European Commission takes further steps towards sustainability and improving sustainable finance

On 21 April 2021, the European Commission adopted a comprehensive package of measures to further help increase the flow of money towards sustainable activities as well as re-orient investments towards more sustainable technologies and businesses, which are instrumental in making Europe climate-neutral by 2050.

1. The ‘EU Taxonomy Climate Delegated Act’

What is it?

As a next step since introducing the EU Taxonomy, the European Commission was tasked to establish technical screening criteria through ‘Delegated Acts’. This first Delegated Act defines the technical screening criteria (TSC) for specific economic activities that can make a substantial contribution to climate change mitigation and climate change adaptation, covering the economic activities of roughly 40% of listed companies, in sectors which are responsible for almost 80% of direct greenhouse gas emissions in Europe.

The climate mitigation TSC cover over 85 activities across the forestry, manufacturing, energy, transport, waste and water, built environment and information and communication technology sectors, as well as professional, scientific and technical activities and environmental protection and restoration activities. The substantial contribution to climate adaptation TSC includes additional activities related to education, finance and insurance, health and social work, and the arts sector.

The Climate Delegated Act has not yet included the nuclear, natural gas and agriculture sectors; however, the Delegated Act, which will apply from 1 January 2022, is a living document and will continue to evolve with new sectors and activities, including transitional and other enabling activities, added to the scope over time. With regards to the agricultural sector, the European Commission explained that it delayed its inclusion because of the ongoing inter-institutional negotiations on the Common Agricultural Policy but aims to cover it in the next Delegated Act. In relation to hydrogen the Commission pointed out that the criteria covered in the Delegated Act are in line with the EU Hydrogen Strategy and encourage the production and use of hydrogen in accordance with the European Green Deal goals. Notably, the criteria for manufacturing hydrogen are set at a level considered sufficiently ambitious to ensure a substantial contribution to climate change mitigation, favouring the production of hydrogen from renewable sources.

Furthermore, the Delegated Act sets-out the ‘does not significantly harm’ (DNSH) to all six environmental objectives for those activities and the generic DNSH criteria for the six objectives of the EU Taxonomy (see below for a short recap).

A short recap: The EU’s Taxonomy Regulation

The EU Taxonomy helps create the world’s first-ever “green list” – a classification system for environmentally sustainable economic activities that investors can use when investing in economic activities that have a substantial positive impact on the climate and environment.

The EU Taxonomy is based on six 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; and
  • protection and restoration of biodiversity and ecosystems.

In order to be considered environmentally sustainable, economic activities must comply with all four of the following criteria:

  • substantially contributes to one or more environmental objectives;
  • does not significantly harm (DNSH) any environmental objective;
  • complies with minimum safeguards based on certain human rights standards; and
  • complies with the Technical Screening Criteria (TSC), which are the detailed conditions for the first two objectives above.

Last year, the European Commission established a permanent expert group, the Platform on Sustainable Finance (the Platform), which plays a key role in bringing together the best expertise on sustainability from the public sector, industry, academia, civil society and the financial industry. Previously, in order to inform its work on sustainable finance, including the Taxonomy Climate Delegated Act, the European Commission established a Technical Expert Group (TEG) on Sustainable Finance in July 2018 - the Platform’s predecessor. In March 2020, the TEG published its final report on the EU Taxonomy. Overall, the development and regular updating of the EU Taxonomy framework via the Delegated Acts will continue to rely on extensive input from experts across the economy and civil society.

The EU Taxonomy, which will also form the core of the EU Green Bond Standard, is an early example of a major jurisdiction defining detailed, science-based criteria about which economic activities contribute most to environmental objectives. Very few countries – China is one example – outside the EU have developed taxonomy frameworks. Consequently, the International Platform on Sustainable Finance (IPSF) has started a working group, co-chaired by China and the EU, to undertake a comprehensive assessment of existing taxonomies from public authorities of its member countries with the aim to develop a Common Ground Taxonomy, which will form a solid basis to develop global common standards.

Who is affected?

Companies seeking sustainable finance; therefore, they will have to meet the expectations of investors, with Taxonomy-aligned reporting very likely becoming the ‘golden standard’ and aligns with Articles 8 and 9 highlighting sustainability of investment decisions, described below.

What is the timing?

Once adopted by the European Commission, which is expected to happen by the end of May 2021, the Climate Delegated Act will be scrutinised by the European Parliament and Council. If there are no objections, the Delegated Act will apply from 1 January 2022.

What are the implications?

The EU Taxonomy Climate Delegated Act delivers the first set of technical criteria for defining activities that contribute substantially to climate change mitigation and adaptation. It includes more economic activities and environmental objectives than used previously in market-based green financing frameworks. This means there will be more reliable, comparable sustainability information publicly available on the market for investors and stakeholders.

Companies can, if they wish, reliably use the EU Taxonomy to plan their climate and environmental transition and raise financing for this transition. Financial market participants can, if they wish, use the EU Taxonomy to design credible green financial products. However, the EC points out that the EU Taxonomy (and Delegated Act) can only guide market participants in their investment decisions, but it doesn’t prohibit investment in any activity. There is no obligation for companies to be Taxonomy-aligned and investors are free to choose what to invest in.

2. A proposal for a ‘Corporate Sustainability Reporting Directive’ (CSRD)

What is it?

This new directive aims to strengthen the existing rules introduced by the Non-Financial Reporting Directive (NFRD) by adding further rules that will over time bring sustainability reporting on a par with financial reporting. According to the European Commission the need for a new reporting directive has become clear on the base of ample evidence that the information that companies report is not sufficient, with reports often omitting information that investors and other stakeholders think is important. In addition to ensuring more information granularity, the CSRD will extend sustainability reporting requirements to all large companies and all listed companies in the EU, while ensuring a homogenous approach. This means that nearly 50,000 companies in the EU will then have to follow detailed EU sustainability reporting standards, an increase from the 11,000 companies that are subject to the existing requirements. Looking at timing: the Commission plans to adopt the first set of reporting standards under the new legislation by the end of 2022, which means that companies would apply the standards for the first time to publicly available reporting published in 2024, covering financial year 2023.

Who is affected?

The draft CSRD requires all large companies (above 500 employees), whether they are listed or not, to publicly account for their impact on people and the environment. In addition, if the proposal goes through, listed SMEs – with the exception of listed micro-enterprises – will be included but they will be allowed to report according to standards that are simpler than the standards that will apply for large companies.

What is the timing?

The next step is for the European Parliament, and the Member States in the Council, to negotiate a final legislative text based on the Commission’s proposal. If they reach agreement in the first half of 2022, then the Commission should be able to adopt the first set of reporting standards under the new legislation by the end of 2022. That would mean that companies would apply the standards for the first time to reports published in 2024, covering financial year 2023.

What are the implications?

Although the proposed CSRD would imply additional costs in the short term for companies, most companies would have to adapt their sustainability disclosure anyway because of the growing demand from investors and other stakeholders for such information.

As the Commission’s proposal anticipates the increasing digitalisation of sustainability information, there’s a good possibility of lower reporting costs over time for companies as well as radical improvements in how investors and other stakeholders can compare and use reported information. Specifically, if the CSRD gets approved it would require companies to prepare their financial statements and their management report in XHTML format in accordance with the ESEF Regulation and to ‘tag’ their reported sustainability information according to a digital categorisation system as and when specified in that Regulation. This digital categorisation system would be developed together with the sustainability reporting standards. This will mean that sustainability information can easily be incorporated in the European Single Access Point envisaged in the Capital Markets Union Action Plan, for which the Commission will put forward a proposal later this year.

These disclosure requirements will support the requirements to categorise financial products into three categories based on their sustainability according to Articles 8 and 9, which will apply to investment firms and credit institutions providing investment advice and / or portfolio management. The enhanced reporting disclosure will feed through to financial products if they would like to be labelled ESG-friendly or based on ESG models.

3. Six amending Delegated Acts

These six amendments encourage the financial system to support businesses on the path towards sustainability and existing sustainable businesses while also strengthening the EU’s fight against greenwashing. The amendments, which are expected to apply from around October 2022, cover three areas:

  • On investment and insurance advice: under the existing rules, advisers obtain information about a client’s investment knowledge and experience, financial situation, ability to bear losses, investment objectives and risk tolerance (a so-called “suitability assessment”). Now, advisers will also have to obtain information about their clients’ sustainability preferences.
  • On fiduciary duties: the amendments clarify the obligations of financial firms when assessing their sustainability risks, such as for example the impact of floods on the value of investments.
  • On investment and insurance product oversight and governance: financial firms and advisers will need to consider sustainability factors when designing their financial products.

Who is affected?

Financial firms, and as such financial advisers (including insurance advisers), investment managers, asset managers, and asset owners.

What is the timing?

The six amendments to Delegated Acts on investment and insurance advice, fiduciary duties, and product oversight and governance will be scrutinised by the European Parliament and the Council (three month periods and extendable once by three additional months) and are expected to apply as of October 2022.

What are the implications?

The six amendments provide clear long-term incentives to direct financial flows towards green investments. They should further stimulate institutional and retail investors to invest in projects and activities with a positive environmental impact as well as encourage financial services firms to develop ‘green’ products. It’s notable that the amendments do not state how much a given financial product (for example an investment fund) should invest in Taxonomy-compliant activities – this should be the result of a dialogue between the financial adviser and their client, with the client ultimately determining their specific ambition. 

In addition, the amendments on fiduciary duties specifically will likely have a ‘pull effect’ from asset owners, who – sensitised to sustainability risks – will have a closer look at their fund managers’ approach to considering and measuring these risks, which in turn will put pressure on asset managers to conduct comprehensive sustainability risk assessments of their portfolios (if they haven’t done it so far) in accordance with Articles 8 and 9. 

Time to act now

The European Commission has pointed out numerous times that the financial system plays a crucial role in the delivery of the EU Green Deal and that significant investments are required to green the economy. This new package of measures, the Commission’s next step towards achieving sustainability, should come as no surprise to companies and investors alike.

And, while these requirements will only apply from next year (and later), it’s become clear over the past few years that not only is there no hiding for those still hesitating to embark on their sustainability journey, but more importantly, that now is the time for companies to take action and turn the green challenge into a business opportunity – helping to gain new customers and new investors.

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