EU Taxonomy reporting: A first look at the challenges and best practices

For the latest insights on companies' reporting under the EU Taxonomy, don't miss: A check-in on Nordic companies’ EU Taxonomy reporting and EU Taxonomy: The period of misalignment for sustainable finance.

The EU Platform on Sustainable Finance's report on data and usability of the EU Taxonomy is based on data collected from companies currently reporting under the Taxonomy Regulation, as outlined in our previous article. The Platform has leveraged publicly available disclosures as well as its market insight to deliver a valuable snapshot of the first round of Taxonomy reporting. The expert group identified a number of challenges and misalignments in non-financial and financial reporting alike and highlighted emerging best practices and subsequent recommendations.

Reporting under the EU Taxonomy

Who, what, when

In 2018 the European commission published its Action Plan on sustainable finance, which triggered several legislative initiatives on ESG disclosures aimed at fostering transparency in the finance industry.  A key component of the Action Plan is the Taxonomy Regulation, which establishes a common classification system for environmentally sustainable economic activities covering six environmental objectives:  

1. Climate change mitigation
2. Climate change adaptation
3. The sustainable use and protection of water and marine resources
4. The transition to a circular economy
5. Pollution prevention and control
6. The protection and restoration of biodiversity and ecosystems

To date, reporting has targeted the first two environmental objectives, pending finalisation of the Environmental Delegated Acts for the remaining four.

The Taxonomy Regulation establishes reporting criteria that inform and provide a basis for other sustainable finance legislation, such as the Sustainable Finance Disclosure Regulation (SFDR). Under the SFDR, financial market participants (FMPs) are required to disclose the extent to which their financial products are environmentally sustainable, address sustainability-related principal adverse impacts (PAIs), and to what extent products align with the environmental objectives laid out in the Taxonomy. 

Financial and non-financial companies in scope of the Non-Financial Reporting Directive (NFRD) are expected to report both Taxonomy eligibility and Taxonomy alignment annually, following the disclosure timeline presented in the table below:

Building blocks of the Taxonomy

The Taxonomy is built as a cascading reporting system within which financial companies are dependent on the self-reported Taxonomy values of their EU-based investee companies to inform their own reporting. As financials and non-financials alike attempt to navigate the new territory of Taxonomy reporting, the use of estimates to supplement both non-financial and financial market participant (FMP) reporting remains accepted in certain instances.

The Platform recognises the need for non-financial companies to rely on assumptions and estimates in cases where data-availability is insufficient, such as reporting of scope 3 emissions where supply-chain companies themselves do not report scope 1 and 2. Where estimates must be used to ascertain Taxonomy alignment, the Platform recommends that estimates are derived from data sources subject to third-party assurance.

To date, there is no mandatory assurance of Taxonomy-related reporting under Article 8 in most EU jurisdictions. This will change with the introduction of the Corporate Sustainability Reporting Directive (CSRD), which will require, at a minimum, limited assurance across the EU.

For FMPs, the use of estimates and proxies is not allowed for the mandatory reporting under Article 8 of the Taxonomy Regulation. Estimation is as such not permitted for undertakings in scope of the NFRD. However, the use of voluntary reporting to disclose additional information is welcomed, provided estimates and/or proxies are clearly identified.

Key observations by the Platform

Usability Challenges

According to the report, there are approximately 2000 companies in scope of the NFRD  in the EU27, which are subsequently expected to report on Taxonomy eligibility and alignment under Article 8 of the Taxonomy Regulation.

Non-financials are required under Article 8 to report on Taxonomy eligibility and alignment of 3 KPIs – turnover, Capex and Opex. Financial entities, on the other hand, must disclose specific KPIs (either Green Asset Ratio (GAR) or Green Investment Ratio (GIR)) according to the specific activity carried out.

The Platform reports that, despite the uptake of Taxonomy reporting among European companies, some key usability challenges remain. These can be categorised as:

1. Structural issues: the use of incorrect templates, number formatting (ranges) and naming conventions (green share of revenues as opposed to Taxonomy-aligned turnover)
2. Interpretive issues: failure to follow the correct disclosure standards, i.e. reporting “investments” instead of Capex or “business expenses” instead of Opex
3. Technical issues: problems with interpreting what constitutes an eligible activity and technical screening criteria

Best practices of non-financial entities

Despite the usability challenges above, there are a number of relatively simple steps that entities can take to bring more clarity to the reporting process. Ensuring that the correct reporting templates and naming conventions are utilised from the outset, for example, can greatly simplify the reporting process.

The Platform explicitly recommends, for instance, that non-financials use the Taxonomy activity and numbering conventions found in the Delegated Act, and are consistent with the use of names/numbers between the mitigation and adaptation activities (specific guidance can be found on p. 74 in the report).

The resources required to adopt a novel reporting framework should not be underestimated. The Platform thus calls for supplementary guidelines and advice from the European Commission .

The Platform highlighted the following three areas of best practice emerging from its review:

1. Non-financial undertakings disclosures have a comprehensive approach and breakdown their eligibility disclosures following the Annex II template
2. Explanation of eligibility mapping is given within the context of the existing financial statement of the firm
3. Including an explanation on the extent to which assumptions and estimates are used for both classification and adherence to technical screening criteria

Best practices of financial entities

Non-financials’ reporting on turnover, Capex and Opex creates the base-layer for FMPs  in their Taxonomy reporting. FMPs should themselves report and disclose KPIs related to the proportion of Taxonomy alignment of their financial activities. The Green Asset Ratio (GAR) and the Green Investment Ratio (GIR) should be used by credit institutions and asset managers respectively. Insurers must also report on the eligibility and alignment of underwriting businesses and, according to the report, have so far achieved this through the use of qualitative/descriptive information to support quantitative data.

To date, only a few asset managers and insurers have reported their Green Investment Ratio (GIR) under Article 8, as few are included in the scope of the NFRD. The Platform’s data and usability report, based on the limited number of disclosures currently available, highlights the following challenges:

1. Inconsistent use of terminology used to present ratios
2. Inconsistency in the definitions or clarity in the use of estimates and proxies
3. Lack of granularity in the extent and the methodologies followed for estimates and proxies
4. Lack of reporting

Although there is no mandatory requirement for FMPs to disclose Taxonomy eligibility as part of product-level disclosures, many firms have chosen to report in order to explain maximum achievable alignment figures. As neither financial nor non-financial companies are yet subject to full reporting requirements, the first year’s alignment figures can, however, be reported as 0%. It is here that, if made clear, estimates and assumptions can be most suitably used to support FMP Taxonomy reporting.

The expectation that FMPs should disclose “how and to what extent” their sustainability-related products align with the Taxonomy provides context for how much progress is yet to be made in this area. Despite low levels of available disclosure, the following best practices were highlighted in the Platform’s data and usability report.

1. Taxonomy reporting is often given its own dedicated section within non-financial reporting.
2. Estimates and proxies are explicitly laid out when used, and financial undertaking marks which sections used them.
3. Eligibility is broken down per section of the balance sheet.
4. Clear breakouts showing the use of estimates and use of reported data are provided.

There are clearly data gaps still to be bridged before we can expect a full set of usable and comparable Taxonomy disclosures from FMPs. This is thanks, in part, to the sequencing of the SFDR and the CSRD which, under the cascading reporting system of the regulation, means that FMPs must report on their own Taxonomy alignment before data from the underlying non-financial entities is available. However, it is encouraging to see that much of the existing reporting seems to follow the spirit of the regulation, transparently and clearly outlining estimations and assumptions where used. Given the fluctuation in reported figures that is expected over the coming years as the new regulatory environment is tested in practice, transparency and clarity will remain cornerstones of good reporting.