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Sustainability reporting - A step-by-step guide

Part III - Environmental aspects – (1) The EU Taxonomy

The first two parts of our series of articles on sustainability reporting provided a comprehensive overview of the new regulations under the EU’s Corporate Sustainability Reporting Directive (CSRD), the new mandatory reporting standards (ESRS) as well as the fundamentally important materiality assessment in the context of ESRS reporting; now, in two further parts, we discuss the environmental aspect (‘E’). In this edition of our newsletter the focus is on the EU Taxonomy, which is quantitative in nature; in the next edition, the ‘E’ topic will be examined more closely from the perspective of the qualitatively-oriented ESRS.

The distinction between the EU Taxonomy and ESRS 

In the context of the sustainability dimensions E, S and G, the ‘E’ for environmental refers to ecological sustainability. Its characteristics are manifold and include, among other things, the climate, the use of resources such as water and energy as well as biodiversity. In the context of sustainability reporting, the vital importance of this sustainability dimension is reflected in the more than 500 datapoints of the environmental ESRS standards E1 to E5 as well as through the comprehensive rules of the EU Taxonomy Regulation, which has ushered in a single classification system for environmentally sustainable economic activities for the first time.

While the topic-related ESRS standards E1 to E5 and the EU Taxonomy deal with conceptually identical topics via their respective underlying environmental objectives, nevertheless, the perspectives and thus the contents of the reporting differ from each other. The EU Taxonomy - which will be considered in more detail here - as an EU Regulation with its financial taxonomy KPIs has its own place alongside the reporting standards (ESRS) of the EU’s Corporate Sustainability Reporting Directive (CSRD). The disclosure requirements of both the legal acts will however be fulfilled ‘under one roof’ within the scope of the sustainability report (cf. the following article).

The EU Taxonomy as a system of rules for measuring economic activity in respect of ‘E’

In 2018, the EU Commission published its Action Plan on ‘Financing Sustainable Growth’. In this plan, the introduction of a unified classification system for sustainable activities was described as being the most important and urgent task. The background to this was the EU’s environmental objectives that were supposed to be achieved via capital flows towards sustainable investments or companies with sustainable activities. From then on, the Technical Expert Group on Sustainable Finance (TEG), which was delegated by the EU Commission, developed a science-based classification system, the so-called EU Taxonomy, which was codified in the EU’s Taxonomy Regulation (EU) 2020/852.

The Taxonomy is aligned with the realisation of six environmental objectives; in this respect, the economic activities from very different industries can make a positive ‘contribution’ towards achieving the objectives of:

(1) climate change mitigation
(2) climate change adaptation
(3) sustainable use and protection of water and marine resources
(4) transition to a circular economy
(5) pollution prevention and control
(6) protection and restoration of biodiversity and ecosystems

Ultimately, the reporting takes place via the following financial KPIs: 

  • sales revenue, 
  • capital expenditure (CapEx) and 
  • operating expenditure (OpEx).

The intention behind reporting these three KPIs is an attempt to quantify the sustainability of ‘relevant’ economic activities. 

So-called Delegated Regulations, which flesh out the EU Taxonomy Regulation, govern whether or not an economic activity can be regarded as being relevant within the meaning of the Taxonomy and the circumstances under which it can make a positive contribution towards achieving one or more of the environmental objectives. For an activity to be relevant it would already be sufficient for it to be included in the Taxonomy Catalogue (Taxonomy eligibility); however, technical screening criteria are the key for determining whether or not an activity can make a material (substantial) contribution. Yet, a substantial contribution alone would not be sufficient for it to be possible to classify an activity as being environmentally sustainable. In addition, the activity must not have a considerable adverse impact for any of the other environmental objectives. For example, if in the course of constructing a wind park a protected moorland had had to be drained then this would go against the ideas behind the Taxonomy. 

This principle is referred to in the Taxonomy as ‘Do No Significant Harm’. Furthermore, when the activity is carried out, so-called minimum protection provisions (such as, for example, the OECD Guidelines for Multinational Enterprises) have to be taken into account. If all of the above criteria are met then the economic activity will be classified as being Taxonomy aligned.

The way the Taxonomy works or how a company’s environmental sustainability performance is measured can be depicted in a simplified form using filters: If all the activities in a company have been identified then these are preselected using the first filter, the so-called ‘eligibility filter’. In the next step, the remaining activities are assessed using technical screening criteria and with reference to so-called minimum social safeguards and, thus, generally narrowed down further through the so-called ‘alignment filter’. Ultimately, the activities that are left over will be those that actually make a positive contribution to environmental sustainability.

Please note: In the management report, besides the qualitative information on the determination of Taxonomy rates, it will also be necessary to disclose the proportion of sales revenue, CapEx and OpEx that is Taxonomy eligible as well as Taxonomy aligned in a machine-readable format (ESEF tagging). 

A practical example

The Volkswagen Group reported sales revenue in the amount of €322.3 bn in its 2023 annual report, Thereof €297.4 bn (92.3%) was attributed to Taxonomy-eligible economic activities - notably, the economic activities 3.3 “Manufacture of low-carbon technologies for transport” and 3.18 “Manufacture of automotive and mobility components” that Volkswagen attributes to its vehicle-related business. All the Taxonomy-eligible economic activities of the Volkswagen Group have to be attributed to the environmental objective of climate change mitigation (cf. 2023 VW Annual Report, p.197). 

Overall, €36.6 bn of Taxonomy-eligible sales revenue complied with the relevant criteria for Taxonomy alignment. This corresponded to 11.4% of the Group’s total sales revenue and notably related to the all-electric vehicles business and a large proportion of the plug-in hybrids (cf. 2023 VW Annual Report, p. 203).

Takeaways

  • The ‘E’ (Environmental) in ESG refers to the ecological components of sustainability.
  • Environmental aspects are the object of the EU Taxonomy (disclosure of sustainability performance via financial KPIs) and the ESRS (disclosure of sustainability information).
  • The EU Taxonomy constitutes a classification system for environmentally sustainable economic activities.
  • Reporting in accordance with the EU Taxonomy occurs in the management report by means of the financial KPIs: sales revenue, CapEx und OpEx.
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