The EU Green Taxonomy: An ambitious framework to redirect financial flows towards sustainability

As the world grapples with the urgent need for sustainable practices, the European Union has spearheaded the development of the EU Green Taxonomy — an instrumental tool in promoting sustainable finance. Following the Green Deal passed in 2019, the regulation was adopted in June 2020 and entered into force in July 2021, with a roll-out plan in several phases. Codo summarizes the potential consequences it holds for Japanese companies operating in the global markets with input from Tatjana Gerling, an ESG Expert based in Europe. For our readers that are not familiar with the EU Green Taxonomy, we recommend checking out the annex at the bottom of the page where we introduce the fundamentals of the taxonomy.

Who is covered by the EU Green Taxonomy?

As of June 2023, it is mandatory for all companies that meet specific criteria to comply with the 6 climate objectives shown below.

The EU Green Taxonomy extends its influence beyond the EU borders. Companies operating outside the EU will also be affected if they have significant operations or listings within the EU. This global reach makes the regulation a key reference point for companies worldwide, encouraging them to align with sustainable practices and disclose their sustainability efforts.

The regulations are mandatory for:

EU-based public companies and private organizations with either 250+ employees, or €40m+ annual revenues, or €20m+ on the balance sheet. Currently, there are 50,000 of such organizations is the EU, including EU-registered Japanese corporate subsidiaries.
Financial market participant, including occupational pension providers, that offer and distribute financial products in the EU (including those from outside the EU)

In addition to the mandatory disclosure, the taxonomy can be used on a voluntary basis, for example to align ecolabels with a set of definitions recognized at EU-level, to issue green bonds with clear definitions of what is green, etc.

The taxonomy serves as a catalyst for global harmonization of sustainable finance standards. As other jurisdictions explore similar initiatives, aligning with the EU Green Taxonomy will ensure consistency and facilitate cross-border investments, further reinforcing its global impact.

How will Japanese companies be impacted?

Japanese companies operating within the EU market or listed on EU stock exchanges will be directly impacted by the EU Green Taxonomy. They will need to comply with the disclosure requirements and ensure their activities meet the taxonomy’s sustainability criteria. According to the ESG expert Tatjana Gerling,

“It means those Japanese subsidiaries will have either to develop in-house ESG management systems and expertise, or to engage external experts. So, the success of Japanese companies at the EU market will be connected to their ESG performance.”

Compliance will allow Japanese companies to showcase their commitment to sustainability, attract responsible investors, and bolster their market position.

Moreover, Japanese companies that supply goods or services to EU-based companies may face indirect consequences. EU companies will likely demand greater transparency from their suppliers regarding their environmental impacts and sustainability practices. Japanese suppliers will need to provide relevant information to meet these expectations and maintain strong partnerships with their EU counterparts.

Photo by Irene Dávila on Unsplash

By making it easier to identify what is green and what is not, with definitions set by a public authority, the taxonomy could also facilitate shareholder activism on environmental matters: shareholders and investors will be able to check if an activity or project of a Japanese company in which they have shares is considered green under the EU regulation. This enhanced ability to screen business operations against a clear set of definitions could encourage European investors to enhance their pressure on Japanese companies, in line with the moves initiated in 2022 and 2023 by European shareholders of J-Power and Toyota.

Navigating the evolving landscape

As other jurisdictions around the world adopt similar sustainability frameworks, the EU Green Taxonomy serves as a precursor for potential future regulatory changes. Even though the government of Japan does not endorse the EU Green Taxonomy and has not announced any clear plan for a Japanese taxonomy, Japanese companies operating globally should proactively familiarize themselves with the EU Green Taxonomy’s requirements and align their sustainability practices accordingly.

“The EU is not the only region introducing the green requirements into financial decisions”, Gerling adds. “Considerable number of countries, with which Japan has economic ties, are developing their own taxonomies. For example, Malaysia, Indonesia, Philippines, Singapore and Thailand developed a joint ASEAN Framework for Taxonomy for Sustainable Finance, and they are moving towards its implementation. This commitment will impact Japanese companies operating in ASEAN.”

There’s also a global inclination to collaborate on developing compatible taxonomies, as both climate change do not stop at national borders. For example, in 2017, G7 countries agreed to launch the global initiative FC4S – Financial Centre for Sustainability – to jointly scale up green and sustainable finance solutions. Keeping informed about the existing taxonomies will enable Japanese companies to stay ahead of evolving global sustainability standards and capitalize on emerging sustainable investment opportunities.

Figure 1: Status of national green taxonomy development and adoption around the world. Source: Green Taxonomies Around the World: Where Do We Stand? – ECOFACT.

Annex

What is the EU Green Taxonomy?

Before we delve into the EU Green Taxonomy, it is important to simplify the meaning of “taxonomy”. Taxonomy refers to the process of classifying and organizing things based on their similarities and differences. It is a system of categorization that helps us understand the relationships between different objects, concepts, or any other items that need to be classified.

At its core, the EU Green Taxonomy encourages sustainable finance by providing investors, businesses and all other stakeholders with a standardized framework for identifying environmentally sustainable activities. It serves as a classification system and a vital component of the EU’s sustainable finance agenda. It sets out clear criteria to determine whether an economic activity can be classified as environmentally sustainable. This comprehensive framework aims to prevent greenwashing, enhance market transparency, and facilitate sustainable investment decision-making.

The EU Taxonomy Regulation, which was adopted in 2020, establishes the legal framework for the taxonomy’s implementation.

As of now, taxonomy primarily focuses on climate change mitigation and adaptation. It sets out technical screening criteria for various economic sectors, including energy, manufacturing, agriculture, and transportation. It is a living framework, with plans to expand its scope to other environmental objectives in the future. With already several years in the making and a very wide scope, the EU Green Taxonomy is often considered as the most ambitious and advanced attempt at regulating sustainable finance and redirecting financial flows towards green activities.

What are the new rules?

Under the EU Taxonomy, companies are required to disclose information about their activities and investments, demonstrating their alignment with the taxonomy’s sustainability criteria.

This disclosure aims to enhance transparency and enable investors to make informed decisions.

The focus lays on the following six environmental 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

Companies must disclose the following:

EU taxonomy-compliant share of turnover
Capital expenditure (CapEx) aligned with the EU Green Taxonomy
Operating expenses (OpEx) aligned with the EU Green Taxonomy

To be recognized as aligned with the taxonomy, an activity must:

Contribute to one of the six environmental objectives
Do ‘no significant harm’ to any of the six environmental objectives
Meet ‘minimum safeguards’ such as the UN Guiding Principles on Business and Human Rights to not have a negative social impact
Comply with the technical screening criteria developed by the EU Technical Expert Group

Three types of activities are defined by the taxonomy, depending on their level of alignment:

Substantial Contribution Activities: these activities are considered the most “green”. They include, for example, the production of renewable electricity.
Enabling Activities: they enable other sustainable activities. Example: construction of charging infrastructure for electric mobility.
Transition Activities: best-in-class activities when low-carbon alternatives are not yet available.

To understand the difference between “substantial contribution” and “transition”, we can look at how the interurban railway transport of passengers is considered in the taxonomy: if CO2 emissions are null on electrified tracks only, the activity is considered as “transition”. If CO2 emissions are null on all tracks, the activity is considered as “substantial contribution”.