Overview Of ESG Regulation Of Financial Products In The European Union

As a result of the 2015 Paris Agreement and the United Nations Sustainable Development Goals, which entered into force almost simultaneously, the European Union put sustainability issues high on the political agenda.
European Union Environment

As a result of the 2015 Paris Agreement and the United Nations Sustainable Development Goals, which entered into force almost simultaneously, the European Union put sustainability issues high on the political agenda. In the March 2018 Action Plan on Financing Sustainable Growth, the European Commission set out 10 measures to steer capital flows toward a more sustainable economy. The financial system is to play a key role and will be comprehensively restructured so that private capital can be specifically channelled into sustainable investments.

Measures outlined in the Action Plan include promoting investment in sustainable products, considering sustainability in financial advice, embedding sustainability in risk management, and clarifying the sustainability obligations of institutional investors and asset managers. The Commission's priority, however, is a common understanding of the term "sustainable", so the development of a uniform classification (taxonomy) of sustainable activities within the European Union is the most important measure of the Action Plan. This is accompanied by the Sustainable Finance Disclosure Regulation ((EU) 2019/2088) (SFDR), which enables investors and stakeholders to invest their capital taking sustainability considerations into account.

The Taxonomy Regulation

The EU Taxonomy Regulation for Sustainable Investments ((EU) 2020/852) came into force on 1 January 2022. It contains-in simplified terms-criteria for determining whether or not an economic activity can be classified as environmentally "sustainable". The Taxonomy Regulation lays the foundation for an EU framework that integrates environmental, social and governance (ESG) considerations into the financial system.

At the moment, however, the Taxonomy Regulation only regulates criteria for environmentally sustainable economic activities and defines environmental objectives that are considered sustainable, such as climate change mitigation or climate change adaption. It does not include a defined label for sustainable financial products, nor obligations for financial market participants to launch or invest in sustainable products. The taxonomy for social and governance aspects are still pending.

According to the Taxonomy Regulation, an economic activity is considered to be environmentally sustainable if it makes a substantial contribution to at least one of the following six environmental objectives and doesn't significantly harm any of the other five (the Do No Significant Harm criteria):

  • Climate change mitigation
  • Climate change adaption
  • 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.

Establishing an accepted taxonomy is a mammoth project, so the environmental objectives of the Taxonomy Regulation, and the precise criteria for when economic activities must meet the environmental objectives, are coming into force in succession. Since the beginning of 2022, objectives 1 and 2-climate change mitigation and adaptation-have come into force. On 1 January 2023, the other four environmental objectives were added, but their exact criteria are currently still open.

The Sustainable Finance Disclosure Regulation

The SFDR came into force on 10 March 2021. The Regulation aims to ensure the transparent disclosure of the sustainability of financial products and prevent "greenwashing", in particular by reducing information asymmetries. Investors in financial products will receive standardised, comparable information on the sustainability aspects of financial products and their providers. The SFDR is also intended to increase investors' awareness of sustainability aspects in investments. To avoid greenwashing, asset managers are prevented from claiming that their products are sustainable or ESG-friendly if they cannot justify that claim.

In order to achieve these goals, the SFDR differentiates between financial products that

  • Have no sustainability goals (Article 6 funds)
  • Promote, among other things, environmental or social characteristics (Article 8 funds)
  • Have sustainable investment as an objective (Article 9 funds).

The Regulation imposes pre-contractual information and subsequent reporting obligations on the providers of financial products, depending on the type of product. The SFDR does not stipulate any qualitative requirements for financial products, instead it simply requires the provision of information on the sustainability of financial products. The specification of any kind of ambition level is not covered by the SFDR.

Relationship Between the Taxonomy Directive and the SFDR

While the SFDR requires disclosure by financial market participants with respect to only certain information, the scope of the Taxonomy Regulation is broader. The classification system contained in the Taxonomy Regulation is intended to establish clear criteria throughout the European Union as to which economic activities can be considered sustainable. At present, there is only an overlap to the extent that, under the SFDR, information must also be provided on the percentage of investments in a product that meet the criteria of the Taxonomy Regulation.

Current Market Practice

Although it is not the aim of the SFDR to introduce minimum thresholds for sustainable products, the categories into which financial products fall are being regarded as a kind of "product label". Funds are being marketed as being Article 8, or Article 9, etc., even though the SFDR does not sufficiently specify what criteria must be met for a product to fall under Article 8 or 9.

There is a corresponding desire in the market for qualitative standardisation by the regulator and/or local supervisory authorities, which would help avoid any civil law or supervisory law risks resulting from greenwashing.

Outlook

The implementation of the Taxonomy Directive and the SFDR is a major undertaking and the European Union is already falling behind on its own ambitious schedule. In practice, this means, for example, that fundamental questions of regulation are still unresolved, even though there are already detailed requirements for reporting obligations. The difficulty of classifying economic activities as sustainable is exemplified by discussions on the question of whether or not nuclear energy or fossil gas are to be classified as sustainable.

The question hanging over the SFDR is whether it should in future serve its actual purpose of creating comprehensive transparency in financial products, or whether it should be successively expanded into a regulation on labelling. If the latter, clear definitions of and requirements for Article 6, 8, and 9 products would be necessary, and the relationship between the SFDR and the Taxonomy Regulation would have to be realigned.

It is likely, given the current status of the project, that the regulation of ESG disclosures will occupy the European Union and business for many years to come. The increasingly obvious progress of climate change means, however, that there is no alternative other than to transform the existing financial and commercial systems.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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