This article was co-authored by Subramanian Kuppuswami, global head, sustainable banking, finance and investments and Saritha B S, domain consultant, sustainable banking, finance, and investments at Tata Consultancy Services.

Climate change is affecting the entire world. According to a recent intergovernmental panel on climate change (IPCC) report, global temperature is expected to be over 1.5°C of warming over the next 20 years. The report also emphasised that extreme heat conditions will be more frequent across Europe, causing an increase in floods 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 tackle 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 economic activities that are environmentally sustainable. This enables the investors to identify a set of criteria regarding sustainability in major sectors and stipulates thresholds against them. It also brings forth more transparency in sustainability reporting and dissuades greenwashing.

How will the EU taxonomy enable stakeholders?

The EU taxonomy equips businesses, investors, and policymakers with proper definitions to identify and consider sustainable projects. This in turn insures investors from risks due to greenwashing by enabling a transparent view on environment-friendly projects. EU taxonomy addresses the challenges in a host of sectors such as manufacturing, transport, agriculture, construction, oil and gas and the like. To cite an example, an oil and gas enterprise focusing on new investments and expansions will qualify as ‘aligned to EU taxonomy’ only if it has renewables and biofuels as project components. This unified approach across countries and sectors will usher Europe’s commitment to achieving climate and energy targets by 2030.

Classification for environmental performance

• EU taxonomy highlights six objectives set for environmental performance —
• 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

How do the financial institutions measure or assess EU taxonomy alignment?

Financial institutions and non-financial businesses can assess their activities in alignment with the taxonomy’s definitions and criteria. For any economic activity to be taxonomy-aligned, it should make a substantial contribution to one of the six environmental objectives outlined above, do no significant harm (DNSH) to the other five environmental objectives, and comply with minimum safeguards. Financial institutions will have an obligation 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 necessary actions to lessen the potential regulatory and financial risk from activities that don’t conform to the taxonomy.

What’s the timeline for EU taxonomy implementation?

The financial market participants need to disclose alignment to the first two EU taxonomy objectives 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 published in 2022. 1st Jan 2023 is the date set for disclosure of other objectives. The implementation is phased out, and a duration of 12 months has been given for adapting and disclosing the alignment.  

What are the challenges?

Data quality and information availability are proving to be the most difficult challenges while evaluating the DNSH criteria, as the thresholds are specific to projects and may or may not be collected by companies. The revenue drill down reported in disclosures is not at project levels, and the alignment of capital expenditures (CAPEX) and operating expenses (OPEX) is not mandated. It gets more challenging if the investments are made outside the EU, where companies are not required to report alignment and data per the national regulations. Harmonising complex data becomes critical for financial institutions, and upgrading the IT process, leveraging big data and technology-enabled solutions can help banks overcome this challenge.

How can technology help?

Data is diverse and scattered across multiple systems internally and externally. Cognitive technologies and ecosystems powered by AI and ML, provide a framework to ensure consistency, comparability of the criteria and measure alignment to the local legislation and EU taxonomy. This is achieved through systematic data collection, acquisition, harmonisation, and alignment with EU taxonomy using data science and analytical capabilities.

To conclude

As financial institutions embark on a new journey, they have to focus on new guidelines, frameworks, and methodologies to assess and engage with stakeholders, bringing in more transparency in the world of finance. The climate emergency calls for substantial reduction of the adverse impact of climate change by urging the financial institution to focus on where they invest, fund, and finance. The EU taxonomy aligned to environmental dimension, is a clear game-changer; but the question is, will other nations follow suit?