As asset owners search for enlightenment, will the EU disclosure and taxonomy regulations deliver?
Long-term investors may be hopeful that the currently evolving EU disclosure regulation will help solve some of the biggest and longest-standing issues in sustainable investment, namely greenwashing and data quality.
But they may also be concerned about how effective the final transparency regime will be in reaching the bloc’s environmental goals. Alongside related measures, the regulation will guide wholesale energy transition, a complex endeavour which will redefine the winners and losers in the region’s economy, and could see stakeholder interests diverge.
In parallel, the European Commission’s planned taxonomy, intended to define ‘green’ investments, will allow investing with substantial positive impact on the climate and the environment. Setting a definition of ‘green’ activities will limit opportunities for asset managers to boost their profits with inflated ESG claims and enable the EU to increase sustainable investment flows.
Channelling sustainable investments
The EU transparency regime aims to channel ESG investments using three key regulations: the Taxonomy Regulation; the Sustainable Finance Disclosure Regulation (SFDR); and the Non-Financial Reporting Directive (NFRD).
The SFDR supports asset owners by providing them with the inputs needed to integrate sustainability considerations into their investment decisions and carry out their redefined fiduciary duties, including selection and monitoring of asset managers.
Alyssa Heath, Head of EU & UK Policy at the Principles for Responsible Investing (PRI), says that the SFDR “sets a regulatory minimum [requirement] around ESG integration where financially material”.
It does this primarily by requiring all financial market participants to carry out certain sustainability-related disclosures at firm and product level, and at a pre-contractual timing as well as periodically.
Disclosures on adverse impacts, for example, will give a new lens on how asset managers are integrating ESG factors, which will help investors who want to do more scrutiny on their overall approach, Heath says.
Sebastien Godinot, Economist at the WWF and a project task force member at the European Financial Reporting Advisory Group (EFRAG), points to the due diligence benefits of SFDR.
He says it can reveal greenwashing by looking beyond impact disclosures to the methodologies used to identify these, and highlights the ability to evaluate “the plans, strategy and measurable targets [asset managers] have to mitigate negative impacts and monitor the evolution of those impacts”.
Asset managers will likely have to disclose their actions, such as engagement strategies, revealing how they plan to reach their targets over time.
Shades of green
Under the SFDR, asset owners can invest in two types of sustainable funds: ‘dark’ green funds that have sustainable investment as an objective (Art. 9 SFDR); and ‘light’ green funds that promote environmental or social characteristics (Art. 8 SFDR).
Remaining funds can still invest in sustainable assets, but not actively promote sustainability, according to Olivier Carré, Financial Services Market Leader at PwC Luxembourg, speaking at a webinar organised by the European Fund and Asset Management Association.
Mikhaelle Schiappacasse, Partner at law firm Dechert, believes most funds will not be able to fulfil the impact requirements for dark green products. She also points to the question of which shades of green an Article 8 fund should include.
The SFDR’s requirements will be further specified via a regulatory technical standard (RTS) and the Taxonomy Regulation, which will lay down additional rules for the financial products defined in Article 8 and 9 of SFDR. The taxonomy disclosures for two of the six environmental objectives, climate change mitigation and adaptation, will apply from January 1, 2022.
As finalising the RTS has been postponed beyond March 10, 2021, only the requirements and general principles contained in the SFDR itself will be applicable to firms from this date, according to Dechert.
Commenting on the draft RTS, Sara Lovisolo, Group Sustainability Manager at the London Stock Exchange Group and project task force member at EFRAG, says the final version should provide tailored indicators for different asset classes to be decision-useful and signpost real adverse impacts.
Not yet fully aligned
Although the EU asserts the finalised disclosure framework “will allow investors to make fully-informed decisions regarding sustainable investments”, full transparency on sustainable investments is still some way off.
Dechert’s Schiappacasse says disclosures will allow for comparison of SFDR products to “a certain degree. But the EU’s core disclosure regulations – SFDR, taxonomy, NFRD – are not yet harmonised, and indeed all are subject to change, in line with its Sustainable Finance Action Plan.
Godinot, who participates in EFRAG’s preparatory work on EU non-financial reporting standards, proposes that alignment should take place with a proposed European sustainability standard.
This standard should streamline the different disclosure requirements via “a comprehensive ‘template’” that will have generic and sector-specific mandatory KPIs “to ensure the much-needed comparable information at all levels”, he notes.
The evolutionary nature of the EU’s disclosure regime means the lack of comparable and high-quality ESG will not be resolved overnight. A recent PwC report says asset managers should report above regulatory ESG reporting requirements to stand out and build long-term trust with investors.
Until objective, comparable and verified data is made accessible via regulation, asset owners could also collect such data from asset managers engaging with corporates.
Even though the SFDR is not yet complete, already available and draft versions may help asset owners in identifying possibly soon-to-be ‘greenwashing’ funds ahead of time and shift their investments into sustainable products.
PwC’s Carré says “only marginal changes” in the RTS text are expected, largely focusing on some inconsistencies. A spokesperson at the European Insurance and Occupational Pensions Authority (EIOPA) told ESG Investor the draft RTS will be submitted to the Commission by the end of January 2021.
According to the PwC report, 85% of surveyed asset managers have already set up a strategy to align their portfolios with the environmental characteristics of the taxonomy.
Watered down?
It’s not only the disclosure regulation that is incomplete. More than 40 experts from NGOs and think tanks found in a joint analysis last week that the EU has ignored recommendations by the Technical Expert Group on Sustainable Finance and the advice of scientists in its recently published draft delegated act for the taxonomy.
Observers believe this is a result of industry lobbying. Representatives of gas, oil and nuclear energy have been lobbying the EU to be classified as green, according to media reports.
According to the NGO analysis of 50 from a total 86 activities relating to climate mitigation, one quarter (11) of the criteria are problematic and require significant changes, about a half (27) need improvement and another quarter (12) meet expectations.
Wrongly set criteria and carbon emissions thresholds in the taxonomy have the potential to endanger reaching the EU’s 2050 net zero emissions target.
According to an EU spokesperson, the draft delegated act is fully compliant with the taxonomy regulation, including “coherence with EU law, environmental ambition, level playing field and usability”.
“The Commission has made certain adjustments to the Teg’s proposals, where necessary, to better meet and balance the requirements of the regulation, in some cases resulting in making the criteria stricter and in others allowing for more flexibility,” the spokesperson said.
The taxonomy draft delegated act is published online for stakeholder feedback until 18 December 2020.
Given the environmental urgency, it should be expected that EU regulation will pave the way for a sustainable shift at large in financial markets. The PwC survey states that 77% of surveyed institutional investors intend to stop investing in non-ESG products by 2022.
