After an avalanche of activity in H1 2021, institutional investors should expect no let-up as the Commission seeks to clarify ESG-related rules ahead of COP26.
Asset owners, managers and corporates need to be prepared for a rush of last-minute decision-making from the European Commission as a slew of sustainability regulation comes into force next year.
The first half of 2021 saw a considerable amount of sustainability-related regulatory activity in Brussels, culminating in the release of the Commission’s Renewed Sustainable Finance Strategy and its economy-wide ‘Fit for 55’ package.
With implementation timelines set to kick in next year, and COP26 scheduled to be held in Glasgow in November, “a lot will happen sooner rather than later” as the Commission looks to clarify and finalise a series of proposals, said Raza Naeem, Counsel at Linklaters.
“Uncertainty isn’t what the European regulators want,” said Vergauwen, ESG Funds Lawyer at the firm, noting that further delays and confusion will slow the progress of the EU’s overall Sustainable Finance Strategy.
Similarly, to last week’s article on UK regulation, ESG Investor has outlined key challenges and deadlines over the next few months.
Sources of ambiguity
A number of regulations put forward by the Commission remain sources of ambiguity for asset owners, managers and companies. In the upcoming months, there is scope for illumination ahead of implementation deadlines.
For example, the Commission’s recent attempt to clarify categorisation of funds under the Sustainable Finance Disclosure Regulation (SFDR) via a Q&A didn’t fully outline the differences between each green-labelled product category.
SFDR asks asset managers to sort their EU-domiciled funds into Article 8 (promoting environmental or social characteristics) or 9 (having an environmental or social objective). If the fund doesn’t possess these characteristics or objectives, then it must be classified as Article 6.
“We definitely need more clarity around what qualifies as an Article 8 product,” said Vergauwen.
At the moment, the Commission hasn’t specified the minimum sustainable investment thresholds for prospective Article 8 funds, meaning a very wide range of green-labelled products can qualify.
Further, earlier this month the Commission’s Platform for Sustainable Finance published a draft report on preliminary recommendations for technical screening criteria for the remaining four environmental objectives of the EU Taxonomy. Open for feedback until 24 September, the report lists qualifying sustainable activities for the following 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 and ecosystems.
The first two objectives and their technical screening criteria – climate mitigation and climate adaptation – were formally adopted on 4 June, with the Taxonomy coming into force from January 2022.
However, delegated acts for the remaining four objectives – expected to be published next year – will be even more complicated to finalise, said Vergauwen, due to the complexity of measuring these remaining issues.
“The first two objectives for the Taxonomy were clearer and easier to implement because they are more scientific and therefore precise. Any changes made were the result of lobbying rather than because it was unclear or subject to differing interpretations. It’s much less controversial from a legal point of view,” she said.
The Platform on Sustainable Finance also published a draft Social Taxonomy, which is open for consultation until 27 August. Following the consultation, the Commission will take this suggestion forward and launch a proposal by October.
However, the “different dimensions” of the Social Taxonomy compared to the existing Taxonomy Regulation “may make the whole thing quite complicated in terms of framework”, said Naeem. Will the Social Taxonomy be separate from the existing Taxonomy, connected by the core objectives and ‘do no significant harm’? Or will the existing Taxonomy evolve into a Social and Environmental Taxonomy?
Meanwhile, Naeem said he doesn’t expect much change in requirements under the Corporate Sustainability Reporting Directive (CSRD). Replacing the Non-Financial Reporting Directive (NFRD) in April, the CSRD will require 50,000 firms to provide a non-financial statement on a series of ESG-related factors, in alignment with the Taxonomy Regulation.
“With CSRD, we may see more changes in terms of scope of entities,” he noted, as some quarters push for an even wider scope in order to accelerate the transition to sustainability reporting.
Companies have been allowed more time to adhere to CSRD’s requirements, as the directive is expected to apply from 2024.
The European Sustainability Reporting Standards (ESRSs) are also due to be finalised by the European Financial Reporting Advisory Group (EFRAG) by October next year. The standards will measure the social and environmental impacts of corporates falling under CSRD’s scope.
Delays in progress
Some proposed sustainability-related regulations have been delayed, leaving those expected to comply in a state of uncertainty.
For example, the draft delegated act specifying how to align disclosure requirements under Article 8 of the Taxonomy Regulation is delayed until 2023. This means that asset managers complying with SFDR are unclear as to how they ensure their SFDR-related disclosures qualify as socially and environmentally sustainable, in line with the Taxonomy.
Level 2 of SFDR has been delayed by six months until 1 July, 2022, due to difficulties in finalising the regulatory technical standards (RTSs). The RTSs will require asset managers to augment their Level 1 green product categorisations with more detailed underlying data across a series of social and environmental factors.
Although the postponement means asset managers are generally being more cautious when categorising their products – or even refusing to categories their funds at this point in time – Vergauwen is hopeful Level 2 guidance is “going to be more comprehensive and in line with other disclosure requirements falling under the Taxonomy”.
A more “controversial” delay was suffered by the Sustainable Corporate Governance initiative, said Naeem, finalised proposals for which were expected in June. The delay came after a summary report on the public consultation, which closed in February, was met with a clear divergence of opinion between NGOs and business representatives. Further, it received a negative assessment from the Commission’s Regulatory Scrutiny Board, which advises the College of Commissioners on all proposed directives during the early stages of the legislative process.
The initiative aims to broaden corporate governance responsibilities of companies so that they cover due diligence of human rights and environmental risks within their own operations and across the value chain.
There are concerns that the Commission’s delay will result in a less effective, watered-down equivalent later this year, highlighted by panellists during a webinar hosted by the UN-convened Principles for Responsible Investment (PRI).
“It will be quite a political agreement in terms of what those requirements should mean. Hopefully, we won’t end up with a halfway house situation in terms of compliance deadlines like with SFDR and the Level 1 versus Level 2 timing discrepancies,” said Naeem.