Sustainable Finance Package

Finalisation of the regulatory framework on sustainable finance in sight

The EU has taken major steps over the past number of years to build a sustainable financial system. On this blog, we have repeatedly given updates on the EU Taxonomy Regulation, the Sustainable Finance Disclosure Regulation and the Benchmark Regulation that form the foundation of the EU’s work to increase transparency and provide tools for investors to identify sustainable investment opportunities. We are now steering toward a final regulatory framework on sustainable finance.

Sustainable Finance Package in a nutshell

On 21 April 2021, the European Commission has adopted a comprehensive package of measures (the Sustainable Finance Package) as part of its wider policy initiative on sustainable finance, which aims to re-orient capital flows towards more sustainable investments and enable the EU to reduce its carbon-footprint by at least 55% by 2030 and reach carbon neutrality by 2050.

The Sustainable Finance Package is comprised of:

  • Corporate Sustainability Reporting Directive (CSRD), which amends the existing reporting requirements under Directive 2014/95/E (Non-Financial Reporting Directive, NFRD) by expanding the scope of sustainability-related reporting requirements to more corporate entities;
  • Taxonomy Climate Delegated Act, which provides technical screening criteria under which an economic activity qualifies as environmentally sustainable, by contributing substantially to climate change mitigation or climate change adaptation while making no significant harm to any of the other environmental objectives;
  • Six Delegated Acts that amend requirements under UCITS, AIFMD, and MiFID II framework by incorporating new rules on consideration of sustainability risks, factors and preferences by investment managers and investment firms.

Corporate Sustainability Reporting Directive (CSRD)

With the aim to capture a wider group of companies and to bring sustainability reporting over time on a par to financial reporting, CSRD expands the scope of the existing NRFD, which currently applies only to companies with over 500 employees (even though national law in certain EU Member States stipulates lower thresholds).

The CSRD expands the scope of application of sustainability-related reporting requirements to all large undertakings (whether listed or not) that meet two of the following three criteria:

  • balance sheet total of EUR 20,000,000,
  • net turnover of EUR 40,000,000,
  • an average of 250 employees during the financial year.

In addition to large undertakings, the CSRD reporting requirements will apply to all companies listed on the EU regulated market as well, with the exception of listed micro companies.

To that end, the CSRD aims to capture nearly 50,000 companies in the EU in comparison to only 11,000 companies that are currently subject to reporting requirements under NFRD. This should provide financial institutions that are subject to Regulation (EU) 2020/2088 (Sustainable Finance Disclosure Regulation, SFDR) with more relevant sustainability-related data about prospective investee companies, based on which they will be able to fulfil disclosure requirements under the SFDR.

As a next step, the Commission will engage in discussions on the CSRD Proposal with the European Parliament and Council.

Taxonomy Climate Delegated Act

The Taxonomy Climate Delegated Act represents the first set of technical screening criteria that are intended to serve as a basis for the determination which economic activities can be deemed as environmentally sustainable under the Taxonomy Regulation. Developed based on the scientific advice of the Technical Expert Group (TEG), the Delegated Act provides technical screening criteria for determination whether an economic activity contributes significantly to either climate change mitigation or climate change adaption while making no significant harm to any other environmental objective under Article 9 of the Taxonomy Regulation.

Final Draft of the Delegated Act still needs to be officially adopted by the Commission, after which the European Parliament and the Council will have 4 months (which can be extended by additional 2 months) to officially adopt it.

Amending Delegated Acts

As part of the Sustainable Finance Package, the Commission has also published six long-awaited final versions of the draft amending delegated acts under MiFID II, UCITS and AIFMD framework with the aim of incorporating additional requirements on consideration of sustainability risks, factors and preferences by investment managers and investment firms.

The proposed changes introduced by delegated acts, which are expected to apply from October 2022, can be summarized as follows:

Product Governance: changes to MiFID II Delegated Directive (EU) 2017/593 put the obligation on manufacturers and distributors of financial instruments to take into consideration relevant sustainability factors and clients’ sustainability objectives in the process of product manufacturing and distribution.

Suitability assessment: changes to MiFID II Delegated Regulation (EU) 2017/565 require investment firms to take into account clients’ sustainability preferences in the course of suitability assessment. Given that requirements on suitability assessment apply only to firms providing investment advisory and portfolio management services, ESMA is separately considering (ESMA Consultation on appropriateness and execution only under MiFID II) whether the consideration of sustainability risks and factors shall be taken into account in the case of provision of other investment services for which requirements on appropriateness assessment apply.

Integration of sustainability risks and factors: amendments to MiFID II Delegated Regulation (EU) 2017/565, UCITS Delegated Directive 2010/43/EU and AIFMD Delegated Regulation (EU) 231/2013 impose new obligations on investment firms and asset managers, by requiring them to take into account sustainability risks and factors when complying with organisational requirements, including requirements on risk management and conflict of interest requirements.

Further, UCITS and AIF management companies that consider principal adverse impacts of their investment decisions on sustainability factors under SFDR (e.g. impact of an investment in a fossil fuel company on climate and environment), will be required to consider this when complying with due diligence requirements stipulated under UCITS and AIFMD framework.

The Sustainable Finance Package also includes similar changes to Delegated Acts under IDD, which affect insurance distributors.

Conclusion

The proposals published as part of the Sustainable Finance Package represent some of the last pieces in the puzzle of the EU regulatory framework on sustainable finance, which aims to support the EU on its way towards creation of a more sustainable economy. These latest efforts by the Commission provide some further clarity to corporate entities and financial institutions that have been facing with new regulatory challenges for quite some time now.  In the meantime, on 7 May 2021 the Commission has also published one additional Delegated Act under the Taxonomy Regulation, which outlines requirements on the content, methodology and presentation of key performance indicators (KPIs) that entities, which are subject to reporting requirements under Article 8 of the Taxonomy Regulation, need to comply with.

Nevertheless, there are some other important legislative proposals that still need to be published, like the final version of regulatory technical standards under the SFDR that is essential for compliance of financial institutions with disclosure requirements stipulated by this Regulation.  Those regulatory initiatives show that aiming at a sustainable financial market in Europe is more than a fancy trend but rather a new effort which needs to be taken seriously and is not to be underestimated. If you have any questions about the EU regulatory framework on sustainable finance and its impact on your business, please get in touch with us.

EBA’s Action Plan on Sustainable Finance

Climate change and the response to it by the public sector and society in general have led to an increasing relevance of environmental, social and governance (ESG) factors for financial markets. It is, therefore, essential that financial institutions are able to measure and monitor the ESG risks in order to deal with risks stemming from climate change (learn more about climate change related risks in our previous Blogpost.

To support this, on 6 December 2019, the European Banking Authority (EBA) published its Action Plan on Sustainable Finance outlining its approach and timeline for delivering mandates related to ESG factors. The Action Plan explains the legal bases of the EBA mandates and EBA´s sequenced approach to fulfil these mandates.

Why is EBA in charge ? EBA mandates on sustainable finance

The EBA´s remit and mandates on ESG factors and ESG risks are set out in the following legislative acts:

  • the amended EBA Regulation;
  • the revised Capital Requirements Regulation (CRR II) and Capital Requirements Directive (CRD V);
  • the new Investment Firms Regulation (IFR) and Investment Firms Directive (IFD) and
  • the EU the Commission´s Action Plan: Financing Sustainable Growth and related legislative packages.

These legislatives acts reflect a sequenced approach, starting with the mandates providing for the EBA to oblige institutions to incorporate ESG factors into their risk management as well as delivering key metrics in order to ensure market discipline. The national supervisory authorities are invited to gain an overview of existing ESG-related market risks. In a second step, the EBA will develop a dedicated climate change stress test that institutions should use to test the impact of climate change related risks on their risk-bearing capacity and to take appropriate precautions. The third step of the work will look into the evidence around the prudential treatment of “green” exposures.

The rationale for this sequencing is the need firstly to understand institutions´ current business mix from a sustainability perspective in order to measure and manage it in relation to their chosen strategy, which can then be used for scenario analysis and alter for the assessment of an appropriate prudential treatment.

Strategy and risk management

With regard to ESG strategy and risk management, the EBA already included references to green lending and ESG factors in its Consultation paper on draft guidelines on loan origination and monitoring which will apply to internal governance and procedures in relation to credit granting processes and risk management. Based on the guidelines the institutions will be required to include the ESG factors in their risk management policies, including credit risk policies and procedures. The guidelines also set out the expectation that institutions that provide green lending should develop specific green lending policies and procedures covering granting and monitoring of such credit facilities.

In addition, based on the mandate included in the CRD V, the EBA will asses the development of a uniform definition of ESG risks and the development of criteria and methods for understanding the impact of ESG risks on institutions to evaluate and manage the ESG risks.

It is envisaged that the EBA will first publish a discussion paper in Q2-Q3/2020 seeking stakeholder feedback before completing a final report. As provided for in the CRD V, based on the outcome of this report, the EBA may issue guidelines regarding the uniform inclusion of ESG risks in the supervisory review and evaluation process performed by competent authorities, and potentially also amend or extend other policies products including provisions for internal governance, loan origination and outsourcing agreements.

Until EBA has delivered its mandates on strategy and risk management, it encourages institutions to act proactively in incorporating ESG considerations into their business strategy and risk management as well as integrate ESG risks into their business plans, risk management, internal control framework and decision-making process.

Key metrics and disclosures

Institutions disclosures constitute an important tool to promote market discipline. The provision of meaningful information on common key metrics also distributes to making market participants aware of market risks. The disclosure of common and consistent information also facilitates comparability of risks and risks management between institutions, and helps market participants to make informed decisions.

To support this, CRR II requires large institutions with publicly listed issuances to disclose information on ESG risks and climate change related risks. In this context, CRR II includes a mandate to the EBA according to which it shall develop a technical standard implementing the disclosure requirements. Following this mandate, EBA will specify ESG risks´ disclosures as part of the comprehensive technical standard on Basel´s framework Pillar 3.

Similar mandates are contained in the IFR and IFD package. The IFD mandate for example requires EBA to report on the introduction of technical criteria related to exposures to activities associated substantially with ESG objectives for the supervisory review and evaluation process of risks, with a view to assessing the possible sources and effects of such risks on investment firms.

Until EBA has delivered its mandates, it encourages institutions to continue their work on existing disclosure requirements such as provided for in the Non-Financial Reporting Directive (NFRD) as well as participation in other initiatives. EBA also encourages institutions to prioritise the identification of some simple metrics (such as green asset ratio) that provide transparency on how climate change-related risks are embedded into their business strategies, decision-making process, and risk management.

Stress testing and scenario analysis

The EBA Regulation includes a specific reference to the potential environmental-related systemic risk to be reflected in the stress-testing regime. Therefore, the EBA should develop common methodologies assessing the effect of economic scenarios on an institutions´ financial position, taking into account, inter alia, risks stemming from adverse environmental developments and the impact of transition risk stemming from environmental political changes.

Also the CRD V mandate requires EBA to develop appropriate qualitative and quantitative criteria, such as stress testing processes and scenario analysis, to asses the impact of ESG risks under scenarios with different severities. Hence, EBA will develop a dedicated climate stress test with the main objective of identifying banks´ vulnerabilities to climate-related risks and quantifying the relevance of the exposures that could potentially hit by climate change related risks.

Until delivering its mandates, EBA encourages institutions to adopt climate change related scenarios and use scenario analysis as an explorative tool to understand the relevance of the exposures affected by and the potential magnitude of climate change related risks.

Prudential treatment

The mandate in the CRR II asks EBA to assess if a dedicated prudential treatment of exposures to assets or activities associated with environmental or social objectives would be justified. The findings should be summarised in a report based on the input of a first to be published discussion paper.

Upshot

Between 2019 and 2025, the EBA will deliver a significant amount of work on ESG and climate change related risks. The obligations for institutions with regard to a sustainable financial economy and a more conscious handling of climate change related risks are becoming increasingly concrete. Institutions should take the EBA’s encouragement seriously and consider applying the measures recommended by the EBA prior to the publication of any guidelines, reports or technical standards.