Sustainable Finance package
On 13 June 2023, the European Commission (the Commission) set out a number of further steps to boost sustainable finance investment. The package included (i) a draft recommendation on facilitating finance for the transition to sustainable economy, (ii) a proposal for the regulation of ESG rating activities (see here for more information), (iii) an update on the approval of two EU Taxonomy Delegated Acts, supplementing the Regulation (EU) 2020/852 (the Taxonomy) and (iv) publication of a suite of documentation to improve Taxonomy usability. We discuss the clarifications to the Taxonomy in more detail below.
Commission approval of draft Taxonomy Environmental Delegated Act and amendment to Taxonomy Climate Delegated Act
The Commission communicated its approval in principle of two draft Taxonomy Delegated Acts:
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the draft Taxonomy Environmental Delegated Act sets out technical screening criteria for economic activities making a substantial contribution to one or more of the four remaining environmental objectives: sustainable use and protection of water and marine resources, transition to circular economy, pollution prevention and control and protection and restoration of biodiversity and ecosystems; and
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the draft Taxonomy Delegated Act amending the Taxonomy Climate Delegated Act which adds technical screening criteria for further economic activities that make a substantial contribution to the climate environmental objectives (climate mitigation and climate change adaptation). Annex I of the Delegated Act sets out additional technical screening criteria for climate change mitigation focussing on activities in the transport and manufacturing sectors, such as the manufacture of automotive and mobility components, the manufacture, installation and servicing of high, medium and low voltage electrical equipment and the manufacturing and leasing of aircraft. Annex II of the Delegated Act sets out additional technical screening criteria for climate change adaptation including activities such as desalination, and software enabling and consultancy for physical climate risk management and adaptation. There are also some targeted amendments to address technical and legal inconsistencies in the existing technical screening criteria.
Once translated into all official EU languages, the Taxonomy Delegated Acts will be formally adopted and then sent to the Parliament and Council for scrutiny (who will have four months to review). Subject to any comments or objections from the Parliament or the Council, the Taxonomy Delegated Acts are expected to enter into force and apply from January 2024.
Clarification on how to comply with the minimum safeguards requirements under the Taxonomy Regulation
As part of the sustainable finance package, the Commission published a Notice on the interpretation and implementation of certain legal provisions of the Taxonomy Regulation and links to SFDR (dated 12 June 2023, the Notice). The Notice clarifies how funds are expected to comply with the minimum safeguards under Article 18 of the Taxonomy (the Taxonomy MS test), one of the four limbs of the test for “environmentally sustainable” activities under the Taxonomy (the Taxonomy criteria). The Notice also provides new insight as to how the Taxonomy MS test interlinks with the ‘do no significant harm’ (DNSH) test for ‘sustainable investments’ under Regulation (EU) 2019/2088 (the SFDR). We have set out the key clarifications below, which will have implications for asset managers’ pre-contractual and website disclosures as well as internal processes and procedures for evaluating compliance with the DNSH test for the Taxonomy Regulation.
Clarification on applying the minimum safeguards test in the Taxonomy Regulation
In questions 2 and 3 of the Notice, the Commission confirmed that in order to meet the minimum safeguards test under Article 18 of the Taxonomy Regulation, economic activities which are considered to be Taxonomy-aligned should:
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implement due diligence and remedy procedures to align with international standards of responsible business conduct (OECD Guidelines for Multinational Enterprises (OECD MNEs) and the UN Guiding Principles on Business and Human Rights (UNGP)) – Article 18(1); and
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meet the DNSH test under the SFDR which requires consideration of the SFDR principal adverse impact indicators (PAI indicators) for social and employee matters, respect for human rights, anti-corruption and anti-bribery matters listed in the table 1 of Annex I of Commission Delegated Regulation (EU) 2022/1288 (the SFDR RTS) – Article 18(2).
The Commission noted that the two limbs set out in Article 18 overlap, however the one indicator covered by Article 18(2) which is not specifically covered by Article 18(1) is the PAI indicator relating to the exposure to controversial weapons. Therefore, by virtue of Article 18(2), investees should ensure that their due diligence and remedy procedures also allow for the identification, prevention, mitigation or remediation of any actual or potential exposure to the manufacture or selling of controversial weapons.
Do Taxonomy-aligned investments qualify as ‘sustainable investments’ under the SFDR?
The European Supervisory Authorities (ESAs) have wrestled previously with how the DNSH test for ‘sustainable investments’ under the SFDR (the SFDR DNSH test) should be treated in relation to the DNSH test under the Taxonomy (the Taxonomy DNSH test). For example, in the March 2021 Joint Consultation Paper on Taxonomy-related sustainability disclosures, the ESAs had proposed that the Taxonomy DNSH test would “supersede” the SFDR DNSH test, such that investments in ‘taxonomy-compliant activities’ would be ‘sustainable investments’ under the SFDR. However, this position was updated and then confirmed in the June 2022 Clarifications on the ESAs’ draft RTS under SFDR, where the ESAs clarified that the Taxonomy DNSH test should be applied in a different way to the SFDR DNSH test. The ESAs stated that, in practice, “to qualify as a sustainable investment in the meaning of SFDR, an investment in a taxonomy-aligned economic activity must also respect the 'do not significantly harm' principle as set out in Article 2(17) SFDR”.
Since then, there has been a fair amount of criticism from financial market participants, as well as by the French Autorité des marchés financiers (AMF), that the ‘sustainable investment’ test under the SFDR does not include sufficient metrics or standards. On 12 April 2023, the ESAs published a joint consultation paper (the Consultation Paper) in response to their joint mandate to review and revise the SFDR RTS. Among other proposals, the ESAs set out certain options for amending the SFDR DNSH test, which the ESAs explained were in response to concerns that the current requirements are being inconsistently applied, undermine the comparability of financial products and could lead to greenwashing. For further information, please see our Engage article here.
In the latest development, the Commission clarified in the Notice that investments in Taxonomy-aligned activities can be “automatically qualified” as ‘sustainable investments’ under the SFDR. In other words, if an investment (or a proportion of an investment) is classified as Taxonomy-aligned, then that investment (or the proportion of that investment) will also be considered as meeting the requirements for a ‘sustainable investment’ under the SFDR.
The Commission justified this position on the grounds that compliance with the Taxonomy MS test relates to compliance with the employee and social PAI indicators under Annex 1 of the SFDR RTS. Interestingly, the Commission has not expressly clarified how compliance with the Taxonomy criteria relates to compliance with the environmental PAI indicators under the SFDR RTS but we assume the Commission considers that compliance with the Taxonomy DNSH test satisfies the environmental PAI indicators under the SFDR RTS. This is because the Commission’s wording in the Notice is quite definitive, stating that Taxonomy-aligned activities would be “automatically qualified” as ‘sustainable investments’ under the SFDR.
It is also interesting that the Commission included this clarification in the Notice further to the ESAs’ proposal in their Consultation Paper published on 12 April 2023 of establishing an optional “safe-harbour for environmental DNSH”, which would mean that investments in activities that already meet the criteria as “environmentally sustainable” under the Taxonomy would not also have to meet the SFDR DNSH test. While the Commission did not comment on the ESAs’ proposals within the Notice, it could be interpreted that the Commission already considers that the “safe harbour” mechanism currently applies.
In their Consultation Paper, the ESAs also considered “shifting” to a single taxonomy-based system for the SFDR DNSH test. However the ESAs noted that this would likely be a longer term consideration for legislators, as the Taxonomy “environmentally sustainable” test is drafted such that assessment should be conducted at an economic activity level, while in contrast the SFDR “sustainable investment” test requires assessment at an entity/investment level.
We suspect that there will be further developments – from the ESAs and/or the Commission – in due course regarding the interaction between the SFDR DNSH test and the Taxonomy DNSH test.
Implications for asset managers
We will wait to see how the market reacts to this development, and whether this may lead to an increased number of funds committing to making ‘sustainable investments’ under the SFDR or even to disclosing under Article 9 of the SFDR as a result of the Commission’s clarifications.
These clarifications could be seen as a positive result for financial market participants, as it highlights further attempts at harmonisation between the SFDR and the Taxonomy (albeit that further guidance in relation to their interaction on these aspects would still be welcomed).
On the other hand, the timing of the Commission’s Notice is not perfect, as a number of funds will have already taken certain decisions relating to the positioning of their funds with respect to Article 8 and Article 9 of the SFDR, and made available their pre-contractual and website disclosures since the application of the SFDR RTS on 1 January 2023. This is indicative of the ever-evolving regulatory landscape, especially in the sustainable finance and investment arena. Nonetheless, for managers establishing new funds or for those planning to refresh their regulatory frameworks in the near future, this clarification may prove to be a useful development as it could allow them to simplify their funds’ policies and procedures in respect of the SFDR “sustainable investment” test and Taxonomy “environmentally sustainable” test going forward.
Next Steps
As indicated above, we wait for the new Taxonomy Delegated Acts to enter into force, which have the potential to facilitate investments in more sectors and economic activities that will be recognised as contributing to all of the EU’s environmental objectives.
We also note the Commission has indicated that future revisions of the SFDR RTS may impact the existing list of SFDR PAI indicators relating to social and employee matters, respect for human rights, anti-corruption and anti-bribery. Any such further changes will need to be considered by asset managers in respect of any existing commitment or intention to make Taxonomy-aligned investments, as they will need to incorporate any such changes into their procedures for compliance with the Taxonomy MS test.
Our Sustainable Finance & Investment practice brings together a multidisciplinary global team to support our clients in this mission-critical area.
This note is intended to be a general guide and covers questions of law and practice. It does not constitute legal advice.
Authored by Julia Cripps, Rita Hunter, and Emily Julier.
