The European Union (EU) has developed a comprehensive policy agenda on sustainable finance. In the EU's policy context, sustainable finance is understood as finance to support economic growth while reducing pressures on the environment and taking into account social and governance aspects. As part of its policy, various instruments have been developed (or are in the process of being developed) that, amongst others, support the EU’s international commitments on climate and sustainability objectives. These include sustainability disclosure obligations for manufacturers of financial products and financial advisers and measures to enhance the transparency of environmental, social, and governance (ESG) benchmark methodologies.
Although the direct application of the instruments is limited to the EU member states, some of the measures have an impact on financial services providers outside the EU that do business with their EU counterparts and, more generally, on sustainable investments outside the EU, as will be described in more detail below.
Sustainability disclosure obligations for financial market participants and financial advisers
Regulation (EU) 2019/2088 on sustainability-related disclosures for the financial services sector (the Disclosure Regulation) introduces a set of ESG transparency and disclosure requirements for EU financial market participants (such as portfolio managers, fund managers and pensions providers) and financial advisers (i.e., providers of investment or insurance advice). The Disclosure Regulation entered into force in December 2019 and certain key provisions must be implemented by 10 March 2021. The Disclosure Regulation is supplemented with regulatory technical standards whose finalisation and implementation have, however, been delayed due to the current pandemic. Nonetheless, in terms of substance, the EU Commission considers that the application of the Disclosure Regulation is not conditional on the formal adoption and entry into force or application of the regulatory technical standards.
According to the Disclosure Regulations financial market participants and financial advisors that are active in the EU should assess the likely impacts of sustainability risks on the financial return of financial products in a systematic manner by integrating such assessment in their due diligence and research processes. A “sustainability risk” is 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 an investment.
The Disclosure Regulation also expects financial market participants to publish their policies regarding sustainability risks in their investment selection processes. In turn, Financial advisers must publish information about their policies on the integration of sustainability risks in their investment advice or insurance advice. Moreover, financial market participants and financial advisers must include in their remuneration policies information as to how sustainability risks are being addressed in this context. The Disclosure Regulation also provides that products actively promoting environmental or social characteristics or products which have sustainable investment as objective are subject to additional disclosure obligations. For example, the product manufacturers must describe in the product documentation how the levels of sustainability are achieved.
Depending on the information to be disclosed, the Disclosure Regulation requires website disclosures, pre-contractual disclosures (such as fund prospectuses), and periodic reporting to investors.
Measures to enhance the ESG transparency of benchmark methodologies
Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment (the Taxonomy Regulation) sets out the criteria for determining whether an economic activity qualifies as environmentally sustainable. This should enable financial market participants and financial advisers to gather reliable, consistent and comparable sustainability related indicators and incorporate this data into their investment decisions and risk management processes and fulfil their disclosure duties under Disclosure Regulation. The Taxonomy Regulation came into force on 12 July 2020, but many key provisions will not apply until a later date when additional details will have been developed by way of delegated acts.
The obligations in the Taxonomy Regulation supplement the rules on sustainability-related disclosures that are included in the Disclosure Regulation. Together, the Taxonomy Regulation and the Disclosure Regulation will require firms to disclose the degree of environmental sustainability of funds and pension products that are promoted as environmentally friendly and include disclaimers where they do not. In addition, companies which are subject to the EU Non-Financial Reporting Directive (basically large companies) will be required to disclose, in their financial statements, information on the proportion of their activities that are classified according to the Taxonomy Regulation as environmentally sustainable, such as the proportion of their turnover derived from products or services associated with economic activities that qualify as environmentally sustainable.
According to the Taxonomy Regulation, an environmentally sustainable economic activity should contribute substantially to one or more of the following 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
Under the Taxonomy Regulation, an economic activity constitutes an environmentally sustainable activity if it:
- Contributes substantially to one or more of the environmental objectives, or directly enables other activities to make a substantial contribution to one or more of them;
- Does not significantly harm any other environmental objective;
- Complies with applicable technical screening criteria (Technical Screening Criteria) set out in delegated acts that have yet to be adopted; and
- Is carried out in compliance with certain safeguards.
The Technical Screening Criteria will be developed gradually over time through delegated acts supplementing the Taxonomy Regulation and will be used to determine whether an economic activity can be considered sustainable. The first set of draft Technical Screening Criteria, for activities which substantially contribute to climate change mitigation or climate change adaptation, were published for public consultation on 20 November 2020. The detailed criteria are set out in annexes to the delegated act which consist of 233 pages (climate change mitigation) and 281 pages (climate change adaptation), respectively. The EU Commission will consider the feedback received before finalising the adoption of the delegated act, which is expected to apply from 1 January 2022. Additional delegated acts with Technical Screening Criteria can be expected for the other environmental objectives.
The obligations that follow from the Disclosure Regulation and the Taxonomy Regulation will affect financial services providers and companies that are organised outside the EU in different ways. More directly, where non-EU investment fund managers market funds to EU investors under a local private placement regime, they may be required to make disclosures that are compliant with the Disclosure Regulation. Furthermore, EU regulated financial market participants and financial advisers will require from sub-funds, investees, and financial product manufacturers established outside the EU and in whose products they invest, relevant information and documentation in order to ensure that they can comply with their disclosure obligations under the Disclosure Regulation and the Taxonomy Regulation.
The disclosure obligations also impact investee companies and funds in which EU financial market participants and large companies invest, given the disclosure and ongoing due diligence and portfolio monitoring requirements to the latter are subject. These investee companies and funds may become subject to more comprehensive disclosure and reporting requirements so that the EU financial market participants and companies can meet their disclosure obligations.
The disclosure obligations and the use of benchmarks to test whether an investment meets the sustainability objectives, may also affect the investment selection process of EU financial market participants and investors. They may prefer to invest in instruments that enable them to comply with the disclosure and reporting requirements under the Disclosure Regulation that and are considered to be environmentally sustainable, as described in the Taxonomy Regulation.
It cannot be expected that the provisions of the Disclosure Regulation and the Taxonomy Regulation are studied in detail by persons who are not their addressees. However, if transactions are promoted or structured as environmentally sustainable investments and the target audience includes EU based investors, the provisions of the Taxonomy Regulation, and in particular the delegated acts, will become relevant.