This article was co-authored by Subramanian Kuppuswami, Global Head, Sustainable Banking, Finance and Investments and Saritha BS, Domain Consultant, Sustainable Banking, Finance and Investments at Tata Consultancy Services.
Climate change affects the whole world. According to a recent report by the Intergovernmental Panel on Climate Change (IPCC), global temperatures are expected to warm by more than 1.5°C over the next 20 years. The report also highlights that extreme heat conditions will be more frequent across Europe, leading to increased flooding in central and western Europe and further melting of glaciers and permafrost. The European Commission aims to make the European Union (EU) climate neutral by 2050.
Measures taken by the European region to address climate risk
The European Green Deal is a set of policies undertaken to make Europe economically sustainable. These objectives aim to direct investments towards sustainable projects. The fundamental tool of the European Green Deal is the EU taxonomy, which classifies environmentally sustainable economic activities. This allows investors to identify a set of criteria regarding sustainability in key sectors and set thresholds against them. It also brings more transparency in sustainability reporting and deters greenwashing.
How will the EU taxonomy enable stakeholders?
The EU taxonomy provides companies, investors and policy makers with appropriate definitions to identify and consider sustainable projects. This in turn insures investors against the risks due to greenwashing by allowing a transparent view of environmentally friendly projects. The EU taxonomy addresses challenges in a multitude of sectors such as manufacturing, transport, agriculture, construction, oil and gas, etc. To cite one example, an oil and gas company focusing on new investments and expansions will be considered “EU taxonomy aligned” only if it has renewables and biofuels as project components. This unified approach across countries and sectors will inaugurate Europe’s commitment to meeting climate and energy targets by 2030.
Classification for environmental performance
- The EU taxonomy highlights six objectives set for environmental performance —
- Climate Change Mitigation
- Adaptation to climate change
- 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
How do financial institutions measure or assess EU taxonomy alignment?
Financial institutions and non-financial companies can assess their activities according to the definitions and criteria of the taxonomy. For an economic activity to be aligned with the taxonomy, it must make a substantial contribution to one of the six environmental objectives described above, do no significant harm (DNSH) to the other five environmental objectives, and comply with safeguards minimal. Financial institutions will be required to disclose the environmental objectives of their investments and the proportion of underlying sustainable funds that align with the taxonomy. Non-financial companies can take the necessary steps to reduce the potential regulatory and financial risk associated with activities that do not comply with the taxonomy.
What is the timetable for the implementation of the EU taxonomy?
Financial market participants must disclose alignment with the first two objectives of the EU taxonomy by the end of 2021, which covers a substantial contribution to climate change mitigation and adaptation. A second set with the remaining objectives will be released in 2022. January 1, 2023 is the date set for the disclosure of the remaining objectives. Implementation is being phased out and 12 months has been granted to adapt and disclose the alignment.
What are the challenges?
Data quality and information availability prove to be the most difficult challenges when evaluating DNSH criteria, as the thresholds are project-specific and may or may not be collected by companies. The detailed revenue analysis reported in statements is not at the project level, and the alignment of capital expenditure (CAPEX) and operating expenditure (OPEX) is not mandatory. This becomes more difficult if investments are made outside the EU, where companies are not required to report alignment and data according to national regulations. Harmonizing complex data is becoming essential for financial institutions, and upgrading IT process, leveraging big data, and technological solutions can help banks overcome this challenge.
How can technology help?
Data is diverse and dispersed across multiple internal and external systems. Cognitive technologies and ecosystems powered by AI and ML provide a framework to ensure consistency, comparability of criteria and measure alignment with local legislation and EU taxonomy. This is achieved through the systematic collection, acquisition, harmonization and alignment of data with EU taxonomy using data science and analytical capabilities.
As financial institutions embark on a new adventure, they must focus on new guidelines, frameworks and methodologies to assess and engage with stakeholders, bringing more transparency to the world of finance. The climate emergency calls for a substantial reduction in the negative impact of climate change by urging the financial institution to focus on the areas in which it invests, finances and finances. The EU taxonomy aligned with the environmental dimension is a clear game-changer; but the question is, will other nations follow suit?