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The EU Sustainability Taxonomy
How circularity can become part of an environmental classification system
What is necessary to reorient capital flows towards environmental sustainable and circular investments? The European Commission aims to tackle this question through the development of a EU classification system; the EU Sustainability Taxonomy. The taxonomy will not only cover themes such as climate mitigation and adaption, but also other topics such as the circular economy, waste prevention and recycling. Read Deloitte’s recommendations for the EU Sustainability Taxonomy from the perspective of the circular economy in the below article.
The EU sustainable taxonomy
Taking ESG factors into consideration stimulates long-term value and creates a competitive advantage. In response, investors, financial institutions and companies are taking valuable and necessary steps to integrate resource efficiency and ‘green’ considerations in their decision-making. A true transition to inclusive sustainability encounters challenges that require radical rethinking of how our financial system functions. In essence, it raises the question: what is necessary to reorient capital flows towards environmental sustainable and circular investments?
In March 2018, the European Commission (EC) presented a EU classification system as the cornerstone of its ‘Action Plan for Financing Sustainable Growth’ . The EU classification system (hereafter: taxonomy) will present a common language to evaluate the impact of activities and a method to redirect capital flows toward environmentally sustainable investments. A universal understanding of environmental sustainability is seen as the needed clarity for member states and financials to mitigate the risk of greenwashing and ultimately increase trust and credibility of green investments. Yet, although the advantages of a clear taxonomy are apparent and its development is mostly welcomed, its actual content has been topic of many discussions.
The Taxonomy Circular Economy report
With the taxonomy, the EC attempts to not only cover themes such as climate mitigation and adaption, but also other topics such as the circular economy, waste prevention and recycling.
Over the past few months, Deloitte’s Sustainability team has conducted a study, commissioned by the Dutch Ministry of Infrastructure and Water Management (I&W), that provides recommendations on how to build a taxonomy for sustainable investments with regards to the circular economy. Throughout a series of interviews, input has been gathered on Dutch financial institutions’ approach when assessing economic activities for sustainability levels and contribution to the circular economy. After all, financial institutions play a pivotal role in encouraging and enabling this journey towards circularity.
What will the taxonomy look like?
Before zooming in on the content of the taxonomy, let’s have a look at the current framework design. On the horizontal scale, the taxonomy visualizes the EU’s objectives ranging from explicit climate change, to broader environmental sustainability and social sustainability. The sequence also represents the priority given to the various objectives, meaning that the focus for 2019 will primarily be on climate change policy goals before continuing to social objectives. On the vertical scale, the taxonomy adopts the NACE industrial classification, the European standard classification of economic activities. Building on this classification the TEG proposes to select certain sectors from the NACE classification based on their impact. In practice, this will lead to an emphasis on the highest-emitting NACE macro sectors (e.g. electricity production) as well as an emphasis on sectors that enable substantial greenhouse gas emissions. These are however not necessarily the sectors that have the highest impact on raw material usage and/or potential waste reduction, which are both important factors in the transition to a circular economy.
A fragmented market: valuable yet scattered approaches
The conducted research illustrated recognition by Dutch financial institutions of the idea that sustainable or circular investments cannot only drive value, but engaging in non-sustainable or non-circular investments can also have a negative impact on performance. This resulted in an increasing focus on sustainable investments and the adoption of a largely risk based, holistic and qualitative approach to classify economic activities. In addition, some institutions have also developed their own metrics or indicators. Although these initiatives are valuable attempts towards more sustainable and circular investments, they also seem to create ambiguity in terminology and inconsistency in application. The metrics and indicators often do not align with EU sustainability and circular economy goals and largely rely on non-financial data while standards for disclosing such information are currently still heterogenous. This creates a fragmented market, with uncertainty and discouragement for investors and unnecessary barriers for the transition towards a circular economy.
Naturally, the question arises: how could the taxonomy encourage a uniform classification system while also taking the sectors’ evolving nature into account? Dutch financial institutions are moving at a high pace but research shows that, at this moment, their varying levels of maturity make a more pragmatic approach of utmost importance. To deliver upon EU sustainability goals, three recommendations can stimulate the development of the taxonomy from a circular economy perspective:
1. Inclusiveness through a sector prioritization
To evaluate economic activities from a sustainable or circular economy perspective, the taxonomy adopts the NACE industry classification system. Though the system presents a classification, it is not fully supported in the market where multiple classifications are being used for different purposes. The goal of the taxonomy is to ensure that the EU economy as a whole transitions to a sustainable and circular economy.
To ensure that the taxonomy has its aspired impact, it should include the many shades of ‘’green’’. Inclusion rather than exclusion should be at the heart of the proposed design, to ensure that the NACE system does not limit valuable sectors from evolving. One way to prevent such a limitation, is by identifying sectors that could have the biggest impact in the transition towards a circular economy and subsequently prioritizing these sectors for financing and investments. By understanding in which sectors improvement is critical, attention can also be devoted to those companies that are willing to take valuable steps to become more circular. We therefore not only encourages alignment with circular economy priority (sub)sectors as identified in policies of the EC and Dutch government, but also with the three critical drivers of the circular economy: material intensity, use of scarce resources and levels of waste.
2. A criteria centered outlook
A second interesting characteristic of the proposed classification is that, in its current form, the taxonomy is activity focused. It shows which economic activities are exposed to sustainability risks and which activities are contributing to a low-carbon economy. At this point in time, a lack of measurability and comparability of data makes it hard to include the progress on circularity. Besides, such a focus on a green activities classification risks the exclusion of activities that might not be labeled as green but could generate a meaningful contribution to the circular economy.
In our view, a more fitting approach is needed to ensure the taxonomy achieves what it is meant to do: enhance transparency on sustainable opportunities and risks in all sectors. From a circular point of view, this means the taxonomy needs to challenge institutions to radically rethink their current investment choices. An activity centered scope does not adequately serve that goal for the simple reason that, in practice, businesses are seen to optimize their linear models, rather than replacing them. As a result, an incentive is given to optimize the current linear activities instead of fostering innovation to close the loop. A taxonomy that contributes to a low-carbon economy should look beyond minimizing harm of the linear economy and instead focus on diminishing our dependency on natural resources from the get-go.
A taxonomy would therefore be most useful for market practitioners when it is inclusive, encourages companies to contribute to a circular economy while also being mindful of the risk of greenwashing. To do so, we suggest to adopt a criteria centered approach. Such criteria can be established following the below four categories, in line with current market maturity levels of Dutch financial institutions:
- Align to the strategic goals with regard to raw material usage from the program ‘A Circular Economy in the Netherlands by 2050’ to classify an economic activity as circular.
- Establish a negative selection list to prevent economic activities being classified as circular or as a contribution to the circular economy while they are harmful or only an improvement to the linear economy.
- Use the 9R criteria framework to assess the level of circularity, running from fully linear to fully circular strategies (recover, recycle, repurpose, remanufacture, refurbish, repair, reuse, reduce, rethink, refuse);
- Adopt the criteria from the Ellen MacArthur Foundation to also be able to measure the impact of investments. Ellen MacArthur has operationalized the R principles by formulating indicators that assess how effective a company is in making the transition from linear to circular models and follow a risk based approach.
3. A dynamic and phased approach
When the criteria centered approach is adopted and the taxonomy comes into force, it does not mean that full circularity is achieved. A growth model will be necessary to stimulate circular investments and transition from a linear to a fully circular economy while preventing greenwashing.
We suggest a four phased growth model approach to achieve such a transition to inclusive circularity. This phased approach is required to encourage innovation and growth with market and non-financial data maturity levels. Ultimately, setting such short and long term standards will create the required flexibility to ensure the taxonomy remains useful and applicable. After all, a dynamic classification system leaves room for improvement for those moving towards higher levels of circularity instead of anchoring fully circular activities. We visualize these different phases, ranging from a risk based viewpoint to the theory of necessary system change of the circular economy.
By prioritizing sectors, focusing on criteria rather than activities and adopting a phased approach to measure improvement, a taxonomy can be developed that is inclusive and encourages companies to contribute to a circular economy. Rather than anchoring fully circular activities, a path is created for those moving towards circularity, while making sure that, in the end, linear activities will not be supported. Ultimately, a clear and shared strategy is identified for companies and investors to make the transition to a circular business model.