30 July 2020

Latest: ESG / Sustainability

A catch-up on fast-approaching, daunting funds industry challenges.

By Mark Kilbride and Mario Mantrisi

“Sustainable Finance is a new topic and requires a specific expertise mix that has not traditionally been found in financial market regulators… that cuts across all ESMA’s activities.”
EU Securities & Markets Authority – Strategy on Sustainable Finance (2020)

 

  1. Background

The Coronavirus pandemic was already on the horizon before the Technical Expert Group on Sustainable Finance (TEG) presented their latest Taxonomy report to the European Commission.

Up until that point, probably everyone in the funds industry would be aware of copious reportage of the parlous state of the world’s climate (i.e. in the opinion of most experts in the field), coupled with radical environmental activism.   Most would also have observed the increased trend of fund managers launching products either tagged ‘ESG’ and / or deemed ‘sustainable’, alongside the recent launch of the European Green Deal.

The EC has since formally extended their proposed Renewed Sustainable Finance Strategy to incorporate the ongoing COVID-19 crisis, alongside the United Nations (UN), who has framed the required global economic recovery from pandemic implications via “a responsible business finance lens”.  These are the latest linkages of Environmental, Social and Governance (ESG) factors to corresponding Socially Responsible Investment (SRI) criteria that now need to be addressed by all – including the funds industry.

Whatever one’s opinion of global warming or eco-investing (now aligned to unfolding epidemic events): sustainable finance is certainly an unprecedented, all-encompassing and emotive subject matter.  It remains an immensely challenging area with an increasing sense of urgency: the need to do something, fairly quickly.

It is also an area of clear opportunity.  Even before Covid-19, the Global Sustainable Investment Alliance estimated a worldwide ESG / SRI market at EUR 30 000 billion (i.e. 46% based in Europe, including assets involved in negative screening estimated at EUR 9 000 billion).  There were also 2,816 Europe-based responsible investment funds identified, with total assets under management of EUR 496 billion (i.e. a 27% increase in domiciled funds and 12.5% increase in AUM, year-on-year).

The coronavirus has since acted as a catalyst to bring sustainability to the forefront of the funds market.

 

  1. Summary: EU Sustainable Finance Action Plan

The EU sustainable finance action plan (SFAP) was launched by the EC in March 2018 as part of its strategy to integrate ESG considerations into its financial policy framework and to mobilise finance for sustainable growth.   It is directly linked to the 2015 Paris Agreement on Climate Change, the UN 2030 Sustainable Development goals and the latest OECD responsible business contact guidance. 

It is also linked to the European Green Deal, announced by the EC in December 2019 as “an overarching framework and programme of actions to transform the European economy”. This includes the proposed ‘Climate Law’ embedding a legal commitment for the EU to achieve climate neutrality by 2050, including interim comprehensive plan to reach 50% of this target before 2030. Other core components of the Green Deal include the supply of clean, affordable energy, biodiversity, a circular economy and sustainable food production.

 

  1. Recent events: key regulatory components

Most of the European sustainable finance regime elements are now included on the European legislation roadmap.  Recent attention has focussed on three central components:

1. EU Taxonomy Regulation (TR)

The taxonomy is a central component of the EU sustainable finance regime, initiated back in 2018.

It is a common EU classification system to define evolving sustainable economic activity, marketed by the TEG as a tool to help stakeholders navigate the transition to a low carbon, resilient and resource-efficient economy.  The taxonomy has been formally identified as a key enabler of the EU Green Deal’s comprehensive sustainable economy reforms; it has also been cited by the EC as a means to reduce instances of ‘greenwashing’ and mitigate market fragmentation risks.

On 22 June 2020, the associated Taxonomy Regulation (TR) was legally adopted and is now applicable to:

  • Financial Market participants: entities offering financial products (e.g. UCITS, AIF firms) via existing EU regimes.
  • Large Companies: public-interest organisations (500+ employees), including listed companies, banks and insurance companies. These firms have current obligations to supply non-financial information c/o the 2014 Non-Financial Reporting Directive (NFRD).

The TR establishes six phased environmental objectives to be met within the next 2-3 years, starting with Climate Change mitigation / adaption measures applicable from 01 January 2022. In time, firms will need to demonstrate their investments substantially contribute to at least one of these environmental objectives, while doing no significant harm to any of the others.

Firms will also need to meet additional minimum safeguards covering additional social and governance factors addressed by the latest UN Guiding Principles on Business and Human Rights (UNGPs) and OECD standards for Responsible Business Conduct (RBC).

While the Taxonomy framework remains effectively non-mandatory, all firms must supply a public disclaimer in the event of opt-out from any product disclosure.

 

2. Sustainable Finance Disclosure Regulation (SFDR)

The Sustainable Finance Disclosure Regulation (SFDR) was published in December 2019, outlining specific harmonised transparency requirements – including sustainability risks and sustainability principal adverse impacts – to be integrated across website content, pre-contractual disclosure, and periodic reports.

In April 2020, the European Supervisory Authorities (ESAs) published a joint consultation paper setting out their Regulatory Technical Standards (RTS) proposals. Currently under consultation, this contains specific disclosure obligations that Investment firms now have to consider, including:

  • Principal Adverse Impact Statement: containing 32 x mandatory environmental and social indicators (along with need to supply at least another 2 x supplementary indicators from those listed by the ESAs).
  • Precontractual disclosures: additional transparency layers, e.g. integration of sustainability risks, the promotion of environmental / social characteristics, sustainable investments. The current regulation specifies additional information to be made available in fund prospectus. There are also two-page Product disclosure summaries covering applicable ESG strategy and Transparency of sustainable investments.
  • Periodic documents (e.g. Annual Reporting) published for financial products with environmental characteristics or objectives will also have to disclose their alignment with the EU taxonomy and how their environmental or social characteristics or objectives are met.

Many SFDR disclosure obligations apply from 10 March 2021 (including materials to be made available on the websites of financial market participants).

 

3. Integration of ESG disclosure: AIFMD, UCITS, MiFID II

In June 2020, the EC published long-anticipated delegated act arrangements necessary for UCITS, AIFM and MiFID II firms to integrate sustainability factors into their current organisational requirements, operating conditions, risk management and target market assessments. MiFID II firms will also have suitability requirements updated to incorporate ESG preferences where indicated by the investor.

However, the proposed extension of principal adverse impact (i.e. beyond SFDR) to UCITS, AIFMD and MiFID regimes was recently contested by many industry firms and fund associations.

 

  1. What will happen next

The Taxonomy Regulation delegated acts on climate change mitigation / adaptation are required for EC adoption before 31 December 2020. The first set of TR disclosure requirements will apply from 1 January 2022.

The Sustainable Finance Disclosure Regulation consultation ends in September 2020 (with respondent feedback eagerly anticipated). Thereafter, the ESAs are faced with finalising their RTS of Disclosure measures ahead of SFDR legal application starting 10 March 2020 .  Clearly, this is will be a major challenge.

Finally, the Delegated Acts for UCITS, AIFMD and MiFID II are provisionally scheduled for publication end-2020 (for legally transposition 12 months later).

Meantime, Kneip stands ready with our expertise to address the challenges of sustainable finance. We continue to monitor these (and other events) to assess the evolving ESG obligations facing our clients and will issue further updates in due course.

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