A taxonomy is a classification system that has been historically embraced by bold scientists desirous of mapping the world, starting with nature. Today, the same method is being developed by the European Union to seek to protect nature. The well-publicized objective is to define what is environmentally friendly or ‘green’ and what is not to support an optimal allocation of capital towards a net-zero emission target.
While a EU tool, the taxonomy has far-reaching implications since EU investors invest globally, as do EU-based companies, including via M&A: one way or another, the EU taxonomy will have to be integrated into the due diligence of all targets, whether in the EU or not.
GENIUS OR FOLLY?
To put everything in a designated box is a complex exercise, as the Union found out about it when writing its first Taxonomy Climate Delegated Act published in late April. Seeking to understand how it works requires a mental exercise akin to making sense of the movie ‘Inception’.
After much reading, I came to the view that the most concise way to summarize the comprehensive approach to be followed by EU companies is buried in Annex II of the May ’21 text of the draft EU taxonomy Article 8 Delegated Act (pages 21 and 22 merged into the table below). Thousands of pages in dozens of documents land in a single matrix highlighting the EU taxonomy’s genius – or folly?
HOW THE EU TAXONOMY WORKS (IN SHORT)
The initial task is to list the various economic activities pursued by a company using the EU classification code (NACE). The next question is whether the identified activity codes are covered by the taxonomy, i.e., are ‘taxonomy-eligible’ (A) or not (B)(yellow highlighting).
Then, each taxonomy-eligible activity must be analyzed to find out whether they are taxonomy-aligned, i.e., ‘green’ (A.1.) or not (A.2.)(blue highlighting). To be taxonomy-aligned, an activity must make a substantial contribution to at least one of the six listed climate change objectives (green highlighting). Each activity can meet a climate objective either by achieving best-in-class performance for its own operations (Transition) or by enabling others to do so (Enabling), hence the ‘T/E’ column (pink highlighting). To qualify, each activity must be benchmarked against activity-specific technical screening criteria. The outcome is binary: either an activity meets the requirements, or it does not. Note that, at present and since April 21, only two objectives, namely ‘climate mitigation’ (CO2 reduction) and ‘climate adaptation’ (asset protection from climate risk), are subject to technical screening criteria (purple highlighting).
In addition and following the same binary approach, the activity in question must not significantly harm any of the other climate objectives by meeting some minimum criteria (grey highlighting). Finally, said activity must respect some basic minimum standards when considering business principles and human rights as set by the OECD and the UN, among other things (orange highlighting)(But let us not be mistaken: the EU taxonomy is essentially about the ‘E’ of ESG).
The bottom line is represented by the percentage of a group’s turnover, which is taxonomy-aligned (red flash). The same matrix can be populated for capex and opex to provide investors with a complete picture.
Easy-peasy [pause] not!
OVERLY COMPLEX, NARROW AND SIMPLISTIC
Putting its sheer complexity aside, the taxonomy is currently focused on high-emitters and zero-emitters. Thus, it does not adequately address (yet) the vast world of companies in the middle, including those with ‘enabling’ activities. These companies will have to report zero percent of their group revenues as being aligned with the taxonomy (while a steel manufacturer may achieve a positive score across some of its activities if they compare favorably against its peers.)
Manufacturing is particularly affected by these shortcomings. Between the heavy CO2e emitters (e.g., steel, cement or aluminum manufacturing) and the providers of critical solutions towards a net-zero emission world (e.g., solar or wind power generation equipment) which are largely covered by the taxonomy, there are vast sections of the industrial world that are not explicitly taxonomy-eligible. They include transmission and distribution equipment, mining, nuclear power, and natural gas.
Furthermore, the ability to set appropriate technical screening criteria on a product-by-product basis (e.g., efficient building equipment) is fraught with risk, especially when the outcome is binary. Where are the shades of green?
In fairness to the EU, building a taxonomy is almost by definition a never-ending discovery process. The EU readily admits that more work needs to be put into the taxonomy in the coming months and years. This includes expanding the scope of activities eligible for a green tag and providing details related to the other four climate objectives. Judging the current product is arguably missing this point.
But can such an intricate system, even when finalized, ever yield a fair outcome or will its complexity opacify the transparency it seeks to achieve and promote? I would like to like the EU taxonomy and its boldness but fear that the answer to this question is not in its favor.
A less ambitious but more effective approach could be reached by combining market-based carbon credits, carefully designed and expanded disclosure obligations with a global appeal, maturing ESG ratings benefiting from enhanced disclosure, and increasingly sophisticated – as opposed to confused – investors. Other countries are watching the EU experience and may opt for such system. In any event, they may reject the binary approach of the EU taxonomy.
For now, M&A practitioners in Europe will need to learn how to incorporate the EU taxonomy in their daily job. Those looking for an E(SG) due diligence framework have just been provided a royal one!