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.
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 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.
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.
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.
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.
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.
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:
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.