Europe

Charting the Course for a Social Taxonomy

The European Commission faces two possible paths for a taxonomy prioritising ‘S’ alongside ‘E’. 

Whether it’s corporates employing thousands in activities that destroy the natural world, illegal wildlife traders exposing mankind to zoonotic diseases or workers in carbon-intensive sectors losing their jobs, many of our biggest challenges underline that ‘S’ and ‘E’ don’t exist in isolation.

Investors, corporates and policymakers are beginning to understand the need to address social-related issues in conjunction with tackling climate risks, particularly when it comes to ensuring a just transition to low-carbon and sustainable economies.

The European Green Deal has a climate-first agenda, ranging across eight policy areas: biodiversity; sustainable food systems; sustainable agriculture; clean energy; sustainable industry; building and renovating; sustainable mobility; eliminating pollution; and climate action.

It follows that the EU Taxonomy Regulation has so far put avoidance of environmental-related risks above social factors. This means the reporting requirements for asset managers under the Sustainable Finance Disclosure Regulation (SFDR) are not as focused on the social impact – positive or negative – of their ESG-labelled products.

But this emphasis is changing. The recent publication of a draft Social Taxonomy signals that the European Commission is expanding its scope beyond environmental factors. The draft is open to feedback until 27 August, with a finalised report to be submitted to the Commission for review in October.

“To avoid blue-washing (social-washing), we need a social taxonomy just as much as we need a green taxonomy,” says Nikolaj Halkjær Pedersen, Senior Lead on Human Rights at the UN-convened Principles for Responsible Investment (PRI).

The draft was published by the Platform for Sustainable Finance, the successor to the Technical Expert Group (TEG) which drafted the original taxonomy. Made up of sustainability experts from business and academia, as well as civil society and the financial industry, the advisory body supports the Commission by further refining the existing green taxonomy and progressing its Sustainable Finance Strategy.

A subgroup was appointed to outline what a Social Taxonomy could look like, then tasked with “extending the existing taxonomy to cover other sustainability objectives” including social factors, says subgroup member Signe Andreasen Lysgaard, Senior Adviser at the Danish Institute for Human Rights.

Once finalised, the Social Taxonomy would likely be incorporated into existing legislative texts, such as the updated Non-Financial Reporting Directive (now known as the Corporate Sustainable Reporting Directive) and SFDR.

But it has yet to be decided whether the subgroup’s work will translate into the evolution of the existing Green Taxonomy into a broader Sustainability Taxonomy, which would have a dual focus on social and environmental factors, or whether there will be two separate taxonomies connected through minimum social and environmental safeguards.

Unsurprisingly, this added complexity has some investors asking: Is this all too much, too soon?

Building on a green foundation 

If social factors feature more prominently in the existing Taxonomy Regulation, European corporates and investors will be better placed to achieve a just transition, experts say.

In force since July 2020, the Taxonomy Regulation establishes a list of environmentally sustainable economic activities, with the aim of limiting the risk of greenwashing and outlining the behaviours companies need to adopt to be considered sustainable.

It defines those activities through six environmental objectives: climate change mitigation; climate change adaptation; sustainable use and protection of water and marine resources; transition to a circular economy; protection and restoration of biodiversity; and pollution prevention and control.

If an asset manager decides to launch a fund which contributes to the protection and restoration of biodiversity, for example, it must also make sure the fund ‘does no significant harm’ to the other core objectives.

Right now, social factors are a feature, rather than the main focus, of this process.

Under Article 18 of the Taxonomy, an entity engaged in a sustainable economic activity must also make sure that activity meets the minimum social safeguards.

These safeguards refer to social frameworks such as the United Nations Guiding Principles on Business and Human Rights, the Organisation for Economic Co-operation and Development (OECD) Guidelines for Multinational Enterprises and the International Labour Organisation’s (ILO) declaration on Fundamental Rights and Principles at Work.

Advice on how to align with these frameworks is “quite vague”, says Pedersen.

The six environmental pillars need to be supported by social-specific core objectives, the subgroup said. These could be represented as social pillars, including human rights, equality and non-discrimination matters. Or, if the taxonomies are to be separate, yet connected, these core objectives would alternatively be subject to minimum environmental safeguards.

“Ultimately, the need for minimum environmental safeguards will have to be considered depending on how it is decided to combine social and environmental taxonomies,” the subgroup noted.

In the longer term, the Commission will further need to consider how core social and environmental objectives will interact with one another, says Lysgaard. “Assuming social objectives are added into the existing Taxonomy, how will the Commission ensure that the ‘E’ and the ‘S’ have equal emphasis?”

The current Taxonomy Regulation is far from finalised, with ongoing debate around whether more carbon-intensive transitional activities such as nuclear, natural gas and related technologies should be included. With four of the Taxonomy’s delegated acts yet to be formally adopted, it remains unclear whether social objectives can, and should, be incorporated, experts warn.

Nonetheless, it is widely understood that the EU Taxonomy Regulation objectives are “a work in progress and will be amended and enhanced continuously over time to align with the real economy, which is far from static,” says Elena Philipova, Director of Sustainable Finance for the London Stock Exchange Group (LSEG), and a former member of the TEG.

“Common classification, consistent language and transparency are critically important to enable the industry to act with confidence, and so the Taxonomy needs to expand beyond only defining what is green,” she says.

The European Commission also has plans to publish a draft Sustainable Corporate Governance initiative, which will broaden the corporate governance responsibilities of companies so they cover due diligence of human rights and environmental risks within their own operations and across the value chain.

A separate taxonomy

While the draft Social Taxonomy is rooted in the same soil as its environmental counterpart, there are key differences that the Commission will need to account for, according to the subgroup. These are also differences that may make merging social and environmental factors under one taxonomy more difficult.

For example, whereas the Taxonomy Regulation works by linking environmental criteria to economic activities, some social aspects – collective bargaining or tax transparency, for example – cannot be so easily connected. “Rather, [social criteria] must be linked to the economic entity,” the subgroup said.

Instead of relying on scientific evidence, the European Pillar of Social Rights, the EU Charter on Fundamental Rights and the European Convention on Human Rights will provide the foundation on which an independent Social Taxonomy can be built, the draft said.

The subgroup has proposed that the taxonomy is developed through vertical and horizontal dimensions.

The vertical axis concerns the promotion of adequate living standards, such as improving accessibility to products and services meeting basic human needs. This could include waste water management, social housing and providing free education.

The subgroup identified that a Social Taxonomy listing only vertical objectives may limit the scope of socially-led investments and thus a broader approach that supports all companies in their contribution to society and social sustainability is also needed.

Therefore, horizontal objectives will concern the promotion of positive impacts on affected stakeholder groups and communities by ensuring decent work, promoting consumer interests, and enabling inclusive and sustainable communities.

Ultimately, the vertical concerns what business is being done, whereas the horizontal considers how business is being done.

“Both vertical and horizontal objectives should rest on internationally agreed standards on human rights, including labour rights. These standards are at the heart of defining social sustainability. Grounding objectives and associated screening criteria in human rights will allow for a robust design that is globally applicable,” says Lysgaard.

Challenges and pitfalls

There are further challenges the Commission will have to contend with if they decide to either proceed with extending the existing Taxonomy Regulation or build a separate Social Taxonomy.

Most notably, social issues are arguably “harder to quantify”, says Elizabeth Gillam, Head of EU Government Relations and Public Policy at Invesco. How can access to healthcare and education or job security be measured?

“At the moment, the draft is quite high-level and theoretical. They haven’t really started thinking about the operational piece, such as what a reporting framework could look like. Will we have two very different reporting obligations across both taxonomies?” she asks.

A Social Taxonomy will also need to clearly identify and distinguish between inherent social benefits and added social benefits to avoid blue-washing, the draft acknowledged. For example, job creation is inherently ‘socially beneficial’ but that doesn’t necessarily mean a corporate is driving positive social performance (e.g., fair pay). In comparison, added social benefits may include improving employee access to quality healthcare.

Dealing with the introduction a new taxonomy requires a lot of time and resources that investors and other regulated entities are already dedicating to the Green Taxonomy and other regulations, Gillam adds.

“We only have a certain amount of time, capacity and political capital to develop the framework. It’s a question of whether it’s better to focus on one aspect – such as the existing Taxonomy Regulation – and develop that first before looking at other areas – such as the Social Taxonomy.”

The draft acknowledged that a Social Taxonomy would add to the already heavy reporting burden the CSRD, SFDR and Taxonomy Regulation are beginning to impose on companies and investors, “especially as there are currently no standardised social indicators on which companies usually report”.

Furthermore, PRI signatories are struggling to understand how all these different pieces of EU regulation relate to each other, agrees Pedersen. “At the PRI, we see it as a key responsibility that we help them understand how it all connects,” he says.

“As much as it can be frustrating and overwhelming for practitioners to wrap their heads around, the spike in regulation is commensurate to the challenges we’re facing – time is of the essence”.

Completing the puzzle

While this patchwork of interconnected and expanding legislation can be headache-inducing, Lysgaard maintains that the potential development of a Social Taxonomy isn’t too much, too soon.

“It’s important that everything is developed at the same time so that there’s ample coordination and the different pieces all fit together. We can’t lift this agenda through just one puzzle piece, they all play different parts in front-loading the sustainability agenda within both public and private sectors,” she says.

Overworked compliance officers should not despair. If the Commission goes ahead either with expanding the existing Taxonomy parameters or developing a separate framework, a Social Taxonomy won’t be seen for a while yet. The Commission will need to conduct an impact assessment and further develop their own ideas based on the advice of the Platform on Sustainable Finance subgroup.

In the meantime, it’s vital that stakeholders, investors, corporates and regulators submit feedback on the draft Social Taxonomy, Lysgaard emphasises.

“Personally, I’m hoping to see a clear signal across stakeholder groups that we need a Social Taxonomy and an ambitious one. Only when we have social objectives fully included on the same level as climate and environment will we really have a holistic European sustainable finance approach. Covid-19 has helped underline the urgency of ensuring the inclusion of the social or human rights domain, so I’m hoping stakeholders demonstrate their full support for the Commission to go ahead,” she says.

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