This year, the world’s third-largest asset manager by assets under management (AUM) and the world’s second-largest accounting firm by revenue predicted, respectively, that sustainable assets, already valued at over $30 trillion, would further grow as a proportion of global AUM, which would pass $100 trillion before year end.
Nevertheless, earlier in the year, one of the two largest credit rating agencies noted that “a lack of standardization of definitions and processes” was impeding the growth of the ESG sector. The logic behind this claim is that the profusion of overlapping voluntary standards has produced a fragmented landscape that inhibits meaningful comparison between investments, thereby discouraging additional sustainable investments.
This lack of standardization was raised by the asset management industry on May 24, 2020, in formal recommendations that called on the SEC to adopt regulation to address the problem.
However, SEC Chair Clayton dismissed the recommendations, arguing that conflation of ESG factors led to an analysis that was insufficiently precise to meaningfully inform investment decisions.
Similarly, a few weeks later, the U.S. Department of Labor went further, proposing a rule that would legally oblige fiduciaries to focus on returns over ESG considerations in a measure that, if adopted, would collide head-on with consensus (but not universal) jurisprudence that consideration of ESG factors is also a fundamental obligation of a fiduciary.
In summary, over the short term, there are no plans in the U.S. to adopt regulation to address the lack of standardization in ESG definitions and processes.
In contrast to the position in the U.S., the EU is adopting standardized definitions through its recently published Taxonomy Regulation. It is also adopting standardized processes through its Sustainable Finance Disclosure Regulation (SFDR). These measures form part of a broader suite of ESG initiatives designed to channel funding to genuinely sustainable rather than greenwashed investments, thereby facilitating compliance with Paris Agreement climate targets and the EU’s commitment to adopt the United Nations (UNs) Sustainable Development Goals as set out in the UN’s 2030 Agenda for Sustainable Development.
Together these new EU measures will have an impact far beyond the geographical boundary of the EU, shaping the flow of investments, the broader financial regulatory arena, and the working practices of many financial professionals.
Background to the Taxonomy Regulation
The viability of the EU’s ESG regulatory regime had been in doubt up until very recently. Specifically, since the broader regime rested to a significant degree on the enactment of the Taxonomy Regulation, which at times looked unlikely to occur, many stakeholders began to question whether the regime would ever “make it over the line,” especially given what appeared at the time to be intractable problems relating to how to classify nuclear power and natural gas from a sustainability perspective, among other issues.
However, on June 18, 2020, the presidents of the European Council and Parliament announced that they had signed the EU Taxonomy Regulation into law, which was published in the EU’s Official Journal just four days later, heralding a new era of financial regulation.
Officially called “Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088,” nowhere is the term “taxonomy” used. Such a peculiar naming convention is not uncommon within the EU however, as the “European Markets Infrastructure Regulation” (EMIR) attests (with its official title being “Regulation (EU) No 648/2012 on OTC Derivatives, Central Counterparties and Trade Repositories”). Moreover, the term “taxonomy,” whilst somewhat oblique, is apposite since, at its simplest, the regulation is a classification system that identifies whether economic activities are sustainable from an environmental perspective.
Social and governance factors also feature in the new Taxonomy Regulation, but only as a component (rather than as a principal focus) of the regime, which is dedicated to environmental considerations. The reason for this is that the EU wanted to get the environmental classification system up and running in time to meet approaching Paris Climate Agreement deadlines. As such, it was decided that a broader ESG taxonomy would be hammered out after the environmental system went live. Under the current timetable, as set out in Article 26(2) of the Taxonomy Regulation, the European Commission will report on proposals for a broader ESG taxonomy by December 31, 2021.
The Taxonomy Regulation and the Broader ESG Regime
The EU ESG regulatory regime is comprised of several disparate measures, nearly all of which intersect with the Taxonomy in some way.
These measures include a suite of prudential rules, proposals for labeling sustainable investments such as EU Green Bond Standard (“EU-GBS”) and a Financial Services Ecolabel, ESG corporate engagement rules (under the Shareholder Rights Directive II), and requirements for the development and maintenance of climate benchmarks (under the Climate Benchmark Regulation). The most pressing ESG rules for investment firms, however, are those set out in the following three interlinked ESG texts:
In summary, the Non-Financial Reporting Directive (NFRD) requires large EU “public interest” corporates (including many financial services firms) to publish data on the impact their activities have on ESG factors. The Taxonomy Regulation introduces a sustainability classification system through which investment firms must classify investments based on NFRD data (and other datasets). The SFDR (as supplemented by the Taxonomy) requires investment firms to disclose:
- The environmental sustainability of an investment and the provenance of any ESG claims made;
- The risks investments present to ESG factors;
- The risks ESG factors present to investments.
Depending on the rule in question, the relevant SFDR disclosure will appear in one or more of the following locations: on the investment firm’s website, in periodic reports, in promotional material, and/or in pre-contractual documentation. The SFDR rules are further broken down into mandatory and “comply or explain” rules, as well as entity- and product-level rules.
Both the Taxonomy Regulation and the SFDR have enormous scope and application, covering more or less the entire asset management industry and beyond. Moreover, the Taxonomy applies directly to Member States, who are prohibited from introducing domestic rules that would compromise the integrity of the Taxonomy regime.
At present, there is a gap between the data disclosed pursuant to the NFRD and the data required by the SFDR and Taxonomy Regulation. However, as discussed further below, Article 8 of the Taxonomy bridges this gap to a degree. Moreover, the European Commission Consultation launched in February 2020 (accompanied by a Background Document) proposes to expand the application of the Directive and reconcile the disclosure requirements of the NFDR with the reporting requirements of the SFDR and Taxonomy. Should the NFRD be modified, practice would match principle, as set out in the simplified diagram below.
The Basics of the Taxonomy Regime: In-Scope Economic Activities
At the core of the Taxonomy is Article 3, which, in conjunction with several other articles, identifies the following categories of “economic activities”:
- Article 3: Environmentally Sustainable Economic Activities
- Article 10(2): Transition Activities
- Article 16: Enabling Activities
The first set of activities—the “principal” Environmentally Sustainable activities—are the core of the regime, while Transition and Enabling activities are classes that facilitate the transition to a sustainable economy that the Regulation is designed to facilitate.
Article 3 activities are those that “substantially contribute” to one or more of the following six Article 9 “Environmental Objectives”:
These Article 9 objectives are further defined in Articles 10 to 15 and in pending delegated legislation that will specify “Technical Screening Criteria” for each objective. The EU Sustainable Finance Technical Expert Group’s (TEG) March 2020 Final Report and Annex sets out detailed proposals for the first tranche of delegated legislation, covering the first two objectives, which must be published by December 31, 2020.
Article 10(2) “transition activities” are activities for which there are no technologically and economically feasible low-carbon alternatives and which support the transition to a climate-neutral economy in a manner that is consistent with “a pathway to limit the temperature increase to 1.5 ⁰C above pre-industrial levels.” Transition activities only relate to Article 9 “Climate Change Mitigation” Environmental Objective (as further explained in Article 10).
Article 16 “enabling activities” are those considered to contribute substantially to one or more of the Article 9 environmental objectives, where they directly enable other activities to make a substantial contribution to one or more of those objectives, so long as the activity does not lead to a lock-in in assets that undermine long-term environmental goals, considering the economic lifetime of those assets. The activity must also have a substantial positive environmental impact based on the “lifecycle considerations.”
Criteria for “Environmental Sustainability”
Returning to the core Article 3 Economic activities, they must meet the four conditions set out in the following Article 3 sub-sections:
- Contribute substantially to one or more of the environmental objectives (in Article 9);
- Not significantly harm any other Article 9 objective (in accordance with Article 17);
- Be carried out in compliance with minimum safeguards (laid down in Article 18);
- Comply with technical screening criteria (established under Articles 10-15 and 19).
Classifying “environmental sustainability” in accordance with the Article 9 objectives, as further specified in delegated legislation made pursuant to Articles 10-15 and 19, is largely uncontroversial, as is the requirement to ensure no significant harm is caused to the other environmental objectives (per Article 17).
Article 3(c) social and governance “minimum safeguards” have, however, raised a few eyebrows. Specifically, Article 18 defines these safeguards as “procedures” that must be implemented by the entity under consideration and which must align with the following international rule sets:
In terms of the final bullet, particular emphasis is placed on compliance with the International Labour Organization Declaration's Eight Fundamental Conventions, as set out therein.
It is arguable that these rules already exist within the EU acquis in some form or other, whether through express legislation or implicitly in fundamental EU constitutional principles such as those found in the Treaty on the Functioning of the EU (TFEU). Moreover, given that the rules only apply when seeking to establish whether an investment is “environmentally sustainable,” their impact is relatively modest. Nevertheless, introducing this enormous body of international rules “by the back door” is somewhat extraordinary, if not unprecedented.
This is not the only quirk of Article 18 either, which is also notable for requiring the entity under evaluation to comply with the “do no significant harm” (DNSH) principle in Article 2(17) of the SFDR, which in itself is uncontentious, but does draw attention to the “link” (or lack thereof) between the SFDR DNSH principle in Article 2(17) of the SFDR and the similar principle in Article 17 of the Taxonomy Regulation, which applies to the Article 9 Environmental Objectives.
The tricky relationship between these two principles has not been lost on the European Supervisory Authorities, who, in their April 23, 2020, Joint Committee Consultation Paper on SFDR delegated legislation, discuss the consequences of having these two similar yet separate principles intersecting, together with a litany of other discontinuities and difficulties that arise between the Taxonomy and the SFDR texts.
Taxonomy – SFDR-Linked Disclosures
Once an investment firm has procured the necessary data, undertaken the relevant analysis, and finally classified the “environmentally sustainable” nature of an investment, what happens next? The firm needs to feed the analysis into the SFDR disclosures by way of Articles 5 and 6 of the Taxonomy Regulation, which is the principal mechanism through which the regulation makes its presence felt in the world: In many respects, the Taxonomy can be regarded as a very elaborate set of marketing rules.
As discussed above, the SFDR has three main types of disclosures: those relating to the risks presented by an investment to ESG factors and vice versa (the so-called “double materiality” perspective), and those relating to how an investment is marketed. In terms of the latter, the SFDR distinguishes between genuinely “sustainable investments” (Article 9 of the SFDR) and investments that merely promote the ESG characteristics of an investment (Article 8 of the SFDR).
Articles 5 of the Taxonomy Regulation interfaces with Article 9 of the SFDR and adds taxonomy-specific pre-contractual and periodic reporting disclosures. Articles 6 of the Taxonomy Regulation does the same for Article 8 of the SFDR. Meanwhile, Article 7 of the Taxonomy Regulation applies the following boilerplate pre-contractual and periodic reporting disclosure to all otherwise in-scope financial products that are not “sustainable investments” and that do not promote their ESG characteristics (in accordance with Articles 8 and 9 of the SFDR, respectively):
“The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities.”
Taxonomy – NFRD-Linked Disclosures
The Taxonomy Regulation also introduces new disclosures for corporates subject to the NFRD. Specifically, Article 8 requires entities subject to the NFRD to disclose in their non-financial statements “information on how and to what extent their activities are associated with environmentally sustainable economic activities under Articles 3 and 9 of the [Taxonomy Regulation]” including:
- The proportion of their turnover derived from products or services associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9;
- The proportion of their capital expenditure and the proportion of their operating expenditure related to assets or processes associated with economic activities that qualify as environmentally sustainable under Articles 3 and 9.
The European Commission is required to adopt a Delegated Act by June 1, 2021, specifying the content and presentation of the information to be disclosed and the methodology used, taking into account the specificities of both financial and non-financial undertakings and the technical screening criteria established under the Taxonomy Regulation.
Whilst the fate of the Taxonomy Regulation hung in the balance, there was still a genuine chance that the ESG regime might wilt on the vine before it had the chance to blossom, especially with Member States publicly challenging the position of their peers on matters ranging from forestry to nuclear power. However, with the publication of the Taxonomy Regulation, the theoretical timelines from a few weeks ago have now crystallized into hard compliance deadlines.
Investment firms, particularly investment managers and product manufacturers, now need to work out what data they need, how they will analyze it, and how they will report it. They also need to consider how the new requirements will affect their marketing as well as their broader and product-/portfolio-specific investment strategies.
Once these steps have been taken, investment firms will then need to identify if they have the resources, data, systems, personnel, and subject matter expertise to meet the requirements. Once their needs are identified, they will have to reach out to senior management, their finance department, and project managers to agree and scope out the project. It’s not “panic stations” yet, but it’s definitely “action stations” given that the first key deadlines under the new regime (specifically the SFDR) are set for March 10, 2021, less the eight months away.
The Taxonomy will in due course replace the morass of voluntary schemes with a single classification system for the EU, starting with the environment, but with the express intention of extending the regime to cover social and governance considerations in the near future.
Since it will have the force of law and since no other legal frameworks are being developed to compete with it, the EU framework will become the de facto global ESG (gold) standard. Moreover, its formal legitimacy, compared with the voluntary nature of other regimes, is likely to draw “appetite” from investors outside of the EU who are seeking reassurance (including from their clients) that their investments are genuinely sustainable rather than greenwashed.
With the first legal, pan-regional framework, the EU will have first-mover advantage and may potentially obtain important network effects that could serve as barriers to entry to the “ESG standards business” in the future. In short, the EU Taxonomy may well pose an existential threat to existing voluntary schemes, creating a new ESG world order.
Nevertheless, just over a week before the Taxonomy Regulation was made law, on June 10, 2020, the Institute of International Finance (IIF) proposed that the main voluntary reporting frameworks should be consolidated into a single global framework, which, though unsaid in the piece, would provide direct competition to the EU taxonomy as the de facto global ESG regulatory framework.
Further, less than 10 days later, on June 19, 2020—the day after the announcement that the Taxonomy had been signed into law—Responsible Investor cited in its Daily Briefing that the Climate Disclosure Standards Board, Sustainability Accounting Standards Board, Global Reporting Initiative, and CDP (formerly the Carbon Disclosure Project), had declared that they were working together to provide a “globally harmonized system” that “delivers on the pillars set out by the TCFD…across all sustainability targets,” whilst also inviting the International Financial Reporting Standards Foundation to join them.
In short, these bodies signaled that they saw the existential threat to their operations posed by the Taxonomy Regulation and were determined to meet it head on. By following the recommendations of the IIF to pool their efforts, they also started a race to create the premiere transnational ESG framework, in a potentially zero-sum “winner takes all” bid to become the principal international ESG standard and one of the most important and impactful rulesets on the planet.
Unconstrained by the EU legislative process, they may succeed in winning the race. However, only time will tell if the lack of legal authority behind the proposed ruleset will prevent it from superseding the EU taxonomy as the default global ESG standard.