On June 13 2023, the European Commission (EC) released a new package of measures aiming to expand on and enhance the EU sustainable finance framework, promoting additional financial flows into sustainable initiatives. The EC’s updates address the existing framework’s inconsistencies, complexity, and regulatory gaps, increasing its readability, coherence and alignment while decreasing firms’ administrative burden.
The package’s key elements are:
An “environmental delegated act” that includes the technical screening requirements for the outstanding four EU Taxonomy Regulation (Regulation (EU) 2020/852) environmental objectives;
Amendments to the EU Taxonomy Climate Delegated Act, providing technical screening criteria that include more economic activities for the EU Taxonomy Regulation's climate change mitigation and adaptation objectives;
An EC proposal for a regulation on ESG rating activities, which aims to increase transparency and confidence in ESG rating providers while enhancing the accuracy and reliability of ESG data and market integrity. The proposal includes organisational principles and clear guidelines for avoiding conflicts of interest, an authorisation criteria for EU-established ESG rating providers, and an equivalence decision and process for non-EU ESG rating providers; and
Notice 2023/C 211/01 of the EC, published in the Official Journal of the European Union on June 16 2023 (FAQ), which clarifies some of the interpretative questions on the application of the EU Taxonomy Regulation. It also clarifies the status of investments in taxonomy-aligned economic activities and assets under the Sustainable Finance Disclosure Regulation (SFDR) (Regulation (EU) 2019/2088).
The user-friendly and long-awaited clarifications on the interpretation and application of certain statutory provisions of the EU Taxonomy Regulation and its link to the SFDR are particularly interesting and the main subject of this article.
The Taxonomy Regulation entered into force on July 12 2020 and introduced the taxonomy - at the EU level - of environmentally sustainable activities. This established a classification system to facilitate the identification of investments that could be considered sustainable from an environmental perspective. This important and complex piece of legislation:
Established the sustainability objectives and conditions that a company must comply with to be considered environmentally sustainable;
Imposed new disclosure obligations regarding environmentally sustainable economic activities; and
Amended the SFDR, a regulation that defines reporting obligations for financial market participants.
Even though the SFDR and the EU Taxonomy Regulation are inextricably linked (they cross-reference and share common principles and objectives), there are various inconsistencies and contradictions in the regulations. Many of these inconsistencies are conceptual, and this creates interpretation difficulties and makes the compatibility between the two legal instruments problematic, posing challenges to financial market participants. For example, while the EU Taxonomy Regulation only refers to environmentally sustainable investments, under the SFDR, the definition of sustainable investment is broader. Also, the concepts of minimum safeguards and good governance in the definition of sustainable investment and the ‘do no significant harm’ test for Article 8 and 9 funds overlap.
While there is still room for greater harmony, the FAQ clarifies two openly debated questions and helps the understanding of the legal instruments’ relationship and what they entail in practice.
Minimum safeguards
The EU Taxonomy Regulation establishes that an economic activity can only be considered environmentally sustainable (and the investment qualified as EU Taxonomy aligned) if, in addition to meeting the other three requirements of Article 3 ((i) contributes substantially to one or more of the environmental objectives of the regulation, (ii) does not significantly harm any of the environmental objectives set out in the regulation; and (iii) complies with technical screening criteria that have been established by the EC), it is carried out in compliance with the minimum safeguards set out in Article 18. This ensures, as the EC now clarifies, that entities carrying out such activities comply with certain fundamental social, human rights and labour principles and minimum governance standards.
The relevant operators assess the compliance of their activities with the specific requirements for minimum safeguards set out in Article 18, which refer both to:
International standards of responsible business conduct (OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the principles and rights set out in the fundamental conventions identified in the Declaration of the International Labour Organization on Fundamental Principles and Rights at Work and in the International Bill of Human Rights), which define these minimum safeguards; and
The principle of ‘do no significant harm’ referred to in Article 2(17) of the SFDR and specified in the Delegated Regulation (EU) 2022/1288 (Delegated Regulation), which ensures that undertakings making sustainable investments do not significantly harm environmental or social objectives. Indeed, the Delegated Regulation requires that, in addition to the mandatory disclosure of the alignment of sustainable investment with international standards, several indicators of key negative impacts should be considered.
Regarding the first requirement for compliance with the minimum safeguards (international standards), the FAQ clarifies that the procedures to be applied to ensure alignment with international standards include good corporate governance practices (i.e. responsible business conduct and responsible supply chain management) described therein. These include due diligence and remedy procedures that are considered appropriate to identify, prevent, mitigate or remediate the relevant actual and potential adverse impact connected with the undertaking and procedures that prevent human rights violations.
On the second requirement for compliance with the minimum safeguards (principle of ‘do no significant harm’), the EC considers that, as part of the due diligence and remedy procedures, the SFDR’s principal adverse impact indicators for social and employee matters, respect for human rights, anti-corruption and anti-bribery matters, and the exposure, sale or manufacture of controversial weapons, currently listed in Table 1 of Annex I of the Delegated Regulation should be addressed, as a minimum, to identify, prevent, mitigate or remedy relevant actual and potential adverse impacts related to undertakings’ operations, value chains and business relationships.
Therefore, regardless of how environmentally "green" an activity is, it will not be considered environmentally sustainable if the relevant undertaking has not adopted adequate measures to reduce human rights concerns in accordance with international standards.
In this context, the EC explains that an undertaking may be complying with the minimum safeguards even if it proves unable to address or eliminate certain adverse impacts. What will be relevant is the application of the appropriate procedures, the disclosure of the identified impacts, and the explanation of the reasonable due diligence and mitigation measures adopted.
By following the European Commission’s Platform on Sustainable Finance’s recommendations and best practices published last October, the EC’s further guidance provides a new understanding of how the EU Taxonomy Regulation minimum safeguards test (which guarantees that environmentally sustainable activities adhere to social standards and guidelines) interacts with the SFDR’s principle of ‘do no significant harm’ used in the assessment of sustainable investments. Consequently, this aligns with the SFDR’s disclosures with such a test of the Taxonomy Regulation.
According to the FAQ, the mandatory reporting of information corresponding to the indicators of key negative impacts required by the Delegated Regulation when complying with the disclosure obligations of the Corporate Sustainability Reporting Directive (CSRD) (Regulation (EU) 2022/2464), will help companies assess compliance with the requirements of Article 18 of the EU Taxonomy Regulation. This will help investors get the necessary information from the former. As mentioned above, under the Corporate Sustainability Due Diligence Directive, companies must have in place human rights and environmental due diligence procedures, also ensuring alignment with the EU Taxonomy Regulation’s minimum safeguards.
Sustainable investments under the SFDR
The EC clarifies that investments in economic activities that are environmentally sustainable and aligned with the Taxonomy are automatically considered sustainable investments under the SFDR. This is because the criteria for fulfilling that concept (the ‘do no significant harm’ principle, the contribution to a sustainable objective and the requirement to ensure that an investee company follows good governance practices according to point 17 of Article 2 of the SFDR) are deemed to be met by compliance with the requirements set out in the aforementioned Article 18 of the EU Taxonomy Regulation. Thus, investments in Taxonomy-aligned ‘environmentally sustainable’ economic activities have to be considered when completing the product level disclosure requirements under the SFDR.
That said, when the activity alignment with the EU Taxonomy is not fully verified, it will still be necessary to check whether the remaining economic activities of the undertaking comply with the environmental elements of the SFDR principle of ‘do no significant harm’. It is likewise necessary to determine whether the contribution to the environmental objective is deemed sufficient for the investment in that undertaking to be considered sustainable under the SFDR. In fact, the FAQ complements the April 2023 Q&A relating to the EC’s statement that Article 9(3) of the SFDR applies to funds that passively monitor an EU climate benchmark and are regarded as having sustainable investments as an investment objective.
Moreover, the FAQ confirms that when a fund’s investments fully align with the EU Taxonomy, provided the minimum safeguards test is applied, it is unnecessary to comply with Article 2(17) of the SFDR “sustainable investments” test, which disregards the SFDR’s ‘do no significant harm’ assessment. Practically speaking, the interplay between the two legislative instruments shows that the mandatory principal adverse impact indicators may not be considered, but Article 8 and Article 9 funds that are taxonomy-aligned must still provide information on the minimum safeguards alignment of their portfolio companies.
This Taxonomy “safe harbour” (to disapply principal adverse impact indicators) appears to come from a European Supervisory Authorities’ (ESAs) suggestion published on April 12 2023. It proposes amendments to the SFDR Delegated Act’s consultation, and the creation of an optional "safe-harbour for environmental do no significant harm’. As such, “environmentally sustainable” investments under the EU Taxonomy would not be required to meet the SFDR’s ‘do no significant harm’ test. That was not the first time the ESAs have argued on how the ‘do no significant harm’ test for sustainable investment should be connected to the ‘do no significant harm’ test under the EU Taxonomy Regulation.
Indeed, the supervisory authorities suggested in their March 2021 joint consultation paper on Taxonomy-related sustainability disclosures that the Taxonomy’ test should replace the SFDR’ test, such that investments in Taxonomy-aligned activities would thus be considered sustainable investments under the SFDR. This latter suggestion was later updated for the correlation between the tests to become conditional to respecting the ‘do no significant harm’ principle.
While the EC now clarifies that this safe harbour is already in place, the following question has been left unexplained. What was the rationale employed if the assessment of the EU Taxonomy “environmentally sustainable” test is at an economic activity level while the SFDR “sustainable investment” test is conducted at an entity/investment level?
Regardless, the clarification of the EU Taxonomy Regulation’s link to the SFDR shows that the first regulation is used beyond the “sustainable finance” regulatory framework. This means it should be seen as a foundation for environmental sustainability and the promotion of the use of proceeds, while acting as a guideline for SFDR product disclosures and fund classification with correspondent changes in pre-contractual and website disclosures. For instance, in “Article 9” funds, asset managers no longer have to use EU Taxonomy criteria to evaluate the alignment of their sustainable investments.
In reality, expectations are high as to whether these clarifications may result in more funds pledging to make 'sustainable investments' under the SFDR or even to disclose under Article 9 of the SFDR. Whatever happens, it will certainly be hampered by the FAQ’s timing, as many funds have already classified their funds and made their pre-contractual and website disclosures available.
Concluding thoughts
Overall, while there is still room to enhance the overall coherence and effectiveness of the EU sustainable finance framework, as well as to improve regulatory consistency and simplification, the FAQ is an important piece of the regulatory puzzle. The EC made it clear that the framework is to be constantly updated and that the EU’s sustainable finance programme is not slowing down.
While waiting for further clarification and harmonisation between the SFDR and the EU Taxonomy Regulation, companies and asset managers seeking to position themselves for the next framework changes should concentrate on the Commission’s consultation on reviewing the SFDR. This is expected in the fall of 2023, and may eventually lead to 'SFDR II'.
