EU Taxonomy: Connectivity with Sustainability and Financial Reporting

Sustainable finance has a key role to play as part of the European Green Deal and delivering on the related policy objectives. With the EU Taxonomy (EUT) being the classification system for measuring contribution towards these objectives, it is closely linked to other EU policies (such as European Green Bond Standard) and when it comes to entity EUT disclosures it is expected that there is clear connectivity to other elements of an entity’s financial and non-financial reporting.

Whilst EUT reporting comprises of several steps as outlined in our previous blog, the requirements are linked to existing CSRD reporting requirements that many entities are already preparing for, including limited assurance over EUT disclosures. Our blog aims to highlight the connectivity between EUT reporting and other external reporting in the annual report, financial statements and other sustainability related disclosures.

EU Taxonomy connectivity throughout the sustainability statement

One of the key areas to monitor for consistency and connectivity when reporting is between the EUT disclosures and the entity’s wider sustainability reporting, for example in the Annual Report or Sustainability Statement. 

The EUT recognises and sets criteria for economic activities that are green or ‘environmentally sustainable’ as having the ability to substantially contribute to at least one of the EU’s environmental objectives, while at the same time not harming any of the remaining objectives and meeting minimum social safeguards. By extension, the inclusion of an economic activity and the associated criteria for defining economic activities as ‘environmentally sustainable’ provides insight into whether the economic activity has an impact on the environment.

Double Materiality Assessment

When performing the double materiality assessment (DMA) as required by CSRD, entities should consider how eligible economic activities and associated criteria under EUT are also considered in their impacts, risks and opportunities (IROs) assessment.

The substantial contribution highlights the complexity of economic activity (and potentially its value chain) in relation to the environmental objective that is being achieved. This aligns with the DMA consideration of the impact of an entity’s activities on the environment and society, throughout the entity’s value chain. Value chain analysis forms a key part of the DMA, as entities must consider their upstream, downstream and value chains when considering sustainability related IROs. The IRO data exercise under DMA will be streamlined if an entity’s financial and organisational mapping is clear for all operational and revenue streams. This will have the dual benefit of supporting calculations for the EUT KPI requirements.

For example, an entity producing solar panels to generate renewable electricity could make a substantial contribution to climate change mitigation. However, the large-scale construction and deployment of the required solar technology may lead to potential negative impacts on other environmental objectives such as biodiversity with regard to impacts on land-use, as well as the circular economy objective when considering materials and chemicals involved in construction that may lack appropriate end-of-life disposal facilities. As part of the CSRD DMA exercise, IROs are assessed for impacts an entity has on people and the environment. As a result, if economic activities are being conducted by an entity to mitigate against climate change, the impacts of these activities would be considered on the other European Sustainability Reporting Standards (ESRS) topics such as E3 (water) and E4 (biodiversity).

Environmental related disclosures 

The EUT requirements also link to ESRS, specifically the ‘E’ standards on environmental topics, including E1 on climate change. For example, an entity could disclose its actions relevant to climate change mitigation under ESRS E1, which should link to its EUT aligned activities under the climate mitigation objective.

There is also a connection between EUT and the transition plan disclosed by entities today under ESRS E1 the Task Force on Climate-related Financial Disclosures or the Transition Path Taskforce (TPT) and in future under the IFRS S2. Per IFRS S2, the climate-related transition plan lays out the entity’s actions for its transition towards a lower-carbon economy, including actions such as reducing its greenhouse gas emissions. The EUT similarly aims to direct an undertaking’s investments to the economic activities most needed to meet the European Green Deal transition objectives, in order to ensure economic growth is decoupled from resource use.

Social related disclosures 

Another example of connectivity between the ESRS framework and EUT regulation are minimum safeguards under EUT, which include OECD Guidelines and UN Guiding Principles. Within the DMA there is a value chain analysis requirement, which considers human rights amongst other topics. Whilst many companies may have established policies covering responsibilities such as human rights, entities should consider the connectivity by looking to ensure that they meet the EUT recommendations. This includes implementing due diligence procedures and avoiding negative impacts.

Sustainable Finance Disclosure Regulation (SFDR)

The SFDR is part of the EU’s transparency framework for financial market participants and financial advisers to communicative sustainability information to investors. The SFDR requires financial market participants to disclose how their products align with the EU Taxonomy. For example, disclosing the extent to which their portfolios are exposed to gas and nuclear-related activities that comply with the Taxonomy (as set out in the Complementary Climate Delegated Act). Editable templates are available from the European Commission to assist entity reporting.

EU Taxonomy connectivity throughout the annual report and financial statements

EUT reporting is focused on understanding the proportions of operating expenditure (OpEx), capital expenditure (CapEx) and turnover that are eligible and aligned to sustainable activities, providing a tool for financing the transition towards clear environmental objectives. The EUT disclosures should be consistent with an entity’s narrative disclosures throughout the annual report and the financial statements. This provides transparency as to whether the activities companies disclose as ‘green’ are truly eligible and aligned with EU definitions.

Per the EUT disclosure requirements, companies are expected to reconcile specific data points (such as total revenue and capital expenditure for example) between those included in the EUT mandatory disclosure templates through to the financial statements (in the case of non-financial undertakings).

An entity’s forecasts, investment plans and capital expenditure disclosed in the annual report (including the financial statements) should be consistent with information used to assess EUT eligibility and alignment of business activities, as well as the EUT template and narrative disclosures. For example, an entity’s loans portfolio may have different taxonomy-aligned components, which will then impact the turnover and capex KPIs under EUT.

Under both the EUT and CSRD, it is critical to have the appropriate teams involved internally. A broad range of key stakeholders – including finance, sustainability, procurement, tax, legal – should be involved early in understanding the reporting requirements.

Conclusion

The taxonomy reporting requirements apply to any entity reporting under CSRD, regardless of whether that entity publishes consolidated financial statements or not. The EU Taxonomy aims to aid transparency over green initiatives as defined by the EU and shows the links between narrative, sustainability and financial reporting. As there is considerable narrative that needs to accompany the EU Taxonomy’s three financial KPIs – to explain to stakeholders why companies have invested in what they have – early consideration of the reporting requirements will help ensure that public disclosure and reporting is aligned with an entity’s wider historic and current sustainability reporting.