Guidance and regulation – Europe

Read: MacFarlanes – EU Taxonomy Regulation Overview

Key points:

• The taxonomy establishes the terminology and toolkit for assessing whether economic activities are considered sustainable
• The aim is to enable investors to more effectively compare ‘environmentally sustainable’ funds, and reduce greenwashing
• A fund is deemed ‘environmentally sustainable’ if the portfolio meets four conditions:
  • ‘contributes sustainably’ to one of more environmental objectives, or enables other activities to make a sustainable contribution
  • Does not ‘significantly harm’ (DNSH) any of the environmental objectives
  • Is invested in compliance with the Taxonomy regulation minimum safeguards
  • Complies with technical screening criteria established by the Commission (when published)
• Environmental objectives:
  • Climate change mitigation
  • Climate change adaptation
  • Sustainable use and protection of water and marine resources
  • Transition to a circular economy
  • Pollution prevention and control
  • Protection and restoration of biodiversity and ecosystems
• Financial products that have sustainable objectives (Article 9 products) are required from Jan 2022 to disclose:
  • Information on the environmental characteristics to which the underlying investments contribute
  • A description of how/ to what extent the underlying investments are made in economic activities that qualify as ‘environmentally sustainable’
  • What proportion of investments are ‘environmentally sustainable’

Read: MacFarlanes – EU Disclosure Regulation Overview

Key points:

• SFDR requires firms to make strategic business and policy decisions regarding their approach to ESG which must be disclosed on the firm’s website and in pre-contractual and periodic disclosure
• Focus of the regulation is on the provisions of information to investors (asset managers), clients (asset owners) and other stakeholders
• In order to meet the disclosure requirements, many firms are likely to require significant system and control changes, as well as significant allocation of resources
• The disclosure applies at the firm and all product level, not just those with an ESG focus
• Given the uncertainty around how EU legislation may be on-shored in the UK following at the end of the Brexit transition period – UK based firms can either take a ‘wait and see’ approach or voluntarily adopt the regulation
• UK firms who market to EU investors, as well as those with EU funds or mandates, will have to comply with the regulation
• The majority of legislation that relates to the firm came into effect in March 2021, with the second stage set to be implemented in December 2022 that relates to product level disclosures on principal adverse impacts

Read: Simmons & Simmons – Top ten things asset managers need to know about the level 2 proposals under the SFDR pages 2-8

Key points:

• Currently still in draft form, the RTS proposes the detail on the disclosure requirements that were first laid out under Level 1 of SFDR.
• The details are significantly more onerous than had been expected by the industry and would represent a very significant undertaking for in-scope firms.
• The UK Government has indicated that the finalised RTS will not be automatically on-shored into UK law, but has provided no indication whether the UK Level 2 provisions may diverge or will be an effective copy-out.
• The SFDR, and the RTS, applies to the defined concept of financial market participant, or FMP. The definition of FMP includes:
  • MiFID firms providing the service of portfolio management
  • AIFMs
  • UCITS managers
  • A sub-set of rules also apply to financial advisers
• The draft RTS sets out granular specifications for the content, methodology and presentation of certain disclosures, covering:
  • Entity-level ‘adverse impact’ website disclosures – details of the asset manager’s policy for assessing the adverse impacts of its investment decisions/recommendations on sustainability factors
  • Product-level disclosure for ESG focussed products – pre-contractual, website and periodic disclosures relating to Article 8 and Article 9 products
• SFDR Article 4 required asset managers with over 500 employees to include a statement on their website communicating their policies for monitoring the adverse impacts of their investment decision on sustainability factors
• The draft RTS proposes that this description includes a KPI grid comprising up to 50 separate quantitative disclosures on complex ESG metrics (see note appendix for full detail)
  • Managers will be required to disclose on:
    • All 32 mandatory metrics
    • At least 1 indicator on adverse climate/ environmental impacts
    • At least one metric on social/ employee/ human rights/ anti-corruption/ anti-bribery impacts
    • Any other impacts qualifying as principle (no guidance has been given yet as to how to define whether an impact qualifies as ‘principle’)
• The purpose of the quantitative disclosure is to provide a comparable measure of the adverse impacts of a given asset manager’s investments
• Managers are likely to face significant challenges to collect the data needed to meet the required disclosures. The RTS suggests methods such as:
  • Direct engagement with investee companies
  • Internal financial analysis
  • External market research providers
  • Specifically commissioned studies
  • Publicly available information
  • Shared information from peer networks or collaborative initiatives
• The narrative/ qualitative disclosure required within the adverse sustainability impacts statement include:
  • Description of policies to identify and prioritise principal adverse sustainability impacts
  • Description of actions to address principal adverse sustainability impacts
  • Description of engagement policies and their efficacy
  • Reference to adherence of international standards
  • As well as an overarching narrative summary of the qualitative and quantitative disclosures
• The main aim of product specific pre-contractual disclosures is to prevent greenwashing by providing information on the characteristics of the product that will not mislead investors
• The draft RTS suggests that information will be disclosed using mandatory templates
• The draft RTS provides more detail to supplement the SFDR requirement for managers of Article 9 or 8 products to publish and maintain sustainability disclosure information on their website – these are less prescriptive than the requirements for pre-contractual and periodic disclosures as there are no required templates
• The focus of periodic disclosures is on the success of a product in attaining its environmental/ social characteristics or sustainable investment objective. The draft RTS introduces the requirement to use a mandatory reporting template

Read: Norton Rose Fulbright –European Commission adopts legislative and regulatory package on sustainable finance

Key points:

In April 2021 the European Commission published a number of legislative and regulatory initiatives with the Sustainable Finance Action Plan (2018), including:

• A Delegated Regulation under Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment (Taxonomy Regulation) establishing the technical screening criteria for economic activities qualifying as contributing substantially to climate change mitigation or climate change adaptation;
• A proposal for a Corporate Sustainability Reporting Directive (CSRD);
• Six amending Delegated Acts incorporating sustainability issues and considerations into the EU financial services regulatory framework

Delegated Regulation laying down technical screening criteria for economic activities qualifying as contributing substantially to climate change mitigation or climate change adaptation

• The EU Taxonomy Climate Delegated Act sets out the technical screening criteria for the first two environmental objectives –  climate change mitigation and climate change adaptation – as well as the application of the ‘do no significant harm’ (DNSH) criteria
• The Climate Delegated Act contains the technical screening criteria setting out the conditions under which a wide range of economic activities qualify as contributing substantially to climate change mitigation or climate change adaptation, and for determining whether those economic activities do no significant harm to one or more of the other environmental objectives

Proposal for a Corporate Sustainability Reporting Directive (CSRD)

• Amends the existing reporting requirements under the Non-Financial Reporting Directive
• Scope is expanded to include large listed and non-listed companies and listed Small and Medium-Sized Enterprises, and will require an audit (assurance) of reported sustainability information
• New rules will introduce more detailed non-financial reporting requirements as well as a requirement to report according to mandatory EU sustainability reporting standards
• The proposal includes an obligation for companies to digitally ‘tag’ the reported information to make it machine-readable

Delegated Acts incorporating sustainability issues and considerations into the EU financial services regulatory framework

• Level 2 measures seek to incorporate sustainability issues and considerations into the EU financial services regulatory framework, including the UCITS Directive, the Alternative Investment Fund Managers Directive (AIFMD), MiFID II, the Solvency II Directive, and the Insurance Distribution Directive (IDD).
• The delegated acts also aim to clarify a number of implications resulting from SFDR
• Overview of the proposed requirements:
  • MIFID 2 Product governance:
    • the delegated act introduces a new definition of sustainability preferences – referring to a client’s or potential client’s choice as to whether a financial instrument that has as its objective sustainable investments, or a financial instrument that promotes environmental or social characteristics as defined in the SFDR should be integrated into their investment strategy
    • Investment firms will be obligated to consider client preferences for sustainable products as part of their client’s needs, characteristics and objective as well as whether the relevant product or instrument’s characteristics are in line with the target market, and continues to be so
  • MIFID 2 organisational requirements:
    • Introduces the definitions of “sustainability preferences”, “sustainability risks” and “sustainability factors”
    • Investment firms will be required to consider sustainability risks when establishing, implementing and maintaining risk management procedures which identify the risks relating to the firm’s activities, processes and systems
    • Three categories of financial instruments are integral to sustainability preferences:
      1. Financial instruments that pursue a minimum proportion of sustainable investments in economic activities that qualify as environmentally sustainable under Article 3 of the Taxonomy Regulation;
      2. Financial instruments that pursue a minimum proportion of sustainable investments, as defined in Article 2, point (17), of the SFDR, where the minimum proportion is determined by the client or potential client; and
      3. Financial instruments that consider principal adverse impacts on sustainability factors, where elements demonstrate that consideration are determined by the client or potential client
• UCITS and AIFMD
  • Management companies and alternative investment fund managers (AIFMs) will be required to consider sustainability risks when complying with the organisational requirements and retain the necessary resources and expertise for the effective integration of sustainability risks. In addition, senior management of the management company or AIFM will be responsible for the integration of sustainability risks, and conflicts of interest will need to include those that may arise as a result of sustainability risks.
  • Due diligence requirements would also need to include the consideration of sustainability risks

Read: Task Force on Climate-related Financial Disclosures Overview pages 4-10

Key points:

• The potential financial implications of climate change include:
  • Natural disasters can lead to financial losses (eg infrastructure, cost of rebuilding etc)
  • Long-term shifts in the environment and weather patterns could impact the global financial markets
  • The process of transitioning to a low-carbon economy can lead to a reduction in the value of certain assets
  • Climate related risk can impact credit spreads, influence saving patterns and cause rapid price adjustments

• Climate-related financial risk is non-diversifiable and has the potential to impact company:
  • Revenues
  • Expenditure
  • Assets & liabilities
  • Capital & financing
• TCFD was developed by the Financial Stability Board to come up with recommendations for more efficient climate-related disclosures that:
  • Could “promote more informed investment, credit, and insurance underwriting decisions”; and
  • “enable stakeholders to better understand the concentrations of carbon-related assets in the financial sector and the financial system’s exposures to climate-related risks.”
• Asset owners and managers at the top of the investment chain have an important role to play in influencing the organisations in which they invest to provide better climate-related financial disclosures
• Leaders in the public sector also recognise the importance of transparency on climate-related issues within financial markets
• The Task Force identified several categories of climate-related risks and opportunities:
• Risks
  • Transition:
    • Policy & legal
    • Technology
    • Market
    • Reputation
  • Physical:
    • Acute
    • Chronic
• Opportunities:
  • Resource efficiency
  • Energy source
  • Products & services
  • Markets
  • Resilience
• The Task Forces’ recommendations are structured around four thematic areas representing core elements of how organisations operate:
  • Governance – Disclose the organisation’s governance around climate-related risks and opportunities.
  • Strategy – Disclose the actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy and financial planning where such information is material.
  • Risk management – Disclose how the organisation identifies, assesses, and manages climate-related risks.
  • Metrics & targets – Disclose the metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material.

Read: European Securities and Markets Authority- Sustainable Finance Implementation timeline for SFDR, TR, CSRD, MiFID, IDD< UCITS, AIFMD

The graphic shows the timelines for the implementation of sustainability regulation from the EU.