The European Union’s Sustainable Finance Regulation Jigsaw Is Almost Complete
With COP26 on the horizon and the latest IPCC sustainability report urging us to take action to stop climate change before it threatens our survival, sustainability has never been higher on the global agenda. The European Union continues to be at the forefront of regulatory efforts to channel capital toward sustainability, though other geographies are catching up.
The EU Has Moved From Pledges To Regulatory Actions
Building on the Paris Agreement, the European Union has committed to becoming the first climate-neutral bloc in the world by 2050. In recent years, this commitment has moved from pledges to real regulatory actions. The European regulators have been busy assembling a jigsaw of interlinked regulations to facilitate this transformation. These are the key pieces of the puzzle:
- The European Green Deal Investment Plan. The European Green Deal Investment Plan (EGDIP), also referred to as Sustainable Europe Investment Plan (SEIP), is the investment pillar of the Green Deal. The Plan seeks to mobilize €1 trillion of public and private funding over the next decade to help the EU become a climate-neutral and sustainable economy by 2050.
What does this mean for financial services? This will create opportunities for financial services firms to invest in green projects and to facilitate green investments. While about €503 billion will come from the EU budget, the public and private sector is expected to contribute €279 billion between 2021 and 2030.
- The EU Taxonomy Regulation. This classification tool, which entered into force on 12 July 2020, is designed to support the Green Deal objectives. Most of the Technical Screening Criteria (TSC), which define the specific requirements for each environmental objective, are still a work in progress. Only the first delegated act on sustainable activities for climate change adaptation and mitigation objectives was approved on 21 April 2021 and will apply from 1 January 2022. It specifies the technical screening criteria under which certain economic activities qualify as contributing substantially to climate change mitigation and climate change adaptation and for determining whether those economic activities cause significant harm to any of the other relevant environmental objectives. A second delegated act for the remaining objectives will be published in 2022.
What does it mean for financial services? The taxonomy is a critical piece of the EU’s sustainability regulation puzzle and works in synergy with the Green Deal Investment Plan. It prevents “greenwashing” by introducing a common framework and understanding of what constitutes sustainable activities and in this way will help investors and financial institutions identify sustainable investments.
- The European Green Bond Standard (EU GBS). This new regulation, which issuers will need to abide by from 31 December 2022, aims to create a “gold standard” for green bonds and bring greater transparency to European capital markets. The EU GBS will be open to all issuers of green bonds — private, public, and sovereign issuers — including those located outside of the EU. The proposed framework will create a voluntary standard for how companies and public authorities can use green bonds to raise funds on capital markets to finance investments. The standard requires issuers to allocate 100% of the issue proceeds to economic activities that align with the EU taxonomy.
What does it mean for financial services? This standard will drive more activity in this area thanks to greater trust and confidence in green bonds. Issuers will have a credible instrument to demonstrate that they are funding legitimate green projects aligned with the EU taxonomy. And investors buying the bonds will be able to assess, compare, and trust that their investments meet EU’s sustainability requirements.
- Sustainable Finance Disclosure Regulation (SFDR). From 10 March 2021, the SFDR requires manufacturers of investment products and financial advisors to disclose how they integrate sustainability concerns into their investment decisions/advice and how they communicate these to customers. Products that promote environmental, social, and governance (ESG) characteristics or that have sustainable investment objectives must also comply with the “do no significant harm” clause of the taxonomy regulation. The regulatory technical standards (RTS) for the SFDR, delivered in February 2021, also require financial market participants to measure and report on Principal Adverse Impact (PAI) of their investments. The regulation defines these as “negative, material, or likely to be material effects on sustainability factors that are caused, compounded by, or directly linked to investment decisions and advice performed by the legal entity.”
What does it mean for financial services? This will put a break on the proliferation of some of the more dubious ESG funds. Investment firms not only now need to integrate sustainability factors in their investment decision-making processes, but they also need to articulate how they do this. This will likely drive a lot more conversations with investors about sustainability and will fuel demand for sustainable investment products. Firms reporting Principal Adverse Impact of their investments will struggle to compete with more sustainable funds.
- Corporate Sustainability Reporting Directive (CSRD). This will replace the current Non-Financial Reporting Directive (NFRD) and is expected to be adopted by October 2022 (with companies first reporting using new standards in 2024). The European Financial Reporting Advisory Group (EFRAG) is collaborating with international initiatives such as GRI, TCFD, SASB, IIRC, CDSB, and CDP to develop EU reporting standards. The aim of this directive is to help improve the flow of capital toward sustainable activities across the EU by standardizing the collection and analysis of reported ESG data. The current proposal increases the number of companies that need to report, makes reporting mandatory, standardized, and digitized (all information must be digitally tagged and machine-readable), and imposes external assurance.
What does it mean for financial services? The extended scope — the number of companies that will need to report will go from 11,000 under the current NFRD to almost 50,000 — and changed format of the reports will make it easier for investors and asset managers to incorporate ESG factors into their investment processes. They will have access to more relevant, more easily digestible, and more credible ESG data. But the CSRD could also influence who banks and insurers do business with through its concept of “double materiality.” Companies have to report both how sustainability issues affect their business and what their own social and environmental impact is. Going forward, banks and insurers could restrict business with firms exposed to climate change risks, for example, to limit their own exposure and negative impact.
Several of these regulations are still at the proposal or development stage, and we are likely to feel their real impact in 2023–2024, but companies need to pay attention and plan for these now. While adhering to all of these new regulations will be challenging at first, companies that do will benefit from better access to capital and improved risk management. In addition, all of these regulations are nudging financial services firms to accelerate their speed to market for ESG products and services, fostering creativity and innovation on our journey toward sustainability.