In this second blogpost of the series on the rules of sustainable finance, we analyse the content of the EU’s recently adopted new rules. Of the various EU measures aimed at integrating sustainability into the financial system, the Sustainable Finance Disclosure Regulation (SFDR) and the Taxonomy Regulation have arguably made the most headlines in recent months. Collectively, the two regulations are designed to assist end-investors to make informed investment decisions, improve industry-wide comparability and prevent greenwashing. The majority of the SFDR’s disclosure obligations came into application on 10 March 2021 while detailed Level 2 measures and certain provisions under the Taxonomy Regulation will begin to apply from January 2022.
The Sustainable Finance Disclosure Regulation (Regulation (EU) 2019/2088)
Broadly speaking, the SFDR requires “financial market participants” (FMPs), including credit institutions (i.e. banks) and investment firms (e.g. securities dealers), to disclose for the first time information on the integration of “sustainability risks” into the investment process (1) and on the outward sustainability impact of investments (2). The scope of the SFDR captures not only EU FMPs but also non-EU FMPs that offer and market financial products in the EU. The requirements consist of both entity (e.g. asset manager)-level and product (e.g. fund or portfolio)-level disclosures. These must be made variously on the FMPs website, in pre-contractual information (e.g. in a product prospectus) and periodically (e.g. in annual reports).
Under the SFDR, sustainability risks (1) are defined as “an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment”. While certain disclosure requirements on the integration of sustainability risks apply to all FMPs and products, requirements regarding the sustainability impact of investments (referred to as “principal adverse impacts”) (2), apply on a “comply or explain” basis unless the FMP exceeds a 500 employee size test. Where a FMP or product does consider principal adverse impacts, it must by January 2022 follow a mandatory reporting template and set of indicators developed by the European Supervisory Authorities (ESAs) for both climate and environment-related adverse impacts and adverse impacts relating to social and employee matters, respect for human rights, anti-corruption and anti-bribery matters.
Financial products that promote environmental and/or social characteristics (so-called article 8 products) or have sustainable investment or a reduction in carbon emissions as their objective (article 9 products) are subject to additional disclosure requirements to explain such characteristics and objectives, and how these are to be attained and assessed. Where the product promotes environmental characteristics (so-called light green products) or invests in economic activity that contributes to an environmental objective (dark green products), the disclosures will soon also need to include information mandated by the Taxonomy Regulation. These additional disclosures lie at the very core of the regulatory objective to combat greenwashing and aim to assist investors with comparing products on the basis of their degree of sustainability.
The Taxonomy Regulation (Regulation (EU) 2020/852)
The development of a taxonomy for climate change and environmentally and socially sustainable activities was a central aspect of the EU’s 2018 Action Plan on Sustainable Finance. The Taxonomy Regulation establishes an EU-wide common classification system (taxonomy) intended to enable companies and investors to identify whether an economic activity may be considered “environmentally sustainable”.
In order to be environmentally sustainable, an economic activity must substantially contribute to one or more of 6 environmental objectives while not significantly harming any of the others. It must also meet minimum social safeguards and comply with certain technical screening criteria established through delegated acts.
The first set of technical screening criteria covering the first two environmental objectives (climate change mitigation and adaptation) was adopted under the EU Taxonomy Climate Delegated Act as part of the European Commission’s Sustainable Finance Package published on 21 April 2021. In March 2021, a leaked Commission proposal denoting some natural gas power plants as “sustainable” under certain conditions revealed the influence of politics and gas lobbying groups. The leak led to wide-spread criticism of opposition groups including threats by advisory experts to step down. The final Delegated Act published on 21 April no longer includes gas nor nuclear energy (being equally contentious) but notes that these (as well as agriculture) will be covered in a future, complementary Delegated Act.
Notably, the Taxonomy Regulation is a living document intended to be supplemented and amended over time. As confirmed in a Commission communication in April 2021, the taxonomy does not currently define how activities other than green ones are to be treated (e.g. transition activities) nor does it define or categorize any activity as “environmentally unsustainable”. Moreover, while the SFDR considers broader sustainability factors (including social objectives), the Taxonomy Regulation currently addresses only environmental sustainability. However, the EU Commission is required to assess by end-2021 whether and how the Taxonomy Regulation could be extended to cover other sustainability objectives, such as social objectives.
Points for consideration
The EU SFDR and Taxonomy Regulation arguably go further than any existing regulation globally to combat greenwashing and assist end-investors in identifying sustainable investments.
Nonetheless, a number of concerns and outstanding uncertainties remain to be addressed. In particular, FMPs subject to the SFDR requirements are still awaiting fundamental clarifications on scope and product classification questions. FMPs have also expressed concern over having to disclose information that is currently not available from, or required to be provided by, investee companies. While the latter will be addressed, at least partially, by the Corporate Sustainability Reporting Directive (referred to in Part 1 of this blog series), as it stands, neither the timings nor concepts of these various pieces of legislation are fully synchronized or aligned with each other.
It should also be noted that neither the SFDR nor the Taxonomy Regulation incorporate any direct sanctions for non-compliance. While the Taxonomy Regulation calls on EU Member States to lay down measures and penalties for non-compliance with disclosure requirements set out in that regulation, the supervision and enforcement of compliance under both regulations rest in the hands of local EU regulators, who have provided limited comment on their expected approach. Akin to the costs of compliance, the costs of non-compliance with the new regulations thus remain rather unpredictable at present. In addition, the efficacy of the new measures was further called into question by admissions of ESA representatives, during a public event of 29 April 2021, that green investment funds may not face any sanctions for missing their environmental targets disclosed under the regulations.
It thus remains to be seen whether the outstanding uncertainties and concerns surrounding these new measures will be ironed out by EU legislative and executive bodies over the coming months, and whether they will achieve their core aims under the EU’s Action Plan.
Next up: Part 3 – The UK