The Moving Target of ESG Regulation in the EU
ESG – the integration of environmental, social and governance considerations into the investment process – has claimed center stage in the financial regulatory space. Global events, and an existing ambitious regulatory agenda, have catapulted ESG to top-of-mind for all parties of the investment management community. The consideration of environmental, social and governance risk in the investment process is often equated with sustainability on a longer time horizon. This year, sustainability has taken on a new level of importance for many investors faced with the confluence of the global COVID-19 pandemic, large-scale protests against racial injustice and climate events such as the Australian and US West Coast wildfires. Investors have as a result quadrupled inflows into ESG products in 2020.
The European Union has led the global movement towards ESG regulation since concretizing its goals in its 2018 Action Plan on Sustainable Finance. Despite recent global events, the EU has maintained a seemingly hawk-eyed focus on progressing the Action Plan by:
- Reaching political agreement on its keystone legislation, the so-called EU Taxonomy Regulation, that will create an EU classification system for identifying and comparing “green” economic activities
- Publishing draft Level 2 regulatory technical standards developed by the three European Supervisory Authorities (the ESAs) under the Sustainable Finance Disclosure Regulation
- Consulting on the review of the Non-Financial Reporting Directive and revisions needed for coherence with the other sustainability legislation; and
- Publishing proposed amendments to the specific financial sector regimes – e.g. UCITS, AIFMD and MiFID II – requiring asset managers and to integrate ESG considerations
Monitoring these developments has already kept the financial sector quite busy. Yet much of the EU legislation remains only in consultation or planned stages, and thus much more work is required before the ESG regulatory standards that will govern the industry for the foreseeable future are fully developed. Today’s post focuses on the SFDR. Future blogs will examine other pieces of the EU’s sustainable finance legislative package.
The SFDR establishes the first ESG compliance deadlines and will usher in a wide range of new requirements on EU financial market participants and financial advisers. All EU financial market participants (including UCITS and AIF managers) and financial advisers will be required to consider ESG risks and disclose how such sustainability risks are integrated in their investment decision-making process. Disclosures will be required at the entity-level regarding the firm’s sustainability policy, remuneration policy and policy on the consideration of principal adverse sustainability impacts. The requirements around the principal adverse impacts may prove to be the market’s biggest “bugbear,” as discussed further below.
At the product level, the nature of the new disclosures will depend on the extent to which the product can be considered an ESG product. In-scope financial products include, among others, AIFs, UCITS, pension schemes and insurance-based investment products. For financial products with an ESG focus, the SFDR (as amended by the EU Taxonomy Regulation) specifies two types. So-called Article 8 products are financial products that promote environmental and/or social characteristics and will require disclosures as to how the environmental and social characteristics of the product are met. Article 9 products are financial products with a sustainability objective and disclosures will be required on the specific objectives and how these objectives are met by the product. The first of these product disclosure obligations come due on 10 March 2021. Therefore, well before the initial disclosures date, firms will need to consider sustainability risks and, in relation to financial products, undergo a scoping exercise to classify their products into the three categories for the purpose of SFDR disclosures: Article 8, Article 9 or non-ESG.
A major difficulty in meeting the disclosure deadlines is that details as to the specific requirements have not yet been finalized by the European authorities. The preview provided to the market through ESA consultations on Level 2 guidance indicates an extensive data collection, integration and reporting exercise. In April 2020, the ESAs consulted on a proposed set of disclosure standards under the SFDR. Drawing the most attention was the proposal for a mandatory template to report on the principal adverse sustainability impacts, the principal adverse impacts statement (PAIS), required by all entities falling under the SFDR. The proposed PAIS template included some 32 mandatory indicators, 16 of them related to environmental factors and 16 relating to social and employee matters, with an additional 18 “opt-in” data points for consideration. The regulators’ view was that the 32 data points, covering issues such as greenhouse gas emissions and water use, would always lead to principal adverse impacts and would therefore always be disclosed. A subsequent consultation in September 2020 on the proposed template for ESG product disclosures drew less attention but revealed again that the ESAs have an extensive disclosure exercise in mind. The ESA survey sought feedback on a proposed universal template involving 16 questions to be answered in narrative form. Numerous industry groups and other respondents raised concerns about the desirability of such a granular level of disclosure and the difficulty of obtaining responsive data in a regulatory environment that does not yet require its disclosure.
The industry now awaits final guidance on the form of the entity PAIS template and ESG financial product templates, but it will not arrive before the SFDR takes effect on 10 March 2021. The European Commission has announced that final Level 2 guidance will be delayed, ostensibly because of the extended consultation period needed as a result of the COVID-19 pandemic, but no doubt also due to the largely negative industry feedback to the proposed form and detail of disclosures. The Commission letter to the ESAs confirming the delay indicates that Level 2 requirements are expected to become effective at an undetermined later date, but no earlier than January 2022.
Considering the scope of the draft Level 2 technical standards, this delay is at least a temporary reprieve. Initial disclosures derived solely from the SFDR Level 1 text should be “high-level and principles-based,” per the Commission letter. Firms will need to decide for themselves how detailed the initial round of policy and ESG product disclosures will be and resolve questions such as to what extent can and should a firm rely on draft Level 2 guidance. Whatever the outcome, it is likely that the disclosures for the SFDR disclosures made in 2021 will be made in two rounds – first, as high-level, principles-based disclosures and later, as more granular disclosures responding to final Level 2 guidance.
The foregoing describes the shifting compliance challenge only under the SFDR. The SFDR requirements will continue to evolve as the legislation with which it interacts also evolves, including the EU Taxonomy Regulation that details criteria on what constitutes sustainable activities and the Non-Financial Reporting Directive that will ultimately impose the granular disclosure requirements on EU issuers. In short, ESG regulation in the EU will be a dominant theme for the months and years ahead.
Timeline of EU ESG Regulation:
10 March 2021: First disclosures under SFDR, including:
- Entity-level sustainability risks policy
- Entity-level updated remuneration policy
- Entity-level principal adverse impacts policy (comply-or-explain)
- Product-level disclosures in pre-contractual documents for ESG products (Article 8/9 products)
30 June 2021: Disclosure of entity-level principal adverse impacts policy for large firms (> more than 500 employees) (comply)
End 2021: Expected effective date of proposed amendments to MiFID, AIFMD, UCITS, IDD and Solvency II requiring sustainability considerations at organizational level, in suitability assessment and product governance requirements
1 January 2022: Product disclosures under SFDR and EU Taxonomy Regulation, including:
- Product disclosures relating to climate change objectives
- Product-level disclosures in periodic reporting on ESG characteristics and/or sustainability objectives.
30 June 2022: Disclosure of entity-level statement on principal adverse impact statements
30 December 2022: Disclosure of product-level statement on principal adverse impact statements
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