Making sense of the EU Sustainable Finance Regulations

With the EU Taxonomy Regulation rightly taking centre stage, it is paramount for specialists and advisors, to also stay attuned to the wider context of the EU Taxonomy.

With this article, we seek to connect the dots between the Taxonomy and the Sustainable Finance Disclosure Regulation (SFDR) as well as the revision of the Non-financial Reporting Directive (NFRD).

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In previous articles we have outlined what the Taxonomy is, why to start aligning today and why to take note of all environmental objectives. In this article, we will zoom out a little and examine the broader context within which the EU taxonomy resides, namely the EU Action Plan on Financing Sustainable Growth.

As with the Taxonomy, time is of the essence. For instance, the SFDR applies as of 10th March 2021. A date already in the past.

The EU Taxonomy applies to both financial market participants as well as non-financial organisations, which fall within the scope of the Non-Financial Reporting Directive. It introduces a classification system to identify and assess sustainable economic activities.

An activity shall contribute positively to at least one of the Taxonomy‘s environmental objectives, while at the same time doing no significant harm to the other environmental objectives as well as complying with minimum safeguards.

The Action Plan on Financing Sustainable Growth supports the objectives of the European Green Deal, by directing private investments towards activities that support the transition to a climate-neutral, climate-resilient, resource-efficient and just economy.

All ten actions of Action Plan on Financing Sustainable Growth in the figure above aim to be coherent and aligned, including the establishment of the EU Taxonomy and the strengthening of sustainability disclosure. Thus far, the action of strengthening sustainability disclosure refers to the development of the sustainability-related disclosures in the financial services sector regulation (SFDR) and the review of the Non-Financial Reporting Directive (NFRD).

Whereas the first disclosures of non-financial companies and financial market participants on Taxonomy-alignment are due by the beginning of next year, the SFRD and review of the NFRD are on a shorter timeline and coming into force already this year. The soonest being the SFDR that applies as early as March 10, 2021, followed by a review of the NFRD by April 2021.

The SFDR will require financial market participants to disclose how they consider sustainability-related impacts in their investment decisions by June 30, 2021. The EU Taxonomy and SFDR use similar concepts to demonstrate alignment of an activity or investment with the respective regulation, allowing for synergetic implementation by the affected organisations.

Revision of the NFRD will support the Taxonomy Regulation by including disclosure requirements concerning Taxonomy-alignment. Thus, financial and non-financial companies that fall under the scope of the NFRD will have to report on how and to what extent they align.

In order to support the reporting requirements of the NFRD and SFDR regarding the Taxonomy Regulation, specifications have been developed in the form of delegated acts. One of these delegated acts applies to companies under the scope of the NFRD, and the other applies to those that must disclose under the SFDR.

The delegated act for the SFDR has been developed as regulatory technical standards and are recommended to apply the 1st of January 2022. The reason that the date of application is later than that of the SFDR (June 30, 2021) is due to the fact that it is closely related to the Taxonomy Regulation, which also applies the 1st of January.

The regulatory technical standards that will supplement the SFDR aim to specify the details of the content and presentation of the information to be disclosed. It will take into account the various types of financial products, their characteristics and the differences between them, as well as the objective that disclosures are to be accurate, fair, clear, not misleading, simple and concise.

The technical standards will be aligned with the technical screening criteria and the environmental objectives and disclosure obligations as set out in the Taxonomy Regulation.

The delegated act that supports disclosure obligations under the NFRD specifies and details the content and presentation of the information to be disclosed by both financial and non-financial companies that fall under the scope of the NFRD.

'The delegated act will include the methodology to be used in order to comply with the reporting requirements, taking into account the specificities of the EU Taxonomy technical screening criteria.

This becomes even more obvious when investigating the requirements of PAI indicators as described within the European Supervisory Authorities’ Draft Regulatory Standard.

These cover a variety of social and environmental issues, which correlate to the environmental objectives and minimum safeguards of the EU Taxonomy and can therefore be used as a benchmark on investments, in a first step towards compliance with the EU Taxonomy.

To enhance transparency and encourage a responsible approach to business, the NFRD requires companies to include non-financial statements in their annual reports from 2018 onwards. These companies include large public interest entities with over 500 employees, covering more than 6000 large companies in the EU.

To support the implementation of the Taxonomy Regulation and the SFDR, the European Commission is to revise the current NFRD. It has undergone a public consultation in 2020, and the Commission plans to publish the reviewed NFRD by April 2021.

As mentioned in the Taxonomy Regulation, companies that fall under the scope of the NFRD will have to disclose their Taxonomy-alignment in their non-financial reporting. Additionally, non-financial companies are to disclose:

• the percentage of their turnover that is derived from Taxonomy-aligned activities,
• and the CAPEX and OPEX of assets or processes that are associated with Taxonomy-aligned activities.

To gain an idea of what further changes might be included in the revised NFRD one could consider the outcome of the consultation, as it can - to a certain extent - indicate what the revision might include. Some insights from the consultation process are:

• Higher alignment. Respondents mentioned they would like to see a higher alignment between the NFRD, the Taxonomy Regulation, the SFDR and well-known reporting standards such as the TCFD and the Global Reporting Initiative (GRI). To support the alignment with the Taxonomy and the SFDR, majority agreed that environmental matters in the NFRD should be defined based on the six environmental objectives in the EU Taxonomy.
• Include smaller companies. Respondents argued that the threshold of a company size, currently 500 employees or more, should be aligned with the threshold established by the Accounting Directive, which is 250 employees or more. There are already several Member States that include smaller companies with 250 or more employees in the scope of their NFRD implementation.
• Special attention towards SMEs. This would be supported by the fact that financial institutions need non-financial information from their clients and investees to meet their own reporting obligations. Some respondents suggested that the scope should be broadened gradually, by first including only SMEs from sectors with a high transition risk in mandatory reporting obligations.It was recognised in the consultation that additional training could be beneficial to support building a common understanding of the taxonomy and disclosure requirements among smaller companies.
• Include non-EU companies operating or listed in the EU.
• Include non-listed companies situated in the EU.

It appears that most organisations within the scope of the EU Sustainable Finance Action Plan are already invested in implementing Environmental, Social and Governance (ESG) criteria into their business decisions and have developed relevant policies and processes to start aligning with the various regulations.

Moving forward, organisations will need to understand which regulations are applicable and how these are connected, for them to decipher their requirements to commit towards meaningful actions. For non-financial organisations this means to:

• Not only focus on the EU Taxonomy but to actively monitor the fast-paced timeline of regulations that might affect their stakeholders (i.e. mainly financial organisations).
• Expand their reporting regimen from policy-based reporting towards performance-based reporting, keeping in mind the specifications of PAI and EU Taxonomy screening criteria.
• Develop a strategy to align their business model with requirements of the EU Taxonomy.
• Take awareness of the upcoming review of the NFRD and the implications it will have on the organisation.

For financial market participants this means to:

• Commit to integrating sustainability-related impacts into their investment decisions promptly.
• Engage in extensive dialogue with their investees on the disclosures required under the SFDR (especially PAI reporting).
• Prepare an initial overview of PAI reports, assess gaps and discuss meaningful actions to close these until fist disclosure by July 2023.

The NFRD, SFDR and EU Taxonomy Regulation all imply various requirements towards non-financial companies and financial market participants in a short timeline.

However, it should be taken into consideration that these instruments of the action plan are developed in alignment. Identifying the synergies and overlap between them will allow for efficient application avoiding double-work in data-collection and reporting.

¹⁾ Disclosure of PAI is mandatory for large entities and parents of large groups, whereas other FMPs may opt to clearly state that they do not consider PAI in their investment decisions and their reasons for non-consideration.