Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment amending Regulation 2019/2088 (the Taxonomy Regulation) entered into force on July 12 2020. The Taxonomy Regulation enables investment fund managers to gather reliable, consistent and comparable sustainability-related indicators from investee companies and incorporate that data into their investment decisions and to fulfil their disclosure duties under the Sustainable Finance Disclosure Regulation (SFDR, Regulation 2019/2088).
These two Regulations are part of the EU Commission’s renewed sustainable finance strategy and implementation of the action plan on financing sustainable growth. The action plan sets out a comprehensive strategy to reorient capital flows towards a more sustainable economy, mainstream sustainability into risk management and foster transparency and long-termism.
The EU taxonomy is the first green European classification system for environmentally sustainable economic activities. It recognises as environmentally sustainable economic activities that make a substantial contribution to a least one of the EU climate and environmental objectives.
As such, the Taxonomy Regulation classification system translates the EU’s climate and environmental objectives into criteria for specific economic activities for investment purposes. However, it is not a mandatory list of economic activities for investors to invest in and it does not (yet) cover social objectives – although a draft report on a social taxonomy has been established by the EU Platform on Sustainable Finance (dated July 2021).
This article outlines the scope of the Taxonomy Regulation and the key requirements. It also expands on the two requirements ‘substantially contributes’ and ‘do no significant harm’ and the interaction between the Taxonomy Regulation and other EU regulations.
Scope and key requirements
The Taxonomy Regulation applies directly in each EU member state. It applies to:
Financial market participants (FMPs) or issuers of financial products or corporate bonds that are made available as environmentally sustainable,
FMPs that make available financial products,
Undertakings subject to the obligation to publish a non-financial statement or consolidated non-financial statement (pursuant to Article 19a or 29a of Directive 2013/34/EU).
As such, the Taxonomy Regulation also lays down disclosure obligations for undertakings subject to the Non-Financial Reporting Directive (NFRD).
The term FMP includes, but is not limited to fund management companies i.e. managers of alternative investment funds and management companies of undertakings for collective investment in transferable securities, managing and/or offering financial products in the EU.
Thus, the Taxonomy Regulation principally applies to fund managers of investment funds that have been classified as ‘light green funds’ (Article 8 funds under the SFDR) promoting environmental or social characteristics and to ‘dark green funds’ (Article 9 funds under the SFDR) which contribute to an environmental objective.
The Taxonomy Regulation (level 1) amends the disclosure framework under the SFDR and imposes disclosure and reporting requirements on FMPs. It provides for the transparency of undertakings subject to an obligation to publish non-financial information.
On October 22 2021, the European Supervisory Authorities issued the final report on draft regulatory technical standards (RTS) (level 2) with regard to the content and presentation of disclosures pursuant to Articles 8(4), 9(6) and 11(5) of the SFDR. This sets out the detail of the EU taxonomy-related fund pre-contractual disclosures and periodic reporting (providing for a mandatory template) and applies from January 1 2023.
Environmentally sustainable investments
Article 5 of the Taxonomy Regulation lays down the requirements for pre-contractual disclosures and periodic reports for funds, referred to in Articles 9 (1), (2) and (3) of the SFDR, that invest in an economic activity that contributes to an environmental objective within the meaning of point (17) of Article 2 of the SFDR (providing a definition of ‘sustainable investment’). This requires FMPs to disclose in their pre-contractual disclosures and periodic reports:
1) Information on the environmental objectives, according to Article 9 of the Taxonomy Regulation, to which the underlying investments contribute; and
2) A description of how and to what extent the investments underlying the financial product are in economic activities that qualify as environmentally sustainable according to Article 3 of the Taxonomy Regulation.
A further requirement is to specify the proportion of investment in environmentally sustainable economic activities selected for the financial product. This should include details on the proportions of enabling and transitional activities referred to in Articles 16 and 10 (2) of the Taxonomy Regulation with a percentage of all investments selected for the financial product.
The Taxonomy Regulation sets out six environmental objectives:
a) Climate change mitigation,
b) Climate change adaptation,
c) Sustainable use and protection of water and marine resources,
d) The transition to a circular economy,
e) Pollution prevention and control,
f) The protection and restoration of biodiversity and ecosystems.
The two first environmental objectives apply from January 1 2022 and the remaining four will apply from January 1 2023. So pre-contractual and periodic disclosure obligations applicable to Article 9 funds apply from January 1 2022 in respect of the environmental objectives climate change mitigation and climate change adaptation.
Article 3 of the Taxonomy Regulation sets out several layers of conditions that apply for an economic activity to qualify as ‘environmentally sustainable’. Not only does Article 3 provide the criteria for what is an environmentally sustainable economic activity, but it also lays down the premises to establish the degree to which an economic activity is environmentally sustainable.
Such economic activity will have to:
a) Contribute substantially to one or more of the environmental objectives (set out in Article 9 in accordance with Articles 10 to 16 of the Taxonomy Regulation),
b) Not significantly harm any of the environmental objectives set out in Article 9 of the Taxonomy Regulation in accordance with Article 17 of the Taxonomy Regulation,
c) Be carried out in compliance with the minimum safeguards laid down in Article 18 of the Taxonomy Regulation, and
d) Comply with technical screening criteria that have been established by the Commission in accordance with Articles 10 (3), 11 (3), 12 (2), 13(2), 14(2) or 15 (2).
The first two requirements will be examined later in this article.
Financial products that promote environmental characteristics
According to Article 8 of the SFDR, various options may exist for the promotion of environmental characteristics. In practice that means that a fund classified as Article 8 of the SFDR may promote environmental characteristics, make sustainable investments that are not taxonomy-aligned and have sustainable investments aligned to the taxonomy.
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“FMPs should also consider applying the SFDR RTS requirements on a best effort basis before the entry into force on January 1 2023” |
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Article 6 of the Taxonomy Regulation provides for pre-contractual disclosures and periodic reports for funds classified according to Article 8(1) of the SFDR. Where they promote environmental characteristics, Article 5 of the Taxonomy Regulation shall apply mutatis mutandis.
The following statement must be included: “The ‘do no significant harm’ principle applies only to those investments underlying the financial product that take into account the EU criteria for environmentally sustainable economic activities.”
The investments underlying the remaining portion of this financial product do not take into account the EU criteria for environmentally sustainable economic activities.
Other financial products
Article 7 of the Taxonomy Regulation relates to financial products that are not classified as either Article 8 or Article 9 funds under the SFDR.
For such products, the following statement must be included: “The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities.”
Undertakings subject to the obligations to publish non-financial statements
Article 8 of the Taxonomy Regulation provides that any undertaking that is subject to an obligation to publish non-financial information pursuant to Article 19a or Article 29a of Directive 2013/34/EU (the accounting directive) shall include in its non-financial statement information on how and to what extent the undertaking’s activities are associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9 of the Taxonomy Regulation. Investment fund managers in scope should therefore disclose:
The proportion of their turnover derived from products or services associated with economic activities that qualify as environmentally sustainable (according to Articles 3 and 9 of the Taxonomy Regulation); and
The proportion of their capital expenditure and the proportion of their operating expenditure related to assets or processes associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9 of the Taxonomy Regulation.
On July 6 2021, the European Commission published the Delegated Regulation, which supplements the Taxonomy Regulation to specify the content, methodology and presentation of information to be disclosed by both financial and non-financial undertakings as regards the proportion of environmentally sustainable economic activities in their business, investments or lending activities.
The Delegated Regulation lays down the key performance indicators (KPIs) to be presented as part of the non-financial report. It also introduces the calculation methodologies for these KPIs and templates for standardised disclosures. Non-financial undertakings should disclose a certain amount of information from January 1 2022 to December 31 2022 (according to Article 10(1)) and financial undertakings should, (according to Article 10(2)), disclose information from January 1 2022 until December 31 2023.
The ‘substantially contributes’ and ‘do no significant harm’ criteria
Substantially contributes
As mentioned above, according to Article 3 of the Taxonomy Regulation, several layers of conditions are necessary for an economic activity to qualify as ‘environmentally sustainable’. A key element of the taxonomy lies in describing how and to what extent the investments underlying the financial product are in economic activities qualifying as environmentally sustainable.
The criteria for making a substantial contribution to one of the six environmental objectives are listed in Articles 10 to 16 of the Taxonomy Regulation and further detailed in the technical screening criteria (TSC) set out in the Delegated Regulation 2021/2139. This Regulation contains TSC for determining the conditions under which an economic activity qualifies as contributing substantially to only climate change mitigation and climate change adaptation and for determining whether that economic activity causes no significant harm to any of the other environmental objectives.
The European Commission considers activities to be making a substantial contribution when:
They have a low impact on the environment and the potential to replace high impact activities,
They reduce impact from other activities (e.g. wastewater treatment), or
They make a positive environmental contribution (e.g. restoration of wetlands).
The Taxonomy Regulation recognises two distinct activities that make a substantial contribution: transitional activities (Article 10(2)) and enabling activities (Article 16).
Transitional activities are defined as activities that support the transition to a climate-neutral economy and for which there is no technologically and economically feasible low-carbon alternative. For example, best-in-class cement manufacturing would qualify with three conditions: a) it has greenhouse gas emission levels that correspond to the best performance in the industry b) it does not hamper the development of low-carbon alternatives and c) it does not lead to a lock-in of carbon intensive assets considering the economic lifetime of these assets.
Enabling activities are defined as activities that directly enable others to make a substantial contribution to an environmental objective. For example, manufacturing of renewable energy technologies would qualify with two conditions: a) it does not lead to a lock-in of assets that undermine long-term environmental goals, and b) it has a substantial positive impact.
Do no significant harm
For an economic activity to be aligned with the climate change mitigation objective, it needs to make a substantial contribution to the objective and meet the do no significant harm criteria for the other five remaining environmental objectives.
According to the RTS, the FMP must do a dual assessment. In other words, in addition to complying with the relevant TSC, the FMP should also take into account the indicators for adverse impacts set out in table 1 annex 1 of the draft SFDR RTS published on February 2 2021.
The main purpose of the do no significant harm criteria is to ensure that an activity intended to make a positive contribution to environmental sustainability does not have a negative impact in pursuit of its objective or do more harm than good. A dual assessment must be made to be satisfied that the relevant investment meets the do no significant harm test. In addition to complying with the relevant technical screening criteria for the economic activity carried out by the investee company, the adverse impact indicators need to be taken into account.
It is intended that, over time, the TSC will be reviewed and will evolve on the basis of the latest developments and technological progress: more economic activities will be included and TSC will be developed for all the other environmental objectives.
For each of the environmental objectives under the Taxonomy Regulation, the TSC has identified relevant economic activities. If such economic activity is listed within the TSC, it is called ‘eligible’ under the Taxonomy Regulation. In practice, this means that this activity is capable of making a substantial contribution to one of the six environmental objectives.
To be aligned to the Taxonomy Regulation, the activity needs to meet all the criteria set out in the TSC, the substantially contribute criteria and the do no significant harm requirement and comply with minimum safeguards.
The NFRD, CSRD and other EU legislation
The Taxonomy Regulation lays down disclosure obligations for undertakings subject to the NFRD, which was transposed into Luxembourg law on July 26 2016 and applies since January 1 2017.
The NFRD requires large undertakings (those with more than 500 employees on average during the financial year) that are public interest entities to disclose information on environmental, social and employee matters, respect for human rights and anti-corruption and bribery matters.
In order to standardise the disclosure of non-financial information in management reports and to extend the scope of the NFRD, the European Commission published a proposal for a Corporate Sustainability Reporting Directive (CSRD). According to the EU Council position of February 18 2022, there are discussions about the application date.
The CSRD would amend four existing pieces of legislation: the accounting directive; transparency directive; audit directive; and audit regulation. It will replace the NFRD and extend the scope of the reporting obligations to all large companies and all companies including SMEs listed on regulated markets except for listed micro-enterprises. It would mean that all large companies are publicly accountable for their impact on people and the environment.
This proposal aims to improve the flow of sustainability information in the corporate world by revising the NFRD. It will make sustainability reporting by companies more consistent, so that financial firms, investors and the broader public can use comparable and reliable sustainability information for the benefit of investors and stakeholders. It also aims to align companies’ disclosures with the Taxonomy Regulation.
The CSRD will integrate the taxonomy alignment through the EU sustainability reporting standards developed by the European Financial Reporting Advisory Group, which released a first draft of sustainability reporting standards in January 2022. Companies could apply the standards for the first time to reports published in 2024 covering the 2023 financial year.
Fund managers offering Article 8 and 9 funds under the SFDR should also take into account the amendments to the Markets in Financial Instruments Directive (MiFID) II. On April 21 2021, the European Commission adopted two amending Delegated Acts to require MiFID firms selling undertakings for collective investment to integrate their clients’ preferences in terms of ESG considerations: (1) Commission Delegated Regulation (EU) (2021/1253 of April 21 2021 amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability risks and preferences into certain organisational requirements and operating conditions for investment firms and (2) Commission Delegated Regulation (EU) 2017/593 as regards the integration of sustainability factors into the product governance obligations.
Among other things, Delegated Regulation (EU) 2021/1253 and Delegated Directive (EU) 2021/1269 (amending Delegated Directive (EU) 2017/593 as regards the integration of sustainability factors into the product governance obligations, and applicable as of November 22 2022) require MiFID II companies to take sustainability risks into account when setting up risk management policies and procedures and when identifying conflicts of interest, including clients’ sustainability preferences in the information about investment objectives.
Distributors must include any sustainability-related objectives in the product governance arrangements and in the assessment of whether the product or service remains consistent with the identified target market.
Next steps
The development of the EU taxonomy should be closely monitored as it will continue to evolve. FMPs should prepare and start considering eligible activities under the taxonomy while understanding the data sources and data availability.
It is expected that data quality should improve within the next few years. In addition, FMPs should also consider applying the SFDR RTS requirements on a best effort basis before the entry into force on January 1 2023.
Isabel Høg-Jensen
Partner
BSP
T: +352 26 0251
Isabel Høg-Jensen is a Partner with BSP. Her practice focuses on assisting fund promoters and asset managers in relation to the structuring and establishment of a wide range of funds including undertakings for collective investment in transferable securities, private equity, real estate, infrastructure and debt funds.
Isabel advises clients on all aspects of the regulatory regime applicable to investment funds and in particular the alternative investment fund managers directive. She is the sustainable finance leader within the investment management department with BSP.