EP 52: The EU Taxonomy, Decoded

Josh Green: Hello and welcome to Sustainable Intelligence. I am your host, Josh Green co-founder and Co-CEO of Novata. Today my guest is Laura Callaghan, who is our Head of Advisory for Novata in Europe. Our subject today is EU Taxonomy, which has been through its ups and downs and we’re gonna talk about the ins and outs of it with Laura who is so knowledgeable on the subject. Laura, thank you for being here today.

Laura Callaghan: Thank you for having me. Very excited to talk about one of my favorite topics.

Josh: All right, well, let’s get into it and let’s start with the basics. What is the EU Taxonomy? What problem was it originally designed to solve?

Laura: Great question. So at its core, the EU Taxonomy is really a classification system and it defines what counts as an environmentally sustainable economic activity in a really detailed science-based way. But in practice, it’s mainly used for disclosures under regulations like the Sustainable Finance Disclosure Regulation and the Corporate Sustainability Reporting Directive. And it’s really used to help assess how much of a company’s revenue, CapEx, and OpEx is linked to sustainable activities. Beyond disclosures, it’s also increasingly used in things like product and service design, target setting, even lending decisions. It’s a really popular thing in Europe when it comes to doing due diligence exercises and thinking about KPIs as well. So, before we kind of got to this point where we are at today, the Taxonomy really meant different things to different people. And I feel like today we’re finally at a point where we’re almost on the same page around what it means. It definitely used to cause quite a lot of confusion and inconsistency with how people were using the term “green.”

And obviously that also results in greenwashing, so investors couldn’t reliably compare companies, and companies didn’t have a clear benchmark to aim for. So the Taxonomy was really designed to help solve that problem and create a common language to set out different criteria around what could substantially contribute as an environmental objective.

Josh: So it’s designed to bring some clarity to the market. Give us a sense of kind of how it’s unfolded in terms of the history of this thing, because I feel like for a moment in time, EU Taxonomy was all anybody was talking about, and then it seemed to kind of fade away, and now it’s back. What happened and how did it go through these ups and downs?

Laura: Yeah, you are right. It definitely felt like it went quiet for a while. But I think that was really the market just digesting how complex it is.

Josh: Mm-hmm.

Laura: What’s driving the resurgence now, I think is still regulation just catching up. So the Taxonomy is now deeply embedded in frameworks, as I said, like SFDR and CSRD, whereas before it was still just more of a voluntary-esque kind of framework.

It was made mandatory for a very large number of companies as well in Europe, but it didn’t feel like it was truly integrated and it wasn’t really, truly understood. I think beyond the regulation, at the same time, investors are also under an increasing amount of pressure to really demonstrate the sustainability of their portfolios in a more rigorous way. So the Taxonomy is one of the few tools I think that really helps to offer that level of granularity and credibility. So, I’d say what’s changed is less about the Taxonomy itself, but more about the ecosystem around it. It’s gone from being a nice to have to a core reporting requirement over the last 12 to 18 months.

Josh: Can I ask your editorial opinion on this? Do you feel like it’s working in terms of bringing clarity to the market?

Laura: I would probably say not yet. I think there is potential. And there’s a lot of work that’s going into trying to simplify it, but my very honest answer right now, Josh would be, it’s not working probably how it’s intended to, to work right now, but fingers crossed they’ll get there shortly.

Josh: Okay, let’s come back to that. I wanna look into the future bit with you and see how you think this is gonna unfold. But let’s go back to basics and talk about how you know as a company or as an investor that this is something that you need to be grappling with. And then would love to get into, okay, now you’ve made the call.

Yes, I need to organize data and be able to report against the EU Taxonomy. How do I do it? So we’ll get to the how, but first, how do you know if you’re in scope, or this is something that you should be doing. Is it something that, you know, comes to you that an investor calls you up and says, Hey, I need you to do this?

Or are there companies that kind of voluntarily step forward and say, I’d like to do this even though it’s not mandatory for me? For our listeners, how do you know that this is something that you should be jumping into?

Laura: You know, great question. Firstly, I would definitely say it’s investor driven.

Josh: Okay.

Laura: That’s particularly what we see from the market is investors that are looking to achieve a certain proportion of sustainability within their portfolio or really demonstrate that they have green investments are the ones that are pushing for it. And how that comes about with conversations with companies is typically at that due diligence process. So, I even work with some investors right now who tried to do an EU Taxonomy screening at the point of due diligence just to make sure that before they make that investment, they truly feel comfortable and confident that they can prove alignment to the Taxonomy. But from a company perspective, I have seen a few companies that are aware that it’s an investor request. It’s something that could make companies look more competitive. Again, it’s a classification system that arguably should work just as well for companies to say, Hey, we are green. This is why we are green.

This is all the criteria we’re hitting just as much as a classification system that investors are asking of companies to use. But to answer your question, Josh, around how do companies know if they’re in scope? If a company is in scope of CSRD or if an investor has an Article 8 or an Article 9 SFDR fund, then they are obligated to report what proportion of their investments are deemed to be green under the EU Taxonomy. So they’re kind of the two core buckets that investors and companies should be thinking about if they fall into either of those regulations.

Josh: Okay, that’s super helpful. So now let’s talk about the how.

So you know that you have to do this or you’re informed by your investor that you need to assess yourself against the EU Taxonomy. What’s the, and of course, Novata’s offering solutions to make this easier, but describe like the most painful version of this.

What does this look like if you were to just try and do it yourself without any kind of outside assistance or expertise or tooling to help you do it?

Laura: Without tooling, honestly, it’s extremely manual and very painful. I used to conduct EU Taxonomy assessments manually a few years ago. And I can hands up say that it is a very difficult and complex task to do. And it’s really time consuming and it puts a lot of onus on the companies to really be doing a lot of the legwork. What you are essentially trying to do at the beginning or the whole concept of EU Taxonomy is map your entire business model to a very long list of economic activities that are defined within the regulation. And that requires things like interpreting the legal text, which we all know is not the most fun job to do.

Josh: Yeah.

Laura: It requires making judgment calls and pulling together. Lots and lots of data from different departments like finance, sustainability, and operations. And then for each of those activities that you’ve managed to map to your business model, you then have to assess your eligibility, which I can talk to in a bit more later. You also have to assess your alignment against very, very bespoke and specific technical screening criteria, have to also prove that you are not causing any significant harm to the six environmental objectives of the EU Taxonomy. And then there is a social layer in there as well, which we call the minimum social safeguards.

And each of these activities also have to prove that they’re not causing any harm to things like human rights, tax, competitiveness laws and things like that. And all of that needs to be evidenced. So it’s not a case of just saying, yeah, we do this. Yeah, we do that. You have to have a really long audit trail as well. Investors in particular will probably be asking for evidence to prove that the criteria has been met. So without having a tool to do it it usually lives in spreadsheets. Lots and lots of conversations with the company and different stakeholders within that company. And it can really make it hard to scale. It’s hard to maintain any consistency, and it’s really difficult to order if you don’t have a tool that’s kind of a centralized place to simplify everything and guide those stakeholders through the process.

Josh: Okay, well let’s, let’s do the Novata commercial now. So how does Novata help? How does Novata make it easier?

Laura: So I’d say at Novata we’re really focused on taking that complexity and making it more structured and more usable. And that really starts with simplifying the activity mapping at the very beginning. So companies can, by using the tool, very clearly connect with what they actually do relevant to the Taxonomy activities. We’ve built in kind of an AI search function so that you can type in keywords about your economic activities and that will help to pop up with some suggestions on which would be the correct NACE codes and economic activities for your business. I’ve personally always found that one of the most difficult parts of the Taxonomy is just doing that official mapping at the beginning. So that was something that I feel we’ve really helped companies to do in a more simple and user friendly way.

But then secondly, we also guide users through that assessment from the beginning all the way through to the end in a really consistent and repeatable way. So if you have the same stakeholder doing it every year, or even if you have new stakeholders doing it, there’s kind of guidance embedded throughout all of the technical criteria, directly into the workflow rather than expecting teams to be able to interpret the regulation from scratch. So we’ve really simplified a lot of that complex terminology and that legal jargon that I was talking to earlier.

And then lastly, I’d say we’ve also put a big focus on auditability. We know this is something that is increasingly demanded from our clients, and we wanted to make sure that the tool, its methodology, the results are as transparent as possible. So, the auditability in the trail that is there really helps to capture the decisions that we used, any assumptions, any evidence all in one place so that the companies aren’t just producing an output, but they can actually stand behind it and, you know, have confidence in what they’re saying. So our tool is really about moving away from a fragmented manual process to something that is much more systemic and defensible.

Josh: So sounds like this is gonna help people do the work more efficiently, stand behind it and then do it consistently again in future years when they need to repeat the exercise. Clearly that has value from a compliance and reporting perspective. Is there any business value beyond compliance and reporting to doing this work?

Laura: Absolutely, yes. I would say the one positive of EU Taxonomy, especially the recent changes that have been applied to it, is that there is much more an onus on materiality. So arguably a lot of the technical criteria that is required for companies to achieve and to prove, to say, Hey, yep, we’re aligned with the Taxonomy should be actually relevant for their business.

So here I’m talking about specific things like climate risk. So as part of the Taxonomy, depending on your industry, one of the types of criteria you might have to prove is that you have a really good understanding of what climate risks exist to your business from a physical risk perspective. And that really encourages companies to do a risk management exercise around climate that we know is still quite new for a lot of companies and it can really have some brilliant insights that companies probably wouldn’t have realized existed in terms of the risks that could be impacting their business in the short, medium, or long term.

Now that there is that thread of materiality throughout the EU Taxonomy and the criteria that is applied, I do genuinely think that there are benefits to companies in going through these criteria and actually just applying them to their own business model and then integrating it into things like their risk management measures general strategy, decision making, even maybe innovation and opportunities from that as well.

Josh: So it sounds like with the focus on materiality, there should be things that, material that are gonna matter to your business and potentially sounds like it gets sustainability professionals speaking in the language that the rest of the business is speaking and hopefully having a seat at the table in terms of driving actual business decisions.

Laura: Yes, I hope so. I think there is always still this gap around, you know, those benefits of ESG sustainability, linking it to real business decision useful pieces of data. So as long as people go into conducting an EU Taxonomy assessment with that lens, then I definitely think it would be something that’s useful for companies to use.

Josh: Let’s lift up a bit and I’m gonna put you on the hot seat, Laura, and get your take. So, imagine that you were in charge of EU regulation and you could wave a magic wand and change anything that you wanted. What would you change?

Laura: I would probably still be doing a bit more work on the EU Taxonomy, to be honest. I know there’s some practitioners out there, or even those people that have written EU Taxonomy, they’ll be screaming at me saying, but we’ve already simplified it and it’s so much better than it was. But I do think there’s more work that could be done to really make it more practical and make it more understandable.

It seems at the moment that the EU is very set on this phrase simplification, which I love. But it seems like their way of addressing simplification is actually just by reducing things, whether that be reducing the scope and the thresholds of companies that need to do these things, whether it be the actual criteria that’s needed to be evidenced. But I think rather than reducing regulations, what needs to be done is actually make them more practical. Bringing in real case studies. Speaking business language is absolutely crucial when it comes to regulations and helping businesses not only comply, but engage with them and actually use the outputs and the processes that they’re having to achieve in terms of making sure they’re compliant. I think they really need to be engaged and they’re not gonna be engaged until they can see the genuine benefits of what those regulations have to offer and what conducting those processes and diligence changes may look like. So if I had a magic wand, I would certainly be simplifying the regulations even further, but my simplification would not be reducing, it would be making them more practical.

Josh: It seems that one of the lines of thinking is that this regulation may be putting European companies at a disadvantage. And that seems to be what’s driving some of the simplification that’s actually reduction. Is there an argument that if this was done right, it could actually be a source of competitive advantage for companies in Europe that are subject to these regulations? That it could put you in a position to speak with more credibility to your customers who care about these types of topics?

Laura: Absolutely. Yes. I think a lot of the pressure towards simplifying these regulations and seeing Europe at a disadvantage to other regions goes into the amount of time and effort that goes into reporting.

So I do think with there being, you know, way more innovation in AI than there was even just 12 months, 18 months ago, there are ways and tools for companies to be doing a quicker job of reporting alongside, you know, other tools like Novata and other things that exist. So I think if there was less effort on reporting and more effort on really understanding, okay, here are the results of what we’ve got from having to comply with these regulations. What do they mean for our business? How do we use them? How do we apply some financial implications to these figures that we may be getting from, you know, climate risk assessment or waste management processes. I think then that is the way that businesses can truly leverage these regulations to be competitive and as you say, meet what I see is an ever increasing demand from consumers and stakeholders, wanting businesses to actually be greener and more ethical in the products and services that they’re delivering.

Josh: Yeah. It seems to me that the push in this direction, I think, very well intentioned. I think the market is hungry for clarity, hungry for consistency. Doesn’t feel like we’ve gotten there yet, but you can see the promise of it. But the simplification does feel like the right concept, even if the execution isn’t quite living up to it. 

We’re in a moment in time where the winds seem to be swirling, so, you know, obviously there’s a lot going on geopolitically. Sustainability went from being the thing that everybody had to do and loved to brag about to being something that was under significant pressure and facing pushback. You have new tools on the horizon like AI. That’s a lot for people who are in a sustainability role to contend with and make sense of. I’m curious, for people who are looking at the range of things that they have to confront and they’re feeling a little overwhelmed, any advice for a sustainability practitioner in terms of how to navigate this moment?

Laura: Yeah, there is a lot. So I can definitely empathize with sustainability professionals that are trying to manage everything that’s going on at the moment. But I really think this is a good opportunity, maybe a moment to refocus on the fundamentals. As you said, there’s been a lot of noise in ESG over the past few years, but ultimately the underlying drivers haven’t gone away. So my advice would probably be to focus on quality over quantity. I know that’s difficult. I see nearly every day so many of our clients wanting to have a hundred percent accurate data and really wanting to have a complete picture of everything. But I honestly think focusing on quality over quantity is a really good way to think about prioritizing that. I’d also say building robust and defensible processes. So for any organizations that aren’t leveraging these tools, do a little bit of investigating, see what tools you think would work for you. How can you implement those into your business because they’re moving so quickly and it’s very easy to fall behind and realize that you are not working as efficiently as probably some of your competitors and peers are that have implemented these tools.

So as I was talking to earlier, spend less time on the reporting and more time on the doing. I genuinely think that the processes and the tools will help with that. And then lastly, I’d say align more closely with financial and strategic decision making. I think we are really starting to see the market move from storytelling to having more substance, and the way in which you get that is being more collaborative with your peers. We know finance teams are absolute wizards when it comes to understanding the financial implications of their business, and we also understand that sustainability professionals can have the exact same ideas but don’t often speak the same language, and so just being able to really align and communicate in an effective way with your finance team and your operational team amongst your sustainability professionals will really help you to put your point forward, put your case forward, probably drive some more return on  investment and help bring a lot of these sustainability concepts to life more if there’s a financial figure attributed to them.

Josh: Great advice. So we want to focus on the fundamentals, and I heard three things from you. Quality over quantity. Building robust and defensible processes, which in theory should free you up to do things that create value. And then aligning with the financial and strategic decision makers and decision making processes all makes a ton of sense.

Looking ahead, any predictions for the future? Where do you think ESG and sustainability go from here?

Laura: I don’t know if this is the way it will go, but I think this is the way it has to go. But it just needs to be less of a standalone concept and more embedded into how businesses operate. We’ll see hopefully fewer broad ESG narratives, more emphasis on measurable outcomes, financial relevance. Regulatory alignment, I think will always stay there. But bringing this full circle to EU Taxonomy, I do think frameworks like the EU Taxonomy are a good example of that shift because they’re really pushing the market towards being more precise, being more accountable, and so I think the direction of travel hopefully will continue to be more rigorous, more integration, and ultimately more impact. That’s what I would hope to see in the future, at least, Josh.

Josh: It can be discouraging at times to be in the sustainability profession. I’m curious what gives you reason for optimism? What gives you the hope that you spoke about?

Laura: I think I’m very fortunate to be in our advisory team and be speaking to so many different clients every single day in that these moments right now where we’ve been working with investors to help them gather their sustainability data from their portfolio companies. This moment now where we can really drill into that data and tell them, did you know that your companies are performing here, or did you know these are some gaps that exist for your companies and they’re actually really material and they’re falling behind the rest of their peers? Having those conversations for me and actually seeing the data come to life, being able to speak with those portfolio companies and, you know, I meet so many enthusiastic professionals who are wearing so many hats.

You know, sustainability might not be their main role. It may not be dedicated to that from a responsibility perspective, but what I do notice is anybody that does touch sustainability is genuinely so passionate and willing to make a positive difference. And so for me, it’s kind of grasping onto those moments where I can really translate those data stories with clients and see their eyes light up and think, wow, okay, this is something that we need to be doing, or this is something that I see genuine positive impact on either for their business or environment or society. So I feel very fortunate to be able to do that every single day when I’m speaking with our clients.

Josh: One more commercial, if you don’t mind, Laura. I think the Novata advisory team is arguably one of the best kept secrets in the business. And would love to hear a little bit more about the advisory practice and what the focus is, why it exists, and when people should think about reaching out and asking for help.

Laura: Yeah, advisory is definitely the best kept secret at Novata. We kind of set up coming on three years ago now after a lot of clients realized that, you know, they just didn’t have time for everything that was being thrown at them, the never ending list of LP requests and questionnaires and things. They wanted to spend more time on the doing, more time on the actions, more time on engaging with their companies and their stakeholders. And so the advisory team was really here to help build efficiencies into things like analyzing that data, refreshing strategies, translating what that data means into business terms, like value creation, financial potential, climate risk, so that we can essentially act as an extension of an ESG team or a business for them to have more time to be able to spend on what they want to spend it on. And a lot of the time, particularly for our investors, we see that they have a lot more time to engage with their portfolio companies because maybe our advisory team has created some really brilliant reports or insights and analytics for those investors to use with their portfolio companies. Or maybe it’s working with companies directly after we’ve established that they’re at risk of, you know, falling behind their competitors because of the benchmarks that we have. Maybe they do need to be setting carbon reduction strategies or conducting climate risk assessments. So the level of support that we can provide is so broad and diverse.

We are really here just to make sure that those companies, those organizations, those investors can really leverage the data that they’re collecting in the Novata platform to their benefit and in a meaningful way than maybe what they have the time to do if they didn’t have a tool or didn’t have an advisory team like they do here at Novata.

Josh: Alright, this has been a fascinating conversation, Laura. Unsurprisingly, every time we talk, I learn something. So, thank you. It is a treat as always to talk with you. I wanna thank everybody for listening today. Until next time, we will keep building sustainable intelligence together. Find out more at Novata.com.