As green politics have gained greater public attention and support, investors who mandate financial intermediaries to take investment decisions on their behalf are calling for more sustainable products and greater transparency about how and where their money is invested.
To accommodate investors’ request, financial intermediaries are offering financial products labelled as “green”. These products are in the process of being regulated by the European Commission whose aim is to encourage capital flows towards sustainability and to provide investors with more clarity on what constitutes a sustainable investment.
In December 2018, the European Commission mandated a group of social, financial and academic experts to develop a strategy on sustainable finance which incorporates Environmental, Social and Governance (ESG) considerations into investment decisions and ensures that clients are accurately informed.
To implement the sustainable strategy, the European Commission adopted a package of proposed measures:
- Regulation on the establishment of a framework to facilitate sustainable investment (the “Taxonomy Regulation”)
- Regulation on disclosures relating to sustainable investments and sustainability risks and amending Directive (EU) 2016/2341 (the “Disclosure Regulation”)
- Regulation amending the benchmark regulation (the “Low Carbon Benchmark Regulation”)
This article analyses each proposed Regulation, explains the proposed requirements for a product to be labelled and branded as “green” and the regulators’ initiatives towards sustainability.
The Taxonomy Regulation
The Taxonomy Regulation establishes uniform criteria to determine whether an economic activity is environmentally sustainable and can, therefore, be labelled as green. When offering green funds, financial intermediaries must indicate the extent to which the criteria for environmentally sustainable economic activities were used. This is to avoid raising capital for “green” purposes without clear benefits to the environment.
The Taxonomy Regulation applies to the Union, Member States and financial market participants. Manager of UCITS, AIFs, EuVECA and EuSEF, insurers and pension products providers fall within the definition of financial market participants and are referred to in this article as participants.
Environmentally sustainable investment
To be considered as environmentally sustainable, an investment must fund one or more economic activities which:
- contribute substantially to one or more of the environmental objectives
- do not significantly harm any of these objectives
- comply with the minimum safeguards and the technical screening criteria
The environmental objectives set out in the Taxonomy Regulation are climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, waste prevention and recycling, pollution prevention and control and protection of healthy ecosystems.
The above activities must comply with the criteria set out in Article 12 of the Taxonomy Regulation which determines whether an economic activity harms any of the environmental objectives significantly.
The economic activities must be carried out respecting the minimum social and governance safeguards, being the principles and rights set out in the International Labour Organisation’s declaration on Fundamental Rights and Principles at Work.
This is to ensure that financial intermediaries do not neglect social factors while promoting environmentally sustainable products.
Technical screening criteria
The economic activities must comply with the technical screening criteria set out in Article 14 of the Taxonomy Regulation:
- identify the most relevant potential contributions to the given environmental objective, over the short and long-term impacts
- specify the minimum requirements to avoid significant harm to other objectives
- be qualitative or quantitative, or both, and contain thresholds where possible
- build upon Union labelling and certification schemes, methodologies for assessing environmental footprint, and EU statistical classification systems, and take into account any relevant existing EU legislation
- be based on conclusive scientific evidence, high quality research and market experience
- consider the life-cycle of an economy activity
- take into account the nature and the scale of the economic activity
- consider the potential impact on liquidity in the market, the risk of certain assets becoming stranded as a result of losing value due to the transition to a more sustainable economy, as well as the risk of creating inconsistent incentives
- cover all relevant economic activities within a specific sector and ensure that those activities are treated equally if they contribute equally towards one or more environmental objectives, to avoid distorting competition in the market
- be set so as to facilitate the verification of compliance with those criteria whenever possible
If the investment funds one or more of the environmental objectives without causing significant harm to any of them and complies with the minimum safeguards and technical screening criteria, that investment can be labelled as green and EU compliant.
It must be noted that the Taxonomy Regulation considers E (environmental) factors only. Social and governance related investments are expected to be regulated through separate legislative proposals.
The Disclosure Regulation
While the Taxonomy Regulation establishes the framework to define an environmentally sustainable activity, the Disclosure Regulation sets out how managers must disclose certain information to provide greater clarity and transparency to investors.
Participants are required to publish policies on the integration of sustainability risks in their investment decision-making process on their websites and keep these policies up to date.
The website must have:
- a description of the sustainable investment target
- information on the methodologies used to assess, measure and monitor the impact of the sustainable investments, including its data sources, screening criteria for the underlying assets and the relevant sustainability
- an index or target as appropriate
- the information included in the periodical reports (discussed below)
The methodology used for calculation of indexes and benchmarks must be made readily available for investors.
The following descriptions must be included in pre-contractual disclosures:
- the procedures and conditions applied for integrating sustainability risks in investment decisions
- the extent to which sustainability risks are expected to have a relevant impact on the returns of the financial products made available
- how the participants’ remuneration policies are consistent with the integration of sustainability risks and are in line, where relevant, with the sustainable investment target of the financial product
Financial products with an index
If a financial product has as its target sustainable investments or investments with similar characteristics and an index is designated as a reference benchmark, the information to be disclosed must be accompanied by the following:
- information on how the designated index is aligned with that target
- an explanation as to why the weighting and constituents of the designated index aligned with that target differ from a broad market index
Financial products with no index
If a financial product has as its target sustainable investments or investments with similar characteristics and no index is designated as a reference benchmark, the information must include an explanation of how that target is reached.
Periodic reports (i.e. annual and/or interim) must include:
- the overall sustainability-related impact of the financial product by means of relevant sustainability indicators
- if an index is designated as a reference benchmark, a comparison between the overall impact of the financial product with the designated index and a broad market index in terms of weighting, constituents and sustainability indicators
The Low Carbon Benchmark Regulation
The Low Carbon Benchmark Regulation establishes a new category of benchmarks comprising low-carbon and positive carbon impact benchmarks, which provides investors with better information on the carbon footprint of their investments.
A low-carbon benchmark is defined as a benchmark for which the underlying assets are selected to have fewer carbon emissions than the assets that comprise a standard capital-weighted benchmark.
A positive carbon impact benchmark, by comparison, is defined as a benchmark for which the underlying assets are selected on the basis that their carbon emissions savings exceed the asset's carbon footprint.
Recently, there has been an increase in ESG benchmarks. The users of those benchmarks do not always have the necessary information on the extent to which the methodology used to establish the benchmark considers ESG objectives. The Low Carbon Benchmark Regulation requires disclosure of how the methodology takes into account the ESG factors for each benchmark or family of benchmarks to enable investors to make well-informed choices.
Technical report on the Taxonomy
The European Commission mandated a technical expert group (TEG) to develop a unified classification system known as a Taxonomy.
In June 2019, the TEG published a report containing technical screening criteria for 67 activities that can make a substantial contribution to climate change mitigation across the sectors of agriculture, forestry, manufacturing, energy, transportation, water and waste, ICT and buildings.
The report also contains methodologies and worked examples for evaluating substantial contribution to climate change adaptation, guidance and case studies.
The TEG’s mandate was extended until the end of the year to refine and further develop some incomplete aspects of the proposed technical screening as well as issuing further guidance on the implementation and use of the Taxonomy.
While the TEG is working on finalising the criteria, in order to avoid disproportionate costs for participants, a number of provisions were put in place to ensure that the Taxonomy will only be used once it is stable and mature. Each activity fund managers would like to invest in must be analysed carefully to ensure that it satisfies the criteria set out in the Taxonomy.
The financial regulators’ initiatives towards sustainability
While some countries are regularly monitoring the EU’s proposed regulations on green finance, others have already enacted domestic legislation to safeguard investors in green products. This will be analysed alongside third countries’ initiatives like China and Hong Kong that are significantly contributing towards a greener economy.
EU Member States
France is the most active country when it comes to sustainability. Article 173-VI of the Law on Energy Transition for Green Growth (LTECV) requires asset management companies and institutional investors to provide information on the social and environmental consequences of their activities. This includes disclosing impact on climate change, social factors, the circular economy, the fight against food waste, discrimination and promoting diversity. However, the “comply or explain” principle applies to Article 173-VI giving flexibility to asset management companies and institutional investors to providing valid reasons for the non-compliance (Article 173-VI: Understanding the French regulation on investor climate reporting).
In July 2019, the Autorité des Marchés Financiers (AMF), the financial regulator in France, established the AMF’s Climate and Sustainable Finance Commission made up of experts mandated to ensure collective progress in understanding the challenges around sustainability.
The AMF is reviewing KIIDs and prospectuses of French authorised funds to ensure that the information provided by asset management companies on their investment strategy and climate-related risks is clear, accurate and not misleading. The AMF’s supervisory power was reinforced by the law on Business Growth and Transformation (the “PACTE Law”).
The Financial Conduct Authority (FCA), the financial regulator in the United Kingdom, issued a Discussion Paper (18/8) on Climate Change and Green Finance last month saying it will challenge firms which provide misleading information on their “green” activities to investors. The FCA will take appropriate action (e.g. issuing further policy and guidance) to prevent consumers from being misled and to align UK rules with EU regulations.
The UK’s exit from the EU should, in theory, not compromise the UK's compliance with the EU legislative proposals. The Taxonomy Regulation, the Disclosure Regulation and the Low Carbon Benchmark Regulation were all listed in the Financial Services (Implementation of Legislation) Bill 2017-2019 as pending EU legislation to be onshored. It is likely that these regulations will be onshored into UK law under the legislation relating to the UK’s withdrawal from the EU and for the purposes and duration of any transitional or implementation period.
The Commissione Nazionale per le Società e la Borsa (CONSOB), the financial regulator in Italy, recently established a Steering Committee to regularly monitor EU proposals, studies, researches and analysis on sustainable finance.
As to the domestic legislation, the Regulation establishing the provisions for implementation of Legislative Decree no. 58 of February 24, 1998, on intermediaries (Decree 58) requires intermediaries to provide accurate information (i.e. objectives and characteristics, general criteria for selection, policies in exercising voting rights, income generated) on products and services defined as “ethical” or “socially responsible”. That information must be made available on the firm's website and disclosed yearly.
Non-EU Member States
In December 2017, the China Securities Regulatory Commission (CSRC) issued standards for the content and format of the information provided in the semi-annual and annual reports produced by listed companies. These standards include requirements for companies to report on relevant ESG matters. The requirements are mandatory for key polluters and apply on a comply-or-explain basis for all other listed companies. CSRC is expected to introduce requirements for all listed companies and bond issuers to disclose environmental risks associated with their operations by 2020 and the requirement will become mandatory for all listed companies by then.
It is important to note that China’s guidelines for establishing a green financial system encourage securities regulators to increase penalties for listed enterprises and bond issuers that falsify environmental information (Sustainable Stock Exchanges Initiative).
The Securities and Futures Commission of Hong Kong (SFC) issued a circular applicable to SFC-authorized funds incorporating ESG factors into their investment objective or strategy.
Under this circular, offering documents of SFC-authorized funds must contain information (i.e. description of key investment focus, relevant green or ESG criteria or principles…) necessary for investors to make an informed judgement of whether or not to invest in these products. The manager of a green fund must regularly monitor and evaluate the underlying investments to ensure their fund meets the investment objective and requirements set out in the SFC’s circular.
The SFC is also in the process of launching a central datable of green funds on a dedicated webpage on its website. Only SFC-authorized green funds complying with the requirements set out in the SFC’s circular will be listed. The webpage is expected to be launched by the end of this year.
An analysis of the European Commission proposals is required for managers who are or will be offering financial products branded as green. These products will have to comply with the criteria set out in the Taxonomy Regulation and participants disclose clear and accurate information so that investors can make well-informed decisions. The Taxonomy Regulation will apply to climate change mitigation and adaptation activities from 1 July 2020 and appropriate measures must be taken by financial intermediaries if their funds invest in one or both of these economic activities.
The European Commission will permit EU Member States to enact domestic legislation on green products. This may help countries establishing national frameworks to facilitate sustainable investments, for example, issuing a special tax regime for green funds.
However, the International Organization of Securities Commissions (IOSCO) has identified some discrepancies amongst domestic legislation on sustainable finance and this may undermine investors’ confidence. The European Securities and Markets Authority (ESMA) stresses that coordination should be sought between countries and sustainability promoted and implemented by global regulators. Similar and consistent measures across different jurisdictions would encourage financial intermediaries to market their green funds across the world enhancing capital flows towards sustainability.
The Taxonomy could be a viable solution for establishing a unified and consistent classification system across several jurisdictions. However, more actions must be taken to enhance investors’ confidence. The SFC’s dedicated webpage listing ESG compliant funds should be considered by other regulators as this might have a positive impact on investing in green funds.
The CSRC’s initiative to making these requirements mandatory and to penalise financial intermediaries who provide misleading information could also be considered by EU regulators. If the EU requirements become mandatory and the EU introduces penalties to financial intermediaries for non-compliance, investors would be properly safeguarded. This would discourage financial intermediaries from offering funds labelled as green which do not have clear benefits to the environment.
European commission, Green Finance: Overview. Available at https://ec.europa.eu/info/business-economy-euro/banking-and-finance/green-finance_es.
Barnard & Peers: chapter 23
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