The EU Taxonomy and SFDR have been recently updated. In this article, we will look at the latest developments, what we have learned so far in 2022, and what it all means for the main actors in the market…For a general overview of the EU Taxonomy, please see our previous article.
Eu Taxonomy and SFDR – What is new in the regulatory landscape
The RTS has gone live
The Regulatory Technical Standards (“RTS”), following the Sustainable Finance Disclosure Regulation (SFDR), have been published in the EU Official Journal (EU OJ) on the 25th of July 2022, with their application date confirmed for the 1st of January 2023.
The objective of the RTS is to detail the disclosures that financial market participants (FMPs) must produce at the entity and financial product levels based on the SFDR requirements.
While FMPs have started acquainting themselves with qualitative disclosures since March 2021 – mainly revolving around how they integrate sustainability risks into investment decisions – it’s quantitative disclosures that pose the major challenges. We will examine them closely in the next sections.
Article 8 and article 9 products: is the distinction finally clear?
The final Regulatory Technical Standards were long awaited by FMPs to get more clarity about the distinction between article 8 and article 9 financial products.What the European Commission has stressed in the explanatory memorandum to the Delegated Regulation, is that the SFDR does not create a labeling regime: article 8 and article 9 financial products simply face different disclosure requirements. However, it is clear from the preamble of the RTS that these two products also face different structure requirements, as we illustrate below:
Article 8 Financial products
| Identifying Trait | Allocation | PAIs reporting (principle adverse impacts indicators) | Assessment of good governance practices of investee companies | EU Taxonomy reporting |
Promotion of environmental and/or social characteristics | Wide range of underlying assets, some of which may not contribute to the specific environmental or social characteristics promoted by the financial product (e.g. hedging instruments, unscreened investments for diversification purposes, investments for which data are lacking or cash held as ancillary liquidity) | Optional, if the product does not make sustainable investments in the definition of the SFDR (see article 9 products) | Always required (in particular with respect to sound management structures, employee relations, remuneration of staff, and tax compliance) | Required if the product promotes environmental characteristics |
Article 9 Financial products
| Identifying Trait | Allocation | PAIs reporting (principle adverse impacts indicators) | Assessment of good governance practices of investee companies | EU Taxonomy reporting |
The sustainable investment objective, i.e. investments pursuing environmental and/or social objectives while also not significantly harming other environmental and social dimensions | Should include sustainable investments only. Other types of investments are allowed if required by sector-specific rules | Always required | Always required (n particular with respect to sound management structures, employee relations, remuneration of staff, and tax compliance) | Required if the product pursues environmental objectives |
As we can see in the table, the main difference between the two disclosure regimes can be reduced to the proportion of sustainable investments, which translates into how the FMP is assessing if the investments made – while contributing to an environmental or social dimension – do not negatively impact other E-S factors.
PAIs reporting: when is it applicable?
It is known that financial undertakings with entity-level disclosure obligations (those subject to the Non-Financial Reporting Directive, NFDR) will have to report on a defined list of PAIs (see RTS, article 6). The ESAs have also clarified in June 2022 that the use of PAI indicators is mandatory to demonstrate that an investment qualifies as a sustainable investment. In any case, the RTS (article 7) explicitly states that if data is not readily available, FMPs can explain the actions undertaken in terms of direct collection from investee companies, research and collaboration with experts and third-party data providers. (1)
What’s new regarding the EU Taxonomy?
Gas and nuclear are now eligible for climate change mitigation
Before moving to the clarifications introduced by the published RTS, it is important to remark that as of 15th July 2022, nuclear and gas are officially part of the list of economic activities for climate change mitigation (Del.Reg. 2022/1214). While the decision has encountered much criticism and even triggered legal action against the EC, official studies (UNECE, 2021) show the current requirements of the EU Taxonomy for gas practically exclude all power plants, unless carbon capture and storage (CCS) is implemented. As for nuclear, it is well established that currently, no mitigation pathway is achievable without its deployment (IPCC, 2022).
On the 30th of September, the ESAs have as well released the proposed amendments to the published RTS, which will require separate Taxonomy alignment disclosure for nuclear and fossil gas, within pre-contractual as well as periodic reporting.
2.2 Objectives 3-6
During March 2022 the Platform for Sustainable Finance (PSF) has issued the draft technical screening criteria for the Taxonomy remaining environmental objectives, which also includes new activities for climate change mitigation and climate change adaptation. At a first glance, the technical criteria will likely pose even more challenges for FMPs to assess within investee companies. While the report does not bind the European Commission on any decision on the matter, it is likely that the final Delegated Regulation will be on the lines of the proposed screening criteria.
2.4 What’s new within the RTS?
When they promote an environmental characteristic or pursue an environmental objective, the published RTS confirms that it requires Taxonomy alignment reporting for article 8 as well as article 9 financial products, respectively.
What still leaves room for uncertainty concerns the type of data used. Recital 35 of the published RTS states that FMPs should rely on publicly reported data or on equivalent data, either obtained directly from the investee company or through third parties. In the words of the European Commission, equivalent data are exactly those required by the EU Taxonomy under article 8 Del.Reg. 2021/2178. It remains unclear how third parties should obtain data that are equivalent to a final Taxonomy alignment from companies that lack any sustainability reporting obligations, or how FMPs will be able to leverage such data in a cost-effective way.
What we have learned so far from the EU Taxonomy?
It is undoubtful that the EU Taxonomy has introduced a clear set of criteria that allows for meaningful comparison across financial products marketed in the EU and labeled as sustainable. One could argue that it provides an even more meaningful comparison metric than the PAIs, whose aggregate nature hides relevant differences between sectors and companies, particularly along some environmental metrics.
As we tried to explain in our previous article, the EU Taxonomy is an extremely complex assessment process, with even harder criteria to understand and verify. We look at some of these complexities in the next paragraphs.
1. The list of eligible activities: the devil’s in the details
Those who are familiar with Del.Reg. 2021/2139 (which outlines the technical screening criteria – TSC – for climate change mitigation, CCM, and adaptation, CCA) know by now that the eligible economic activities are extremely niche. While for each activity the correlated NACE codes are signaled, these latter have an exact match with the eligible activities in approximately 30% of the cases. This element alone leaves financial undertakings with a significant gap to cover in terms of data, especially when dealing with non-NFDR entities, and in the absence of adequate segment reporting.
Furthermore, with the RTS explicitly stating that turnover should be the default KPI for financial products when calculating Taxonomy alignment, this leaves out most of the eligible activities for climate change adaptation: the most applicable requirement for this objective revolves in fact around the performance of climate risk assessments and the implementation of adaptation solutions, actions that are best measured by opex/capex KPIs.
2. The substantial contribution criteria: unclear assumptions
Practitioners of the EU Taxonomy know that technical screening criteria pose significant challenges. Issues revolve not only around the complexity of the metrics but also around inconsistent criteria.
For example, why should the construction of transmission and distribution lines connect only generation facilities within the 100 g CO2e/kWh threshold, while the construction of thermal energy storage facilities carries no mandates as for the source of stored energy? But first and foremost: why should the infrastructure enabling electrification bear the responsibility for the type of carried energy?
Other issues revolve around approximate measures employed, such as thermal transmittance thresholds (U-value) for roofing and external wall systems. Latter, these being themselves the result of multiple assembled materials adapted to the final welcoming building, and therefore hard to be defined ex-ante in terms of U-values.
3. DNSH: do not significant harm or best practice?
While the principle of “do not significantly harm” carries high value in encompassing all the environmental dimensions (e.g. not considering aligned solar farms that have a detrimental impact on biodiversity), the mismatch between its literal meaning and the Taxonomy requirements are evident.
The Taxonomy text ranges from generic requirements such as the implementation of waste management plans ensuring maximal recycling and reuse, to specific technical criteria for air pollutants.
Manufacturing activities such as cement, chemicals, iron, and steel, should also fulfill air pollutants thresholds as indicated in BAT (Best Available Techniques) Conclusions. Such documents feature an even higher complexity than the TSC document of the EU Taxonomy. But even most importantly, emission thresholds are in units of measure (e.g. mg/Nm3) that find no correspondence in usual company reporting, making it hard to get the actual picture not only of the company but of the entire industry.
4. Minimum safeguards: controversy screening or due diligence disclosure?
Practitioners might know that on the 11th of July the Platform for Sustainable Finance (PSF) issued a draft Report on Minimum Safeguards (MS) criteria. Such criteria encompass human and labor rights, corruption matters, tax compliance, and fair competition. The PSF clearly identifies the elements that would signal non-compliance with MS:
- Inadequate or non-existent corporate due diligence processes on the identified topics;
- final conviction of companies in court in respect of any of the four topics;
- lack of collaboration with a National Contact Point (NCP), and an assessment of noncompliance with OECD guidelines by an OECD;
- non-response to allegations by the Business and Human Rights Resource Centre.
The MS mainly builds on the OECD Guidelines for Multinational Enterprises (OECD MNE Guidelines), the UN Guiding Principles on Business and Human Rights (UNGPs), the International Labour Organization Core Conventions (ILO CC), and the International Bill of Human Rights. Some aspects of these documents are, however, mandatory in many countries, and will be further covered through the EU-proposed Directive on Corporate Sustainability Due Diligence (CSDDD) and the Corporate Sustainability Reporting Directive (CDRD). As requirements are set for companies meeting specific employee, turnover, and balance sheet thresholds, this leaves out more than 90% of EU companies, which are SMEs.
PSF’s position on controversial screening as a proxy for MS assessment
Before understanding which are the proposed requirements for SMEs, it is worth spending some time examining the PSF’s position on controversial screening as a proxy for MS assessment. It is worth noticing that currently, FMPs employ controversy screening tools as provided by ESG Rating agencies for monitoring the management of social and ethical dimensions. According to the PSF, this fails to capture if companies have put in place adequate human rights and ethical due diligence processes (HREDD): “This approach would however be against the meaning of [the Taxonomy]”.
ESG Providers know that controversy screening is a factual test against companies’ self-reporting, usually providing more insights on the risks faced by the industry and the management of the company pertaining to a specific issue. Also, when evaluating the severity of an incident, it usually factores in company response, as well as the systematicity of the incident. Furthermore, high disclosure rates do not necessarily correlate with lower controversy detection, sometimes the contrary.
With this respect, getting back to SMEs, it remains unclear why the self-reporting of existing policies, risk assessment, and governance should weigh more than a scrupulous detection of company breaches.
Conclusions
Much has changed in the sustainable finance landscape during the past quarter. According to Morningstar, global sustainable funds registered a 62% fall of new net money in Q2 compared to the USD 87 billion of inflows in the first quarter, amid concerns over a global recession, inflationary pressures, rising interest rates, and the conflict in Ukraine. However, sustainable fund launches have not stepped back, with Europe still leading the way.
Current contingencies have not however slowed regulatory development in the EU, and while Taxonomy disclosure for financial products remains timid, from January 2023 we are very likely to see a different picture if FMPs are to keep marketing environmentally sustainable investments in the EU. (2)
(1) See also the European Commission Q&A on the SFDR from July 2021.
(2) Entities subject to Articles 19a or 29a of Directive 2013/34/EU.
