The EU shows no signs of giving up its reputation as an international leader in financial regulation. Ripples were sent worldwide when the bloc introduced the Markets in Financial Instruments Directive (Mifid II) and the General Data Protection Regulation (GDPR). This time the aim is to create a carbon neutral economy.
One of the areas to feel the pressure of this latest set of reforms has been finance. Financial services throughout the EU – and beyond – can expect to have to comply with a variety of new rules, ranging from the EU disclosure regime to the EU Taxonomy on Sustainable Finance.
Why are these changes being implemented?
Since 2018, the EU has been exploring how to integrate sustainability considerations into its financial policy framework in order to rally sustainable growth.
Measures introduced include the corporate disclosure of climate-related information – based on recommendations from the industry-led Technical Expert Group on Sustainable Finance, the Commission has developed new climate reporting guidelines. While non-binding, these compliment the 2017 non-financial reporting directive (NFRD).
There is also the EU Green Bond Standard, announced in January 2020 as part of the EU’s European Green Deal Investment Plan. Although not complete, it is largely based on the standards set out by the International Capital Market Association (ICMA) with its Green Bond Principles (GBP).
“Industry standards such as the GBP have successfully paved the way for the growth of sustainable finance and are arguably informing legislators and policy makers to a great extent,” said Nicholas Pfaff, head of sustainable finance at ICMA.
Beyond these non-legally binding areas of the sustainable finance plan, there are also two new pieces of regulation: the EU taxonomy for sustainable activities and the EU climate benchmarks and benchmarks’ ESG disclosures – both of which market participants are gearing up to comply with.
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While these will result in added reporting, most accept the necessity of the regulation. “At this moment in time it is not a case of being satisfied, but rather being something that is needed,” said Florence Bindelle, European Issuers general secretary. “We would like to ensure that there are proper definitions and that these can enable transition activities. There is, however, a need to better define how this works in practice. Some finalisations are still needed.”
What is the purpose of the EU taxonomy?
Having come into law last month following its approval by the European Parliament, the EU taxonomy acts as a tool to help investors assess whether an economic activity is environmentally sustainable, and navigate the transition to a green economy. By establishing a universal set of definitions for investors, issuers, and policy makers, it helps the market analyse whether investments are meeting environmental standards, and align with global policy commitments, such as the Paris Agreement.
Within the taxonomy, there are six objectives: climate change mitigation, climate change adaptation, sustainable and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems.
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“The plans for the taxonomy have been being discussed for some time, so people are aware of it and have had time to look what it will entail,” said Laetitia Hamon, head of sustainable finance at the Luxembourg Stock Exchange. “It is significant how the other regulations refer to the taxonomy. As something on its own, it is huge, but it is also embedded elsewhere in new regulations and standards such as the disclosure regime, as well the EU Green Bonds Standards.”
While market participants have largely welcomed the regulation, an area of contestation is how to navigate the ‘do no significant harm’ requirements. This requirement stipulates that when investments must not undermine any of the other definitions in the taxonomy.
The taxonomy remains an unfinished project. While accounting for many climate issues, what has not yet been confronted are social and governance problems. Climate change took precedence early on – especially as work begun before policy makers or the market were to discover the problems that the Covid-19 crisis has unleashed on society – but the issues of social and governance will soon be addressed.
“The EU taxonomy is a good start, but more work is needed. I like that the ambition level is high, as far as economic activities go it is pretty straight forward,” said Samu Mikael Slotte, head of sustainable finance at Danske Bank.
“There are some concerns about categories where the criteria are not necessarily correct, as well as economic activities that haven’t been covered at all, such as aviation and shipping. However, we need to start somewhere and I look forward to the EU expanding the taxonomy to other environmental areas beyond climate.”
The fact that the EU taxonomy is incomplete is a source of disappointment for some. “It is felt that there still isn’t enough detail yet for firms to begin to make the necessary changes to their structure, operations and product disclosure,” said Allen and Overy’s Emma Danforth. “One of the difficulties is that firms can’t look at the Taxonomy Regulation in isolation, but it needs to be looked at in parallel with the Disclosure Regulation where we are still waiting for the detail contained in the underlying secondary legislation.”
What is the EU disclosure regime?
The EU regulation on Sustainability-Related Disclosures will take effect on March 10 2021. Its aim is to enhance transparency regarding integration of ESG into investment decisions and recommendations. Many of the requirements of the Disclosure Regulation will apply to investment managers that do not focus on ESG mandates.
However, in spite of being less than a year away from the deadline, there is concern that many in the finance space are not yet up to speed with the requirements. A recent report by Linklaters found that a third of fund managers at infrastructure investment firms are unaware of the upcoming EU disclosure requirements, and out of those surveyed just over half were aware.
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“The EU disclosure requirements are due to come into force in just over seven months,” said Vanessa Havard-Williams, partner at Linklaters. “The clock is ticking for those funds who are yet to be across the detail, they will need to move quickly to ensure compliance.”
This was echoed by Hamon: “People only realised how much the ESG disclosure regime would hit them a few months ago, and it came as a surprise. Now that there is an awareness that mainstream products will be impacted too, there is under a year to prepare.”
Once in force, the regulation will require alternative investment fund managers (AIFMs), undertakings for collective investment in transferable securities (UCITS) management companies, as well as portfolio managers and investment advisers authorised under MiFID, to implement policies and make certain disclosures with regards to sustainability risks and sustainability factors relevant to their investment activities.
In spite of the new requirements, what works in the firms’ favour is that this is a soft law and operates on a comply or explain basis – leaving the market to determine the consequences of opting not to disclose.
Within the regulation, a sustainability risk is defined as an ESG event or condition that, if it occurs, could cause a negative material impact on the value of an investment. As stated in Article 3: “Financial market participants shall publish on their websites information about their policies on the integration of sustainability risks in their investment decision‐making process.”
Financial advisers must also make public information about their policies on the integration of sustainability risks in their investment advice or insurance advice.
Factors in scope include environmental, social and employee matters, as well as respect for human rights, anti-corruption and anti-bribery matters.
What about elsewhere?
While the regulations are European, there has been speculation that they could be applied elsewhere, though with a market push.
Another concern for market participants is the political element to this. For example, while the UK has been as vocal as its former partners in the EU on the need to tackle climate change, remaining aligned with rules from Brussels won’t bode well with the UK’s political classes. Despite the fact that fund managers tend to vocally object to fragmentation. “It is unclear whether a number of the EU's proposed regulatory reforms, including the taxonomy, will be adopted in the UK following Brexit. This adds another layer of uncertainty for UK firms,” said Baker McKenzie partner Caitlin McErlane.
Regulators in other jurisdictions are also expected to introduce parallel initiatives – and there are some who argue in favour of an alignment in international standards. “But as you’d often expect, others prefer to push back on this and go their own way,” said Allen and Overy counsel Tamara Cizeika. “It seems unlikely at the moment that the current US administration, for example, would be willing to work towards alignment with the EU.”
Chris Bishop, partner at Allen & Overy in Singapore, agreed. “Europe has provided a framework for the world, but I predict that Asia will be more piecemeal in its approach to ESG. Decisions to align with EU standards, such as the taxonomy on sustainable finance, will be made incrementally.”
The fact that enthusiasm is not rampant has concerned players in the EU. The Commission appears to have taken note, launching an international platform for sustainable finance as part of its action plan in 2018.
“It is worrying that, internationally, we could end up having different definitions for sustainability in other jurisdictions’ taxonomies,” said Slotte. “As it stands, the EU taxonomy could – with some adjustments – be used in third countries.”
Hamon agreed. “I hope that the taxonomy acts as an inspiration internationally, as it is the first step towards a universal classification system. It would be great to see the other countries not reinventing the wheel,” she summarised.
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