Sustainability briefing | Environment & Regulatory, Environment & Climate Change |

Taxonomy reporting under the Non-Financial Reporting Directive

Taxonomy reporting under the Non-Financial Reporting Directive

Overview

On the eve of the first requirements under the Sustainable Finance Disclosure Regulation (SFDR) coming into force, the European Securities and Markets Authority (ESMA) released its final advice to the European Commission on Taxonomy reporting for companies in the scope of the Non-Financial Reporting Directive (NFRD). While there is some overlap between the companies covered by these two sets of requirements, certain large listed companies who are not obligated under the SFDR will be interested to read ESMA's advice which will inform the requirements applicable to them from 1 January 2022.

UK companies may be relieved to know that none of the Taxonomy-related requirements are directly implemented into post-Brexit UK law, but those with EU investments or EU parent companies are still likely to feel the impact of the Taxonomy reporting requirements. Concurrently, the UK Government is consulting on climate reporting in line with the TCFD (Task Force on Climate-related Financial Disclosures), which would apply to NFRD-scope companies plus further categories of large companies and partnerships (see our separate briefing here).

Who is in scope?

The NFRD covers companies (including partnerships) with (i) more than 500 employees (on average) and (ii) a balance sheet total of EUR 20 million or net turnover of EUR 40 million in a financial year, and (iii) which is an EU Public Interest Entity (PIE), i.e. a traded company on a regulated market, a banking company, an authorised insurance company or a company carrying on insurance market activity.

Some asset managers will be covered by NFRD, creating an interesting intersection with the SFDR: while taxonomy reporting under the SFDR is only mandatory for funds promoting environmental objectives (so-called "environmental Article 8" or "environmental Article 9 funds"), the NFRD requirements apply simply on account of the asset manager's status as a large PIE and, when they apply, will be applicable to the asset manager's portfolio as a whole, rather than only to specific products.

While it is the PIE that needs to report, in the case of asset managers, it is the PIE's investment companies that are the subject of the report.

ESMA was particularly asked to focus in its advice on the reporting requirements for financial entities including asset managers, as these requirements are less clearly defined in the Taxonomy Regulation itself. Article 8 specifies that non-financial undertakings will need to report on Taxonomy-aligned turnover, capital expenditure and operating expenditure, but there is no such specification for financial undertakings: Article 8 simply specifies that the report should be on "how and to what extent the undertaking's activities are associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9 of this [Taxonomy] Regulation" without reference to any particular KPIs.  

While most asset managers are not currently covered by the NFRD, ESMA's advice (and particular focus on asset managers) should be read in the wider context of NFRD revision. Though no draft text has yet been published, the Commission's consultation showed broad stakeholder support for extending the scope of the Directive to large companies listed in EU markets but established in third countries (which could include the UK), large companies established in the EU but listed on non-EU markets, and/or large non-listed companies.

What needs to be reported?

Entities covered by the NFRD will not be required to undertake the same degree of broad and detailed reporting required under the SFDR, against principal adverse impacts of their activities, but NFRD entities will nonetheless be forced to undertake a deep investigation of their or their investee companies' activities in order to assess whether they make a substantial contribution to any of the six environmental objectives listed under the Taxonomy Regulation, to what degree and whether any of their activities cause any significant harm to any of the other Taxonomy factors.

Non-financial undertakings

According to Article 8, non-financial undertakings must report what proportion of their turnover, capital expenditure and operating expenditure is Taxonomy-aligned.

Annex V to the ESMA report sets out three possible reporting templates for this purpose. Covered non-financial entities will indicate what percentage of their turnover, CapEx ad OpEx is Taxonomy-aligned. All six environmental objectives must be assessed and a percentage indicated, not just those relevant for the entity. Activities may also be categorised, where relevant, as "enabling" in relation to any of the six environmental objectives or "transitional" in relation to climate change mitigation.

For turnover, the entity must disclose the proportion of eligible Taxonomy-aligned activities, eligible not Taxonomy-aligned activities, and non-eligible activities. For CapEx and OpEx, entities must disclose eligible Taxonomy-aligned activities and eligible not Taxonomy-aligned activities. When it comes to "significant harm", entities need only indicate in a yes/no manner whether or not their activities do significant harm to each of the factors.

The advice and accompanying commentary contain significant levels of detail around the calculation of turnover, operating and capital expenditure, both overall and that which counts as environmentally sustainable. Consistent with the Taxonomy generally, turnover, CapEx and OpEx may be counted as environmentally sustainable where they make a substantial contribution to one of the environmental objectives, do not significantly harm any of the other objectives, and meet the minimum safeguards. CapEx and OpEx, however, may also be considered as environmentally sustainable where it is part of a plan to make an economic activity Taxonomy-aligned over a maximum period of 5 years (with some exceptions – see below).

There will also be a significant narrative element to the reporting, despite the brevity of the reporting templates: entities will be required to explain how their KPIs were prepared, including information on the avoidance of double counting, disaggregation, assessment against the substantial contribution criteria and other matters.

From the second year, entities will be required to disclose comparative data from the previous year.

Asset managers

Annex VI to the ESMA report contains a reporting template specific to asset managers. These entities must give an overall percentage of Taxonomy-aligned investments, as well as a breakdown of this percentage into the six environmental objectives, in each case further broken down by transitional activities and enabling activities where relevant. There is no requirement to report investee companies' CapEx and OpEx. This reporting template in particular is deceptively simple - it is no surprise that the real challenge for companies covered by these obligations comes not from the report itself but from the underlying analysis.

ESMA acknowledges the difficulties that asset managers are likely to face in disclosing what share of their investee companies' activities are Taxonomy aligned, where many investee companies will not be in the scope of the NFRD due to their size or location, and even those which are in scope are just beginning to report their data. With this in mind, Annex VII to the advice is a methodology developed by the EU Commission's JRC, to estimate the level of Taxonomy-alignment for certain activities. The methodology first provides a more granular breakdown by NACE code of Taxonomy-covered sectors, and then provides a coefficient for each NACE code based on available evidence of the share of Taxonomy-eligible activities by sector. ESMA indicates that estimates based on the methodology may not be used by non-financial undertakings as they are expected to assess their own activities, and should be treated cautiously by financial market participants as not equivalent to company-level disclosures. The methodology does not take into account the minimum social safeguards and therefore the true number of Taxonomy-aligned businesses within a particular sector is likely to be lower than indicated by the JRC's methodology.

ESMA's advice is that the Commission adopts the methodology and that it is maintained and expanded by an independent body such as the JRC, but only for an initial period, following which its use should be phased out in favour of company-reported data. ESMA makes very clear in the consultation responses that company-disclosed data should always be favoured over methodology-based estimates.

Existing guidelines on climate-related disclosures under NFRD

The European Commission has already published non-binding Guidelines on non-financial reporting of climate-related information, back in 2019. The Guidelines suggest climate-related disclosures for each for the five reporting areas under the NFRD, such as principal risks and KPIs. For each of the five areas, a small number of recommended disclosures are given that organisations should consider using, however the guidance stresses that these will not be required for all entities and a proportionate approach should be taken. Equivalence to TCFD is noted in the guidance, where relevant.

Notably, ESMA makes only a passing reference to the Commission's Guidelines in its report and gives no indication that they should form the basis for disclosures under Article 8 of the Taxonomy Regulation.

Taxonomy-alignment planning

As noted above, capital and operating expenditure can only be counted as Taxonomy-aligned when it is part of a plan to meet the technical screening criteria for a substantial contribution to one of the environmental objectives, over a maximum period of five years unless a longer period can be justified. The requirement for entities to prepare a five year plan to align their economic activities to the Taxonomy, in order to count them as "environmentally sustainable", is one of the most controversial aspects of ESMA's advice. Of 54 consultation responses, 22 disagreed with this point, with some noting the lack of a basis for such a plan in the original regulation (the concept of five year alignment planning was first mentioned in the TEG report). Despite the objections, ESMA did not elect to materially change its draft advice on this point.

The requirement for entities to prepare a plan aims to ensure that "undertakings are embarking on a trajectory aimed to make their economic activity Taxonomy-aligned ". ESMA acknowledges that at the two ends of the scale, certain projects such as large infrastructure may need more than five years to achieve Taxonomy-alignment, while other investments may be immediately Taxonomy-aligned without needing to be part of a plan, such as building renovation measures. Its draft advice was therefore adjusted to ensure that the plan should aim to make the economic activity in question Taxonomy-aligned within a maximum period of five years unless a longer period can be justified by the undertaking on the basis of the features of the concerned investments, and on the other hand that activities and processes which are already aligned can be counted, even if not part of the plan.

Other ESAs' advice to the Commission

The two other ESAs, the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority have both issued separate advice to the Commission on Article 8 reporting by entities they regulate.1

1 EIOPA: https://www.eiopa.europa.eu/content/eiopa-advises-insurers-key-performance-indicators-sustainability-non-financial-reporting and EBA: https://www.eba.europa.eu/eba-advises-commission-kpis-transparency-institutions%E2%80%99-environmentally-sustainable-activities

 

Next steps

The Commission will consider the ESAs' advice and use it in drafting a delegated act (level 2 measure) on Taxonomy reporting which should be adopted by June 2021. The first requirements under the Taxonomy for NFRD companies are due to come into force on 1 January 2022 for climate change mitigation and adaptation, and for the other four environmental factors in January 2023. ESMA also recommends a transitional approach to reporting, with a lesser burden in the first year compared with subsequent years. However, the European Commission currently has a backlog of sustainable finance-related delegated regulations to finalise – delays to the current timetable for implementation could easily occur. Entities looking to make early preparations for Taxonomy reporting could begin to examine their activities in light of the draft technical screening criteria, but these have also been delayed; at this point, "watch and wait" would also be a reasonable approach.

 

Linkedin - Free social media icons Follow us on LinkedIn for all our updates from Travers Smith Operational Risk.

For more information, please contact

Read Doug Bryden's Profile
Read Sarah-Jane Denton's Profile
Back to top