EXPERT'S VIEW ESG: A new Framework in the Making - New requirements and how they (probably) fit into each other

Sustainability and activities aimed at reducing the carbon footprint are currently at the top of the political agenda in virtually every major economy in the west. Notably, they were also at the heart of 2021s G7 summit, showing the commitment that the major western economies have.

Google currently counts roughly 3,7 billion pages that somehow cover the topic of sustainability. For comparison: Compliance only results in a meager 700 million pages and governance only counts 341 million.¹

In the EU, the European Commission follows a clear agenda of no less than transforming the European Economy. The European Green Deal, a bundle of initiatives on the EU level, aims to support achieving the UN sustainable development goals as well as the climate protection targets of the Paris Climate Agreement. ESG – abbreviation of Environmental – Social – Governance – is the key topic in regulatory discussions this year.

Of key importance to reach these goals is the reallocation of financial flows: European politicians agree that it won’t be sufficient to change general political norms or support sustainability initiatives through governmental means. Instead, the private sector will have to contribute its resources to achieve these goals.

“The Green Deal represents a new growth strategy that aims to transform the Union into a fair and prosperous society with a modern, resource-efficient and competitive economy where there are no net greenhouse gas emissions from 2050 onwards and where economic growth is decoupled from resource use. That objective requires that clear signals are given to investors with regard to their investments to avoid stranded assets and to raise sustainable finance.”²

The EU has started a regulatory agenda that is supposed to ensure this reallocation of resources. While some of the initiatives have more of a “push” character, for example trying to push industrial companies to reduce CO2 emissions, others try to implement a “pull” strategy: If retail investors were to ask for their funds to be invested in a sustainability-aligned way, financing of sustainable projects would become easier and cheaper – while funding for “unsustainable” projects will become unavailable, or at least more expensive.

SFDR – Sustainable Finance Disclosure Regulation

The SFDR – abbreviation for Sustainable Finance services Disclosure Regulation³ – was the first regulation to put into force some of the new elements of the Green Deal Agenda. It establishes harmonised rules for financial market participants and financial advisers on transparency with regard to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability‐related information with respect to financial products.While many questions on what and how to report remain to be answered, the SFDR includes some key definitions.For example, in Art 2 (17) the SFDR includes a definition for what a sustainable investment is supposed to be – key to understanding the approach of the European Commission in regard to sustainability.

CSRD – Corporate Social Responsibility Directive

A particularly tricky abbreviation is the CSRD – the Corporate Social Responsibility Directive¹ – which is not to be confused with the Central Securities Depositories Regulation (CSDR).The CSRD is supposed to amend existing directives on the so called non-financial disclosure⁵ – the disclosure of information by companies on – among others – sustainability related information. Up to now, as a minimum, such information had to include information on environmental, social and employee matters, respect for human rights, and anti-corruption and bribery matters. With regard to these topics, Directive 2014/95/EU required large companies of public-interest and with more than 500 employees to disclose information under the following reporting areas: business model, policies (including due diligence processes implemented), the outcome of the policies, risks and risk management, and key performance indicators relevant to the business.

Under the new CSRD framework, which is currently still being discussed, companies are obliged to publish significantly more information on sustainability topics. And it is not only that more information must be published: The scope of companies that have to publish corporate sustainability information is significantly expanded to include large companies and – as of January 2026 – additionally all companies (large, medium sized and small), that are of public interest.⁶

The details of what has to be published are still being developed. Nevertheless, it is clear that a substantial amount of information on the so-called “principal adverse sustainability impacts” or “PASIs” will form part of the new obligations. Part of the PASIs are, for example, CO2 emissions. These will have to be reported on three different levels, with the first level only including direct emissions by the company, the second including the emissions of energy used (including indirect emissions of electricity) and scope three: emissions including those of the company’s supply chain and its products (for example, the CO2 emissions of oil and gas sold for oil and gas producing companies).

The information has to be made widely available. On the one hand, the information will likely remain part of the financial information to be published as part of the annual report. On the other hand, it is envisaged that the information has to be published via a public database. This will enable all interested parties to easily access this information – this is of particular importance, as for example scope three CO2 emissions can only be determined if all members of the supply chain provide information on their CO2 profile.

Furthermore, as financial market participants and financial advisers need to publish sustainability information on their investments and incorporate sustainability risks into their investment processes, this data pool will form a ventral puzzle piece in implementing the EU’s Sustainable Finance agenda.

TR – Taxonomy Regulation
The success of the sustainable finance agenda hinges on the proper implementation of the different components. One of the key challenges faced is the so-called greenwashing: Products are promoted as being sustainable, although they do little to truly achieve or support the UN-sustainable development goals.

Therefore, the EU has developed the Taxonomy Regulation (“TR”)⁷, which is supposed to deliver the needed definitions of sustainable activities. It establishes the criteria for determining whether an economic activity qualifies as environmentally sustainable for the purposes of establishing the degree to which an investment is environmentally sustainable.

These definitions – for example what are environmentally sustainable economic activities, what are environmentally sustainable investments and what are environmental objectives – are supposed to be used for all European regulations that are part of the European sustainable finance strategy.

While the TR is surprisingly short, it includes references to technical screening criteria and additional delegated acts. In fact, the first technical screening criteria published – which give additional insight into what is considered to be a sustainable activity – cover hundreds of pages and themselves again reference other regulations, which makes a rather hard read.Furthermore, the TR includes a number of additional transparency obligations.

While the CSRD requires information on strategies, risk management and PASIs, the TR enhances the disclosure of companies by the means of KPIs. For example, companies have to publish the proportion of their turnover derived from products or services associated with economic activities 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 the rules of the TR.

Furthermore, in addition to the requirements of the SFDR (see before, the TR defines additional reporting obligations on financial products that promote environmental characteristics in pre-contractual disclosures and in periodic reports.

While the aforementioned regulations are truly new and introduce new requirements, the Markets in Financial Instruments Directive (“MiFID”), as well as the delegated regulation 2017/565, have been around for a number of years now. However, they are amended in a number of key aspects to ensure that sustainability aspects are included in the regulatory framework for financial services companies.MiFID⁸ is the key European Framework that establishes common rules on retail investor protection.⁹ It is supported by delegated regulations that cover specific aspects of the sales- or investment management aspects.

One of these delegated regulations is the delegated regulation 2017/565¹⁰, which, among other topics, defines minimum standards for the assessment of suitability and appropriateness of investment products (including portfolio management mandates) for clients and organizational requirements for investment firms.

The delegated regulation was adjusted on August 22nd 2021 to integrate sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms.¹¹ Accordingly, as of August 2022, investment firms are required to explicitly include sustainability risks in their risk management. Furthermore, investment firms are required to ask clients for their sustainability preferences.

What sounds technical and complicated, is supposed to achieve the “pull” effect described above: If investors have to be asked for their sustainability preferences – and investment decisions aligned accordingly – investment firms will reallocate resources from normal and potentially “brown” (unsustainable) investments toward green and sustainable investments.

Sustainability risks are first and foremost supposed to be taken into account by investment firms when designing and implementing their own risk management. However, as the risks of client portfolios are to be considered to constitute indirect risks to the investment firms, it is not perceivable that investment firms will not also include risk management processes and tools to also actively monitor and manage the sustainability risks associated with their clients’ portfolios.

Sustainability risks can be defined in different ways. They are often understood to include direct (for example risks arising from droughts) and indirect (for example, financial risks for oil&gas producers if offshore drilling were to be banned) ecological risks, social practice risks (for example, if labor contracts don’t follow local standards resulting in boycotts) and governance risks (for example, if weaknesses in the internal control system lead to fraud cases or legal penalties).

Furthermore, investment firms and consultants have to evaluate a client’s sustainability preferences prior to rendering any kind of investment advice. Sustainability preferences are to be understood as the client’s or potential client’s choice as to whether and, if so, to what extent, one or more of the following financial instruments shall be integrated into his or her investment:

1) a financial instrument for which the client or potential client determines that a minimum proportion shall be invested in environmentally sustainable investments as defined in Article 2, point (1), of the Taxonomy Regulation

2) a financial instrument for which the client or potential client determines that a minimum proportion shall be invested in other (and especially socially) sustainable investments as defined in Article 2, point (17), of the SFDR;

3) a financial instrument that considers principal adverse impacts on sustainability factors where qualitative or quantitative elements demonstrating that consideration are determined by the client or potential client.

As can be seen, the amendment of the Delegated Regulation 2017/565 – and therefore the investment process – brings all the aforementioned changes together:

• Companies have to publish information on the sustainability risks they face and how they manage them, due to the requirements of the CSRD,
• Additionally, companies have to classify their activities and publish the proportion of taxonomy aligned, ecologically sustainable revenues, operating expenses and capital expenditures (due to Art. 8 TR),
• Furthermore, companies will have to publish information on the principal adverse impacts on sustainability factors as to the requirements of the CSRD.

Financial services companies have to analyze this information to be able to incorporate these factors in their investment strategies and risk management. The SFDR pushes them to publish information on how they do this and how successful they are in reducing the principal adverse sustainable impacts of the portfolios they manage.

At the same time companies have to prepare to publish the additional sustainability related information – and work on improving their sustainability KPIs, for example through improved use of circular packaging or reduction of CO2 emissions.

The changes to the Delegated Regulation 2017/565 shall apply from 2 August 2022.

Footnotes:

[1] Own analysis, performed on December 5th 2021. Data taken from Google.com.
[2] From the pretext to COMMISSION DELEGATED REGULATION (EU) 2021/1253 of 21 April 2021 amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms
[3] Or, more precisely, REGULATION (EU) 2019/2088 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 27 November 2019 on sustainability‐related disclosures in the financial services sector
[4] Or, more precisely, DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Directive 2013/34/EU, Directive 2004/109/EC, Directive 2006/43/EC and Regulation (EU) No 537/2014, as regards corporate sustainability reporting
[5] Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups (OJ L 330, 15.11.2014, p. 1)
[6] As defined in Art. 2 (1) a of DIRECTIVE 2013/34/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 26 June 2013 on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings, amending Directive 2006/43/EC of the European Parliament and of the Council and repealing Council Directives 78/660/EEC and 83/349/EEC; micro companies are however exempted
[7] REGULATION (EU) 2020/852 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088
[8] DIRECTIVE 2014/65/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU
[9] The MiFID-Framework focuses on order execution, financial advice and portfolio management. Other regulation exists that also aims at improving investor protection, like the UCITS- and AIFMD-frameworks.
[10] Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive
[11] Commission Delegated Regulation (EU) 2021/1253 of 21 April 2021 amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms (Text with EEA relevance).