1. The SFDR and the Taxonomy Regulation: Key Developments and What Firms Can Expect in the Coming Year

Almost a year on from the date on which the European Union's Sustainable Finance Disclosure Regulation (SFDR) came into force on 10 March 2021, the market interpretation of the new environmental, social and governance (ESG) rules is beginning to settle, but the hard work is not over as firms will need to continue to focus on their internal arrangements to obtain the data they need, and find ways to identify or create appropriate proxy data. The SFDR saw introduction of the product categories, and the attendant disclosure requirements under the SFDR for the product and the product provider, as well as the environmental sustainability classification system under the Taxonomy Regulation. The delayed application of key provisions under the long-awaited secondary legislation (providing additional colour on the requirements under the SFDR and the Taxonomy Regulation) (RTS) to 1 January 20231 provides more time to prepare for the more detailed disclosures. However, the absence of meaningful data and guidance regarding acceptable proxy data, and the absence of technological solutions allowing firms to more effectively harness their proprietary data and enrich it with relevant external data from sustainability ratings providers and others continues to complicate compliance.

The Devil in the Detail – Secondary Legislation

While the relatively high level requirements and flexible definitions under the SFDR have allowed for the prescribed disclosures to include more or less detail, and the broad definition of "Article 8" products has meant that products categorised under Article 8 of the SFDR may include material differences of degree in terms of commitment to ESG strategies, the much more granular and quantitative provisions under the RTS are likely to be more revealing of the ESG credentials of a product. The same is true also with respect to the subset of Article 8 and Article 9 products that are subject to the additional disclosures under the Taxonomy Regulation.

The RTS sets out, among other things, details of:

  • Information required to be disclosed for an investment to satisfy the "do no significant harm" test pursuant to the SFDR (which is distinct from the "do no significant harm" test under the Taxonomy Regulation – see below)—in order that it may qualify as a "sustainable investment" within the context of the SFDR, provided such investment also contributes to an environmental or social objective under the SFDR.
  • The key performance indicators required to be considered to make the Principal Adverse Impact (PAI) disclosures. These are heavily prescribed quantitative data fields which firms must populate to complete the disclosure.
  • Prescribed content requirements for each item of information that must be included in the precontractual disclosures and website disclosures in respect of financial products that fall within the definition of Articles 8 and Article 9 of the SFDR, and their providers.
  • Prescribed content requirements for each item of information that must be included in the periodic reports under Article 11 of the SFDR in respect of financial products that fall within the definition of Article 8 and Article 9 of the SFDR.
  • Prescribed content and presentation requirements for the additional information required to be included in the pre-contractual disclosures and periodic reports in respect of the sub-set of financial products under each of Article 8 and Article 9 of the SFDR that make "environmentally sustainable" investments within the meaning of the Taxonomy Regulation

While regulatory guidance to date has indicated that firms should comply with the primary requirements on an evidenced best efforts basis, taking into account the provisions under the SFDR RTS until the relevant provisions under the SFDR RTS take effect, the regulatory initiatives are only starting to focus on harmonising the production of ESG and sustainability related market data, including ratings, and has provided no satisfactory response to how firms struggling with plugging gaps in the investment level data.

The Gold Standard – the Taxonomy Regulation

The Taxonomy Regulation, which takes effect in stages from 1 January 2022, introduces additional disclosure requirements, particularly in respect of Article 8 and Article 9 products. In addition, it introduces the standard for a harmonised assessment of what it means for an investment to be "environmentally sustainable" as the term is used in the EU.

An "environmentally sustainable" investment under the Taxonomy Regulation is defined as "an investment in one or several economic activities that qualify as environmentally sustainable under [the Taxonomy Regulation]". There are four key tests that an economic activity must satisfy to be "environmentally sustainable" under the Taxonomy Regulation. The activity must:

  • "Contribute substantially" to at least one of the environmental objectives under the Taxonomy Regulation.
  • "Do no significant harm" to any of the other environmental objectives.
  • Be carried out in compliance with minimum social and governance safeguards.
  • Comply with the relevant technical screening criteria.

The technical screening criteria required to be adopted (via delegated legislation) under the Taxonomy Regulation will prescribe the granular requirements for determining the conditions under which an economic activity qualifies as "contributing substantially" to the relevant environmental objective(s) and whether that economic activity "does no significant harm" to any of the other environmental objectives.

An investment may therefore qualify as a "sustainable investment" within the meaning of the SFDR but is required to separately meet the arguably more stringent requirements to qualify as an "environmentally sustainable" investment within the meaning of the Taxonomy Regulation.

Climate Change Delegated Regulation

Following a period of feedback and consultation, on 9 December 2021, the European Commission adopted a proposed Delegated Regulation (the "Climate Change Delegated Regulation"),2 containing the technical screening criteria for determining:

  • The conditions under which an economic activity qualifies as "contributing substantially" to climate change mitigation or climate change adaptation.
  • Whether that economic activity "does no significant harm" to any of the other environmental objectives.

The Climate Change Delegated Regulation comes into effect on 1 January 2022, though given the delay to general applicability of the RTS, it remains to be determined how the results of an assessment of an investment by reference to technical screening criteria will ultimately be disclosed by investment managers.

Possible Taxonomy for Social Objectives

At present, the Taxonomy Regulation sets out the criteria for determining whether an eligible economic activity qualifies as "environmentally sustainable." It is expected that work on developing an EU taxonomy for "socially sustainable" investments will commence in earnest in the following months. The teething problems in rolling out a significant new framework may have eased off by then, hopefully making application of and compliance with such a taxonomy a more straightforward task.

Footnotes

1 The mandatory entity-level requirements for reporting of the PAI of investment decisions was not delayed and took effect from 1 January 2022. Similarly, the requirement under MiFID to report on sustainability preferences is set to take effect from 2 August 2022 without delay

2 See https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CE LEX:32021R2139&from=EN.

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Co-authored by Hallie Tucker

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