On July 6, 2021, the European Commission (“EC”) published, as announced, its new Strategy for financing the transition to a sustainable economy. This strategic plan leverages on the prior Sustainable Finance Action Plan (and the related actions already undertaken), further developing the ambitious targets in order to finance the Green Deal objectives.
1. Financing the transition of the real economy towards sustainability:
The EC will continue efforts to extend the Taxonomy framework, recognising transition efforts, establishing a framework for intermediate level of environmental performance and extending the scope of covered activities. Asset managers will be interested to note that the EC also plans to consider labels for ESG benchmark and minimum sustainability criteria for financial products that promote environmental or social characteristics. We shall indeed acknowledge that the Sustainable Finance Disclosure Regulation (SFDR) had often been misunderstood by the market, being erroneously assimilated to a product classification regulation rather than a disclosure requirement—in fact SFDR is not a compliance regulation but a disclosure regulation: whenever a manager claims that a product promotes certain ESG characteristics, he must commit to a full transparency on how these characteristics will affect the investment decision process and the portfolio of the product. This pervasively-spread misunderstanding of the SFDR objective had led to the frequently heard criticism that SFDR shall include minimum sustainability requirements for Article 8 products, which seems the approach now contemplated by the EC. Let’s hope that this initiative, which seems at first glance, to alter the nature of SFDR rather than address the market misperception, will not undermine the SFDR objective on transparency, by discouraging managers to embrace the Article 8 disclosure requirements. In that context, the recent EC response to the ESA’s questions on SFDR (see below) is encouraging, as it confirms the SFDR approach in defining an Article 8 product: as soon as a fund “promotes” Environmental or Social characteristics, directly or indirectly, it shall apply the transparency requirements foreseen by Article 8 SFDR to explain how these characteristics are attained, without imposing certain thresholds or preset investments requirements.
2. Towards a more inclusive sustainable framework:
Specific actions are contemplated for SMEs (supporting them in their sustainability transition) and retail investors (green retail lending, sustainability education/literacy of advisors and citizens). Digital tools will also be considered as potential enablers for measuring and disclosing sustainability aspects. On the other hand, more consideration will be given to the potential negative sustainability impact of certain digital finance technologies such as crypto-assets. Finally, whilst the focus so far had been predominantly on the E of ESG, the S and the G will not be forgotten, with the planned launch of the Social Taxonomy in 2021 and a proposal on Sustainable Corporate Governance.
3. Improving the financial sector’s resilience and contribution to sustainability:
Further emphasis will be placed on the double materiality concept i.e. how sustainability risks could affect the financial sector as well as how the financial sector can impact the sustainability transition. As sustainability risks are expected to have adverse impact on financial stability and the financing of the real economy, measures to improve assessment and the monitoring of such risks are planned such as, integrating the assessment of these risks in financial reporting and accounting standards (IFRS), in credit ratings methodologies, in risk management systems and prudential requirements, including at system and macro-level. On the other side, measures will be taken to encourage financial institutions to commit to sustainability targets and a transition plan, to ensure that pension funds take into consideration members and beneficiaries’ sustainability preferences and sustainability goals, to review the investors’ stewardship and engagement activities (SRD II) and improve the availability and reliability of ESG data, research and ratings. Members States and National Competent Authorities shall also play a key role in preventing green washing.
Fostering global ambition: As the leader in Sustainable Finance, the EU plans to promote the sustainability consensus agenda within international forums as well as supporting the work of the International Sustainable Finance Platform and the efforts of low and middle-income countries.
The EC had also issued a proposal for an EU Green Bond Standard. The standard will be available for EU and non-EU issuers, including corporates, sovereign and financial institutions and issuers of covered bonds and asset-backed securities. The issuer shall allocate 100% of the bonds’ proceeds to projects aligned with the Taxonomy (at the time when the bonds mature), including the financing of long-term alignment plans (up to 10 years) of transitioning activities. The standard will require pre-issuance and post-issuance reviews by external reviewers. ESMA will maintain a list of authorised external reviewers.
On July 6, the EC also published its proposal of delegated acts under Taxonomy Article 8.
The Article 8 of the Taxonomy foresees that financial and non-financial corporates required to issue non-financial report under Directive 2013/34/EU (i.e. very large listed undertaking with more than 500 employees for the time being, until CSRD expands the scope of NFRD) will be required to disclose the alignment of their activities with the Taxonomy. It does not concern financial products (such as investment funds) for which separate RTS in relation with Taxonomy disclosure are under preparation (see JC 2021/22).
The delegated acts specify the calculation and disclosure requirements for non-financial and financial companies (banks, asset managers, investment companies and insurance companies). Asset managers reporting under NFRD will be required to publish a ratio between the aligned assets (numerator) and the total AUM that they manage (denominator). Sovereigns (except certain green bonds) will be excluded from both the numerator and the denominator. For banks, the Green Asset Ratio will also take into consideration lending and commission generating activities.
The proposal does not, unfortunately, address certain of the shortfalls of the exposure draft:
Financial undertakings will not, in the short term, be allowed to consider in their numerator potential alignment voluntarily reported by companies below the NFRD threshold. By creating such size-related distortion, the text actually disincentivises smaller aligned companies to publish Taxonomy alignment as they will not be able to fully leverage on their alignment level when negotiating financing terms with financial institutions.
In 2022, companies will only report the portion of their Taxonomy-eligible activities. Non-financial undertakings will only start reporting their actual level of alignment with the TSC from 2023. This implies that asset managers will struggle in getting comprehensive data on their investments’ Taxonomy alignment ahead of committing on a certain level of minimum taxonomy alignment at portfolio level (required in 2022).
The EC announced its intention to defer the implementation of SFDR level 2 (including Taxonomy alignment disclosure at product level) by six months (July 1, 2022 instead of January 1, 2022). This would be a welcomed move as the previously announced sequence in the timeline (endorsement of SFDR level 2 in July 2021 to be subsequently modified by the Taxonomy RTS) was creating a lot of headaches for project managers. The delay shall allow for the combined RTS to be adopted as a single package. Managers shall nevertheless not defer their implementation plans as the timeline remains really tight and challenging. Moreover, the six month delay will not be enough to address the data time gap between the reporting at product level and reporting requirements from the underlying investments. Indeed, as mentioned above, Taxonomy alignment data shall not be reported before 2023. Moreover, SFDR-related data from underlying companies (like the “PAI”) will only be reported when CSRD will be implemented (at best in 2024, if the very ambitious EU timeline is met).
On July 11, the Sustainable Finance Platform issued a report on a potential Social Taxonomy, setting up the first foundation milestones for a Social Taxonomy envisaged by the end of 2021. The report elaborates on the merits, but also the challenges, in building a Social Taxonomy. It is proposing a two dimensional structure (vertical and horizontal dimensions) as well as covering the differences, but also the possible interactions, between a potential Social Taxonomy and the Environmental Taxonomy.
The platform also issued in July a report proposing an approach to extend the Environmental Taxonomy, allowing better recognition of the transition efforts. The current Taxonomy follows a binary approach: an activity is either aligned or not. Under the new proposed approach, more granularity would be introduced through the definition of Significantly Harmful activities (“SH”), Not Significant Impact activities (“NSI”), as well as an intermediate performance level and a “traffic light” color system.
Both reports are open for consultation until the end of August.
On 6 July, the EC adopted its answer to the SFDR related questions raised by the ESAs back in January. The EC confirms that registered AIFMs as well as non-EU AIFMS operating in the EU under NPPR shall apply SFDR.
It also clarifies the definitions of Article 8 and Article 9 products:
Article 9 products shall have sustainable investment as their objective. They may also, when required by prudential or product-related specific rules, include other investments for specific purposes such as liquidity or hedging - these investments shall meet minimum environmental or social safeguards in order to fit with the overall product sustainability objective.
The notion of “Promoting environmental or social characteristics” shall be understood in the broader sense as encompassing any direct or indirect claims that would give the impression that the product consider ESG characteristics in whatever form (investment policies, goals, targets, general ambition, standards) or media used (marketing documents, factsheets, use of labels, names).
SFDR is neutral in terms of product design, investment styles, tools, strategies, methodologies and the Article 8 does not impose composition of investments or minimum investment thresholds.
Alongside its ongoing consultation on sustainability disclosure for asset managers, the International Organization of Securities Commissions (IOSCO) recently issued another consultation on ESG ratings and data product providers. The consultation closes on 6 September 2021.
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