Updating the EU Sustainable Finance Framework

June 2022

The European Commission (EC) has published a new package of measures designed to build on and strengthen the foundations of the existing EU sustainable finance framework, thereby encouraging and facilitating much-needed additional financial flows into sustainable investments. The package addresses issues relating to misalignment, complexity and gaps in regulation, improving the usability and coherence of the framework, and reducing the administrative burden on firms. 

Valdis Dombrovkis, EC Executive Vice President, stressed the need for rules and instruments that are `coherent, user-friendly and work effectively on the ground'. FS firms will be particularly interested in the additions, amendments and clarifications relating to the EU Taxonomy and new proposals for a regulation for ESG rating providers.

Key elements in the package

1. Overarching communication

The communication describes the package as `an important step towards completing the sustainable finance framework' and notes the considerable progress in implementing the EU's sustainable finance agenda over the last five years, including adoption of the Taxonomy Regulation, the Sustainable Finance Disclosure Regulation (SFDR), EU climate benchmarks in the Benchmarks Regulation, the European Green Bond Regulation and the Corporate Sustainability Reporting Directive (CSRD). 

The EC finds that the EU sustainable finance framework is beginning to work as intended and is starting to facilitate investment into the transition to a climate neutral and sustainable economy. However, it acknowledges that further refinements will be necessary to achieve the intended goals and support the objectives of the European Green Deal. 

The communication introduces the key areas covered by the package and comments on the recent publication of the draft European Sustainability Reporting Standards (ESRS). The EC intends for EFRAG to develop a voluntary standard for non-listed SMEs, which are outside the scope of the CSRD.

Finally, the communication reiterates the Commission's commitment to international cooperation to ensure interoperability of sustainable finance frameworks where possible.

2. Updates and amendments to the EU Taxonomy

A new Delegated Regulation, the `Environmental Delegated Act', has been approved in principle by the EC, supplementing the EU Taxonomy Regulation. The new Delegated Act builds on the drafts previously issued by the EC and includes:

• Technical screening criteria (TSC) for economic activities making a substantial contribution to the four remaining Taxonomy objectives: 

i. The sustainable use and protection of water and marine resources.

ii. The transition to a circular economy.

iii. Pollution prevention and control.

iv. The protection and restoration of biodiversity and ecosystems. 

• Do no significant harm (DNSH) criteria for the four environmental objectives. The Delegated Act prioritises economic activities and sectors that have been identified as having the greatest potential to make a substantial contribution to one or more of the four environmental objectives and for which it was possible to develop or refine the recommended criteria without further delay. For certain sectors and activities, such as agriculture, forestry or fishing, as well as certain manufacturing activities, further assessment and calibration of criteria will be needed.
  
  
• Targeted amendments to the Disclosures Delegated Act (which sets out the requirements for certain Taxonomy-aligned disclosures) to clarify the disclosure obligations for the additional activities  — including amendments to Annex V — KPIs for credit institutions, updating the wording for calculation of KPIs to include all environmental objectives and replacing the associated templates.
  
  
• Complementary targeted amendments to the existing Climate Delegated Act (which specifies the TSC for Taxonomy objectives one and two: climate change mitigation and climate change adaptation), to expand on economic activities contributing to climate change mitigation and adaption that have not been included so far — particularly in the manufacturing and transport sectors. 

The EU Taxonomy Delegated Acts are expected to apply as of January 2024. The EC notes that inclusion of more economic activities across all six climate and environmental objectives will increase the useability and potential of the EU Taxonomy in scaling up sustainable investment in the EU. 

The package also includes a Commission Notice on the interpretation of certain legal provisions of the EU Taxonomy Regulation and links to the SFDR. This Frequently Asked Questions (FAQ) document aims to provide clarification on:

• Compliance with `minimum safeguards' under Article 18 of the Taxonomy Regulation (reiterating the role of the minimum safeguards, recapping how they are defined, and explaining the link between Article 18(2) and the consideration of certain Principal Adverse Impact indicators in the context of SFDR).
  
  
• Whether Taxonomy-aligned investments qualify as sustainable investments under the SFDR. The EC notes that investments in Taxonomy-aligned `environmentally sustainable' specific economic activities automatically qualify as `sustainable investments' in the context of SFDR product level disclosures. Where a company has some degree of taxonomy-alignment through instruments such as general equity or debt, firms need to do additional checks under SFDR. 

3. A proposal for a regulation for ESG rating providers

The EC is proposing a new Regulation to improve the integrity, transparency, governance and independence of ESG ratings provided in the EU. The proposal is broadly aligned to the existing Benchmarks Regime (BMR), reflecting the close relationship between ESG ratings and benchmarks used in the EU. 

The proposal defines an ESG rating as: `an opinion, a score or a combination of both, regarding an entity, a financial instrument, a financial product, or an undertaking's ESG profile or characteristics or exposure to ESG risks'. Providers of in-scope ratings would require authorisation by ESMA or, for non-EU providers, endorsement or recognition by ESMA.

For detailed analysis of the proposal, see our article here.

4. Commission Recommendation on facilitating finance for the transition to a sustainable economy

The Commission Recommendation emphasises the important role of transition finance in meeting the EU's climate and environmental goals. It:

• Clarifies the concept of transition finance, describing it as: `the financing of climate- and environmental performance improvements to transition towards a sustainable economy, at a pace that is compatible with the climate and environmental objectives of the EU'.
  
  
• Encourages companies to use sustainable finance tools (including the EU Taxonomy, transition plans, EU climate benchmarks and science-based targets) to channel investment into transition activities and help manage the risks arising from climate change and environmental degradation.
  
  
• Provides tailored recommendations for companies seeking transition finance and financial intermediaries and investors willing to provide transition finance. 

Transition planning is described as `the process by which undertakings translate their environmental and climate ambitions into action'. Transition plans are not currently mandatory in the EU but the Recommendation notes that they are emerging as a key strategic planning tool. Looking ahead, the CSRD will require in-scope companies to adopt a plan. 

5. Staff working document — Enhancing the usability of the EU Taxonomy and the overall EU sustainable finance framework

This document addresses key implementation issues and usability issues, focusing on:

• The foundations of the sustainable finance framework — the EU Taxonomy and the various disclosure regimes and tools for stakeholders.
• Measures to enhance the usability of the EU Taxonomy criteria and disclosures.
• Measures to enhance the usability of the wider sustainable finance framework, including:
• Measures to support the implementation of the EU Taxonomy, the SFDR and the Benchmarks Regulation.
  
• Measures to support financial undertakings with sustainability disclosure obligations and in addressing ESG data gaps.

The Commission acknowledges implementation and usability challenges and commits to continuing to enhance the framework's usability and coherence.

Looking ahead

There is a lot for firms to digest in the EU's Sustainable Finance package and they should expect further refinements over time. However, the European Commission acknowledges the implementation challenges faced by firms and appears willing to engage in a constructive manner to improve the usability of the sustainable finance `toolbox'.