In 2018 the EU Taxonomy was adopted to provide a framework for classification of economic activity based on environmental impacts. Subsequently, the Taxonomy has been used as the basis for expanding compliance and reporting obligations on asset managers, institutional investors, insurers and financial advisers to include sustainability and ESG characteristics of investments. The precise nature of these obligations has been refined in subsequent legislation with important reporting obligations coming into effect for the 2022 fiscal year. It is imperative to have a compliance plan in place and to already be gathering required information for financial products.
The Taxonomy’s classification system establishes a scientifically rigorous method to assess impacts Taxonomy’s vocabulary, classification system and scientific choices will thus resonate across EU legislation. Changes in the underlying taxonomy will, similarly, impacted regulated entities. The Taxonomy defines sustainable activities according to the environmental objectives established in other EU legislation, specifically:
- Climate change mitigation
- Climate change adaptation
- The sustainable use and protection of water and marine resources
- The transition to a circular economy
- Pollution prevention and control
- The protection and restoration of biodiversity and ecosystems
Corporate reporting and financial market participants are the first subjects of legislation implementing the Taxonomy. Regulation of financial intermediaries is already in place with the Sustainable Finance Disclosure Regulation (SFDR) coming into in March 2021 with first reporting obligations now pushed to January 2023. The regulation applies broadly to financial advisors and other market participants such as asset managers, insurers and pension funds. For companies, the proposed Corporate Sustainability Reporting Directive (CSRD), covers listed companies and large corporates. CSRD is under negotiation and is expected to be implemented for reporting on 2023 fiscal year.
SFDR reporting obligations are a means to a broader end: action on environmental objectives. The Directive intends to achieve the EU’s environmental objectives by influencing the direction of capital. For investors in financial products, the Directive makes it possible to to compare investments and make informed decision to direct capital according to individual ESG goals. For investment market participants and financial advisers, the Directive is intended to avoid greenwashing, so ESG capital provides maximum impact, and to include considerations of sustainability objectives in the process of determining suitability of investments for clients. Finally, for companies seeking debt and equity investment, the SFDR raises the importance of delivering Taxonomy aligned reporting to access financing on competitive rates, driving action at the corporate level independent of the scope of the CSRD.
ESG Claims for Financial Products Must Satisfy the Taxonomy
Today there are many financial products making ESG and sustainability claims but investors are left on their own to determine credibility of claims based on self-reporting by the financial intermediary. SFDR requires standardized disclosures by financial market participants and financial advisors to support marketing of financial products making these sustainability, ESG and impact claims. The Directive relies on the Taxonomy to provide the classification system for reporting claims, providing an objective set of criteria to measure ESG claims, permitting comparison across financial products.
The new requirements under the SFDR for financial market participants are substantial. Investments must be marketed in accordance with Taxonomy classifications in one of three catergories:
- Article 8 governs green financial products with ESG characteristics as part of marketing promotions
- Article 9 governs “light-green” financial products claiming claim to be promoting social or environmental characteristics the objective and indices designated as reference benchmarks
- Funds without any claims of sustainability in the investment process
Marketing promotions must include the relevant designation and any ESG claims subject to reporting and on-going due diligence obligations. Going forward marketing claims based on sustainability can only be made if the investment substantially furthers an environmental goal without causing significant harm to other goals and meets basic social safeguardsFinancial market participants and advisors can no longer consider ESG products as a simple labelling exercise; branding must be replaced with transparent reporting pursuant to a standardized Taxonomy.
Compliance obligations of financial intermediaries
Scope: The SFDR obligations apply to all asset managers, financial advisors and insurance providers in the EU. The SFDR establishes a single set of rules for transparency in the sustainability related information for financial products, including UCITS and European ETFs. Basic reporting obligations extend to all asset managers, even those without any ESG claims.
All Asset Managers: All asset managers must report on two primary ways that sustainability risks can impact investment returns, known as the “double materiality of sustainability”. First, market participants must report on processes to assess the risks to investments from sustainability impacts. Second, compliance reporting is required to identify any negative environmental impacts investments can have. The EU has emphasized the import of the additional obligation in that sustainability factors should be taken into account by Alternative Investment Fund Managers (‘AIFMs’) as part of their duties towards investors.
Sustainable Asset Managers: Market participants promoting financial products with sustainability or ESG characteristics have higher reporting obligations, including reporting what percent of assets under management are allocation to sustainable activities according to Taxonomy classifications and integration of sustainability into renumeration policies.
ESG Financial Products: For financial products, regulated entities must assess “Principle Adverse Sustainability Impacts” of the investments as they are defined from time to time in the legislation. Prospectuses must be updated to reflect the level 2 disclosure requirements for reporting on 2022 activities from January 2023.
On-going Due Diligence Obligation: Deploying the Taxonomy in accordance with the SFDR brings the compliance obligation within the Alternative Investment Fund Manager regulations for ongoing due diligence to identify any divergence from previous reporting and promotions. AIFMs should therefore assess sustainability risks and outcomes on an ongoing basis, to determine if there is an actual or potential material negative impact on the value of an investment.
Watch this space.
The initial round of compliance obligations has been set. However, the issuance of the Taxonomy is the beginning of a long process. The SFDR and the CSRD are part of a constellation of regulations driving the environmental objectives that include the EU Greenbond Standard, Climate Benchmarks, eth EU Ecolabel and the Non-Financial Reporting Directive. The overlaps and interrelations of these policies with existing regulatory framework for financial market participants is just beginning. One can expect continued policy evolution in response to feedback from market participants and investors. Regulated entities must be prepared to adapt and respond to avoid the consequences of falling into non-compliance.
