As discussed in our previous blog, the EU legislator believes immediate action is needed to address global environmental challenges. To incentivise the financial services sector to mobilise capital, the EU has taken several legislative initiatives, which also impact the real estate sector. One of these initiatives is the EU Taxonomy Regulation, which entered into force on 1 July 2020.
What is the EU Taxonomy Regulation?
The EU Taxonomy Regulation describes a framework to classify economic activities performed in the EU as ‘green’ or ‘environmentally sustainable’. The classification system purports to assist investors to understand how sustainable a financial product is. To achieve this, the proportion of underlying environmentally sustainable activities related to the product should be presented as a percentage. Setting harmonised requirements at a European level through the EU Taxonomy Regulation both prevents barriers from forming and removes existing barriers. This is of benefit to the functioning of markets within the EU.
In case a financial product is offered, the underlying investments of which are in economic activities that qualify as environmentally sustainable according to the EU Taxonomy Regulation, information should be disclosed to substantiate that qualification. The information should specify the environmental objective or objectives to which the economic activities contribute. It should also stipulate the extent of environmentally sustainable activities; in other words, how “Taxonomy-aligned” the product is. When the criteria for environmentally sustainable activities are not considered, the party offering the financial product should provide a statement to that effect. This avoids circumvention of the disclosure obligation.
How does the EU Taxonomy work?
The focus of the EU Taxonomy Regulation lays on the following six environmental objectives:
- Climate change mitigation: focusing on the stabilisation of greenhouse gas emissions and consistency with the long-term temperature goal of the Paris Agreement.
- Climate change adaptation: focusing on the reduction or prevention of adverse impact of the current or expected future climate.
- The sustainable use and protection of water and marine resources: focusing on sustainable use and protection of water and preventing or solving water scarcity and droughts.
- The transition to a circular economy: which can be achieved in various ways, for instance by increasing durability and reusability of products or reduce the use of resources through the design and choice of materials of a product but also through creating ‘product as a service’ business models.
- Pollution prevention and control: focusing on avoiding the use of certain materials or products that (may) cause pollution, improving levels of air, water or soil quality and cleaning up litter and other pollution.
- The protection and restoration of biodiversity and ecosystems: which can be achieved in various ways, for instance by provision of food and water, control of climate and disease, production of nutrient cycles and oxygen and provision of spiritual and recreational benefits.
To be classified as an environmentally sustainable or green activity according to the EU Taxonomy, an economic activity should meet four overarching criteria. It should:
- substantially contribute to one of the environmental objectives outlined above;
- do no significant harm to the other five environmental objectives;
- meet the so-called ‘minimum safeguards’ such as the UN Guiding Principles on Business and Human Rights to not have a negative social impact; and
- comply with the technical screening criteria.
The scientifically based technical screening criteria (item (iv)) are in fact an elaboration of items (i) and (ii). They are being established by the European Commission to provide for the legal clarity to assess if an activity is compliant. In other words, the technical screening criteria describe – in technical detail – when an activity provides a substantial contribution to a certain environmental objective (item (i)), and when an activity does no significant harm to a certain environmental objective (item (ii)).
The technical screening criteria are being elaborated in secondary legislation called Delegated Acts. In December 2021, a Delegated Act was released describing the criteria for a substantial contribution to two objectives. Namely, these were climate change mitigation and climate change adaptation for approximately 102 economic activities. The do no significant harm technical screening criteria for these economic activities have been worked out and released for all objectives in the Delegated Act. Further Delegated Acts describing the technical criteria for a substantial contribution to the other objectives are expected to be issued in due course. In addition, the EU is preparing advice on the expansion of the EU Taxonomy Regulation to social objectives. This would also require the development of appropriate technical screening criteria.
The 102 economic activities for which technical screening criteria have been detailed in the Delegated Act are activities within various sectors. These include transport, construction & real estate, manufacturing, and energy. There are three main economic activities relevant to the real estate sector that fall within the scope of the EU Taxonomy Regulation. These are (i) acquisition and ownership of buildings, (ii) construction of new buildings and (iii) renovation of existing buildings. This means that a large element of real estate transactions is in scope of the regulation.
Impact on real estate sector actors
The use of the EU Taxonomy Regulation is largely voluntary at this stage. However, various EU regulations and directives with reporting obligations demand entities to disclose eligibility and alignment of economic activities with the EU Taxonomy. At the time of writing, entities subject to the Non-Financial Reporting Directive (currently under revision as per the proposal for the Corporate Sustainability Reporting Directive) are required to disclose the proportion of turnover derived from, and capital and operational expenditure associated with, EU Taxonomy aligned activities.
Entities that fall under the Sustainable Financial Disclosure Regulation (SFDR) also need to disclose information on Taxonomy-alignment of their products. The disclosure should outline how and to what extent the investments underlying the financial products are in economic activities that qualify as environmentally sustainable under the EU Taxonomy Regulation. As explained in our ESG blog on SFDR, many real estate actors, such as investors and asset managers, qualify as financial market participants or financial advisors under the SFDR.
As it is not yet mandatory to be aligned with the EU Taxonomy Regulation, an entity can, in its disclosure, state that its economic activities are not EU Taxonomy aligned. At the present time, we see in practice that relevant parties seem to be struggling to collect the required data to establish whether their economic activities are EU Taxonomy aligned. However, in view of the future expansion of the EU Taxonomy, it is valuable to attempt to collect sufficient data to start measuring against the guidelines. This will also give insight into the proportion of economic activity that is sustainable and the steps that can be taken to improve this. Moreover, transparency on the extent of environmentally sustainable economic activities can provide entities with a competitive advantage. It allows them, for example, to demonstrate to potential investors that they are taking steps to reduce the environmental impact of their properties.
To ensure that a real estate activity is in line with the relevant technical screening criteria and that such can be evidenced, arrangements in sale and purchase agreements, construction agreements and lease agreements can be of relevance. The Loyens & Loeff Real Estate practice group would gladly assist in this context.
