EU Taxonomy Regulation and the Sustainable Finance Disclosure Regulation: making green investments recognisable

To support the transition to a climate-neutral economy, financial flows need to be channelled into green activities. Yet, sustainable investing requires a common understanding of the term ‘sustainable’. The EU intends to use its Taxonomy Regulation and Sustainable Finance Disclosure Regulation to provide clarity on this issue. The following article takes a closer look at the two regulations considered to be the key components of the EU’s Sustainable Finance Action Plan.

The Taxonomy: making sustainability measurable

The Taxonomy Regulation is one of the cornerstones for establishing the European Commission’s comprehensive sustainability glossary. To achieve its aim, the European Commission is supported by the Platform on Sustainable Finance, an expert group comprising representatives from the financial sector, environmental groups, industry and other areas. Published in 2020, the Taxonomy is a classification system that enables investors to compare companies with regard to their sustainability credentials and to invest in companies that operate ecologically. The Taxonomy features criteria for determining whether an economic activity or investment can be classified as ecologically sustainable.

This regulation initially concerns certain environmental objectives, some of which have already been formulated by the European Commission. Once the environmental objectives have been fully defined, a social taxonomy (incorporating working conditions, living standards, sustainable communities, etc.) will then be developed using the environmental taxonomy as a template.

There are six environmental objectives of the Taxonomy: climate change mitigation; climate change adaptation; sustainable use and protection of water and marine resources; transition to a circular economy, waste prevention and recycling; pollution prevention and control; protection of healthy ecosystems. Economic activities are classified as sustainable as per the environmental taxonomy when they contribute significantly to at least one of the six environmental objectives while having no negative impact on any of the others.

Two out of six environmental objectives defined

To date, the Regulatory Technical Standards (RTS) have been formulated for the first two environmental objectives (climate change mitigation and climate change adaptation). The technical assessment criteria for the other four environmental objectives are still pending.

Since 1 January 2022, all published reports are subject to the classification system in relation to the first two environmental objectives. The first full disclosure of all six environmental objectives will be mandated starting 1 January 2023. The disclosure requirements for companies and financial products are regulated by the EU’s Sustainable Finance Disclosure Regulation (see below), which itself refers to the Taxonomy.

By adopting the Taxonomy Regulation, the European Commission aims to prevent greenwashing, i.e. the dissemination of false information to create a green image without fulfilling the relevant environmentally friendly criteria as exemplified by a recent case. In May 2022 investigators in Frankfurt raided the premises of DWS, a Deutsche Bank subsidiary, following greenwashing allegations. Contrary to the information in DWS’s sales prospectuses, the public prosecutor’s office in Frankfurt alleges that DWS had only applied ESG standards in a minority of investments.

EU Sustainable Finance Disclosure Regulation: disclosing sustainable investments

Introduced by the European Commission in March 2021, the Sustainable Finance Disclosure Regulation (SFDR) for financial service providers expands existing rules for the sale of financial products to include sustainability. The SFDR governs the sustainability-related disclosure obligations of product providers and financial advisors in strategies, processes and products. The regulation applies to all financial market participants and financial advisors in the EU. According to the regulation, insurance agents considered financial advisors, as are life insurers and providers of company pension schemes, since they provide insurance-based investment products. Relevant information about sustainability must be provided in periodic reports, on the website, in prospectuses and in pre-contractual documents.

The regulation requires financial market participants and financial advisors to identify sustainability risks. These are environmental, social or corporate governance events whichcould reduce the value of an investment, such as production harmful to the environment, corruption, etc. At the same time, Principal Adverse Impact Indicators (PAIs) need to be disclosed. Examples of PAIs include the acceleration of climate change or the destruction of natural resources.

From normal to dark green funds

Part of the regulation involves classifying financial products into three categories, depending on the extent to which a fund considers sustainable investing and ESG aspects. The EU Taxonomy has been incorporated into the SFDR to provide guidance on what can be considered sustainable.
For each category (Articles 6, 8 and 9 of the SFDR), binding investment criteria with specific information are required:

• Article 6: Financial products that integrate ESG aspects into the investment decision-making process or declare that they consider sustainability risks to be irrelevant and do not meet the additional criteria set out in Articles 8 and 9. These funds are considered ‘normal’ funds in the financial sector. They do not attach any importance, or any official importance, to environmental and ethical aspects.
• Article 8: Financial products that promote social and/or environmental characteristics and invest in sustainable investments. However, the main objective of these ‘light green’ funds is not sustainable investment.
• Article 9: Financial products whose investment strategy explicitly pursues sustainability objectives. These are referred to as ‘dark green’ funds.
  RTS intended to be adopted from January 2023

The Regulatory Technical Standards (RTS) specifying the implementation of the SFDR were scheduled to be adopted at the beginning of 2022, even so the European Commission has now postponed the deadline to 1 January 2023. In order to be able to meet SFDR obligations in the meantime, the three European Supervisory Authorities (ESAs) recommend that the financial market participants concerned follow the final draft of the RTS. In April 2022, the European Commission submitted the final draft of the RTS to the EU Parliament and the EU Council for consideration. If there are no objections, the final RTS will be published in the EU Official Journal.
We will keep you informed about disclosure regulation on sustainability preferences, which has been in place since August 2022, and other EU initiatives.