Those who have had to navigate and consider the EU Sustainable Finance Disclosure Regulation (SFDR) have faced its challenges and noted its deficiencies. Specifically, these have included data gaps, the SFDR's use as a labelling rather than disclosure framework, and its failure to accommodate transition assets. Generally, the need for greater legal certainty, more straightforward and tailored application, and better international co-ordination. Despite its September 2023 consultations on a possible SFDR II, noted in our recent alert, the way in which the European Commission (the Commission) (or European Supervisory Authorities (ESAs)) would address these challenges and deficiencies has remained unclear.
With European Securities and Markets Authority (ESMA)'s 4 June 2024 final report on greenwashing, the 18 June 2024 Joint ESA Opinion on SFDR and, most recently, ESMA's 24 July 2024 Framework Opinion, a clearer picture is emerging.
The Framework Opinion takes a longer term view and looks at the entire sustainable investment value chain (issuers, ESG rating providers, benchmark administrators, asset managers, financial advisors and both retail and professional investors). It identifies various themes, with medium-term interim measures, aimed at simplifying the sustainable investment framework. It also draws on other EU workstreams and publications and is likely to be a useful indicator in setting the agenda for what the sustainable investment market could look like in the medium to long term.
We discuss its key themes below.
EU Taxonomy as a Central Point of the Framework
ESMA recommends that the EU Taxonomy should become the "sole, common reference point for the assessment of sustainability and should be embedded in relevant sustainable finance legislation." ESMA outlines what this involves, in particular:
- extending the EU Taxonomy to include all environmentally sustainable economic activities, including those with the potential to improve and for those that should be decommissioned (because they are significantly harmful and need to be retired or transitioned);
- developing a social taxonomy; and
- phasing out the SFDR "sustainable investments" Article 2(17) definition. Its inherently flexibility can result in weak "do no significant harm" (DNSH) tests being applied to portfolio holdings; also the use of overly generic sustainable objectives at fund level can have the consequence of inconsistent market approaches that hampers comparability.
Given that full deployment of the EU Taxonomy is an ambitious ongoing process, ESMA supports the ESA's view of the need in the medium-term to revisit some SFDR overarching concepts, including the application of principal adverse indicators and the definition of 'sustainable'.
Implementation of a Product Categorisation System
ESMA supports the ESA call (also consulted on by the Commission) for creating 'transition' and 'sustainable' categories with clear eligibility requirements and minimum criteria and with tiered disclosure requirements and naming and marketing restrictions and that would provide clarity to retail investors in particular, and also support investors' 'sustainability preferences' and product governance under MiFID II. Whilst there is no reference to the FCA's Sustainability Disclosure Requirements and labelling regime (that we discussed most recently here), there are several common strands with ESMA's suggestions – a regime that is voluntary, with strict eligibility criteria and regular review requirements and accompanying disclosures/transparency obligations.
ESMA sets out some detailed thoughts around expectations of the categories, as detailed in the table below. A complementary grading tool (considered in the ESA Opinion as a 'sustainability indicator') could be used in the long term, following consumer testing to assess retail investors' understanding.
| Sustainable Investments Category | Transition Category |
|---|---|
| Products with a common denominator to make sustainable investments i.e. EU Taxonomy-aligned |
Products with a common denominator to make transition investments i.e. that achieve sustainability over time, in line with headline EU and global objectives Build on transition-focussed tools such as EU Climate Benchmarks and funds with GHG emissions reduction objectives |
| Standardised set of metrics | |
| Comply with DNSH principle (i.e. not harm the Taxonomy objectives, even if they do not yet comply with the substantial contribution criteria) | |
| Ease the application of the DNSH criteria for currently harmful transitionary activities and activities that are decommissioning that cannot avoid significant harm | |
| Regular review of the eligibility criteria (adjusted as alignment in the real economy increases) related to Taxonomy-alignment | Consider obligation to ensure a minimum share of reduced “financed environmental or social impacts” reflects actual reduction in E/S impacts of investee companies based on active engagement as an example |
Effectively Supporting the Transition
More broadly, ESMA recommends incorporating a definition of transition investments into the wider framework, in order to provide legal clarity and support the creation of transition-related products. This involves an overall mapping and assessment of current obligations of financial and non-financial undertakings in terms of transition planning and transition plan disclosures. Also, enhancing the scope and robustness of transition investing tools, such as "raising the ambition" of EU Climate Benchmarks minimum standards and creating high-quality EU labels for transition bonds and sustainability-linked bonds.
Adapted Transparency Requirements
ESMA suggests that there should be uniform disclosure requirements for all products under SFDR (again, an area that the Commission sought feedback on in its SFDR consultations), regardless of their sustainability claims — which would be a departure from specific disclosures required for only those that fall under SFDR Article 8 and 9.
As part of this, ESMA recommends the application of a limited selection of sustainability metrics in the form of KPIs, that are based on existing Taxonomy information and leverage off European Sustainability Reporting Standards (ESRS) and SFDR datapoints that are applied proportionately, are subject to consuming testing and regular review to reflect their evolving nature and ensure their continued relevance. ESMA also invites the Commission to first gather industry feedback and carry out a cost-benefit analysis.
In addition, ESMA recommends a review of products not in scope of SFDR, in particular those that can effectively contribute to channelling capital flows to sustainability objectives (such as MiFID II financial instruments), and that should be subject to minimum disclosures.
Given that this is another long-term project, ESMA supports the ESA proposal in interim, that: products that fall under product categories would provide disclosures appropriate to the given category; products that have sustainability features but do not qualify for categories would make limited disclosures on their sustainability features; while products with no sustainability features would make minimal disclosures on adverse impacts on sustainability.
ESG Data Quality
ESMA makes various recommendations in this area, including on monitoring the practical application of the ESRS; continuing improving consistency of ESG metrics across the framework, along with standardisation and machine-readability and bringing ESG data products within the regulatory perimeter.
Conduct of Market Actors
ESMA states that in principle all market actors should be responsible for conducting their own proportionate due diligence and materiality assessments and calls for active engagement with investee companies, clear goal setting, escalation mechanisms and disclosures on goal achievements. It supports the Corporate Sustainability Due Diligence Directive (CS3D) as a "step in the right direction" to promote deeper integration of sustainability matters into investment strategy and risk management practices. CS3D entered into force on 25 July 2024 and will apply on a phased basis from 2027. It requires in-scope companies (which includes non-EU companies generating a net turnover > €450 million within the EU) to integrate due diligence measures into their policies and risk management systems to identify and address human rights and environmental risks that result from their own operations, as well as those of their subsidiaries and business partners. Although financial services downstream activities are not in scope to start, a review earmarked for July 2026 may change this.
Finally, ESMA suggests that the Commission considers introducing an EU-wide voluntary stewardship code for market actors, that would apply to asset managers and institutional investors, alongside benchmark administrators and investment service providers and would be of particular benefit to smaller market actors.
Final Thoughts
Areas of future focus are broad and tall but the ESMA framework opinion helps identify key areas of expected outputs. Regulatory focus in this area, along with more appetite for scrutiny and challenge, is inevitable.
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