European Commission Releases New Sustainable Finance Package: Q&A to Bring you Up to Speed

Q&A on the EU's New Sustainable Finance Package

1. What's the latest sustainable finance package from the European Commission?

On 13 June 2023, the European Commission (Commission) released a new sustainable finance package. Broadly, these comprise:

• EU Taxonomy:
  • the approved EU Taxonomy Environmental Delegated Act (Environmental Delegated Act);
  • amendments to the EU Taxonomy Climate Delegated Act (Climate Delegated Act);
  • amendments to the EU Taxonomy Disclosures Delegated Act (Disclosures Delegated Act);
  • a Commission Notice on the interpretation and implementation of certain legal provisions of the EU Taxonomy Regulation and links to the Sustainable Finance Disclosure Regulation (SFDR); and
  • a staff working document on enhancing the usability of the EU Taxonomy and the overall sustainable finance framework.
• ESG Ratings: A proposed regulation on ESG rating providers; and
• Transition Finance: A Commission Recommendation on facilitating finance for the transition to a sustainable economy.

2. Why has the Commission introduced this package?

The package builds on the EU's existing sustainable finance framework, the three pillars of which are said to be:

• The EU Taxonomy, the cornerstone of the sustainable finance framework, is a classification system for companies, investors and policymakers to identify economic activities that can be regarded as environmentally sustainable or green.
• Rules on disclosures and reporting that apply to companies and investors to increase transparency across the market and mitigate the risk of greenwashing.
• Tools, including standards and labels for Climate Benchmarks and the EU Green Bond Standard.

In recognition of the challenges faced by companies and investors in meeting new disclosure and reporting requirements, the Commission says its package is intended to ensure workability of the sustainable finance framework on the ground.

This package follows the publication of the draft delegated act setting out the first set of general EU sustainability reporting standards (ESRS1 and ESRS2) under the Corporate Sustainability Reporting Directive (CSRD) on 9 June 2023. We will release a separate blog on this shortly.

EU Taxonomy

3. What's the current status of the EU Taxonomy Delegated Acts?

The Environmental Delegated Act, the Climate Delegated Act and the Disclosures Delegated Act together make up the EU Taxonomy Disclosures Delegated Acts (Taxonomy Delegated Acts). The Commission's package approved (in principle) the Environmental Delegated Act, and adopted (in principle) amendments to the Climate Delegated Act and the Taxonomy Disclosures Delegated Act.

These are by no means unexpected developments. On 5 April 2023, the Commission published for consultation its proposals in respect of the Taxonomy Delegated Acts (see our briefing, Commission consultation on environmental taxonomy is underway). The latest Commission package has largely kept these earlier proposals intact. Broadly, these are as follows:

• Environmental Delegated Act: sets out criteria for economic activities making a substantial contribution to one or more of the following environmental objectives:
  • the sustainable use and protection of water and marine resources;
  • the transition to a circular economy;
  • pollution prevention and control; and
  • the protection and restoration of biodiversity ecosystems.
• Amendments to Climate Delegated Act: these expand on economic activities contributing to climate change mitigation and adaptation that are not yet covered.
• Amendments to Disclosures Delegated Act: these clarify the disclosure obligations for the additional activities.

4. What next for the Taxonomy Delegated Acts?

Having been approved in principle, the Taxonomy Delegated Acts will be formally adopted and sent to the European Parliament and the Council for their scrutiny for up to four months (extendable by two months on request). If, after this period, neither the European Parliament nor Council object, the Taxonomy Delegated Acts will be published in the Official Journal of the EU and apply from 1 January 2024. Companies disclosing on Taxonomy-alignment as part of their non-financial reporting will profit from a phase-in of the rules like those applied to the first two EU Taxonomy objectives (first Taxonomy eligibility, then Taxonomy alignment). Banks, insurers, asset managers and other financial companies have a longer phase-in. There are no transition rules for financial market participants disclosing under SFDR and they will have to make disclosures from 1 January 2024. 

For more information, see our earlier briefings, Commission consultation on environmental taxonomy is underway and Taxonomy Regulation: the EU unveils grand plan to define green business.  

5. What's in the Commission Notice?

The Commission Notice on the interpretation of certain legal provisions of the EU Taxonomy Regulation and links to the SFDR contains two important clarifications on open issues debated in the industry:

• Minimum Safeguards (Article 18, EU Taxonomy Regulation):
  • The provision requires that companies carrying out Taxonomy-aligned economic activities need to: (a) be aligned with the OECD Guidelines for Multinational Enterprises (OECD Guidelines) and the UN Guiding Principles on Business and Human Rights (UN Guiding Principles); and (b) adhere to the "do no significant harm" (DNSH) principle under the SFDR. To date, companies and investors have struggled to understand what this means in practice. (On the updated OECD guidelines, see our blog, OECD revises guidelines for multinational enterprises on responsible business conduct.)
  • The Platform on Sustainable Finance provided recommendations on the concept to the Commission last year. The Commission now takes these up and builds on them, developing its own concept of Minimum Safeguards. To this end, companies will have to: (a) implement due diligence and remedy procedures to ensure alignment with the OECD Guidelines and UN Guiding Principles; and (b) take into account the mandatory social principal adverse impact (PAI) indicators under the SFDR (i.e., the UN Global Compact/OECD Guidelines violations; lack of processes and compliance mechanisms relating to the UN Global Compact/OECD Guidelines; unadjusted gender pay gap; board gender diversity; and exposure to controversial weapons). (For more information on PAI, see our blog, More light in the dark? A first analysis of ESAs Q&A on the SFDR Delegated Regulation published on 17 November 2022 for the asset management industry.)
• "Safe harbour" for Taxonomy-aligned investments under SFDR:
  • The Commission clarifies that, provided the above concept for Minimum Safeguards is applied, Taxonomy-aligned investments are considered sustainable investments under the SFDR without the need for a further DNSH assessment. In particular, this means all mandatory environmental PAI do not have to be taken into account.
  • This above suggestion comes from the European Supervisory Authorities (ESAs) in their current consultation on amending the SFDR Delegated Act, on the basis that Taxonomy assessment already contains an environmental DNSH analysis tailored to the respective activity. Note, however, that this "safe harbour" only applies if the investment finances only Taxonomy-aligned activities (e.g., project finance or an investment in a company that only carries out one or more Taxonomy-aligned activities). For all other investments, the SFDR DNSH test based on the environmental PAI indicators will still need to be performed for the non-Taxonomy-aligned activities.

6. What's in the staff working document?

The Staff Working Document on enhancing the usability of the EU Taxonomy and the overall EU sustainable finance framework provides an overview of the main pillars of the sustainable finance framework and reflects on recently adopted measures to enhance the useability and effectiveness of the framework. 

Regulation of ESG Rating Providers

7.  What has the Commission proposed for ESG rating providers and why?

The Commission has proposed new rules for ESG rating providers to improve the integrity, reliability and transparency of their activities. This is in direct response to widespread criticism regarding the opaqueness of the ESG rating industry.

The proposed rules are therefore intended to enhance the quality of information about ESG ratings by: (a) improving the transparency of the characteristics and methodologies of ESG ratings by enhanced disclosures to the public and to subscribers; and (b) introducing quality standards for the operations of ESG rating providers, including how they prevent and manage conflicts of interest, maintain records and qualify their personnel. Prevention of conflicts of interest is a strong focus of the proposal.

The proposal further prohibits ESG rating providers from carrying out certain activities such as consulting or benchmark administration, which may lead to some reshuffling on the ESG rating market. While publicly available ESG ratings (e.g., on listed companies) very clearly fall within the scope of the new rules, support to companies and asset managers in developing and applying their own ESG scores are likely not covered, which is good news for the ESG consulting and advisory industry.

The rules, if approved, will require ESG rating providers offering their ratings in the EU to have prior authorisation from the European Securities and Markets Authority (ESMA). The proposal also provides for the recognition of equivalent third-country authorisations, but since the EU is first in regulating ESG rating providers, these provisions will initially have little effect.

8. When will the new rules apply?

The rules, if approved, will apply six months after entry into force. ESG rating providers wanting to continue to operate in the EU will need to notify ESMA within three months of entry into force, but then have another six months from the application date to submit the application (with an even longer application period for small and medium-sized ESG rating providers).

Transition Finance Recommendation

9. What's in the Commission Recommendation?

One of the major criticisms voiced in relation to the Commission's sustainable finance framework (notably EU Taxonomy and SFDR) was that it did not sufficiently take into account the transition from a "brown" to a "green" economy. The Commission has taken this up in its extensive draft Commission Recommendation on facilitating finance for the transition to a sustainable economy, which emphasises the need for urgent action to reduce GHG emissions by 55%, and to achieve environmental objectives in relation to nature and water, among others, by 2030. The Commission says the EU will need to invest an additional EUR 700 billion each year from 2021 to 2030 (above investments made between 2021 to 2020) to decarbonise the economy, achieve its overall environmental objectives and those of the proposed Net Zero Industry Act. The Commission Recommendation defines key terms ("transition", "transition finance" and "transition plans") and sets out how companies, investors and financial intermediaries can voluntarily use the sustainable finance framework to finance the transition to a climate-neutral and sustainable economy, supplemented with practical examples.

Note that "transition" according to the Commission is a fairly limited concept, including only activities linked to the Paris climate objectives and EU climate neutrality by 2050, which are resilient to climate change and do not significantly harm any of the four environmental objectives (water, transition to a circular economy, pollution and biodiversity). The Commission Recommendation only applies to investments in companies; transition for real estate is not covered (presumably awaiting the review of the European Performance of Buildings Directive and other related legislation).

The Commission recommends measuring a company's transition by one or more of four means, these being: (a) "credible" transition plans (meeting the CSRD criteria); (b) science-based targets (including ongoing reporting on target achievement); (c) EU Taxonomy (moving from Taxonomy eligible to Taxonomy-aligned); and (d) Climate Benchmarks methodology. The Commission also provides a view on suitable instruments for financing the transition.

Image: Annex to Commission Recommendation

While the Commission Recommendation is, by its nature, voluntary (and currently only a draft), it has the potential to significantly impact the discussions on transition and transition finance. It contains specific recommendations to investor and asset managers on tools and methodology to apply to transition investing, the level of engagement with investee companies and the consideration of climate transition and physical risks. Moreover, it also contains a recommendation to national regulators to consider the Commission's view on transition finance when supervising greenwashing.

If you have any questions or would like to know how this might affect your business, get in touch with our key contacts.