In a recent speech delivered by Verena Ross, Chair of the European Securities and Markets Authority (ESMA), she underlined the important role of all financial services companies in supporting the EU sustainability strategy by saying that if we want investors to continue supporting, with their money, the EU economy becoming more sustainable, we need to maintain trust in sustainable investment opportunities.
This point will be reinforced soon at the 29th United Nations Climate Change Conference (COP29), being held in Baku, Azerbaijan, from 11 to 22 November 2024, where the EU will support an effective, achievable and ambitious global goal on climate finance and will call for ambitious climate plans in order to keep the goal of limiting global warming.
The European Council has called for an ambitious and balanced COP29 outcome that:
• Keeps the 1.5°C temperature goal within reach, in light of the best available science
• Moves us all forward towards long-term resilience
• Includes agreement on an effective, achievable and ambitious new collective quantified goal
The Council stressed the importance of agreeing a new collective quantified goal (NCQG) on climate finance that is achievable and fit for purpose. The new goal should be designed on the basis of a broad, transformative and multi-layered approach, including various flows of finance and a broader group of contributors. This would reflect the evolution of respective economic capabilities and increasing shares of global greenhouse gas emissions since the early 1990s.
Somewhat predictably, the Council reiterated that public finance alone cannot deliver the levels of finance needed to achieve a climate-neutral and resilient global economy; private investment will have to provide the largest share of the required investment in the green transition.
Financial services firms will play a pivotal role in this exercise. One, by facilitating increased private investment via both the banking and non-banking sector. Secondly, by collaborating on the sustainability agenda with their clients and customers, by explaining how they are embracing eco-friendly practices, and using sustainability reports, annual reports, and other disclosure mechanism to convey their commitment to ESG principles. According to consultants McKinsey, studies are increasingly illustrating that strong ESG performance is positively correlated with higher equity returns and reduction in downside risk.
What is expected of the financial industry?
• Reorienting capital flows towards sustainable investment in order to achieve sustainable and inclusive growth
• Managing financial risks stemming from climate change, resource depletion, environmental degradation and social issues
• Fostering transparency and long-termism in financial and economic activity.
So, what the EU is doing and why?
Since 2021, the EU has put in place a major transparency legislative framework, known as the Sustainable Finance Disclosure Regulation (SFDR), which sets out how financial market participants have to disclose sustainability information that helps those investors who seek to put their money into companies and projects supporting sustainability objectives to make informed choices.
The SFDR is also designed to allow investors to properly assess how sustainability risks are integrated in the investment decision process. In this way, the SFDR contributes to one of the EU’s big political objectives: attracting private funding to help Europe make the shift to a net-zero economy.
SFDR is a mandatory ESG disclosure regime with obligations for EU-based financial market participants with over 500 employees. It imposes sustainability disclosure requirements on financial actors in the EU covering a broad range of environmental, social and governance (ESG) metrics at both entity- and product-level.
The scope includes:
• Banks, investment firms, asset managers, fund managers, pension funds, insurance companies, institutional investors, fund managers, institutional investors, venture capital funds, alternative investment and UCITs funds and credit institutions that offer portfolio management services
• Financial advisors providing investment advice or insurance advice regarding insurance-based investment products (IBIPs) are also included. The SFDR is also applicable to investment managers and financial advisers based in the EU, even if they are based elsewhere.
What is the threshold for SFDR?
Fund names which contain ESG-related words should have a minimum threshold of 80% of its investments meeting a specific goal or objective. An additional threshold (minimum of 50% investment) as defined in SFDR, for the use of “sustainable” or any sustainability-related term only, as part of the 80% threshold.
Entity-level disclosures (Level 1)
As a financial market participant, the entity-level sustainability disclosures require firms to disclose their entity-level policies on sustainability. These requirements apply from 10th March 2021. To comply, firms will need to provide the following information on your website:
Sustainability risk policy:
How are sustainability risks factored into your investment decisions?
Principal adverse impact:
How do your investments affect a range of sustainability factors, such as social matters and climate-related indicators? You’ll need to report on 14 different sustainability factors to comply, six of which address greenhouse gas emissions.
Sustainability risk remuneration policy:
Are risks factored into your company remuneration policy, and if so, how?
• If the firm does not consider the sustainability impact of its investment decisions, a clear statement is required the firm’s website, together with a clear reason for why management choose not to do so
• As part of principal adverse impact, the SFDR requires firms as a financial actor to report on the volumes of investee companies. This includes Scope 1 and 2 emissions, and since January 1st, 2023, it also includes Scope 3 emissions, which broadly cover a company’s value chain. Further disclosures are required on any actions the firm s to address these principal adverse impacts, as well as a summary of company engagement policies.
• From 1st January 2022, reporting on principal adverse impact is compulsory for companies covered by SFDR.
Product-level disclosures (Level 2)
Reporting on product-level disclosures, or Level 2 disclosures, is required from 1st January 2022. This entails adopting a further series of disclosures for each of the financial products that you produce or promote.
What are the 4 key Regulatory Technical Standards reporting requirements under SDFR 2?
Principal adverse impact reporting requirement: to align their ESG disclosure with the Principal Adverse Impact (PAI) reporting framework.
Pre-contractual disclosure requirement: to share information on what they intend to do to mitigate the social and environmental negative impact of their products and services.
Periodic disclosure requirement: to review how the firm has performed in relation to their intentions and promises in the pre-contractual disclosures.
Website disclosure requirement: to communicate the information above on their website.
Product classification under the SFDR
SFDR introduces three types of product classification
Article 6:
These products do not always integrate sustainability and ESG considerations into the investment decision-making process. They are typically known as ‘mainstream’ financial products but they should consider sustainability risks. These products do not meet the criteria of Articles 8 or 9.
Such funds do not integrate in any fashion sustainability into the investment process and can include stocks currently excluded by ESG funds, ie, tobacco companies, thermal coal producers. These funds are allowed to continue to be sold in EU, subject to being clearly labelled as non-sustainable
Article 6, however, imposes on all financial firms the obligation to disclose the way in which sustainability risks are integrated into investment decision making
Article 8:
These financial products promote environmental and/or social characteristics, and the companies in which the investments are made have good governance practices. However, ESG investing is not core to these products.
They are often referred to as Light Green Funds, promoting environmental or social characteristics of the investment, either alone or in combination with other characteristics.
Financial firms must complete Taxonomy disclosures where the, however, environmental characteristics are promoted:
• Information to be disclosed on proportion of environmentally-sustainable economic activities in FS’s business, investments, lending policies
• Asset managers: value of all green investments (ratio)
• Banks: green investments as % of T/O, capital expenditure, operating expenditure
• Derivatives excluded
Article 9:
Known as Dark Green Funds, these are financial products which have sustainable investment as their core objective.
The funds must rigorously respect the notion: does not significantly harm any of the environmental objectives. The rule establishes whether or not a given financial product causes any significant harm.
What is the EU taxonomy Regulation?
The taxonomy is a classification system that defines criteria for economic activities that are aligned with a net zero trajectory by 2050 and the broader environmental goals other than climate.
In more specific terms, the Taxonomy Regulation sets out the criteria for determining whether an economic activity is an environmentally sustainable investment, one which seeks to integrate environmental, social and governance (ESG) factors into investment decisions in order to improve the management of the risk and generate sustainable returns over the long term.
The Taxonomy Regulation provides for six environmental objectives as follows:
1. Climate change mitigation
2. Climate change adaptation
3. Sustainable use and protection of water and marine resources
4. Transition to a circular economy, including waste prevention and recycling
5. Pollution prevention and control
6. Prevention and restoration of biodiversity and ecosystems
In a recent Opinion issued by the three ESA’s – EBA, EIOPA and ESMA, provides some insights into how he SFDR and Taxomony Regulation treat ‘transition investments’. In other words, those investments earmarked to transform assets that are not currently considered to be environmentally sustainable. Some examples include:
• Upgrading assets to reduce their carbon emissions, such as by using carbon capture processes;
• Putting in place “enabling” technologies to improve the efficiency of a process and reduce its environmental impact;
•The adoption of green sourcing policies, such as to procure renewable energy to replace existing carbon-based supplies;
• “Greening” a company’s facilities and support functions, such as improving the energy efficiency of its buildings or adopting electric vehicles; and
• Financing the decommissioning of facilities, such as coal-powered energy generation, where technology does not exist to improve their environmental performance.
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