European Commission adopts legislative and regulatory package on sustainable finance

Introduction

The European Commission (Commission) has published a number of legislative and regulatory initiatives in the context of its Sustainable Finance Action Plan. The aim of the Sustainable Finance Action Plan, which was first presented in 2018, is to channel more investment towards sustainable activities. The Commission has published the following initiatives:

• 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.

Please find an overview of the main aspects of the initiatives below.

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

On 21 April 2021, the Commission published the EU Taxonomy Climate Delegated Act setting 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 has been published as a provisional version, although it has been approved in principle by the Commission and its formal adoption will take place as soon as it has been translated into all the official languages of the EU.

The Commission had launched a consultation on the Climate Delegated Act in November 2020, which ran for one month. The technical screening criteria are based on the recommendations of the Commission’s Technical Expert Group (TEG), which published its final report in March 2020 relating to the overarching design of the taxonomy, the technical screening criteria for climate change mitigation and climate change adaptation objectives and the application of the DNSH criteria. The Climate Delegated Act broadly reflects the recommendations of the TEG and the feedback received from the Commission’s inception impact assessment. However, there have been some concerns that the Commission deviated from the scientific evidence as a result of political and industry pressure by weakening some of the thresholds in areas such as the manufacturing, construction, agriculture, forestry and bioenergy sectors, compared against the TEG’s recommendations.

As had been rumoured prior to the publication of the Climate Delegated Act, the decision on whether to include nuclear energy generation and gas-fired electricity generation under the EU Taxonomy has been deferred and as such these two important economic activities were not included in the technical screening criteria.

The Climate Delegated Act is accompanied by two annexes: Annex 1 contains the technical screening criteria for climate change mitigation, and Annex 2 contains the same for climate change adaptation.

As had been rumoured prior to the publication of the Climate Delegated Act, the decision on whether to include nuclear energy generation and gas-fired electricity generation under the EU Taxonomy has been deferred and as such these two important economic activities were not included in the technical screening criteria.

The Climate Delegated Act is accompanied by two annexes: Annex 1 contains the technical screening criteria for climate change mitigation, and Annex 2 contains the same for climate change adaptation.

EU Taxonomy Regulation – Recap

In summary, the EU Taxonomy Regulation aims to establish a unified EU classification system setting out criteria for determining whether an economic activity qualifies as environmentally sustainable. The Taxonomy Regulation establishes six environmental objectives:

1. Climate change mitigation
2. Climate change adaptation
3. The sustainable use and protection of water and marine resources
4. The transition to a circular economy
5. Pollution prevention and control
6. The protection and restoration of biodiversity and ecosystems

There are four overarching conditions that an economic activity must meet in order to qualify as environmentally sustainable. The economic activity must (1) substantially contribute to one or more of the environmental objectives; (2) do no significant harm (DNSH) to any of the other environmental objectives; (3) be carried out in compliance with minimum social and governance safeguards; and (4) comply with technical screening criteria, which the Climate Delegated Act sets out in relation to climate change mitigation and climate change adaptation.

Climate Delegated Act

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.

Annex I of the Climate Delegated Act groups economic activities into the following nine categories.

• Forestry
• Environmental protection and restoration activities
• Manufacturing (e.g. manufacture of cement, steel, plastics and hydrogen)
• Energy (e.g. energy generation using solar PV, wind power and hydropower)
• Water supply, sewerage, waste management and remediation
• Transport (e.g. passenger cars, rail and maritime transport)
• Construction and real estate activities (e.g. construction of new buildings and renovation of existing buildings)
• Information and communication (e.g. data processing and hosting)
• Professional, scientific and technical activities (e.g. market research, development and innovation).

Annex II contains the same categories as Annex I, as well as:

• Financial and insurance activities (e.g. non-life insurance and reinsurance)
• Education
• Human health and social work activities
• Arts, entertainment and recreation

Nuclear energy

The TEG had concluded that nuclear energy generation has near zero GHG emissions with respect to electricity generation, but does have impacts in relation to waste from the production process, which may not be compatible with the circular economy and waste management environmental objectives and therefore breach the DNSH criteria. As such, nuclear energy generation was deemed beneficial from the perspective of combatting climate change, but could be viewed as damaging to the environment more generally. The Commission might aim to harness the EU Taxonomy to prompt industry players to innovate and develop better solutions for the storage and disposal of nuclear waste. It is understood that the Commission’s Joint Research Centre, which had been instructed to undertake an assessment of nuclear energy generation, will recommend that the activity does no more harm to the environment or human health than other electricity production technologies that have been deemed environmentally sustainable.

Gas-fired electricity generation

The decision on whether to include gas-powered electricity generation within the EU Taxonomy has proven to be controversial. The draft TSC had included gas-powered electricity generation only where it can be demonstrated that the life cycle carbon emissions were below a certain threshold (100 grams of CO2-equivalent per kWh), which would have necessitated carbon capture, utilisation and storage (CCUS) systems to be in place. However, following the publication of the draft TSC, the Commission proposed to substantially increase the CO2 emission rates for electricity production from gas, such that up to half of EU production would fall within the Taxonomy as a transition activity. This change of position was due to concerns about grid stability if there is too much reliance on intermittent renewable energy generation, but was opposed by some Member States.

Impact

As sustainable finance has become more popular among institutional investors, there has been a growing need to classify commercial activities appropriately from an ESG perspective. This marks the finalisation of a unified classification system of sustainable economic activities concerning climate change mitigation and climate change adaptation, a vital step towards helping investors identify what is and is not green, and in turn tackle so-called greenwashing. The classifications given to the underlying investments of investment products will be crucial in ensuring that they are achieving their sustainability goals while delivering high levels of transparency in the market. As firms start to consider how they might go about implementing the requirements of the Taxonomy, the publication of the TSC will provide much-needed clarity as the implementation date of 01 January 2022 draws near.

The Taxonomy has the potential to have a significant impact on the flow of investment towards economic activities deemed to be environmentally sustainable and away from others. Although the Taxonomy Regulation impacts products offered in the EU market, in practice, given the global nature of international finance, it will have implications for market participants more broadly. As such, there is a risk that companies that are not engaged with the ESG agenda will encounter difficulties in attracting the same level of investment and financing in Europe moving forward.

Next steps

The Commission advises that, although the College of Commissioners reached a political agreement on the text of the Climate Delegated Act on 21 April 2021, it will be formally adopted only once it has been translated in all EU languages at the end of May.

While the publication of TSC for climate change mitigation and climate change adaptation will be an important milestone, it is by no means the end of the process of developing the EU Taxonomy. The technical screening criteria for the remaining four environmental objectives under the Taxonomy Regulation (water, circular economy, pollution control, and biodiversity) will now be developed by the Platform on Sustainable Finance (which has replaced the TEG), with a view to that adoption by the end of 2021 and coming into force from 1 January 2023. In addition, a further legislative proposal setting out the position of nuclear energy generation and gas-fired electricity generation under the EU Taxonomy is expected in the second half of this year.

The Taxonomy Regulation is a very wide-reaching piece of legislation, with implications for what projects will be entitled to access some of the funds under the EU’s Covid-19 recovery package as well as accessing capital from other lenders, and will also form the basis for the EU Green Bond Standard legislation, due to be proposed in Q2 2021.

2. Proposal for a Corporate Sustainability Reporting Directive

The Commission proposal for a Corporate Sustainability Reporting Directive (CSRD) amends the existing reporting requirements under the Non-Financial Reporting Directive (Directive 2014/95/EU) (NFRD)

• The scope of the NFRD is extended to include large listed and non-listed companies and listed Small and Medium-Sized Enterprises, but excludes listed micro-enterprises;
• The CSRD will require an audit (assurance) of reported sustainability information. Starting with a ‘limited’ assurance requirement, the Commission can make it a ‘reasonable’ assurance requirement once it adopted sustainability assurance standards. Under the proposal, Member States are allowed to open up the market for sustainability assurance services to so-called ‘independent assurance services providers;
• The 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 European Financial Reporting Advisory Group will develop these standards. The technical recommendations and roadmap for the development of these sustainability standards were published in February 2021. Once it received final draft standards, the Commission will consult with different stakeholders and authorities before adoption;
• Lastly, the proposal includes an obligation for companies to digitally ‘tag’ the reported information to make it machine-readable. This is in line with the Commission’s goal to establish a European single access point for financial and non-financial company information.

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

The long-awaited 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 the 2019 adoption of Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (SFDR).

The texts are based on the technical advice submitted by the European Securities and Markets Authority (ESMA) in April 2019. The Commission consulted upon draft versions of the texts in June 2020. The adopted delegated acts will be subject to scrutiny by the European Parliament and the Council. With one exception, the amended rules will apply from 12 months after their publication in the Official Journal of the EU.

The sections below provide an overview of the proposed requirements, focusing on investment firms and asset managers.

MiFID II

Product governance

The delegated act introduces a new definition of “sustainability preferences” into Delegated Directive (EU) 2017/593, 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. In addition, the definitions of “sustainability risks” and “sustainability factors” under the SFDR would be introduced into the Delegated Directive.

The delegated act sets out the obligation for investment firms to consider any preference for sustainable products as part of the clients’ needs, characteristics and objectives if these investment firms identify at a sufficiently granular level the potential target market for financial instruments and the types of clients for whom they are compatible. When carrying out this assessment, investment firms would be obliged to examine whether the financial instrument’s sustainability characteristics are in line with the target market. This will also need to be incorporated more generally into product governance arrangements.

The delegated act also introduces the obligation for firms to make sure that the financial instrument remains consistent with the needs, characteristics and objectives, including any preferences for sustainable products, of the target market when regularly assessing the financial instruments they manufacture. If an inconsistency between the product and the target market is detected, firms should reconsider the target market and/or product governance arrangements of the given product.

Unlike the other delegated measures, the Delegated Directive described above will need to be transposed in the national laws of the Member States. The transposition deadline is 12 months after the entry into force of the Delegated Directive (which is, 20 days after publication in the Official Journal of the EU). The transposed provisions will apply as of 15 months after the entry into force of the Delegated Directive.

Organisational requirements

The delegated act amending Delegated Regulation (EU) 2017/565 on organisational requirements also introduces the definitions of “sustainability preferences”, “sustainability risks” and “sustainability factors” into the Delegated Regulation. Under the delegated act, 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.

When conducting the assessment of sustainability and providing suitability reports under Article 54, investment firms would under the new rules need to take into account in the selection process to recommend financial products to their clients, including risks, costs and complexity of the financial instruments, and including any sustainability factors. The delegated act also requires firms to prepare a report for the client explaining how the investment recommendation meets their sustainability preferences alongside their investment objectives, risk profile and capacity for loss bearing.

Under the Delegated Regulation, three categories of financial instruments are integral to sustainability preferences. These are:

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

As in the MiFID delegated acts, the Commission Regulation amending the UCITS Delegated Directive (2010/43/EU) and the Commission Regulation amending the AIFMD Delegated Regulation ((EU) 231/2013) introduce the definitions of “sustainability preferences”, “sustainability risks” and “sustainability factors” definitions into the level 2 measures, as well as the concept of ‘material adverse impact’ on the value of investments.

If endorsed by the Parliament and the Council, 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. In the event that management companies or AIFMs consider principal adverse impacts of investment decisions on sustainability factors, this would need to be considered in undertaking due diligence. In addition, risk management policies would need to consider exposures of the UCITS or AIF to sustainability risks.