During the three years since the European Commission (EC) adopted the Action Plan on Financing Sustainable Growth, European institutions have moved at a rapid pace to regulate the nexus between finance and climate change. Between 2017 and 2020, the European Union (EU) went from holding the High-Level Expert Group’s first meeting, to adopting the regulations on sustainable finance disclosures and a Taxonomy for sustainable economic activities.
These efforts were emboldened by commitments set out in the Commission’s European Green Deal, which, ultimately, aims to achieve climate neutrality by 2050, by tackling climate change in all core policy areas, including biodiversity, agriculture, energy and mobility sectors. The Green Deal makes clear that the EU’s policy work is far from over and is in fact likely to extend to a wider set of environmental, social and governance issues.
As a recent insights report published by State Street Global Advisors shows, regulatory developments will continue to predominate the EU’s policy agenda in 2021 and beyond, with significant impacts envisaged across the financial services ecosystem, particularly implicating institutional investors and asset managers. Disclosures, the banking union and potential ESG data regulations will be at the top of the bloc’s to-do list, according to the note’s authors – Dr Michael Huertas, Co-Head Financial Institutions Regulatory Europe at Dentons, Ciara Horigan (pictured above), Regulatory & Government Affairs at State Street and Carlo M. Funk (pictured below), Head of ESG Investment Strategy for EMEA at State Street Global Advisors.
Key Dates Ahead
Four main milestones stand out among the many regulatory deadlines scheduled for the next two years. The transparency obligations laid out in the Sustainable Finance Disclosures Regulation (SFDR) will be in place from 10 March 2021, with full application expected from 2022. In parallel, the EU will enact corporate sustainability reporting requirements via the Non-Financial Reporting Directive which had been intended from mid-2021 but is now likely to come earlier. The European Banking Authority (EBA) is also expected to publish technical advice for the EU Commission on the prudential treatment of sustainability risks towards the end of 2021; meanwhile the European Central Bank has already finalised Guidance on the management and supervision of climate-related risks by supervised entities, and recently announced that it would incorporate climate related scenarios in the 2022 stress testing cycle. Finally, although the technical screening criteria underlying the EU taxonomy were due to be adopted by the Commission at the end of 2020, to, they have been slightly delayed thought it is expected that they will still enter from the end of this year before becoming fully applicable in 2023.
European Green Deal: Key Dates
According to Huertas, Horigan and Funk, the SFDR is one of the EU’s sustainable finance regulatory package’s critical items over the next two years. Investors should be mindful of their new investor duties under the regulation and the tight deadlines ahead.
SFDR, essentially, also imposes disclosure requirements for activities expected to have a negative ESG impact, according to the report. The onus is on rules to avoid human rights violation, corruption and bribery. The regulation recognises that sustainability-related risks have a potential material impact on the value of an investment and specifies governance requirements for investee companies.
To this end, SFDR’s transparency rules target financial products and a wide range of financial market participants and advisors, requiring the disclosure of considerations underlying the assessment of sustainability risks and factors in the investment process, both at the entity and financial product level – i.e. on company websites and in pre-contractual documentation. So-called Article 8 and 9 products, which specifically promote sustainability characteristics or outcomes, will be subject to enhanced transparency requirements. To facilitate pre-contractual disclosures, for example in prospectuses, the European Supervisory Authorities (ESAs) have proposed mandatory reporting templates and a set of principle adverse impact indicators.
Huertas, Horigan and Funk note that “in practice, at the entity level, financial market participants and financial advisors must make available a statement on the integration of sustainability risks and a statement on adverse sustainability impacts on their websites. In addition, they will have to show how their remuneration policies are commensurate with their sustainability objectives. Financial market participants will further have to state on their websites how their environmental and social characteristics impact on sustainable investments.”
An important point of contention emerged at the end of 2020. According to Huertas, Horigan and Funk, SFDR requires disclosing sustainability risks and adverse sustainability impacts in pre-contractual documentation. Products that either promote ESG characteristics or pursue sustainability objectives face even steeper requirements. “Although SFDR enters into force on 10 March 2021, the ESAs have not been able to deliver final technical standards by the [intended] end-2020 deadline. Instead, this is expected to be submitted to the [EU Commission] for adoption by end-January 2021,” the authors explain.
With just a few weeks between final requirements being published and compliance, the SFDR timeline has been a long-standing concern for financial market participants. EU authorities have also contended with the ambitious deadline, which even prompted the Chair of the ESAs, last summer, to effectively request that the EU Commission delay the application date. Although the March 2021 deadline has been retained, the Commission has publicly agreed to defer the ‘level 2’ regulatory technical standards (RTS) until a “later date”, which the authors speculate could be 1 January 2022 in line with the application of the EU Taxonomy Regulation. This means that market participants can provide ‘high-level’ and ‘principles-based’ disclosures by 10 March where requirements are expected to be further specified in level 2.
The uncertainty in the absence of final requirements, particularly as the ESAs had been expected to substantially rewrite of the draft RTS, set against an already compressed timeline, was heightened when the Chair of the ESAs requested urgent clarification from the Commission on a number of important interpretational issues at the start of January 2021. The queries focused on the application of SFDR to non-EU Alternative Investment Fund Managers (AIFMs) and registered AIFMs, the application of Article 9 of SFDR and the application of SFDR product rules to MiFID portfolios and tailored funds. The letter also sought clarification on the meaning of “promotion” in the context of products promoting environmental or social characteristics, as well as the application of the 500-employee threshold with respect to the principal adverse impact reporting requirement on parent undertakings of a large group.
Following the publication of State Street’s insights report, the ESAs have published their final joint report containing draft Regulatory Technical Standards (RTS) on these disclosures, which are now subject to a scrutiny period before being adopted by the EU. The authors were correct in speculating that the ESAs would substantially reduce the total number of key performance indicators to calculate the principal adverse impact of investments on sustainability factors, and, more importantly, that the ESAs would recommend to delay the requirements in the draft RTS until 1 January 2022.
The Banking Union
In parallel with these developments, the European Central Bank (ECB) has also taken steps to push banks to integrate climate change risks into their operations. It has become an avid purchaser of green bonds and accepts them as collateral for repurchasing operations. In its financial and economic analysis, it also highlights the economic case for tackling sustainability challenges head-on. Christine Lagarde’s appointment as President of the ECB Governing Council significantly added to the ECB’s sustainability credentials. As a candidate for the position, Lagarde made no secret of her intention to push the item into the central bank’s agenda as early as her confirmation hearings. However, it is perhaps through its regulatory responsibilities that the ECB’s commitment to climate change mitigation will be most felt.
As the ultimate supervisory authority for the EU’s Banking Union, the ECB published its Final Guide on Climate-related and Environmental Risks in November 2020. Co-authored together with national supervisors, the Guide sets supervisory expectations with regard to the management and supervision of climate-related risks, which will take center stage when the ECB rolls out its next supervisory stress-test in 2022. According to Huertas, Horigan and Funk, while the Guide is not legally binding, these expectations “serve as a basis for supervisory dialogue, including as part of the Supervisory Review and Evaluation Process (SREP), which, in turn, is binding on directly ECB-SSM (Single Supervisory Mechanism)- supervised institutions.
By incorporating climate change in its stress tests, the ECB has internalised the medium-term risks associated with global warming into its financial stability work. However, the central bank also leads the way through its work in monetary policy and economic analysis. The authors also signal the potential disconnect between EU authorities given the European Banking Authority is also consulting on the management of climate-related risks by banks and investment firms. Interestingly, the EBA points to State Street Global Advisors’ proprietary build of R-Factor as an effective example of current risk management practices which the EBA dubs the ‘exposure method’.
Next Up: ESG Data Regulation and Carbon Trading
Further along the policy-making route, Huertas, Horigan and Funk suggest that the EU is taking steps to regulate providers of ESG/sustainability data. Although there has been some focus on this at the global level by the international securities regulator, Dutch and French representatives (and now Members of the European Parliament) have called on the Commission to include a legislative proposal that would regulate entities providing sustainability datasets in the EU where they are not currently subject to EU legislation. Hence, the Commission may consider this as part of its upcoming Renewed Sustainable Finance strategy, which had been expected in March but is now likely to slip later in Q2/early Q3.
The Dutch and French proposals seeks to impose “transparency on methodologies, management of conflicts of interest, internal control processes and enhanced dialogue with companies subject to sustainability ratings” to protect investors from greenwashing and avoid conflicts of interest. According to the proposal, the European Securities Market Authority (ESMA) would be granted powers to supervise ESG data providers.
Finally, the authors point to the road ahead and more specifically the global agenda where there may also be hope for international collaboration with the Biden Administration keen to put climate change and wider ESG issues at the top of the agenda, in a start turnaround from the previous Administration. The authors note that President Biden’s vision of a ‘Green New Deal’ “shares conceptual similarities to the EU’s efforts around Carbon Border Taxes to prevent offloading from companies in countries with laxer environmental rules.” More importantly, they point to the possibility that the EU and the USA may join forces and create a joint carbon trade zone. “Members of the European Parliament are already considering groundwork for a Transatlantic Green Deal, as part of the EU outreach strategy to the Biden Presidency”, the authors note.