In 2020, the EU launched its classification system for environmentally sustainable economic activities, the so-called “EU Taxonomy Regulation” (hereafter: the Taxonomy). The Taxonomy is part of an integrated system of new EU-wide sustainability regulations, including new disclosure requirements for investors. While the Taxonomy is based on EU regulation, it can be expected that it will also have effects on businesses beyond Europe.
Basically, there are two ways in which the Taxonomy can affect non-EU companies. First, there are direct regulatory effects on non-EU companies. Because of the global nature of financial markets and the existence of global trade flows, non-EU companies will be directly exposed to the Taxonomy in different ways. Secondly, there will also be more indirect consequences, which I call “ripple effects”. Such effects exist because the Taxonomy raises the bar globally for how sustainability information should be disclosed, by whom it should be disclosed, and it which ways it can be disclosed. I briefly discuss both effects.
In the short run, some non-EU companies will be exposed to the Taxonomy because of direct regulatory effects. Consider the following two examples:
- A non-EU investor or financial advisor that wants to offer products on the European markets will be exposed to the Sustainable Finance Disclosure Regulation (SFDR) which requires an alignment with the EU Taxonomy. To offer financial products on European markets non-EU investors will therefore have to align with SFDR and hence the Taxonomy.
- A non-EU company with EU-based investors is very likely to receive questions from these investors about the company’s alignment with the Taxonomy. Investors need this information to meet disclosure requirements under SFDR, for instance to classify their financial products in terms of their sustainability exposure. In other words, at least some non-EU companies will start disclosing more on Taxonomy-related indicators.
I could list more examples here (e.g., non-EU asset managers wanting to raise money in the EU), but the message is clear: the effects of the Taxonomy are not limited to businesses located in Europe. Particularly, the Taxonomy’s interaction effects with SFDR will affected non-European companies as well as investors.
Ripple effects are more indirect effects. They occur if an intervention, such as the introduction of a new regulation, creates further effects that reach beyond the system that was supposed to be influenced by the intervention. Such regulatory ripple effects can occur in different ways.
In the context of the Taxonomy, one important ripple effect is related to the practices of European businesses. Many of these businesses are global players, and they will apply the Taxonomy to their global operations regardless of whether these operations occur in a country that is legally covered by the Taxonomy. Sustainability reporting is usually done at the corporate level and therefore also includes firms’ non-European operations. The EU’s new disclosure regulation the Corporate Sustainability Reporting Directive (CSRD) will require that such reporting at the corporate level is taxonomy-aligned. In this way, European global players will “export” the Taxonomy to other parts of the world.
There are also ripple effects at the political level. The system of new EU legislation – including, the Taxonomy, SFDR, CSRD and other regulatory elements – is unique in the world. So far, no other region or country has a comparable system. However, the major economic regions in the world have also realized that future business will be difficult without sustainability-related regulations that enhance transparency and prevent greenwashing.
Consider two recent examples: In June 2021, the UK announced the creation of a Green Technical Advisory Group. This Group is supposed to develop and implement a UK green taxonomy, which is expected to be based in part on the EU Taxonomy system (e.g., in terms of metrics). In the US, President Biden signed Executive Order (EO) 14008 during his first days in The White House. While this EO does not aim at creating a US-based taxonomy, it has created a National Climate Task Force across different federal departments, which at least some see as an important step into the direction of more rigorous ESG-related regulation.
Other countries and regions are likely to look to Europe when thinking about how to design a workable taxonomy regulation, as the challenges that have driven the creation of the EU Taxonomy are the same throughout the world: we need more transparency around sustainable economic activities, we need to better benchmark firms’ sustainable activities, and we we need to prevent greenwashing.
It is too early to say whether there will be convergence among the taxonomies developed by different countries and regions, but one thing is for sure: they are here to stay…