Adding a voice to the discussion – a brief analysis of ESMA's Opinion on the functioning of the EU Sustainable Finance Framework

On 24 July 2024, the European Securities and Markets Authority (ESMA) has published an opinion titled "Sustainable investments: Facilitating the investor journey" (Opinion) containing proposals for the improvement of the European Union's Sustainable Finance framework. In this blog, we describe the main recommendations made by ESMA in the Opinion and the impact they may have on the future development of the framework.

Background and purpose

The Opinion is intended to complete the greenwashing assessment carried out by the three European financial services regulators (ESMA, EIOPA and EBA, together the ESAs) at the request of the European Commission since the end of 2022. The Opinion extends to the entire EU Sustainable Finance framework which consists of various elements, such as disclosures and reporting under the Sustainable Finance Disclosure Regulation (SFDR), the Corporate Sustainability Reporting Directive (CSRD) and the EU Taxonomy framework, due diligence under the new Corporate Sustainability Due Diligence Directive (CS3D), new rules on ESG rating providers, provisions on climate benchmarks in the EU Benchmarks Regulation and the EU Green Bond Standards as well as sustainability risk management and investor sustainability preferences under broader financial services regulation (MiFID II, IDD, AIFMD, UCITSD). In doing so, the Opinion is broader in scope than the recently published Joint ESAs Opinion on the assessment of SFDR (Joint ESAs Opinion).  

Although the opinion has been published as part of the greenwashing assessment, it is not limited to greenwashing supervision. Slightly extending the scope of its original mandate, ESMA aims to provide a "holistic vision for the long term" on how to facilitate sustainable investments – albeit with a clear focus on more supervision, standardization and retail investor protection. Interestingly, some of the recommendations take a more pragmatic and market-focused view than the Joint ESAs Opinion. Moreover, it is noticeable that neither EIOPA nor EBA have published their views on the further development of the EU Sustainable Finance framework, although they have received the same greenwashing mandate from the European Commission.

Main recommendations

Consumer and industry testing

Future policy solutions should undergo consumer testing if addressed to retail investors and industry testing to receive input on feasibility and workability – definitely something which market participants would support. The mismatch between technical SFDR disclosures and retail investor horizons or the idea that retail investors would be able to make an informed decision on sustainability preferences based on EU technical concepts are good examples where prior consumer and industry testing may have helped.

EU Taxonomy as sole common reference point for sustainability

ESMA proposes that only the EU Taxonomy framework should determine what is sustainable. The SFDR definition of "sustainable investments" should be phased out. Before this gives rise to misunderstandings, it is important to note that ESMA sees this as "long shot", requiring first the completion of the EU Taxonomy framework to cover all relevant economic activities and being extended to social objectives. ESMA recognizes that this will require time and effort for the development of appropriate criteria.

Given the recent experience with the amendments to the climate-related activities and the addition of four environmental objectives (which took very long, are extremely complex and cover only very few activities), this is probably not something that can be achieved in the next years. Nevertheless, ESMA sees huge benefits in a "science-based" framework permitting to objectively establish sustainability – noting that anyone dealing with EU Taxonomy implementation in practice knows that this is still far from being a "scientific equation" due to unclear rules, lacking standards and the quest for data.

In the meantime, ESMA suggests making the key parameters of a sustainable investment under SFDR more prescriptive to enhance comparability and combat greenwashing, as suggested in the Joint ESAs Opinion.

Tools facilitating transition investing

In line with earlier recommendations of the European Commission, ESMA emphasizes the role which "transition investing" plays for the European Green Deal. "Transition" covers activities by which companies transition from current climate / environmental performance levels to a climate-neutral, climate-resilient and environmentally sustainable economy in line with European Union objectives.

ESMA recommends introducing additional disclosures on harmful activities which are being transitioned or decommissioned to be able to verify company transition claims. Moreover, transition investments should benefit from a legal definition (currently only being subject to an informal European Commission recommendation). Transition plan disclosures should add to more clarity on company plans and the development of transition benchmarks and standards for transition bonds and sustainability-linked bonds should provide standardised product categories for transition investing.

Creating common disclosures and making them more "retail friendly"

ESMA proposes introducing minimum sustainability disclosures for all financial products based on a small number of simple KPIs (in line with one of the options suggested by the European Commission in its SFDR consultation in 2023). These should also apply to financial instruments which are currently not captured by SFDR (e.g. bonds), thus permitting investors to better understand and compare the sustainability profile of all types of investments.

Moreover, ESMA recommends splitting sustainability disclosures into a sub-set of "vital" information for retail investors (which should be disclosed in a simplified format and simple language similar to the Key Information Document under the PRIIPs Regulation) and a more comprehensive set of sustainability information provided elsewhere which is accessible both to retail and professional investors. It is questionable whether the "vital" or "key information" piece should also be mandatory for professional investors – the PRIIPs KID is not.

ESMA also emphasizes the need for alignment between products names, marketing material and sustainability profile of products, as described in the Joint ESAs Opinion and in the recently published "ESMA Guidelines on funds' names using ESG or sustainability-related terms" (for our respective briefing see here).

​​​​​​​Introducing a product categorisation system

In line with the Joint ESAs Opinion, ESMA calls for a product categorisation system focusing on sustainable and transition investments and introducing minimum criteria as well as associated transparency obligations. Different from the Joint ESAs Opinion, ESMA considers that these categories should be addressed mainly to retail investors and that their use could be voluntary. ESMA repeats the proposal from the Joint ESAs Opinion to demonstrate the grade of sustainability of a product by a single indicator (similar to the synthetic risk return indicator (SRRI) in the PRIIPs KID) but also acknowledges that in the absence of a completed EU Taxonomy (see Section 2.2 above), it may be very difficult to compare products with different sustainability strategies. Finally, the concept for investor sustainability preferences should be revised to reflect the new product categories.

​​​​​​​Improving ESG data quality

Not surprisingly, ESMA refers to the need to improve ESG data quality by monitoring how the European Sustainability Reporting Standards (ESRS) are applied, ensuring consistency of metrics across the framework, applying high standards to estimates and regulating ESG data and ratings.

​​​​​​​Ensuring responsibility of all market actors and improving engagement

ESMA points out that obligations relating to sustainability should not focus only on issuers of financial products. All market actors should, commensurate to their role, be responsible for conducting own due diligence and assessing materiality of sustainability information. ESMA considers active engagement with companies to be a powerful tool for transition which should be better substantiated and potentially subject to national "engagement / stewardship codes".

Relevance for market participants

The Opinion does not have any legal character and the European Commission as its formal addressee is not bound by any of the recommendations. However, ESMA undoubtedly is an important voice in the discussion on how to further develop the EU Sustainable Finance framework. The Opinion has been published at an interesting time of the European political cycle, with a new European Commission taking office in October 2024 – under the lead of European Commission president Ursula von der Leyen who has been the most prominent supporter of the European Green Deal.

Given the political shift in the European Union, the new Commission's work program is likely to focus more on reducing administrative burdens and simplifying implementation, as set out in Von der Leyen's "Political Guidelines for the Next European Commission 2024-2029". However, these guidelines also state that channelling private investments into core themes such as decarbonisation, clean energy and circular economy remains an integral part of the revised Green Deal.

It can therefore be expected that the new European Commission will continue to build and optimize the EU Sustainable Finance framework from October 2024 – and listen to what ESMA has to say on making it better.

Further reading on the EU Sustainable Finance framework

• The market has voted – looking at the results of the consultation on SFDR published by the European Commission
• EU's due diligence directive has crossed the finishing line
• ESG rating regulation in Europe: Key takeaways for asset managers
• Quo Vadis SFDR? European Commission launches two new consultations
• Global Sustainability Disclosures: Navigating the Landscape
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