From the EU Taxonomy to the EU Social Taxonomy?

From the EU Taxonomy to the EU Social Taxonomy?
From the EU Taxonomy to the EU Social Taxonomy?
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How it started…

The EU Taxonomy, which came into effect on 12 July 2020, is a classification system that provides a standardised definition of environmentally sustainable economic activities (“green activities”) across the EU. Technical criteria for the listed activities are being checked and updated on an ongoing basis. They are meant to facilitate a situation where the financial sector can contribute significantly to the achievement of the climate and energy goals of the EU and can guide the required investments in the desired direction.

Sustainable investment, however, takes an even wider view. In addition to environmental aspects, it also takes into account social and governance aspects in investment decision-making. For these areas, no goals have been set so far. Upon request by the EU Commission, sub-group 4 of the Platform on Sustainable Finance started in October 2020 to think about the relevance and possibilities of expanding the EU Taxonomy to include social goals. In addition, it is to look into the relationship between Social Taxonomy and Environmental Taxonomy, other sustainability goals like governance, and the regulatory framework. After an interim report on 12 July 2021 it released the final report on Social Taxonomy on 28 February 2022, which takes into consideration 268 responses from the consultation on the interim report.

The purpose and goals of a (possible) Social Taxonomy

The Social Taxonomy is meant to support the guidance of capital flows into those companies and economic activities that respect human rights and at the same time promote investments that improve living conditions, especially for disadvantaged people. It is meant to provide investors with a classification system in their investment decisions. The existing EU Taxonomy will be used as template, with the caveat that it will be difficult to establish quantifiable criteria for a Social Taxonomy.

The Social Taxonomy is meant to drive the achievement of the Sustainable Development Goals (SDGs) and the creation of the social single market as defined in article 3 of the treaty of the European Union.

Comparison of the EU Taxonomy and a (possible) Social Taxonomy

Significant differences between a Social and the Environmental Taxonomy:

  • Most economic activities have damaging effects on the environment, but they can be regarded as having social utility on the basis of their creation of humane jobs, the raising of tax revenue, and the production of socially useful goods and services. Therefore, a Social Taxonomy has to distinguish between the inherent social good and additional utility such as the enforcement of human rights, the creation of jobs, or the facilitation of access to healthcare.
  • Whereas environmental goals and criteria can be scientifically founded, a Social Taxonomy has to be based on international standards such as for example the International Charter of Human Rights.

The proposed structure of the Social Taxonomy relies on structural aspects of the EU Taxonomy, among them, for example, the development of social goals, types of considerable contributions, criteria for the avoidance of significant damage caused by economic activities (“Do no significant harm”, DNSH), and minimum standards (“minimum safeguards”).

Employees (including supply chains), end users, and affected communities (directly or via the value chain) have been identified as stakeholders who could be affected by economic activities.

The proposed structure defines three social goals:

  • Humane working conditions (including supply chains)
  • Adequate standard of living and well-being for end users
  • Integrative and sustainable communities and societies

The formulation of sub-goals – a difference to the EU Taxonomy – is to ensure that the following aspects be considered: health(care) and safety, housing, wages, non-discrimination, well-being of end users, and the livelihood of communities.

Basically, the EU Taxonomy distinguishes between two kinds of significant contributions:

  • Additional social good of the activity itself (e.g. medical drug research)
  • Avoidance of negative effects, e.g. via health and safety measures at work

The topic of governance is discussed at length in chapter 6 of the report. It says that sustainable governance is regulated by corporate in-house rules and procedures and by state guidelines. Since they are closely tied to the company that pursues the respective activity, the regulation concerning governance within the Taxonomy is seen as part of the minimum safeguards. The report proposes that the link should not be based on a set list of indicators for companies or the sector, but on the sustainability strategy and the social performance indicators (KPIs) of the scrutinised company, such as employee and supplier satisfaction, working and social standards at the suppliers, measures aimed at closing the gap between minimum wage and living wage, and corporate spending on education and training.

The report also discusses socially harmful economic activities, i.e. mainly those that are to be seen as harmful under any circumstances. Internationally agreed conventions, e.g. on certain kinds of arms, and the research about harmful social effects of certain activities, e.g. the use of tobacco, have been suggested as sources to identify such activities.

Finally, the report covered the requirements for future social criteria and indicators and the ideas for the next steps towards developing a Social Taxonomy.

Conclusion

This report has come out at a crucial time, as the admission of nuclear power and natural gas into the EU Taxonomy has recently been discussed vigorously (N.B. the Platform and many asset managers were highly critical about said admission).

The task of developing a Social Taxonomy could turn out even more challenging, with the attack on Ukraine highlighting the importance of the context in defining socially sustainable or harmful activities and defensive activities. Companies in the arms industry currently like to refer to the Sustainable Development Goal (SDG) No.16, “Peace, Justice, and Strong Institutions”. This is probably the case as they have not been taken into account by the EU Taxonomy, section “Green Activities”, nor by the suggestions for a Social Economy and are therefore possibly worried about their future source of finance. These efforts also fail to clarify what sort of weapons are to be regarded as socially acceptable. Are controversial ones such as for example nuclear arms or fragmentation bombs included? Sub-goal 16.4 (of the aforementioned SDG 16) stipulates that the illegal movement of finance and arms is to be reduced drastically by 2030. This is a very ambitious goal, especially for arms manufacturers, and it certainly does not suggest an increase in weapons output.

Without a doubt, there is rising demand from investors for social investment opportunities, but the units of measurement for social issues are even more fragmented than the ones used to assess the environmental impact. The effort required to develop a Social Taxonomy is therefore expected to be bigger. One can also expect the bureaucratic input to increase both for companies and the financial sector.

It is important to bear in mind that this report is a proposal, not a binding decision. The EU Commission will probably release an announcement by the end of the year in which it will explain its own conclusions and intentions in this matter.

Sources:
European Commission EU taxonomy for sustainable activities
European Commission Platform on Sustainable Finance
Cric e.V.
Handelsblatt, Artikel vom 10.02.2022
Natixis, Newsletter, EU Social Taxonomy Proposal: simpler and meaningful but half-way through. 24.03.2022
pwc.at, Artikel zu Entwurf soziale Taxonomie Sommer 2021
Lexology, Artikel 01.03.2022
Resolution der UN Generalversammlung verabschiedet am 25.09.2015 – Die Agenda 2030

This article is part of the ESGenius Letter on the topic “Social – The ‘S’ in ESG”. Further information and insights from our experts on social factors in sustainable investment can be found here.

For a glossary of technical terms, please visit this link: Fund Glossary | Erste Asset Management

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