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.

ESMA updated AIFMD and UCITS Q&As

On June 4, 2019 ESMA published updates questions and answers on the application of the AIFM Directive (available here) and the UCITs Directive (available here). ESMA’s intention of publishing und regularly updating the Q&A documents ensures common supervisory approaches and practices in relation to both the AIFM Directive and the UCITS Directive and their implementing measures.

The latest update refers to the depositories and the possibilities to delegate the safekeeping of assets of the funds. ESMA clarifies that supporting tasks that are linked to depositary tasks such as administrative or technical functions performed as part of the depositary tasks could be entrusted to third parties where all of the following conditions are met:

  1. the execution of the tasks does not involve any discretionary judgement or interpretation by the third party in relation to the depositary functions;
  2. the execution of the tasks does not require specific expertise in regard to the depositary function; and
  3. the tasks are standardised and pre-defined.

Where depositaries entrust tasks to third parties and give them the ability to transfer assets belonging to AIFs or UCITS without requiring the intervention of the depositary, these arrangements are subject to the delegation requirements, in Germany subject to Para. 36 KAGB.

Another question relates to the supervision of branches of depositories. The AIFM Directive, the UCITS Directive, the CRD and the MiFID II do not grant any passporting rights for depositary activities in relation to safekeeping assets for AIFs or UCITS. Branches of depositories located in the home Member State of the AIF or UCITS that is not the home Member State of the depositary’s head office may also be subject to local authorisation in order to perform depositaries activities in relation to AIFs or UCITS. In this case, the competent authority for supervising the activities in relation to AIFs or UCITS is the one located in the Member State of the depository’s branch.

The guidance provided by ESMA in the Q&A documents for AIFs and UCITS regarding the depository function do not contain any surprising elements but further strengthen the harmonized interpretation and application of the AIFM and UCITS Directives in Europe.

Why equivalence is not the easy solution for Brexit

When reading the news, one cannot deny that a hard Brexit may well be looming. While we all hope that a political solution will be agreed upon in the end, it still makes sense to discuss legal possibilities that might soften the impact if no agreement can be reached.

When it comes to the UK’s loss of access to the European single market, the “equivalence solution” is almost automatically mentioned as a solution for the financial market. But what exactly does equivalence entail? And does it really represent a viable way for the UK and the EU in case of a hard Brexit? In this post we will provide an overview of the current equivalence regime within the European regulation.

In the event of a hard Brexit, the UK will lose access to the European single market overnight and will become a third country under European law. The solution for maintaining access to the European single market could be the so-called equivalence solution. This would allow companies established in third countries to gain access to the European single market, even if no bilateral agreement is concluded in time between the UK and the EU, which seems likely at the moment. The prerequisite is that the third country’s legal and supervisory standards would need to be recognised by the EU as equivalent to the European regulations. UK banking and financial services providers and fund managers would thus continue to have access to the European single market if the EU recognises the British legal and supervisory standard in the financial sector as equivalent to that of the EU. Since the UK currently applies EU regulations, this should at a first glance be a no-brainer.

However, the European legislator does not provide market access for third countries in all areas of banking and financial services easily through regulation. Specific third country rules are contained, for example, in:

  • the European Financial Markets Regulation (MiFIR);
  • the Second Financial Instruments Directive (MiFID II);
  • the Regulation on OTC derivatives, central counterparties and trade repositories (EMIR); and
  • the Directive on Alternative Investment Fund Managers (AIFMD).

In the Fourth Capital Requirements Directive (CRD IV), the Second Payment Services Directive (PSD II) and the UCITS Directive, the European legislator has not stipulated third country rules. In these contexts, access to the European single market through recognition of the equivalence of the supervisory regime is not currently possible. In the areas of the concerned financial services sectors (i.e. credit institutions, payment institutions and the management of UCITS), the UK would therefore be dependent on a bilateral agreement with the EU in any case in order to keep (or regain) access to the European single market.

In those areas where third country rules are provided for, the recognition procedure and the number of third countries recognised as equivalent differ.

For example, under EMIR, the following applies: If a Central Counterparty (CCP) established in a third country wishes to provide clearing services to clearing members or trading venues established in the EU, it may do so only if it has previously been recognised by the European Securities and Markets Authority (ESMA). For this purpose, the CCP must submit an application to ESMA. The latter may only recognise a CCP from a third country if the EU Commission has recognised the legal and supervisory mechanism of the third country as equivalent to that of the EU, and provided that the CCP is authorised in its home country and is subject to effective supervision and enforcement in that country. Moreover, it is required that ESMA has concluded a cooperation agreement with the local supervisory authorities which, for example, simplifies the exchange of information and the home country of the CCP must have an equivalent system for combating money laundering and terrorist financing. If these conditions are no longer met, ESMA may withdraw recognition from the CCP.

CCPs currently recognised by ESMA are located in Australia, Hong Kong, Japan, Singapore, South Africa, Canada, Mexico, Switzerland, South Korea, USA, UAE, India, Dubai International Financial Centre, Brazil and New Zealand.

The recognition procedure for trading venues under MiFIR is slightly different. It is not the trading venue for derivatives itself that can apply for equivalence. Rather, the EU may, at its own discretion and in cooperation with ESMA and the member states, issue a resolution recognising the legal and supervisory framework of a third country as equivalent to that of the EU. Before issuing a resolution, the member states must approve equivalence. The recognition of the equivalence of a third country in the area of MiFIR requires that: (i) the trading venues are admitted in their home country and are subject to effective and continuous supervision and enforcement; (ii) the trading venue has transparent admission rules; (iii) the issuers are subject to regular information obligations which guarantee a high level of investor protection and (iv) rules against market abuse in the form of insider dealing and market manipulation are in place.

So far, the EU has only recognised the USA as an equivalent third country under MiFIR. Under MiFID II, however, the EU has recognised four countries providing trading venues for other financial products (such as listed shares) as equivalent to EU venues: USA, Australia, Hong Kong and Switzerland (the recognition of Switzerland is limited to one year until 31 December 2018 but may be extended if there is sufficient progress on a common institutional framework).

This shows that even if the UK is recognised by the EU as a third country with equivalent regulatory standards, this is far from resolving all the difficulties.

On the one hand, the UK would actually have to maintain its current regulatory and supervisory standards and adapt to those of the EU in the future; a substantial deregulation is thus ruled out. A comparatively minor problem, on the other hand, is that the recognition of equivalence by the EU may well take some time. The UK’s supervisory standard currently corresponds to that of the EU, so if it were to be maintained after Brexit, there would at least be no legal grounds against swift recognition. However, much more serious for the UK, would be that as a third country they would no longer be able to influence the European legal and supervisory standards for lack of voting rights; they would be referred to the role of a “rule-taker”.

Therefore, it remains questionable whether recognition as an equivalent third country is really a good solution for the UK. The alternative would be one or more bilateral agreement(s) with a dispute settlement mechanism. In any event, the advantage of such an agreement would be that it would be negotiated by both sides and would not refer the UK to the passive role of an equivalent third country.