The EU Taxonomy is an attempt to define what makes a “green” investment and is a cornerstone of the EU’s sustainable finance policy agenda. The EU Taxonomy can be thought of as a dictionary defining which economic activities can be considered environmentally sustainable. The core question now facing companies, investors and financial institutions is how to identify Taxonomy-aligned activities and revenue.

Taxonomy alignment is the positive assessment that an eligible activity meets the applicable Taxonomy requirements to substantially contribute to at least one of the Taxonomy’s six objectives; does no significant harm (DNSH) to any other objective; and meets the minimum social safeguards (MSS). Once an activity and associated revenues have been identified as eligible, the next step toward alignment is assessing their substantial contribution to one of the Taxonomy’s objectives. Currently, substantial contribution criteria have been finalized for two objectives — climate change mitigation and climate change adaptation — and criteria related to the other four objectives will be finalized in the future. The European Commission on April 5 began accepting feedback on a new set of Taxonomy criteria for economic activities making a substantial contribution to the other objectives.

The first part of this blog series described the general approach the S&P Global EU Taxonomy Data Solution takes in assessing economic activities and revenue to determine their eligibility for the Taxonomy. This second blog will focus on assessing the substantial contribution of eligible activities.

From eligibility to alignment

Economic activities are considered eligible based on their potential to mitigate climate change by contributing to one of the six objectives. Beyond classifying eligible activities by their Taxonomy objective, activities can be further categorized by three types: whether they can contribute directly to a Taxonomy objective; only enable other activities that contribute directly; or are transitional, which can apply to some activities associated with the climate change mitigation objective that do not have a low-carbon alternative.

To measure contribution to an objective, the Taxonomy regulation includes technical screening criteria and performance thresholds for each eligible activity. The technical screening criteria is meant to ensure that companies are making a substantially positive environmental impact and to set sectors on a path to reach the EU Green Deal’s environmental goals.  A company’s business activity must meet  the criteria’s conditions and performance thresholds to formally qualify as making a substantial contribution.

The Taxonomy’s screening criteria can be quantitative and/or qualitative in nature. Examples of quantitative criteria include requiring an activity to show how much lower its emission are versus an alternative or how its energy efficiency improves over time. Qualitative criteria may require a company to implement or become compliant with new sustainability-related processes or standards.

The Taxonomy also treats some activities as meeting the substantial contribution test by default, and these activities do not have criteria. They include wind or solar power generation.

The S&P Global Sustainable1 approach to assessing substantial contribution

To assess substantial contribution for the two released objectives — climate change mitigation and climate change adaptation — the S&P Global EU Taxonomy Data Solution starts with the relevant screening criteria set out in the Taxonomy regulation for an activity, then assesses company performance against the criteria using relevant company-level data points sourced from internal S&P Global databases. When no data is available for a company, the assessment defaults to the Taxonomy Alignment Coefficient (TAC) published by the European Commission Joint Research Centre for that activity.

The S&P Global EU Taxonomy Data Solution was developed in 2022, when Taxonomy reporting was only on a voluntary basis. Few companies were choosing to publicly report on Taxonomy performance or the specific data points required to assess against the technical screening criteria. As a result, S&P Global Sustainable1 developed the EU Taxonomy data solution as an independent assessment of companies’ Taxonomy performance using information from S&P Capital IQ Pro and other S&P Global datasets to measure activity-level performance against technical screening criteria. This approach allows for consistent assessment across companies and creates transparency into how Taxonomy alignment is or is not achieved. If a company is aligned, the S&P Global EU Taxonomy Data Solution can identify which activities are contributing to alignment and which are not. Similarly, if a company fails the assessment, a user will have visibility on any individual metric the company failed to meet and which assessment stage was not passed, out of substantial contribution, DNSH and MSS.

European companies under the scope of the Non-Financial Reporting Directive have been required to disclose alignment performance starting from 2023. The availability of company-reported Taxonomy alignment data is expected to increase during 2023. The Sustainable Finance Disclosure Regulation also asks financial market participants to use Taxonomy performance disclosures made by investee companies. With these developments in mind, S&P Global Sustainable1 is building a process to capture “as reported” Taxonomy performance data.

Currently, modeled performance data relies on several S&P Global datasets: Trucost Sector Revenue, S&P Capital IQ Pro Topic Tags and Trucost Paris Alignment.

Trucost Sector Revenue is used to differentiate revenue related to the product or process identified in the Taxonomy criteria. For example, the manufacture of aluminum is a Taxonomy-eligible activity, and the manufacture of secondary aluminum is considered an activity that makes a substantial contribution to the climate change mitigation objective. The Trucost Sector Revenue dataset isolates revenue from secondary smelting and alloying of aluminum.

In cases where the Trucost Sector Revenue database is not granular enough, S&P Capital IQ Pro Topic Tags are retrieved from a company’s Business Description in Capital IQ Pro. These tags can also be used to identify relevant activities. For example, producing vehicles with zero tailpipe emissions is the primary substantial contribution criterion related to the Taxonomy activity for low-carbon transport manufacturing. The topic tag for “electric vehicle” is used to identify automobile companies that manufacture electric vehicles, which have zero tailpipe emissions.

Trucost Paris Alignment data is also used to assess substantial contribution when criteria require a certain threshold of emissions performance. This dataset uses company data on carbon emissions and production to calculate carbon intensity per unit of product. This ratio is calculated for companies in high-emitting sectors: steel, power, cement, aluminum, airlines and automobiles. For example, the Taxonomy has set a threshold in metric tons of CO2-equivalent per metric ton of cement. The Trucost Paris Alignment assessment captures an emissions intensity metric for cement companies that can be measured against the Taxonomy threshold.

Where no data is available to assess substantial contribution performance for a given eligible activity, the analysis defaults to the TAC for that activity. These set coefficients reflect an estimate of the proportion of each individual activity that is expected to be Taxonomy aligned. S&P Global Sustainalbe1 uses this data only for the assessment of substantial contribution and not the final alignment results. 

For example, a hypothetical Company A has total revenue of $10 million. It generates 30% of the revenue from developing building projects and 20% from cement production, while the remaining 50% of revenue is from activities that are not included in the Taxonomy. The $5 million of revenue from building development and cement production are eligible for Taxonomy alignment. If data is insufficient to assess this revenue’s substantial contribution, the TAC is applied:

• The TAC of 40% is applied to the $3 million of revenue generated from the development of building projects, which results in $1.2 million of revenue meeting the relevant substantial contribution criteria.
• The TAC of 3% is applied to the $2 million revenue generated from cement production, which results in $60,000 of revenue meeting the relevant substantial contribution criteria.

Assessing substantial contribution in a portfolio

Measuring revenue that passes the substantial contribution assessment at the company level can also be aggregated at the index or portfolio level. In the previous blog, we saw that about 25% of the revenue of S&P Euro 350 companies is eligible for the first two Taxonomy objectives — climate change mitigation and adaptation — while about 38% of the revenue of companies in the S&P 500 is eligible. That difference reflects the fact that many of the sectors prioritized for inclusion under the climate change mitigation objective are high-emissions sectors that have a significant need for decarbonization under Paris Agreement climate targets.

S&P Global Sustainable1 data shows that only a fraction of eligible revenue meets the relevant Taxonomy criteria for substantial contribution. In the S&P Europe 350, 26.6% of total revenue is Taxonomy eligible, but only 3.3% of total revenue passes the substantial contribution assessment. For the S&P 500, 38.4% of total revenue is eligible, but only 1.7% of total revenue makes a substantial contribution.

The substantial contribution test is binary, and an eligible activity must meet all the relevant criteria to pass and qualify for alignment. A portfolio’s Taxonomy may have far more eligible revenue than aligned revenue, even based only on testing how much of it passes the substantial contribution assessment.

The next step in assessing full alignment with the Taxonomy is to consider the requirements under the do no significant harm criteria and to determine if an activity complies with minimum social safeguards, which will be the focus of our next blogs in this series.