In anticipation of the EU social taxonomy

For several years now, experts have predicted an upswing in the somewhat neglected social aspect of ESG. Nevertheless, environmental and governance issues continue to dominate the agenda of most sustainable investors. As we have written before, there are many logical explanations as to why investors have been slower to embrace the ‘S’ in ESG. Above all, it is because social aspects are proving particularly challenging to define and measure. Issues related to human rights, well-being or a sustainable society are often perceived as important but somewhat diffuse externalities and uncertainty remain about what constitutes a social investment. In order to direct capital to socially valuable activities, it is therefore important to have clear and rigorous definitions.

A first step towards clarity

One ambitious attempt to address this lack of clarity is the EU’s planned social taxonomy. Using the same approach as the EU taxonomy for sustainable finance, the idea is to use the social taxonomy to guide capital flows towards activities that respect human rights and investments that improve people’s living and working conditions. Just as the environmental taxonomy aims to give investors guidance on which activities are environmentally sustainable, the social taxonomy will do the same for social activities.

However, work on this important piece of the EU’s sustainable finance plan has stalled recently. It has already been a year since the Platform on Sustainable Finance submitted its final proposal on social taxonomy to the European Commission. In its report, the Expert Advisory Board had made an effort to capture the extensive feedback on the initial July 2021 version received during the public consultation. Unfortunately, the experts’ solid analysis and thorough proposals have not succeeded in speeding up the process, rather the opposite. To date, the European Commission has not announced whether and how it intends to proceed with a social taxonomy.

Although the European social sustainability framework is still under development and the current proposal is on hold, it may be worthwhile for investors to familiarize themselves with the proposed social taxonomy and its principles. The details set out in the Expert Council’s report provide a useful insight into what a future regulatory framework might look like and thus the opportunity to get ahead of future social reporting requirements.

What does the proposal mean?

An advantage for sustainable investors who are already familiar with the structure and vocabulary of the environmental taxonomy is that a social taxonomy will look familiar to them. The proposed framework clearly defines a number of social objectives, types of substantial contributions, ‘do no significant harm’ (DNSH) criteria and minimum safeguards.

Although the similarities between the green taxonomy and the intended social extension are high, one should be aware of the structural differences between them. Environmental objectives and criteria are usually based on natural science, while a social taxonomy is based on the relevant international authoritative standards, such as the Convention on Human Rights. Another feature to keep in mind is that most economic activities are fundamentally beneficial to society, by creating jobs, contributing to tax revenues and producing goods and services that benefit the public. It is therefore important when creating a social taxonomy to distinguish between such inherent positive attributes and the specific social activities that should be rewarded by investors.

The Sustainable Finance Platform identifies three key groups of stakeholders that an economic activity can impact: employees, consumers, and the community in which it operates. The proposed structure of the social taxonomy is thus based on three objectives that clearly address each of these three groups. The objectives they have formulated are as follows:

  • The business should provide decent work for employees in the company and along the value chain. Sub-objectives include strengthening social dialogue and promoting collective bargaining;
  • Operations should contribute to a decent standard of living for consumers. This can be achieved through increased product safety, quality health care, affordable housing, etc;
  • Activities should strive for inclusive and sustainable societies in relation to affected groups. This refers to sub-goals such as equity, inclusive growth and sustainable livelihoods.

The experts have also worked to clarify what can be considered a “significant contribution” in this context. They point out that in order to claim that a business activity makes a significant contribution to promoting social objectives, what is achieved should be available and easily accessible. The activity’s outcome must also meet the acceptance of the community and must be of high quality following the important DNSH principle of not causing significant harm.

Will the EU reach its goal?

Many financial actors are keen to see a social taxonomy in place. They argue that a well-designed framework would support the growing demand for socially oriented investments by providing a coherent concept for measuring social sustainability and discouraging social washing. It would also promote fair competition and increase the visibility of companies and organizations contributing to social sustainability.

However, there are also critical voices. There are concerns that a new framework would impose an excessive administrative burden. Skeptics also cite the lack of data on social issues as a major obstacle to implementing the proposed framework. Hopefully, the EU’s Corporate Sustainability Reporting Directive (CSRD) will improve the availability of sustainability data, including social data.

It may be some time before we have a social taxonomy in place. However, thinking about the social aspects of ESG and trying to develop a coherent framework to address them is not something that investors should delay. The work done by the architects of the EU taxonomy project may be an appropriate starting point.

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