EU Advances ESG Related Reforms to Financial Services Regulations (UPDATED 10 JUNE 2020)

Building on the Action Plan on Financing Sustainable Growth and the reports of the Technical Expert Group on Sustainable Finance (TEG), the European Commission (the Commission) is currently working on a Renewed Strategy. With the adoption of the Sustainable Finance Disclosure Regulation and the Climate Benchmarks Regulation, as well as the political agreement on the Taxonomy Regulation, important milestones have been reached. However, much work remains to flesh out the details and push forward other projects that are still in the legislative pipeline. See the boxes below for an overview of these legislative initiatives.

Many of the (proposed) rules apply directly to asset managers and financial advisers while others affect them indirectly by targeting investors or investees. The new regime is a complex puzzle of regulations and standards aiming at the integration of ESG along the entire investment chain. In light of these developments, asset managers and financial advisers operating in the EU need to re-assess their approach to ESG in several respects, in particular as to how they:

• organize internal processes, risk management and control functions
• adjust investment strategies, policies and questionnaires
• close the data gap (especially in case of private investee companies)
• design and classify financial products and analyze the underlying economic activity
• negotiate contractual terms with investors (such as investment management agreements, limited partnership agreements and side letters)
• draft disclosures as well as periodic and incidental reporting
• exercise stewardship and set priorities for active engagement

The application of the EU ESG package to the UK from the end of the Brexit transition period (being 31 December 2020) is currently unclear, given that the UK Government has yet to announce the scope of application in the UK of the various EU ESG legislative initiatives, in particular the Taxonomy Regulation. It is expected that the UK Government will make an announcement on the subject in due course.

To benefit from business opportunities arising from the EU’s transition to sustainable finance, it is key to stay ahead of the regulatory curve. Sidley’s ESG team regularly advises asset managers and financial advisers on the fast-changing ESG landscape, drawing on extensive experience with investment transactions across multiple disciplines and sectors. Leveraging our expertise in the world’s main financial markets, we also provide practical guidance as to how the EU reforms fit into global best practices and the architecture of international ESG initiatives.

 

The Sustainable Finance Disclosure Regulation introduces disclosure requirements on the integration of sustainability risks, on the consideration of adverse sustainability effects, on sustainable investment objectives, and on the promotion of environmental or social characteristics, in investment decision‐making and in advisory processes. The three European Supervisory Authorities (EBA, EIOPA and ESMA) are currently consulting on proposed standards regarding the content, methodology and presentation of these disclosures at both entity and product level.

 

The Climate Benchmarks Regulation creates a new category of benchmarks to help investors compare the carbon footprint of their investments. The Commission recently consulted on the delegated acts specifying the minimum standards and content of ESG-related benchmark disclosures. The new requirements were meant to apply by 30 April 2020, but the relevant delegated acts have not been adopted yet. ESMA therefore issued a No Action Letter on 29 April 2020, in which it expressed its opinion that EU member state competent authorities should not prioritize supervisory or enforcement action in relation to the new requirements until the delegated acts apply.

 

The Taxonomy Regulation establishes a unified EU classification system of environmentally sustainable economic activities. Based on recommendations of the TEG, the Commission will specify the technical screening criteria that determine if, and to what extent, an economic activity is environmentally sustainable. These criteria will be developed through delegated acts in two batches: one on climate-related objectives and one on four other environmental objectives. The taxonomy will become applicable only when the relevant delegated acts have been public for one year.

 

Other ESG Reform Projects underway in the EU focus on: the improvement of disclosure by large companies of information about their social and environmental performance and effects the sustainability factors, risks and preferences to be considered by investments firms as regards their organisation and operations as well as their product governance obligations the sustainability risks and factors to be taken into account for mutual funds and by alternative fund managers the potential introduction of a regulatory and supervisory framework for ESG rating agencies (as recently suggested by Steven Maijoor, the chair of ESMA) the development of criteria for the EU Ecolabel for Financial Products and the definition of the minimum environmental performance of this product group the establishment of an EU Green Bond Standard (EU GBS) building on recommendations of the TEG the consideration of sustainability characteristics in credit ratings and the harmonization of disclosure of ESG considerations by credit rating agencies the integration of ESG risks and factors into prudential bank regulation as well as guidance on the management of climate-related and environmental risks and the consideration of ESG factors in loan origination and monitoring the sustainability risks, factors and preferences to be integrated into the regulation of (re)insurance undertakings and insurance distributors as well as the climate risks to be integrated into the Pillar 1 aspects of the Solvency II framework potential measures against undue pressure from the financial sector on corporations to prioritize short-term performance over long-term objectives including ESG matters (as recently discussed in the reports of the EBA, ESMA and EIOPA) a review of recently-introduced requirements on the development and public disclosure of shareholder engagement policies by which institutional investors and asset managers describe how they engage with investee companies on, inter alia, ESG matters the monitoring by EIOPA of national supervisory practices regarding the management of ESG risks in occupational pensions businesses due diligence requirements through the supply chain to identify, prevent, mitigate and account for abuses of human rights, including the rights of the child and fundamental freedoms, serious bodily injury or health risks and environmental damage, including with respect to climate