The EU Taxonomy and the role of AI
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In today's financial landscape, sustainability is becoming as essential as profitability. Green fintech, also called climate fintech, drives this shift, which blends financial technology with environmental stewardship. This sector is rapidly expanding within the fintech ecosystem, capturing increasing venture capital interest and driving the growth of green finance, reflecting a deepening commitment to investments that consider environmental factors.
In 2022 alone, the sustainable finance market reached a valuation of $4.2 trillion and is predicted to grow at a considerable 22.4% CAGR over the next decade. The EU Taxonomy and the Corporate Sustainability Reporting Directive (CSRD) are central to this transformation, establishing rigorous standards for sustainable economic activities.
While these regulations mark significant advancement, they bring complexities that can be daunting for companies. This is where the synergy of AI and ESG becomes evident, with Artificial Intelligence streamlining regulatory compliance and enhancing the integration of Environmental, Social, and Governance (ESG) criteria into financial practices.
Exploring further the EU Taxonomy reveals how AI is not just a supporting tool but a catalyst in the widespread adoption of these new standards, proving indispensable in the journey towards a sustainable financial system.
Understanding the EU Taxonomy
What is the EU Taxonomy Regulation?
The EU Taxonomy Regulation is a classification system that specifies which economic activities can be considered environmentally sustainable. It is a critical element in the EU's strategy to transition to a net-zero carbon economy by 2050 under the European Green Deal, promoting sustainable finance and addressing other key environmental concerns beyond climate change.
Basically, the Taxonomy is designed to guide investment toward environmentally sustainable projects, providing clarity while preventing misleading claims about sustainability.
The EU Taxonomy objectives and the criteria for sustainability classification
The EU Taxonomy delineates four essential criteria for an activity to be deemed sustainable:
1. Contribution to environmental objectives: An economic activity must contribute substantially to at least one of the six environmental EU Taxonomy objectives, which are climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and the preservation and restoration of biodiversity and ecosystems.
2. Do No Significant Harm (DNSH): The activity should not significantly harm any of the other environmental objectives. This principle ensures that an activity promoting one objective does not adversely affect another.
3. Compliance with minimum safeguards: Activities must comply with minimum social and governance safeguards, such as adhering to established international norms like the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.
4. Technical screening criteria: The activity must meet specific technical screening criteria set by the EU technical expert group.
The Timeline of the EU Taxonomy
The Taxonomy Regulation was published in the Official Journal of the European Union on June 22, 2020, and entered into force on July 12, 2020.
Starting January 2023, it becomes mandatory for approximately 4,000 large companies under the Non-financial Reporting Directive (NFRD) to disclose their alignment with the Taxonomy's criteria.
Sustainable Finance Disclosure Regulation (SFDR): Clarifying ESG Impact
Together with the EU Taxonomy, the SFDR plays a pivotal role in sustainable investing by requiring financial market participants to disclose sustainability risks and the Principal Adverse Impact (PAI) of their investment decisions. PAI refers to the adverse effects on sustainability factors that investments might cause, such as environmental damage or social injustices. By demanding transparent reporting on PAI, the SFDR aims to mitigate harmful ESG impacts and facilitate informed investment choices. This ensures that financial products' ESG claims are backed by tangible actions and comprehensive data, complementing the transparency goals of the EU Taxonomy.
The CSRD: A New Chapter in Sustainability Reporting
Complementing the SFDR and the EU Taxonomy, the Corporate Sustainability Reporting Directive (CSRD), which became effective on January 5, 2023, expands the sustainability reporting requirements.
It mandates a broader spectrum of large companies and all listed SMEs to provide detailed accounts of their environmental and social impact. This directive aims to enhance transparency for investors and stakeholders, allowing for a more accurate assessment of sustainability practices and alignment with the EU Taxonomy.
The CSRD updates and broadens the scope of the former NFRD, setting out more extensive ESG reporting obligations within a dedicated segment of management reports. The rules introduced by NFRD remain in force until companies must apply the new rules of the CSRD.
What does the CSRD timeline look like? Companies will begin applying these rules in the 2024 financial year, with the first reports expected in 2025, marking a new era of corporate accountability in sustainable finance.
CSRD Reporting Requirements
Previously, under the NFRD, only large EU-based entities considered of public interest with over 500 employees were required to report sustainability metrics. This was applied to roughly 11,700 companies. The CSRD significantly widens this scope, requiring all large companies that meet two of the following criteria to disclose non-financial information:
- Exceeding 250 employees;
- Generating more than €40 million in turnover;
- Possessing over €20 million in total assets.
Additionally, the CSRD's reach extends beyond European borders, mandating non-EU companies with substantial operations in the EU—defined as having a net turnover of over €150 million within the bloc—to also submit reports detailing their ESG impacts.
The Growing Importance of ESGs and the Challenges in Data Collection
As we have seen, Environmental, Social, and Governance (ESG) criteria increasingly influence investment decisions. Data shows that more than 60% of people base their purchasing decisions on sustainability and ethical standards, growing by 10% annually. Consequently, this is becoming increasingly important for companies as well, where they are pushed not only by the new regulations, we explored above but also to meet customer preferences.
ESG and AI
Green fintech companies are revolutionizing ESG data analytics by harnessing AI and Natural Language Processing (NLP), thus transforming the financial sector's approach to sustainability data management. These companies utilize cutting-edge technology to enhance sustainability efforts within the financial industry by enabling more efficient data management and informed decision-making.
In fact, AI-driven green fintech solutions can address the scarcity of ESG data by automating the collection process from diverse sources, ensuring that even SMEs with limited reporting capabilities are included. Furthermore, AI and NLP are instrumental in refining the ESG scores database, sifting through the excess when there is an information overflow and pinpointing the most relevant data points that align with ESG criteria and the EU Taxonomy.
AI in green fintech also means that the data collected is more extensive and of higher quality. NLP algorithms can interpret complex language, sentiment, and context within large datasets - this allows for a more nuanced understanding of ESG disclosures, leading to more accurate and actionable insights.
In conclusion, as the financial sector forges into a future where sustainability is critical, green fintech's role becomes increasingly pivotal. Fintech entrepreneurs and professionals are at the forefront of this transformation, harnessing the power of AI and NLP to navigate the complex regulatory landscape shaped by the EU Taxonomy and the CSRD.
The intersection of ESG and Artificial intelligence is showcased as AI-driven green fintech solutions adeptly meet the challenges of ESG data collection—be it scarcity or the daunting task of managing abundance, offering a beacon of hope for both financial institutions, large corporations and SMEs striving to meet the new standards. Through clever technology integration, these companies can ensure easier, more precise reporting that aligns with the stringent ESG criteria, ultimately contributing to a more sustainable and resilient financial system.
Now, as we stand on the cusp of new mandatory reporting and the impending broad application of CSRD requirements in 2024, there is no doubt that AI and NLP will be indispensable tools.
For fintech founders and professionals, this is a call to innovate and invest in green fintech solutions to define a new era of corporate accountability and sustainable finance. Together, we are not mere observers but active contributors to the green finance transformation, shaping a future where environmental and social integrity are necessary for economic success.