and speed in dealing with regulatory requirements.
What we did with TAXO TOOL is to digitise the EU Taxonomy Regulation and the first step was to translate the complexity of the regulation into logical decision trees that allow easy processing of the respective assessment both for bank employees during the loan application process and for companies during the self-assessment regarding the EU Taxonomy.
Secondly, we had to overcome the dilemma of lack of data by introducing appropriate models for calculating carbon emissions that are based on procedural knowledge. This makes a big difference when it comes to cases with missing data, as is often the case with SMEs.
And thirdly, we used and extended our Natural Language Processing (NLP) stack, which allows us to capture text and answers from available documents related to the project being assessed (e.g. energy performance certificates for buildings) and use them automatically for the assessment.
The time to postpone planning is over. Feel free to reach out for a free demo and let us help you in this challenging but well-worth journey toward sustainability.