Corporate alignment with the EU taxonomy for sustainable activities: First evidence from financial accounting data

What is sustainable? This question is of paramount importance given the trillions of assets invested according to different sustainability criteria. While until now we have had no standard for answering this question, the European Union's (EU) Taxonomy1 for sustainable activities aims to provide a comprehensive classification system for environmentally sustainable economic activities. This research paper examines the disclosures of European companies that are part of the Stoxx 600 index in relation to the EU Taxonomy. The EU Taxonomy went into effect in July 2020, following the adoption of the Taxonomy Regulation (Regulation (EU) 2020/852). It can be a critical piece of legislation for investors, as it establishes a common language and framework for identifying environmentally sustainable investments. The taxonomy provides clear criteria for determining whether an economic activity can be considered environmentally sustainable based on six environmental objectives, including 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 protection and restoration of biodiversity and ecosystems. Fiscal year 2022 disclosures, the first year that the regulation went into effect, relate only to the first two objectives. Companies subject to the Non-Financial Reporting Directive (NFRD) are required to report on their alignment with the EU Taxonomy. This includes large, publicly listed companies with more than 500 employees. Activities that contribute to one of the six goals are deemed “eligible.” To be considered “aligned,” a company must not only contribute to one or more of the above objectives, satisfying specific technical criteria, but do so while also meeting a “do no significant harm” standard: while supporting sustainable goals, aligned activities must not otherwise impinge upon any other sustainable goals. These companies must disclose data related to the taxonomy, including information on the proportion of their revenues, capital expenditures, and operating expenditures that are aligned with the taxonomy's criteria. These disclosures could be helpful for investors, policymakers, and other stakeholders to assess the progress of companies toward sustainable activities and specifically, the transition to a low carbon economy. We undertake a comprehensive analysis of the newly reported corporate disclosures related to the EU Taxonomy, focusing on the alignment of revenues, capital expenditures (Capex), and operating expenditures (Opex) with the taxonomy's criteria. Leveraging this unique dataset for the first year of reporting, we aim to answer several pertinent research questions that can shed light on the current state of corporate sustainable activities in the context of the EU Taxonomy. We start by documenting several empirical patterns. To be aligned, a sustainable activity first needs to be eligible, by contributing substantively to one of the six sustainability objectives. We find that the largest percentage of eligible revenues are in the Real Estate, Utilities, and Industrials sectors. But for all the implied progress, there is nonetheless significant variation within sectors and across industries. For example, while the Consumer Discretionary sector has a relatively low percentage of eligible revenues overall, the Automobiles industry ranks as one of the highest industries in terms of eligible revenues. This reflects the ongoing transformation due to electric vehicles. Other industries with high eligible revenues include Real Estate Development & Management, Building Products, Construction Materials, Metals & Mining, Transportation Infrastructure, Utilities, and Electrical Equipment. An activity is aligned if it is eligible and satisfies a host of technical criteria. We find that aligned revenues are much lower than eligible revenues, consistent with the technical criteria representing a bar that most companies are not currently meeting. This trend is evident in the Automobiles industry, which has a high percentage of eligible revenues but very low aligned revenues. In contrast, Transportation Infrastructure exhibits an almost equal percentage of aligned and eligible revenues, suggesting that all eligible revenues are aligned in this industry. Building Products and Electrical Equipment industries also demonstrate higher aligned revenues, while Utilities and Real Estate exhibit the highest alignment at the sector level. Moreover, significantly higher variation exists within sectors and across companies for aligned rather than eligible revenues, suggesting that firm-specific strategies are an important driver of alignment. Our data is cross-sectional in nature, given the first year of available data required by the regulation has been for the 2022 fiscal year end. The absence of a panel dataset and exogenous shocks to a firm's aligned investments and revenues does not allow us to make any causal claims about the relation between them or with other variables of interest. Nevertheless, we uncover several empirical patterns that are of interest to investors and managers. For example, modeling the relation between aligned capital and operating investments and aligned revenues we find that a 1% increase in aligned operating expenditures is associated with a 0.84% increase in aligned revenues with an additional 0.37% contribution from capital expenditures. Moreover, given the significant variation in alignment metrics across competing companies within industries, we analyze the relationship between alignment metrics, business fundamentals, and corporate valuation ratios. There are three plausible scenarios for how these might relate. First, some companies may choose not to align because alignment leads to suboptimal financial outcomes, while other firms value the environmental benefits of the alignment. For example, eligible products that meet the technical criteria might face lower demand by customers due to higher prices, or they might require higher production costs leading to lower margins. Second, some firms may choose to align because alignment leads to better financial outcomes by tapping unmet customer demand for new products, while other firms are slower to align as they are reluctant to make the necessary investments, or they do not have the capabilities to adapt. Third, neither strategy may dominate so far. Firms with higher alignment may sell products and services to satisfy emerging customer demands while optimizing their investment profile, while at the same time firms with lower alignment satisfy existing customer needs. Consistent with this third scenario, we find little difference in sales growth, profitability ratios, or corporate valuation ratios across firms with high or low alignment within the same industry. However, we document that companies with higher enabling revenues and capital investments exhibit lower profitability (i.e., ROA) and (1-year sales growth). Then, we analyze the ability of models that rely on business segment data and a classification of business segments to sustainable activities to predict eligibility of revenues and the correlation between alignment metrics and other environmental data. We find that models significantly overestimate the percentage of revenues that would be eligible as a sustainable activity. This is particularly true in the Information Technology, Communication Services, Industrials, and Utilities sectors. This discrepancy reflects the challenges associated with accurately estimating these figures from corporate business segment disclosures. Moreover, the alignment metrics are only moderately correlated with environmental data and ratings. Strikingly, we find that many firms in industries with high exposure to carbon emissions have close to perfect environmental ratings while having close to zero Taxonomy-related revenues or expenditures. We conclude that the disclosure regulation has provided investors with novel data and a differentiated assessment of firm strategies. The analyses conducted in this paper are valuable for investors for several reasons. First, by examining the alignment of revenues, capital expenditures, and operating expenditures with the taxonomy across sectors, industries, and firm characteristics, investors can gain a deeper understanding of the extent to which large European companies are embracing sustainable practices. This can help investors identify investment opportunities in firms that are more likely to benefit from the transition to a low-carbon economy and avoid those that may face increasing regulatory risks and stranded assets. Second, by documenting the intra-industry variation in alignment with the taxonomy, this research can provide insights into the differences in the adoption of sustainable practices within industries. This information can be used by investors to better assess the relative performance of firms within an industry and make more informed investment decisions based on environmental considerations. Lastly, by investigating the relationship between alignment with the taxonomy and commercial environmental ratings, this research can help investors evaluate the consistency between the EU's classification system and other widely used environmental ratings. This information can support investors in their due diligence process and portfolio construction by identifying potential discrepancies and complementarities between different sustainability frameworks. Fiscal year 2022 is the first year that companies are obliged to report the amount of revenues, capital expenditures, and operating expenditures aligned with the EU taxonomy for sustainable activities. Moreover, companies need to report the amount of revenues that are eligible for evaluation of alignment with the taxonomy. Finally, companies have the option to also report revenues, capital expenditures, and operating expenditures in enabling or transitional activities. We collect these data from Bloomberg for all companies that have reported as of the end of December 2023 for the fiscal year 2022. We focus on companies in the Eurostoxx 600, as these companies represent the largest European companies and as a result, we expect that the quality of the disclosures will be robust given that these companies have the accounting resources, internal control systems, and regulatory, as well as market scrutiny, to produce reliable financial data. After removing firms that have no data on Bloomberg as of the end of June as well as all financial sector firms,2 our sample includes 319 firms with reported eligible data and with reported aligned data. To be eligible as a sustainable an economic activity contribute to at one of the six environmental of the Taxonomy. However, only activities that contribute to the first two environmental climate change and have been for 2022 fiscal year disclosures. In the disclosures, we find that almost all reported activities relate to rather than adaptation, so all the to climate change In our a percentage of revenues and operating expenditures are eligible while a much higher percentage of capital expenditures is eligible This is the across all sectors. that capital expenditures are toward assets that are we these as that companies are investments in eligible more so than activities that revenues or that are by operating expenditures. We find that eligible activities are the highest in the Real Estate and sectors, by Industrials and for the three However, this variation across industries within sectors. For example, a low of eligible activities in Consumer the industry is the highest industry in eligible revenues and expenditures An eligible activity it to one of the six economic activities in with the in relation to the other environmental objectives, and with as in the Taxonomy For example, the of for is an eligible activity. However, for the activity to be aligned, there are specific to be for and systems, a than or equal to and the percentage of revenues and expenditures aligned will be lower than those The EU a on sustainable of from and the as well as additional from EU and with for the technical criteria. The criteria are to be the available on a contribution to climate change or adaptation, while significant to other environmental objectives. The and subject to from stakeholders to and and how much lower those across all the percentage of revenues aligned to from the percentage of capital expenditures to from Moreover, all sectors very For example, Real Estate revenues by from eligible to This the that many do not meet the on that aligned revenues are lower than eligible revenues across almost all industries. The is an industry from the the is an industry from eligible revenues to The relate to companies in and and industries. a of the between eligible and aligned revenues on for industry. that high on the as and have significantly more to their aligned revenues. that the of variation substantively for aligned eligible as most industries the This reflects the that eligibility is more by but significantly whether activities are aligned or For example, in the and of are eligible activities. However, the of reflects Real Estate Development and firm strategies and and the industries in terms of alignment. Utilities and high given the focus on from and However, other as Transportation Infrastructure and Building and we analyze company disclosures for of aligned activities. In the of Transportation Infrastructure, aligned activities include electric for Building Products, include or we find that aligned capital expenditures aligned revenues. This that some is not but rather or to or to and in or that is leading revenues, with companies to revenues that have to in to produce for electric alignment is particularly high in the Utilities, Real Estate, Information Technology, Materials, and Industrials sectors. aligned aligned operating expenditures (Opex) are at a as aligned revenues. Finally, we find that climate change is with only a companies in the Industrials, Communication Services, and Consumer Discretionary sectors from related most investments are toward climate rather than climate those firms with some capital expenditures, most are in the Real Estate The Taxonomy a firm to report two additional of transitional and enabling activities. activities support the transition to a low carbon economy but do not as For example, the of is a transitional activity if the emissions production are than of the of carbon and as transitional activities if they are with of than the by the Taxonomy. activities the aligned activities. For example, the construction and of that as are considered enabling activities. and that enabling activities in Utilities and in other sectors, as industries, we enabling activities in industries. For example, in companies report enabling activities the and of Moreover, transitional activities are reported in Utilities, Real Estate and and For example, in the of with electric is a transitional activity. For Construction is considered In terms of expenditures, enabling is in the Utilities, Building Products, Construction & and & industries. is in Consumer Communication Services, and sectors. Moreover, we find that enabling is higher than transitional with significant enabling in the Electrical Utilities, and Automobiles industries. We expect a correlation between aligned revenues and investments. Firms that to and to produce products that are aligned with the EU taxonomy exhibit higher revenues from aligned activities. For example, an company that to a that electric and to for and in the exhibit higher revenues from the sales of electric vehicles. However, there are two we expect the and investment relation to be in our empirical First, not all aligned expenditures are expenditures are not to revenues but rather they are toward the carbon emissions of a For example, the in an with from of Second, some expenditures might not produce revenues the same example, the might not be any but the expenditures are to to the empirical relation between aligned revenues and expenditures is likely to be than the relation if one to identify investments and revenues a the on a that has as a aligned revenues and as variables aligned expenditures. We all variables so the can be as of We control for industry to allow to be only from within industry We find that for 1% increase in capital and operating expenditures, revenues increase by However, capital and operating expenditures the of the relation with revenues across the two of expenditures. the relation with capital and operating expenditures we find a on the 1% increase in operating expenditures is associated with a increase in revenues while a 1% increase in capital expenditures The higher with operating expenditures is given that capital expenditures can be as an because they will to economic consistent with the of an in financial accounting models for the three sectors with the highest of we find that the on expenditures significantly across sectors. For example, in and a 1% increase in operating expenditures is associated with a increase in revenues. expenditures do not exhibit a significant with revenues. In contrast, in capital expenditures exhibit a significant with revenues. 1% increase in capital expenditures is associated with a increase in revenues. 1% increase in operating expenditures is associated with a increase in revenues. the significant variation in firm alignment with the taxonomy, we whether companies with higher alignment exhibit different business To the analysis we focus on two of the and We use and as our We use operating and on assets as our sustainable products higher or they for equal production we expect companies with higher alignment to exhibit In contrast, if demand for sustainable products is or if their production higher we expect companies with higher alignment to exhibit In some industries, the percentage of activities as sustainable is very for all In those industries, it would be rather for a part of a firm's activities to sales or operating to increase the of our we focus on a of industries there is at one firm with or aligned revenues. This our sample by a little more than and that the alignment metrics are not significantly associated with sales for industry and of We control for the given that it might be to more from of Moreover, the with profitability is This that firms that are products and services aligned with sustainable activities have not been at lower or higher that their and have been lower profitability ratios. For enabling and transitional metrics, we find a and significant correlation with sales and In we analyze enabling and transitional metrics and find that the is by enabling activities. Firms with more enabling from and and industries, are at a slower and a lower of on their assets. While activities are important in that they the of climate that can carbon emissions they do not carbon emissions Companies that in more enabling activities do not to be so for the investments they make in terms of profitability or sales In contrast, transitional activities are associated with sales in some of the the we analyze if firms with alignment with sustainable activities are at higher or lower valuation For example, if investors expect that alignment with sustainable activities might make a firm or that it a firm to business growth, these firms might at higher In contrast, if investors expect that these activities will not and that these firms are that will not be they might lower valuation to those For this we focus on two widely used valuation the value and the We control for industry of market sales growth, and in the of also for that firms with higher alignment exhibit no difference in valuation all of the on the Taxonomy variables is This is the for and In this we whether the new disclosures are by three data First, data from models that rely on business segment disclosures and their as sustainable or Second, environmental ratings provided by commercial Third, carbon metrics reported by existing data are to the activities of a company and their relative to the disclosure could be Bloomberg provides of the percentage of revenues for a company that might as eligible activities. This is as the of percentage within an eligible business segment disclosures and their assessment as sustainable activities or not are we would expect very difference between and reported percentage of eligible revenues. that this is from the are large with models eligible revenues across all industries. The of is most in Information Technology, Communication Services, Industrials, and but in Materials, and Consumer The models much better in Consumer and Real In the of and Consumer this is because a very percentage of revenues is eligible, while the is true for Real In we that business segment disclosures and their classification to sustainable activities would to large of eligible activities. the correlation between the Taxonomy financial data and data. we carbon emissions from and environmental ratings from and two widely used We all carbon data by firm revenues to that are across companies of different We expect that these data will be only moderately correlated with the Taxonomy financial but we are in understanding the of those We expect a relatively low correlation because it is that these data are for a revenues from sustainable activities or how much they in capital or operating expenditures. For example, a company might have very low carbon emissions in or from the use of the but a low amount of revenues from sustainable activities. a company might have a very environmental because it has a low exposure to environmental risks and a of but little in revenues or expenditures to sustainable activities. Nevertheless, there are to expect a For example, environmental ratings will firm investments in sustainable or the amount of revenues from In the absence of of need to be about the of a firm that might have lower emissions from use and end of might be more likely to have higher revenues from sustainable activities as products with these will be more likely to across industries and within industry industry all the the are and rather than industries. For environmental ratings, the correlation is in the and it to than for the industry The correlation with carbon metrics is higher but exhibits a correlation than and The highest are between emissions and operating expenditures in aligned, enabling and transitional activities we do not industry the and the on cross-sectional models that has as a the environmental from or and and taxonomy metrics as We use different ratings in our given have a in We use market as a control for the in ratings and control for industry in our We find a significant and on metrics but the in ratings. aligned metrics in our we only find a significant and the analysis that Taxonomy alignment data are not correlated with environmental ratings. In we a more analysis to the disclosure to and to help investors identify economic activities in with our environmental and climate we the correlation between environmental ratings and Taxonomy data for firms in industries climate change is the driver of the This includes industries, as and and construction and marine We the of the as companies might be high environmental ratings because of low exposure to climate risks rather than of them would to high insights from this First, there is almost a absence of companies that on the of the ratings, many of those firms have close to zero Taxonomy aligned, enabling and transitional revenues or expenditures. This is consistent with most firms the necessary in and and other to gain a of by and that those allow a firm to of the satisfying any of the technical and other criteria in the Taxonomy. Second, most firms in the of the in the These firms high ratings but have close to zero revenues or Strikingly, some firms close to perfect while having close to zero aligned revenues or expenditures. Third, a of firms in the having high ratings and higher of Taxonomy with more firms in this we use expenditures rather than revenues as the Taxonomy This reflects that ratings are more likely to be of climate rather than of climate products and services that allow customers to carbon In we find only correlation between Taxonomy financial data and existing environmental data. these with the from the we that the disclosure are to a revenues and investments in sustainable activities. We have data from more than large European companies on their first year of corporate disclosure of financial accounting data that whether their activities are sustainable or not based on technical criteria. We several based on the analysis of this First, our data that because of the technical criteria by the EU Taxonomy, only a percentage of business activities align with the taxonomy as in and This is consistent with the EU taxonomy a for a sustainable activity. However, we expect that the percentage of activities will as companies are their investments and products toward activities that align with the taxonomy. In other we expect that the we document in to Second, we significant differences in the percentage of activities that are aligned with the taxonomy across suggesting that some firms are much and more than to align their activities. However, we find little in that to alignment can into benefits in operating performance or market valuation at the time of the but do we find suggesting that firms that to align more with the taxonomy have at a so far. in the as and capital alignment with sustainable companies with higher alignment will their revenues higher profitability and at higher valuation An that this might be the would be the on investments in increasing suggesting that aligned investments at a higher to revenues. Third, we find little that existing data are correlated with alignment with carbon metrics and environmental ratings very We that carbon metrics a different from that of alignment metrics provide a of the carbon emissions in the value of a This in provides a of the contribution of the of a and the use of products to the of climate while at the same time a of exposure to risks from the transition to a low carbon economy as a of regulatory (i.e., carbon or and or market (i.e., to lower carbon products by In contrast, alignment metrics represent the extent to which an products and services can be as sustainable and investments are toward sustainable activities. the low correlation with environmental ratings, we expect that the increase in available data of EU activities will likely increase that correlation as will data into their In other we expect time the in the in to the This is for The in this are the of the are provided at the time of first are not for to any or in any or use would be to and are not an or to or sell or any The do not represent the of and