An ecological crisis that has been brewing for decades is intensifying. The answer? International regulations and changing demand in all markets. It seems to be a motion that knows only one direction. Those who want to turn this shift in values into an opportunity should act quickly and decisively.
Apart from a heart for beavers and sparrows, there are other good reasons for this. Those who do not respond will soon make themselves legally vulnerable – this is what the new EU taxonomy aims to ensure with pressure on both sides, for companies aswell as investors. What exactly is EU taxonomy, and how can it be defined?
The EU taxonomy is a key regulatory tool designed to significantly increase transparency on sustainable business practices. In this way, investment flows from the financial sector to sustainable companies are incentivized in order to fulfill the EU's obligations under the European Green Deal.
Between many acronyms such as ESG, EGD, NFRD and SFDR, one should see the outlines of an overall picture of the taxonomy cosmos, but no article in the research phase gave a complete overview of all the connections and moving parts. This article is intended to change that and give you, as a decision-maker in the construction industry, a bulletproof basic understanding of existing and upcoming regulations into which you can fit all the other pieces.
Before we get to the taxonomy itself, let's look at the full context: How did the need for this taxonomy emerge? Why have ESG and the Paris Climate Agreement not yet been enough to make our economy truly sustainable?
And what do digital twins have to do with this?
Imagine everyone sitting in the same boat....
... having the same goal. Everyone is doing their best to reach that goal – well, almost. A few Olympic athletes on steroids are actively rowing in the other direction.
Is this the story of lobbyism thwarting every effort toward a healthier environment? Not necessarily, it's not that simple. Lobbying doesn't have to be bad per se - policy makers can also be sincerely influenced in a positive way.
The catch in lobbying arises where, despite our knowledge of the ecological consequences of our actions, no regulatory objection comes when Canada's last virgin forests are sacrificed to the quarterly figures of backward corporations.1
It becomes critical when the concern instead is with the financial stability2 of forestry enterprises and verdicts3 are imposed against the right to protest for a livable future.
Meanwhile, in Germany, we see job losses in the solar industry5 and billions in environmentally harmful subsidies4. Excuse me? Yes, that's solar industry job losses. Yes, exactly, the most popular argument in opposition to resolute environmental legislation. Time for the solar lobby to turn their efforts up a notch?
If the wrong incentives are set, sustainable change is simply doesn't get attractive enough. No surprise, then, that even the implementation of international conference resolutions leave much to be desired.
Wrong signals and regulatory setbacks
Accounting takes care of environmental bores
What if even the budget for influencing political decision-makers does not produce the desired result, so that one day a piece of environmental legislation happens to affect your own business?
Then there's a budget to absorb penalties. Penalties thus do not become a reason to change corporate behaviour for the long term, but merely a bearable or even planned for expense6.
Accordingly, companies invest vast sums in enforcing a profitable status quo and finding legal loopholes, rather than leading sustainable change with sincerity and determination – counting on their lobby to outmanouver sincere regulators.
Recently, this destructive trend culminated in COP26 results disappointing so dramatically that reactions speak a clear language:
- Big Oil provided the largest7 delegation at the conference, larger than any individual country
- Activists leave8 the conference in protest against the final regulations
- First estimates expect a course toward 2.4°C9 after COP26 deal
- Indigenous people judge the outcome as death sentence10
Myopic corporate interest behind the results were too visible, the motives too insincere, the solutions too half-baked. The president of the conference apologized11 for the results and expected many delegations to be disappointed with the final wording12.
And not only COP26 delegations were disappointed: This article was once supposed to be published on the results of the conference. But in order to invite companies to stay one step ahead of upcoming regulations, I had to look elsewhere. The results from Glasgow simply did not allow that.
Setbacks on the way to sustainable construction specifically
In January 2021, just a few months before the world climate conference, Horst Seehofer blocked13 a regulation on debris recycling after 15 years of negotiations, after the federal council had already approved it with changes at the end of the previous year. This decision, which resulted from lobbying by the Bavarian construction industry14, could have long-ranging ecological consequences.
An announced subsidy for energy-efficient houses was spontaneously withdrawn at the beginning of 202215 and only the first wave of applications was approved. In the second attempt16, the budget for new construction was exhausted very quickly and only the renovation budget was left after just a few hours. A sign of strong demand or too tight a budget for sustainable trend-setting projects – or both?
Signals like this not only subsequently remove the basis for any planning security and financing for conscientious construction projects, but also erode confidence in the reliability of promised funding.
And yet no one, not even the Bavarian construction industry, should rely on the sluggish implementation of sustainable regulations to date and sit back.
Changes in trend emerge
Playing with a limited number of laps
Five decades have passed since the Club of Rome first sounded the alarm, with us almost17 cracking our global emissions problem in its early stages. Well, almost – it didn't work out that way.
Sustainability and environmental protection have clearly gained relevance and urgency since a photograph of our planet from space first made us awaken to it's beauty and fragility. The live view from space has an even stronger impact on the mind:
»You develop an instant global consciousness, a people orientation, an intense dissatisfaction with the state of the world, and a compulsion to do something about it. From out there on the moon, international politics look so petty. You want to grab a politician by the scruff of the neck and drag him a quarter of a million miles out and say, ‘Look at that, you son of a bitch.'«
- Edgar Mitchell, Apollo 14 astronaut, on looking back at Earth from space
Now, companies respond to a collective change in mind and values with varying degrees of sincerity. So it happens that in 2022, we have the same issues on the table that we had back then, only now tackled by a growing number of dedicated pioneers. At the same time, the communication around sustainability had become watered down, twisted and polluted by an endless loop of useless lip service – with no sincere intention to implement the promises.
We should ask ourselves: Do we really want to keep playing the game of self-sabotage until we find irreversible ecological tipping points from sheer negligence and ignorance? Or do we instead find sufficient integrity and intelligence within ourselves to take a smarter path?
The variant of lobbying that stubbornly places short-term revenue targets19 over long-term systemic health will only be able to prevail up to a certain level of visible ecological damage.
The discourse may be distorted, but when climate change is the number one issue and climate protection is not possible without a true circular economy20, circular principles can be anticipated as part of increasingly stringent environmental legislation21.
The construction sector as a focal point for regulators
If you are looking for the greatest lever for a sustainable transformation of the global economy, you will find it in the construction sector. With a triple gold medal in resource load, emissions, and waste production among all industries22, the construction sector quickly became the focus of international regulators.
A sustainable transformation of the construction sector towards a circular standard is one of the key objectives of the European Green Deal23 and market research companies estimate immense market opportunities24 for circular innovation in the building sector.
Companies, governments and regulators have long noticed where the journey is headed. Change is on the way, and even an inert system is slowly but surely starting to move.
The foundation for regulations emerges
Players across all disciplines and industries are already beginning to work devotedly on the vision of a healthier economy without political pressure. Ironic, because in the process they are creating the foundation for ... growing political pressure.
For example, the NGO GermanZero25 has developed a 1.5-degree-plan26 to make a tangible impact on policymakers. They explicitly highlight circular construction as a key solution for climate legislation.
The German Institute for Industry Standardization (DIN) has already formulated a series of standards on material efficiency27 and next door in Luxembourg, Product Circularity Data Sheets28 are being developed to enable users to make informed decisions under the flag of circularity.
Thus, as the transition to a general circular industry standard is being prepared, emerging material cadastres such as Madaster29 and Concular30 are laying the groundwork for a thrust of sustainable regulation in the construction sector.
Digital Twins: Simulation-enabled models mold a new playing field
All of these bit of data can be documented in digital twins and synchronized with other systems, which is why they are already increasingly being used in construction project planning. It is here where the idea of a circular construction sector becomes feasible, because the necessary digital infrastructure emerges to actually document buildings as material stores.
Digital twins can also be physically modeled31 and thus become able to simulate future scenarios. Important parameters for the simulation of real world conditions can be collected and turned into dynamic images of a complex world. This allows insights into local as well as global cause-and-effect principles, allowing us to find effective approaches for solving identified problems.
It is anticipated that as development progresses, the physical simulation capability of digital twins will produce a degree of validity and information value that will influence policy makers and regulators.
This is how digital twins would turn into a real threat to eco-sabotage lobbying: When nudged by a friendly allowance, it is not as easy to look the other way when a precise digital simulation shows the environmental effects of an open-cast mine, large-scale soil sealing or complete forest clearance. While we're on it, what if ecological follow-up costs could be calculated and decision-makers would actually be held responsible for their decisions?
»At the moment, profit is privatized and risk is socialized. That can't be right. Whoever has the profit must also have the risk.«
- Prof. Michael Braungart
Digital twins become ever more valuable the more they contribute to an open-source model of information and enable a democratization of our knowledge – think Wikipedia in 3D, only more trustworthy. Thus, they can be used as a rich source for informed policy decisions and as a jump-start for sustainable innovators.
Local, national and global movements
Many cities on their way to smart city status are working on digital twins, and cross-city projects are also in the works:
- Munich32 has completed its digital twin and is now putting the finishing touches to it
- For Amsterdam33, half of the city was mapped as a digital twin four years ago, and the Netherlands34 seem to lead the field overall
- A digital twin is being created for the whole of Germany35 and even one for the entire globe36
The aim is to create universal standards and synchronize digital twins with each other, take the Connected Urban Twins project37:
»In the project Connected Urban Twins - Urban Data Platforms and Digital Twins for Integrated Urban Development (CUT), Munich, together with Hamburg and Leipzig, is developing common standards for the development of digital twins for all municipalities and cities by 2025. At the end of March , more than 30 organizations met on their initiative to jointly develop a national DIN standard for digital twins.«
- From the article on Munich's digital twin38
We see that the necessary digital foundation for sustainable regulation is emerging. At the same time, the valuation of material information for investors is being restructured to meet the need for sustainable change.
Information for investors
Does it matter?
The concept of materiality is based on this question. In other words, it is not about the properties of sustainable materials, but whether non-financial yet material dimensions of a company are worthy of reporting.
In a nutshell, it's about everything beyond money. In order to be able to assess the viability of a company in the 21st century, its non-financial dimensions are increasingly transparent to investors.
What is non-financial information? Initially, it was information about outside-in risks: Industry trends and consumer signals.
Investors wanted to look beyond figures and not just assess the future on the basis of past quarterly figures. After all, knowledge about what trends are affecting the company can provide clarity around future performance and returns.
The topic of public health was probably the last big surprise that suddenly influenced the performance and sales of many companies - until 2019, few companies and investors were interested in it, then a steep change in trend39.
»… the recent developments following the global COVID emergency emphasized how quickly what appears financially immaterial today can become business-critical tomorrow.«
- From the Datamaran Double Materiality Report40
But for all its relevance, this perspective is only checking in with how the world affects the company. With double materiality, we now also look in the other direction.
Double Materiality now adds a second layer of non-financial reporting: Inside-out Risks. It is no longer only important how what happens in the world affects the company - but also how the company affects the world.
As a result, ecological damage from blind corporate action suddenly become relevant for investors and, against the backdrop of a growing collective change of mind towards sustainability, increasingly unattractive.
It's the quest to recognize the full context of the company in this world, without blind spots and nasty surprises. The era of »privatize profit, socialize risk« is ending ... maybe.
Because only if applied correctly we will regain our sense of accountability that has been lost through too narrow a focus on short-term profit maximization.
What is sustainable?
Sustainability can be defined in many different ways - for example, by:
- Generally rather weak exclusion criteria (What is not sustainable? Then everything else must be sustainable)
- Significantly stronger best-in-class approaches (the most sustainable product or company in an area is declared the benchmark of sustainability)
- Or much more differentiated assessments of sustainability, such as a dedicated eco-accounting like the Integrated Life Cycle Sustainability Assessment41 (ILCSA)
Reading between the lines, the message is not a new one: Sustainability plastered on a label doesn't mean there's suatainability inside – and Double Materiality is no exception.
What is declared material information for investors is subject to the official standard of the U.S. Securities and Exchange Commission (SEC) as to whether »a reasonable person would consider the information important.«
Quite obviously, there is room for maneuver in this interpretation. Depending on how sincerely the principle of the »reasonable man« is implemented, we now have two possibilities42:
- Environmental damage is only used as a basis for calculating retroactive financial risks for the company, for example through penalties and loss of image. This is the weak interpretation of double materiality – a sure sign that we have learned nothing and still believe that we can eat our money in the end.
- We actually take a »reasonable person« as orientation – someone sincerely concerned about creating a future worth living for our children. In this strong interpretation of dual materiality, an attempt is made to grasp the overall context of a company in the world, to actually make all material information transparent, and thus to enable sincerely sustainable decisions.
This decision is of existential importance: Which approach will underlie the sustainability assessments of the future? Doing only what is necessary for a green image or actually understanding the signs of the times?
In order to provide a legal framework for true sustainability, the new EU taxonomy is being written as a key reference for both companies and investors to resolve such uncertainties and inconsistencies in the interpretation of sustainability.
Will it succeed?
An overview of the new EU taxonomy
The path from an initial idea to binding legislations
Since the first mention of Environmental, Social & Governance in 2004(43), ESG criteria have evolved from an idea into a framework that increasingly influences international regulation and high-dollar investments.
There are just a few stumbling blocks: The current ESG criteria represent a general push toward progressive business practice with limited consistency that is difficult to measure and ultimately does not provide enough predictability for companies and investors to conclusively depend on.
»Creating ESG metrics, tracking dashboards and demonstrating progress will not be straightforward and presents the biggest barrier for most firms.
Like culture, ESG is difficult to measure, so it’s hard to define what 'good' looks like or set tangible goals. This is becoming a real problem, particularly for listed companies and the financial sector, where investors need assurance over products. Greenwashing is concerning, and mis-selling could result in legal action, reducing trust in the market and investment in ESG projects.«
- From an article44 by Sonia Shah for Grant Thornton
In addition, ESG criteria compare companies in an industry with each other, it is a relative model of valuation. The most recent peculiar result of this model was that Tesla Inc. did not meet ESG criteria while ExxonMobile received a nod45.
Blind faith is not a good attitude when Microsoft46, accompanied by other monopolistic tech giants47, occupies the top ranks and questions about the auditors' impartiality could arise.
»… the more information a company discloses about its ESG practices, the more rating agencies disagree on how well that company is performing along these dimensions. According to the research, a 10 percent increase in corporate disclosure is associated with a 1.3 to 2 percent increase in ESG score variation among major ratings providers, which all interpret and process disclosures differently.«
- From a Harvard Business School article48
Can we blindly rely on ambiguous ESG criteria49 that, possibly with the blessing of bought rating agencies, only invite to smug box-checking without a reality backlayer of dedicated action? How exactly is that supposed to generate true change?
Is it here where the possibility comes up that the results are not only not sustainable, but even actively harmful50 through the deceptive assurance that progress is being made.
A taxonomy to meet the European Green Deal
Should we want to generate sufficient regulatory pressure to reach the goals set by the European Green Deal (EGD), we need to come up with something better than the ESG framework.
After all, the EGD is intended to provide hundreds of billions of euros for the climate neutrality of the European continent by 2050 and, before that, to achieve the milestone of a 55 percent reduction in emissions by 2030.
Therefore, the new EU taxonomy51 concretizes what was started with the ESG criteria: A central and standardized reference for both companies and investors as to which economic activities are sustainable.
You have doubts about the spotless purity of this good piece of news? Rightly so, but more on that later. Nevertheless, investors are assessing the fitness of their options to meet the following key objectives of the EU taxonomy:
- Prevention of climate change (mitigation)
- Adaptation to climate change (adaptation)
- Sustainable use and protection of water and marine resources
- The transition to a true circular economy
- Pollution prevention and control
- Protection and restoration of biodiversity and ecosystems
While regulations around the first two items will already be in force from January 202252 the rest of the regulations will become fully legally effective as of January 2023.
Sustainability is to be given an unambiguous definitional framework to, by the necessary measurability and calculability, finally ensure that both entrepreneurial efforts and investors' money are finally flowing in the right direction.
How so? By setting clear standards for reporting.
NFRD, CSRD, SFDR: Pardon?
Not the result of the latest Scrabble match at the Kleinbernsbach retirement home, but ever more legally binding reporting standards for companies that will provide a future for our children if implemented with sincerity.
These standards are separate regulatory works and have already been defined before and outside the taxonomy framework. They are mentioned here because they will significantly influence the final version of the Taxonomy Regulation and foreshadow its architecture.
On the corporate side, the NFRD or Non-financial Reporting Directive forces companies to expand the scope of their reporting to include non-financial information in accordance with the principle of double materiality and to subordinate it to certain standards.
Started as a voluntary initiative, the NFRD has been a legally effective standard since 2018, currently requiring over 11,000 companies to be transparent about selected non-financial information around the company.
»The NFR Directive is a leading example of how the landscape has changed – and continues to change. The evolution of accountability shows us it is only a matter of time before prominent voluntary initiatives will become mandatory regulations, as such being ahead of the curve will help business mitigate any backlash. Companies of much smaller size are impacted by the NFR Directive too. Business who fails to take note of the change are leaving themselves exposed.«
- From a Datamaran article on non-financial reporting53
On the investor side, the SFDR or Sustainable Finance Disclosure Regulation ensures that investors not only receive a handout for more transparency of corporate data, but their hand is also guided in the direction of sustainability in regulatory terms: It also requires players in financial markets to disclose the extent to which they incorporate sustainability into their portfolio strategy.
So both the corporate side and the investor side have been considered to point money flows in the right direction – and there was more to be done at the corporate level.
Corporate Sustainability Reporting Directive: NFRD 2.0
As the scope of the NFRD was not sufficient to cover all relevant companies, the CSRD or Corporate Sustainability Reporting Directive will come into force as an extension of the NFRD from the first of January 2024 - with a retroactive reporting requirement for 2023. This reporting directive now covers almost 50,000 companies and refines the reporting standard.
There are proposals for another step that will again increase legislative reach, increase the number of affected companies and capture their reporting in an even more granular way.
An old investor rule of thumb says that including non-financial and sustainability criteria in investment decisions has a negative effect on returns. That certainly says a lot about how we got here in the first place.
This could soon come to an end: The increasing consideration of consequential ecological damages will lead to a complete re-evaluation of investment returns. Should we manage to make the best investments for our economy and the preservation of the environment also the investments with the highest returns?
This is a question of interpretation: How serious are we about the criteria we apply?
Still a long way to go
Disappointment, irritation and anger spread when both nuclear power and natural gas were judged to be bridging technologies, and thus sustainable, in the taxonomy's preliminary regulations.
Although there was early headwind54 in the EU Parliament, which was strengthened in a preliminary vote55, the final vote gave in56 to an assessment natural gas and nuclear power as sustainable. It looks like eco-sabotage lobbying has won another battle for now – bridging technologies these may be, but that's still a long shot from being truly sustainable.
This breaks the narrative of the stringent regulatory tool that is supposed to be a fortification of environmental legislation. Instead, these assessments lead to some paragraphs of the taxonomy flying even below previous standards that had previously assessed these technologies as unsustainable, and rightly so.
The EU Commission unfortunately did not even stop at classifying the all too sustainable sounding bioenergy as, well, sustainable:
»However, according to the European office of the World Wildlife Fund (WWF), it is 'disastrous news for the climate and biodiversity' that industrial logging and burning trees for energy are classified as sustainable investments. The WWF accused the EU Commission of greenwashing the financial sector. With this decision on bioenergy, which bears the signature of the forest-rich EU countries Sweden and Finland, 'the science-based taxonomy becomes a lobby-based taxonomy'.«
- From an article57 of the EU Environment Office
Alright, converting functioning ecosystems into wood pellets and burning them at an abysmal efficiency rate to generate electricity is judged to be sustainable. This brings up a certain question: Really?
What else has to happen before we are ready for sincere environmental action and make lobbying of this kind impossible? When the last old-growth forests – simply irreplaceable by planting a few new trees – have fallen?
Let's hope that we will see the EU taxonomy grow up.
Hardly feasible without lean digital systems
In a survey58 among companies and their stakeholders about the NFRD, active users of non-financial information did not consider it comparable (84%), reliable (74%) or relevant (70%) enough.59
For small and midsize companies, 74% of respondents support simpler reporting standards, while 67% agreed to stricter audit conditions.
What does this mean in practice? A large number of interviewed stakeholders felt that tagging systems for machine readability, clear standardization of reporting and facilitated accessibility through central archives will greatly facilitate the enforcement of such regulatory works:
»Many respondents saw digitalisation as a game changer that would enable corporate reporting policy to improve analysis, comparability and decision-making, and fundamentally change the way business is conducted, with benefits for all. By contrast, failure to digitalise would lead to real world inefficiencies that could hamper or jeopardise the entire non-financial reporting effort.«
- From a briefing document60 of the European Parliament on the NFRD
If we get it right, clear standards within digital systems could soon bring order to the current regulatory chaos and refine the sustainability reporting of the future. Until then, it is the fear of misplacing money that creates a willingness to think ahead on our own.
For fear of stranded assets, things are suddenly moving forward
Uncertainty about the exact final provisions of the taxonomy makes investors prefer to look closely and think ahead rather than end up with a stranded asset - that is, an investment that »strands« without a return of investment.
Since long-term investments quite often flow into the real estate market, there is a direct spillover effect toward the construction sector.
»The construction and real estate industries in particular will be looked at particularly closely by lenders because of their long-term impact investments.«
- From a guide61 for the construction and real estate industry on the EU taxonomy
In a Tagesspiegel survey62 many participants expect a drop in market valuation for unecological buildings. In the future, the ability to finance real estate projects will increasingly depend on their sustainability.
The anticipation of stricter rules seems to be the element that now makes sustainable change attractive even to those who otherwise prefer to think between revenue numbers and investment returns.
Sustainability is evolving from idealism to business acumen.
Even if some companies and investors will do the right thing for the wrong reasons, it is still a departure in the right direction: How much long-term-thinking can we bring into our economics, how ecologically sound can we build?
We see an economic motivation for true foresight, anticipating upcoming regulations and staying one step ahead of them, rather than being rudely shoves again and again with each new paragraph only to eventually trip.
Summary and outlook
An era ends
We are seeing the end of years of setting political goals and then doing nothing to meet them. They are transitioning into a paradigm of urgent collective attention to the preservation of our habitat.
Between the work of sustainable pioneers and ever-increasing environmental pressures, policymakers are feeling compelled to finally use cash flows as a regulator.
Sure, there are setbacks – but let's take a bird's eye view on the macro trends: Ecological damage is becoming more visible, regulators more attentive and sincere sustainability increasingly rewarded.
These trends will only grow. We have every reason to dedicate our actions to a necessary transformation toward a healthy economy – if we fail to do so, we will lose a lot, if not everything.
Aggressive eco-sabotage lobbying is increasingly having it's game spoiled. That's a good deal for the lobbyists themselves, even if they don't know it yet: It would probably be a brief and bittersweet joy to be the market leader in a dying world.
The signs of the times are unmistakable
In this article alone, what signals heralded a systemic shift toward a circular economy paradigm?
- Regulators explicitly focus on the construction sector
- Tangible legislative proposals are developed outside of politics (GermanZero)
- Circular industry standards are being defined (DIN)
- Material cadastres and material passports emerge (Madaster & Concular)
- We see growing pressure to innovate due to digital systems
- Digital twins in particular are growing up and starting to collaborate
- Sustainability criteria become more concrete with the new EU taxonomy
- Investors feel massive pressure to avoid stranded assets
These points join a general trend of once voluntary sustainability reporting initiatives suddenly becoming applicable law. In every single point, there are direct consequences or at least indirect implications for the construction sector.
When the entire value chain is being critically reassessed, suppliers will increasingly have to prove their sustainability. Regional building materials with low amounts of gray energy will be preferred. The classification of building materials will change and their cyclability will become increasingly important.
Quality in construction and use of space will become more important than the quantity of construction projects. Efficiency standards in water, light and heat will change.
It is up to each of us to ask ourselves a question:
What kind of impact will these innovations, movements, and trends have on cumulative innovation and maturing regulations over the next decade?
And how will an increasing precision of digital twin simulations affect an EU taxonomy 2.0 and beyond?
Being shoved by regulators or leading the charge?
At this point, it's a case of wait and see ... or perhaps a case of charging ahead?
In the automotive industry, Tesla has chosen to lead – even if that is not currently reflected by their ESG score. Volkswagen, on the other hand, is being pushed. Which position in the market do you want to take?
This is about company self-image, about having a spine and an upright posture:
To be shoved or to lead?
Victim, saboteur or rather role model?
Fifty years ago, a first door was open, and since then there have been other opportunities to find brakes and steering wheel on our sliding ride into ecocollapse.
Now another door is opening: A circular economy that promises unimagined regeneration potential for our planet and awakening regulators, seeking to install ever more guardrails for backward companies.
The story has been about more than quarterly figures for a while now. Let's see the open door this time, walk through it, and finally be sincere about giving our children some air to breathe, literally.