ESG Regulation: What's new (December 2023)

While financial professionals dream of regulatory stability on ESG, the European Commission and European authorities face important questions and challenges.

Important Consultations Regarding the Future of SFDR

On 14 September, the European Commission launched two consultations regarding SFDR implementation: one for the general public and a second, targeted one.
The ambition of the EC and the need to regulate ESG-related investments have been applauded.

However, the timeline, particularly between the different pieces of sustainable finance regulation, as well as their implementation, has been a significant challenge for the entire market.

Five years ago, Europe was a pioneer and leader, but in the meantime, other models have also emerged, notably the SDR in the United Kingdom and the SEC-proposed investor disclosures in the United States.

The rationale behind launching this consultation is based on the output of a regulation which aimed at creating a disclosure framework and has resulted in a sustainability hierarchy closer to a label process.

SFDR or the headache of a product typology without being a categorisation and labelling system

The main argument for launching the consultation on the EC’s flagship policy (SFDR) is:

“The fact that Articles 8 and 9 of the SFDR are being used as de facto product labels, together with the proliferation of national ESG/sustainability labels, suggests that there is market demand for such tools to communicate the ESG/sustainability performance of financial products. However, there are persistent concerns that the current market use of the SFDR as a labelling scheme might lead to risks of greenwashing. This is partly because the existing concepts and definitions in the regulation were not conceived for that purpose. Instead, the intention behind them was to encompass as wide a range of products as possible, so that any sustainability claims had to be substantiated. In addition, a proliferation of national labels risks fragmenting the European market and thereby undermining the development of the capital markets union [European Commission, Targeted Consultation Document, Implementation of the Sustainable Finance Disclosures Regulations (SFDR), page 30].

The idea would therefore be either:

a similar approach of the current one but with finetuning of definitions notably the concepts of environmental/social characteristics, sustainable investment, do not significant harm etc.

an approach based on labeling process to answer the market demand by splitting categories focusing on type of the investment strategy (sustainability themes, exclusions, transition, positive contribution, etc.). This approach could count around 4 categories.

01

“Products investing in assets that specifically strive to offer targeted, measurable solutions to sustainability-related problems that affect people and/or the planet, e.g., investments in firms generating and distributing renewable energy, or in companies building social housing or regenerating urban areas.”

02

“Products aiming to meet credible sustainability standards or adhering to a specific sustainability-related theme, e.g., investments in companies with evidence of solid waste and water management, or strong representation of women in decision-making.”

03

“Products that exclude activities and/or investees involved in activities with negative effects on people and/or the planet.”

04

“Products with a transition focus aiming to bring measurable improvements to the sustainability profile of the assets they invest in, e.g., investments in economic activities becoming taxonomy-aligned or in transitional economic activities that are taxonomy-aligned, investments in companies, economic activities, or portfolios with credible targets and/or plans to decarbonise, improve workers’ rights, reduce environmental impacts.”

As of today, 53% of the AUM managed worldwide are in Article 8 products, as opposed to only 3.5% in Article 9 [Source: Morningstar], testifying to the “catch-all” nature of Article 8 versus the more demanding Article 9 products.

The French financial market regulatory authority has already expressed its sentiment on a system based on minimum expectations linked to the category of the product [AMF, Proposal for minimum environmental standards for financial products belonging to the Art.9 and 8 categories of SFDR, Position paper from the AMF] - a proposal closer to a labelling approach than the initial disclosure objective of the regulation.

Next to the typology of products concept, the consultation raised key questions regarding:

Principal adverse impact indicators, including the double materiality option, opening a door for convergence between SFDR and mandatory PAI and CSRD and double materiality check option;

Costs impact in terms of human and financial resources;

Convergence and interaction between sustainable instruments, taxonomy and PAI for the sustainability options of MIFID.

SFDR brought transparency but not clarity. This is the second challenge for the European Commission. The market needs transparency, clarity and also comparability.

In terms of clarity, the market needs minimum definitions to speak the same language with the same rules and principles. For example, the sustainable objectives of the products should be clarified, notably the interconnection with financial objectives.

Regarding comparability, there is a need to address consistency in asset owners’ strategy regarding sustainable commitment when working with multiple financial products and market participants.

The months ahead are going to be exciting!

CS3D: an acronym which could shake up the market!

The proposal for a Corporate Sustainability Due Diligence Directive from the European Commission should not be underestimated.

Firstly, listening to emerging economies' participants, these are watching carefully and closely all developments regarding CSDDD to remain a key trade partner of Europe.

Secondly, because the European Parliament voted on 1 June 2023 for higher ambition for the proposed Directive, notably by doubling the number of companies. Indeed, with new criteria based on a minimum €40 million turnover and minimum 250 employees, but also including some non-EU firms, the number of companies in the scope will likely double!

Table 1: MEPs voted to expand the number of companies in scope of the regulation

Source: J.P. Morgan based on the EP and the EC. For EU firms, employees should include temporary agency workers and other non-employee workers.

The question of the inclusion of financial institutions in the scope of CSDDD remains a key point to keep an eye on.

The version reviewed by the EP should now be adopted (by 2024 or earlier). As a directive, it needs to be transposed into the national law of each member state within two years of the Directive coming into force. The in-scope companies will therefore have to be accountable for the human rights and environmental impacts at their level but also at the level of their subsidiaries and value chains. An important mention is also the obligation to adopt a climate transition plan.

Taxonomy – 4 new objectives, 4 new opportunities but where are the data?

The taxonomy is an essential tool the European institutions have set up. Nevertheless, as of today with the first two objectives (climate change mitigation and climate change adaptation) and the available data, the reference to taxonomy as one option of the MIFID sustainability preferences has created tensions around a too restrictive investment universe, not sustainable in the long run and regarding diversity, liquidity, valuations.

Indeed, the first two objectives cover roughly 40% of the European listed companies but 80% of the direct GHG in Europe. The priority was clear.

The extension of the taxonomy - with the four additional objectives i.e. sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems. The so-called “Taxo4” are covered by a Delegated Act with the technical screening criteria adopted by the Commission on 27 June 2023 - is therefore a crucial step towards more impact and better investment opportunities. If neither the European Parliament nor the Council objects to the delegated acts regarding Taxo4, these will be applied from 1 January 2024.

Nevertheless, access to the data remains a challenge as well as getting an idea of the issuers eligible and aligned with the new additional objectives.

Indeed, the more than 1000 pages of Delegated Acts regarding the extension of the Taxonomy are highly technical but do not really provide investable actions. Several hurdles make the reading not practical:

The overlap between the 6 objectives for certain activities, without guidance on how to prioritize one objective over another.

The reference of the activities, not easy to map to NACE codes typology – used mainly in Sustainable Finance regulation. The mapping with other standards like GICS or BICS is challenging and creates gaps between the different categorizations.

The stringency and usability of the technical screening criteria, notably the non-homogeneous reference tools sometimes based on national regulation or international standards, on technology eligibility, on intensity level performance, or on relative improvement performance requirements.

All these hurdles make it very complex for financial market participants and ESG data providers to assess the eligibility and calculate the alignment of the economic activities to the new four additional objectives. A good understanding of the technical screening criteria as well as the description of the economic activities is required for corporates as well as ESG data providers to ensure the reporting of the alignment figures.

General Timeline

January 1, 2024: The Corporate Sustainability Reporting Directive enters into force for corporations that are within the scope of its former Non-Financial Reporting Directive (NFRD). The Corporate Sustainability Reporting Directive (CSRD) is the new EU legislation that mandates all large companies to publish regular reports on their environmental and social impact activities. This directive allows investors, consumers, policymakers, and other stakeholders to assess large companies' non-financial performance. All large undertakings that are currently not within the scope of the NFRD but are within the scope of the CSRD will need to report a year later, on January 1, 2025.

Starting from January 1, 2024, - if Delegated Acts are finally approved by the European Parliament and Council - investments' alignment with the final four EU Taxonomy objectives must be reported (i.e., circular economy, pollution, effect on water and biodiversity).

May 2024: Proposal for the 2040 climate target.


June 2024: European elections.


Q3/Q4 2024: New European Commission in place.


January 1, 2026: CSRD applies to listed SMEs and small & non-complex financial institutions on an optional basis.


January 1, 2028: CSRD applies to third-country companies and listed SMEs and small financial institutions.

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