Sustainability

ESG Policy and Regulation Round up: April 2022

Providing a comprehensive ESG* Policy and Regulation update to help those in sustainable finance get ahead of the latest directives shaping the market.

Table of contents

Recent key policy developments in the EU and UK and implications for those in sustainable finance:

  • EU Platform on Sustainable Finance Report with recommendations on Extended Environmental Taxonomy
  • EU Platform on Sustainable Finance Report with recommendations on the Technical Screening Criteria (TSC) for remaining four environmental objectives in the existing Environmental Taxonomy


Other publications:

  • ISSB proposal on general sustainability-related disclosure requirements and climate-related disclosure requirements and the SEC climate disclosure proposal 
  • Adoption of the final Regulatory Technical Standards (RTS) under the EU SFDR
  • European Commission’s proposal for Ecodesign for Sustainable Products Regulation 
  • IPCC report on Mitigation of Climate Change


What to look out for?

  • FCA consultation on SDR requirements for asset managers/owners on sustainable investment labelling
  • EU Corporate Sustainability Reporting Directive (CSRD)

 

Recent sustainable finance developments and implications for investors, lenders, issuers and borrowers

EU Platform on Sustainable Finance publish report with recommendations on Extended Environmental Taxonomy

As mentioned in our March edition of ESG Policy and Regulation Round up [1], on 28 March, the EU Platform on Sustainable Finance published its Final Report on Extended Environmental Taxonomy [2]. In this report the Platform is recommending extending the Taxonomy framework to classify activities as 1) unsustainable performance requiring an urgent transition to avoid significant harm; 2) intermediate (or amber) performance; 3) unsustainable, significantly harmful (red) performance where urgent, managed exit/decommissioning is required; 4) Low environmental impact (LEnvI) activities. The European Commission will consider the recommendations and will publish its own report outlining the next steps, such as, for example, whether a new legislative proposal will be put forward or whether voluntary guidelines could be issued first.

 

Key considerations for sustainable finance market participants

 

Whilst the Platform’s Report provides the recommendations on the potential structure of a future extended environmental taxonomy without yet outlining the actual technical screening criteria, market participants should be mindful that, according to the Report, the overall market feedback on the extension was favourable which increases the probability of the proposed taxonomy construct to materialise via future developments of the EU Taxonomy Regulation.

 

Investors / Lenders

 

According to the feedback summarised by the Platform, extending the Taxonomy beyond green could bring:

 

  • Increased transparency for all investors who want to support finance for urgent and ambitious environmental transitions and who need to manage their climate and environmental risks (including managing investments not making a transition away from environmentally harmful performance)
  • Enhanced tools to identify projects resulting in a positive environmental impact as well as stranded assets 

 

We also think that the availability of such an extended taxonomy would allow investors to design more nuanced and granular exclusion policies.

 

It would also provide for better risk diversification opportunities for investment portfolios (as to date, for example, investing in pure green taxonomy aligned assets would often fail to achieve optimal diversification). 

 

Issuers / Borrowers 

 

Issuers/borrowers may benefit from the following potential benefits of the extended taxonomy:

  • More sophisticated toolbox covering a different environmental performance levels to describe transition plans and progress by companies across all sectors could become available. According to the Platform’s report, some corporates indicated that clarity on the aspects of significant harm would enable them to make better transition plans, inform their investors more clearly on those plans and avoid being at the ‘whim’ of a variety of different stakeholders and shareholders with different views.
  • Obtaining clarity on the expected speed of the transition in the EU across sectors would provide an impetus for companies to align their business decisions and assess respective financing needs. 
  • Climate-related KPIs in sustainability-linked structures could be built based off the extended taxonomy framework (for example, a KPI to move from intermediate performance level into green. 

 

However, there may be unintended consequences such as the risk of company “blacklisting”, which may need to be considered further in the development of the Taxonomy.

 

Potential challenges

 

A key issue that may arise as a consequence of extending the taxonomy is a significant increase in the complexity of the framework that can hamper its usability, including the associated reporting. Implementation of the EU Green Taxonomy has not been completed yet whilst proving to be a complicated process. Operationalising the extended version of the taxonomy can prove difficult and costly in practice. 

 

With regard to any related future reporting, optimal sequencing of disclosure obligations would need to be ensured with corporates providing information first and followed by investors/lenders. This would be necessary to avoid the challenges experienced so far with the implementation of the Green Taxonomy whereby some reporting obligations for investment managers and institutional investors started to apply prior to those for the portfolio companies.

 

EU Platform on Sustainable Finance Report with recommendations on the Technical Screening Criteria (TSC) for remaining four environmental objectives in the existing Environmental Taxonomy  

 

On 30 March, the EU Platform published its recommendations [3] (and Annex [4]) to the European Commission on the TSCs for the rest of other four environmental objectives (shown below), with details on how it makes a substantial contribution to at least one of the environmental objectives without doing significant harm to any of the other objectives. The Platform also presented its report during a dedicated webinar [5]. 

 

The report includes criteria for about 60 economic activities in 12 sectors. The prioritisation of the activities has been performed based on the magnitude of their impact and improvement potential. Some high-impact activities, such as mining or biodiversity in agriculture, have been left out for future consideration. The Platform plans to release additional criteria in May 2022. The European Commission is then expected to adopt the whole package of the new criteria via delegated acts by the end of 2022. 

 

The four additional environmental objectives are:

 

  • Sustainable use and protection of water and marine resources: To ensure at least good status for all water bodies by 2027, and good environmental status for marine waters as soon as possible; and to prevent the deterioration of bodies of water that already have good status or marine waters that are already in good environmental status.
  • Transition to a circular economy: By 2030 economic growth is decoupled from extraction of non-renewable resources and depletion of the stock of renewable resources is reversed, and by 2050 economic activity is largely decoupled from resource extraction, through environmental design for a circular economy to eliminate waste and pollution, keep materials and products in use at their highest value, and to regenerate ecosystems.
  • Pollution, prevention and control: By 2030, pollution sources, sinks and pathways due to human activities have been fully identified and measures have been applied that prevent and eliminate pollution across air, water, soil, living organisms and food resources. By 2030, the production and use of substances, materials and products is safe and taxonomy-aligned.
  • Protection and restoration of biodiversity and ecosystem: To ensure that by 2050 all of the world’s ecosystems and their services are restored to a good ecological condition, resilient, and adequately protected.

Key considerations for sustainable finance market participants

 

Investors / Lenders

  • A range of asset managers, institutional investors and banks that fall in the scope of the EU Taxonomy Regulation and EU SFDR will need to prepare for their future reporting obligations under both Regulations which will be extended to cover the additional environmental objectives. 
  • Having learned from the experience with the TSC for climate change mitigation and adaptation, investors/lenders should start the screening of their investment portfolios and lending books as soon as possible to assess the Taxonomy eligibility in the first place. 
  • The recommendations can already be used as an engagement tool with portfolio companies/ borrowers to ensure that the latter begin the assessment of their economic activities as early as practicable. To this end, the criteria on the preservation and restoration of biodiversity and ecosystems can become particularly relevant given the interconnectedness of biodiversity and climate, and biodiversity loss being recognised a key risk factor alongside climate related risks.  
  • Investors and lenders could already begin considering the preliminary criteria in future product development, including the establishment of thematic funds, e.g. focused on circular economy, and some innovative structures, such as blended finance.

 

Issuers / Borrowers

We see the following key implications:

  • Applying these TSC criteria as part of identifying and reporting Taxonomy-aligned activities (for non-financial corporate issuers starting in 2023 for climate change mitigation and adaptation): While these are only recommendations, issuers/borrowers can start the process to define how their activities align to the new EU Taxonomy criteria. 
  • Consideration of eligible projects for future EU Green Bond Standard (EU GBS) issuance: Issuers who are considering issuing a bond in line with the upcoming EU Green Bond Standard (EU GBS) will now have the TSC for all the objectives to help support disclosures in their Frameworks and relevant appendices. More generally, it is expected to become easier for issuers to issue more “all encompassing” green bonds that cover climate as well as other environmental objectives such as sustainable use of water and biodiversity.
  • Consideration of sustainability KPIs in sustainability-linked instruments: Issuers may refer to the recommended criteria when considering sustainability-linked structures. The preliminary criteria can also be referred to when defining impact reporting metrics for green, sustainability and sustainability linked financing.
Other publications

ISSB proposal on general sustainability-related disclosure requirements and climate-related disclosure requirements and the SEC climate disclosure proposal 

 

On March 31, The International Sustainability Standards Board (ISSB) published its first two draft sustainability disclosure standards. The two draft standards [6], General Requirements for Disclosure of Sustainability-related Financial Information and Climate-related Disclosures, utilize the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD) and incorporate Sustainability Accounting Standards Board (SASB) industry-based disclosure requirements. The ISSB is seeking feedback on the proposals over a 120-day consultation period closing on 29 July 2022. The ISSB aims to issue the new Standards by the end of 2022.

These draft standards are intended to form a comprehensive baseline for sustainability disclosures designed to meet the information needs of investors. The ‘General Requirements’ would require companies to disclose information to help investors to assess significant sustainability-related risks and opportunities. “Climate-related disclosures” sets out standards in relation to the identification, measurement and disclosure of specifically climate-related risks and opportunities. The proposed standards, together, ask companies to report on all relevant sustainability topics as part of a company's financial statements and released at the same time – highlighting the equal importance the ISSB has placed on sustainability reporting alongside financial reporting.

These standards come shortly after the SEC’s proposed rule, which also incorporated the principles of the TCFD, like the ISSB. However, the SEC did not incorporate elements of climate disclosure contemplated by the ISSB climate disclosure prototype, such as climate considerations regarding executive remuneration. The proposed SEC rule also does not incorporate the SASB standard. In terms of direct comparison, the reference frameworks and definition of materiality overlap are shown in the table below:



Source: NatWest


Adoption of the final Regulatory Technical Standards (RTS) under the EU SFDR

 

On April 6, the European Commission adopted technical standards [7] to be used by financial market participants when disclosing sustainability-related information under the EU Sustainable Finance Disclosures Regulation (SFDR). The RTS will begin applying from 1 January 2023.

 

The standards specify the exact content, methodology and presentation of the information to be disclosed, aiming to improve its quality and comparability. The adopted legal act does not introduce significant changes to the draft standards previously published by the European Supervisory Authorities. Under these rules, financial market participants (such as asset managers, insurance companies that offer insurance-based investment products and pension funds offering financial product in the EU) will have to provide detailed information about how ESG risks and factors may impact on the investment valuation as well as how the investment decisions made could affect the environment and society – by reporting on a range of principal adverse impact indicators (PAIs). 

 

The standards are setting out disclosure rules around the “Article 8” products (products promoting, among other characteristics, environmental or social characteristics or a combination thereof) and “Article 9” (sustainable investment products). The standards do not establish any minimum EU Taxonomy-alignment thresholds or additional requirements for the products to be considered as Article 8 or 9. 

 

European Commission’s proposal for Ecodesign for Sustainable Products Regulation 

 

On March 30, the EU Commission published a proposal for Eco-design Regulation [8], designed to make sustainable products the norm in the EU. This new regulation would set energy efficiency standards for most consumer goods and will also cover durability and recyclability of goods in the future. For example, manufacturers may have to use a certain amount of recycled content in their goods or curb the use of materials that make them hard to recycle. The EU Environment commissioner said the Commission wanted fast fashion “to get out of fashion” by 2030, and expects textiles placed in the EU market to be long-lived and recyclable. The Commission also wants to amend EU consumer law to standardize the terms “environmentally friendly” or “eco” which is aimed at preventing greenwashing and requiring better transparency for consumers. This regulation is expected to affect all companies that produce or sell consumer products in the EU. 

 

IPCC report on Mitigation of Climate Change

 

On April 4, the UNs Intergovernmental Panel on Climate Change (IPCC) published its latest report [9] which finds that emissions are still rising and that the world at risk for runaway climate change. The report shows that the world has not yet managed to reduce its emissions output, hitting about 59 gigatonnes in 2019. That's a 12% jump from global 2010 emissions of 52.5 gigatonnes, or an average increase of 1.3% each year during the last decade. By comparison, global emissions in the previous decade climbed by about 2.1% each year, or nearly twice as fast. While total emissions are still rising, the rate of increase has slowed.

 

Increases in emissions came from all industries, including energy, transportation and agriculture. In the power sector, the expanded use of renewable energy as well as improvements in energy efficiency did not go far enough to counteract emissions from growing industrial activity and population growth worldwide, the report says. The report also weighs in on how market and regulatory tools can help stimulate innovation and technological competition which may boost incentives to cut emissions. 

Next 3 months – what to look out for?

June 2022: UK FCA consultation on SDR requirements for asset managers / owners on sustainable investment labelling

 

The FCA will consult on Sustainability Disclosure Requirements (SDR) for real economy companies, asset managers and asset owners, as well as the sustainable investment labelling regime. By Q4 2022 the UK government is expected to introduce primary legislation for the SDR regime. The SDR would require companies in scope to report on their sustainability risks, opportunities and impacts.

 

July 2022: EU Corporate Sustainability Reporting Directive (CSRD) 

 

The final text of the EU Corporate Sustainability Reporting Directive (CSRD), an EU-wide sustainability reporting framework, is expected to be agreed upon during Q2 / beginning of Q3. As a reminder, the CSRD proposal [10] significantly increased the scope of the existing EU Non-Financial Reporting Directive (NFRD) rules to cover all large undertakings as well as all those listed on EU regulated markets, with the exception of micro-entities. In contrast to the NFRD, the CRSD sets out in far greater detail the non-financial information that entities should report as well as requiring third-party assurance of the reported information. 

 

Comprehensive EU sustainability reporting standards will be prepared by the European Financial Reporting Advisory Group (EFRAG) and adopted via secondary legislation - with a first set of standards due for adoption by 31 October 2022. The rules are expected to achieve reasonable alignment with the ISSB proposal; however they are expected to go beyond – specifically in relation to the disclosures around the impact of business activity on the environment and society.

 

Finally, as noted in our previous newsletter [11], a few additional deliverables are still pending:

 

24 May 2022: The Bank of England will publish aggregated results of it CBES (climate stress testing). 

Before June 2022: The UK Government is due to launch a consultation on the UK Green Taxonomy. 

2022: European Banking Authority (EBA) is due to publish a discussion paper on differentiated prudential treatment of assets based on their environmental performance. The paper was due in Q1 of 2022 [12] but is being delayed. EBA has a mandate to deliver its final assessment on this topic to the European Commission by the end of 2023. A similar initiative will be conducted by the EU insurance sector supervisor EIOPA. 

For those looking to discuss any of the above further, please reach out to our authors:

*For any unfamiliar terms used within this article please refer to our Insights glossary.


References

 

1 https://www.natwest.com/corporates/insights/sustainability/esg-policy-and-regulation-round-up-march-2022.html

 

2 https://ec.europa.eu/info/sites/default/files/business_economy_euro/banking_and_finance/documents/220329-sustainable-finance-platform-finance-report-environmental-transition-taxonomy_en.pdf

 

3 https://ec.europa.eu/info/sites/default/files/business_economy_euro/banking_and_finance/documents/220330-sustainable-finance-platform-finance-report-remaining-environmental-objectives-taxonomy_en.pdf

 

4 https://ec.europa.eu/info/sites/default/files/business_economy_euro/banking_and_finance/documents/220330-sustainable-finance-platform-finance-report-remaining-environmental-objectives-taxonomy-annex_en.pdf

 

5 https://youtu.be/879pRFVUW28

 

6 https://www.ifrs.org/news-and-events/news/2022/03/issb-delivers-proposals-that-create-comprehensive-global-baseline-of-sustainability-disclosures/

 

7 https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/sustainability-related-disclosure-financial-services-sector_en

 

8 https://ec.europa.eu/environment/publications/proposal-ecodesign-sustainable-products-regulation_en

 

9 https://www.ipcc.ch/report/ar6/wg3/

 

10 https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52021PC0189

 

11 https://www.natwest.com/corporates/insights/sustainability/esg-policy-and-regulation-round-up-march-2022.html

 

12 https://www.eba.europa.eu/sites/default/documents/files/document_library/About%20Us/Work%20Programme/2022/1021339/EBA%202022%20Annual%20Work%20Programme.pdf

 

13 https://www.eba.europa.eu/sites/default/documents/files/document_library/About%20Us/Work%20Programme/2022/1021339/EBA%202022%20Annual%20Work%20Programme.pdf.

 

 

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