Alex Nabaum/theispot.com
Despite a recent retrenchment of corporate environmental, social, and governance (ESG) initiatives, asset managers and companies know that sustainable business practices are crucial for reducing risk and delivering shareholder value. Still, they need a reliable way to tell when a business’s activities are truly green and when it’s greenwashing — claiming that its products, services, and initiatives benefit the environment when they do not.
That critical question — what is or isn’t green — has been difficult to answer definitively and authoritatively. That is where the European Union’s taxonomy steps in.
Introduced in 2020 as part of the EU’s European Green Deal strategy for achieving economywide climate neutrality by 2050, the taxonomy uses objective, largely science-based criteria for identifying sustainable business activities. Most important, it establishes the notion of “green by law”: Companies can’t simply claim that their activities are green but must show that they satisfy applicable EU benchmarks. That can make it a powerful safeguard against greenwashing. Large companies with significant operations in the EU, which eventually will include many U.S.-based concerns, have to report on their activities under the taxonomy.
Primarily designed to provide clarity to capital markets and other investors, the taxonomy sets criteria for the sustainability of more than 150 economic activities, such as manufacturing cars, operating a data center, running a water treatment plant, or generating electricity. It asks companies two questions: Do any of your activities contribute to the EU’s sustainability objectives, and do you conduct those activities in a sustainable way?
To be considered green under the taxonomy, an activity has to meet certain benchmarks showing progress toward the Green Deal’s six objectives for sustainability: (1) climate change mitigation and (2) adaptation, (3) contribution to a circular economy, (4) sustainable use of water and marine resources, (5) prevention and control of pollution, and (6) protection and restoration of ecosystem biodiversity. For example, under the criteria, in order to be considered green, a cement manufacturer’s greenhouse gas emissions can’t exceed a certain level for each ton of cement produced. Manufacturing cars counts as green only if the vehicles manufactured don’t produce tailpipe emissions. In a data center, the global warming potential of refrigerants used in cooling can’t exceed a certain level.
The taxonomy isn’t prescriptive — it doesn’t say what companies can or cannot do. Instead, it simply defines what activities are green and leaves it up to capital markets to decide which activities to support and which to avoid.
The EU’s approach has advantages over preexisting assessments of ESG performance. Such report cards tend to grade a company’s performance blended across all three elements of the ESG spectrum and do so in ways that cause their aggregate results to vary across providers. In contrast, the taxonomy’s primary focus is on environmental sustainability. By using well-defined criteria for what counts as green for each activity it covers, the taxonomy provides a level of specificity that has largely been missing in ESG disclosures to date.
While other measures grade performance at the corporate level, the taxonomy assesses sustainability at the level of a company’s economic activities. Corporations often operate a variety of business lines, each of which can contribute to sustainability in different ways. This makes it difficult to capture green performance in a single corporatewide score. A technology company, for instance, might make electronic equipment, operate a data center, and write software. Because the taxonomy is applied at the activity level, it gives capital markets a way to identify operations most deserving of green investment.
Disclosures under the taxonomy are financial, derived from companies’ existing financial statements. After identifying the activities that qualify as green, a company must report how much the green activities are contributing to total revenue and what share of the total capital spending the company is devoting to the activities.
Say, for example, that an automaker reports that 95% of its revenues come from the sale of internal combustion engine vehicles and the rest from zero-emission vehicles; this means that only 5% of its revenues count as green. At the same time, the manufacturer dedicates 60% of its capital spending toward investing in manufacturing plants and equipment to produce future zero-emission vehicles. That gap between low green revenue today and a high green capital expenditure indicates that the company is making a rapid transition to a low-carbon future, which is a sign that the company’s green revenue can be expected to be much higher in the future. That makes it attractive for investors interested in sustainability.
In another case, a company that generates electricity with offshore wind farms could report that 100% of its revenue counts as a substantial contribution to climate mitigation. But it would still have to demonstrate that it has prevented or mitigated any potential harm to water quality or biodiversity.
Disaggregating financial data in this way is unusual, and most companies won’t have thought about their businesses in the way that the taxonomy requires. Navigating the taxonomy can present particularly tricky accounting difficulties. Although companies segment their revenue in financial reporting, they may not have done so in the activity-based way expected by the taxonomy. They also are unlikely to report capital spending in the way the taxonomy wants them to. This poses a conceptual and technical challenge.
The goal is to provide capital markets with better information for directing investments toward green activities. Investors want to know that their money is supporting truly sustainable practices. Since sustainability initiatives frequently are eligible for discount interest rates, lenders want to know that they really are green. If money is cheap because it is funding sustainability, it should go to activities that are truly green. Otherwise, it shouldn’t be cheap. To guide investors, European regulators have set standards for investment products that wish to receive a European Green Bond label, and, to qualify for the label, bond issuers have to invest in activities considered green under the taxonomy.
The hope is that over time, taxonomy disclosures will enable the EU to assess the funding gap between what the green transition requires and where investments are currently going. The European Commission’s Platform on Sustainable Finance, a group of industry and other experts established to advise on sustainable finance, uses taxonomy disclosures to track fund flows to sustainable activities. This allows the EU to assess, on an industry-by-industry basis, whether the transition is being funded at the scale required to meet the Green Deal’s objectives.
Exposing Weak Claims
Companies are increasingly under pressure from customers, employees, nongovernmental organizations, and investors to provide detailed plans for meeting their sustainability objectives. Institutional-investor oversight, through mechanisms such as Climate Action 100+ and the regulations laid out in the Green Deal, provides some rigor in evaluating these plans. With its formal benchmarks for sustainability, the taxonomy can provide additional clarity in assessing whether sustainability plans are real or illusory and whether they are worth investing in. Disclosures under the taxonomy could either lend credibility to a transition plan or reveal its lack of seriousness — or its absence.
For example, the 2015 Paris Agreement set benchmarks for reducing greenhouse gas emissions, and companies have been making claims and setting ambitious targets for meeting those goals. Disclosures under the taxonomy may reveal, with uncomfortable specificity, that those claims are unmoored from any sustainability performance standards and that the targets lack a capital spending plan to back them. When compared with the taxonomy’s science-based benchmarks, a company’s own claims may not be close to being green, in many cases.
Indeed, some common practices considered sustainable don’t pass muster under the taxonomy. Carbon credits, which companies use and trade to offset their greenhouse gas emissions, do not count as green under the taxonomy. This is partly a feature of the Green Deal’s ambitious emphasis on absolute reductions in emissions to achieve its objectives; carbon credits, critics say, simply shift polluting activities around but don’t lead to net reductions. Given that, many companies will want to supplement their core taxonomy disclosures with commentary on the other ways they contribute to achieving sustainable outcomes. Because the taxonomy does not try to cover all corporate activity, companies can legitimately claim to be contributing to sustainability in ways that aren’t captured by the core taxonomy disclosures.
The taxonomy currently covers several thousand primarily EU-based companies, and another wave of companies — including those that are part of U.S.-based corporate groups — will begin their reporting a couple of years from now. It is estimated that around half the corporate groups in the S&P 500 will have to report on Green Deal regulations, and a subset of that group will report on the taxonomy, too. (Draft EU omnibus legislation designed to simplify regulation and make European businesses more competitive proposes to reduce the number of companies subject to the taxonomy. The legislation is expected to be finalized in early 2026.)
Because the EU accounts for a significant share of global economic activity, many of its regulations have effects that, by design, extend beyond Europe — what is known as the “Brussels effect.” A U.S.-based company that does more than a modest amount of business in Europe may find that it has European operations that are scoped into the taxonomy.
Over time, the taxonomy’s criteria for defining what is green may become the one standard to rule them all, especially in any industry whose core activities fall under the taxonomy’s criteria. Companies have certainly demonstrated their interest in aligning their green product claims with taxonomy criteria, in the interests of consistency, comparability, and access to finance. Many companies are also planning to report on Green Deal regulations such as the EU’s Corporate Sustainability Reporting Directive and the taxonomy at the global level, not just for those entities sited in the EU.
With the taxonomy, EU environmental regulators are betting on the power of financial disclosure to speed the transition away from fossil fuels. If it works as designed, it will provide the information needed to separate real from ersatz sustainability claims and enable capital markets to play a rigorous and dominant role in financing our urgent collective transition to a low-carbon economy.