The European Securities and Markets Authority (ESMA) issued three notes on 22 November 2023 to explain key concepts that apply across the EU Sustainable Finance framework, in particular the Taxonomy Regulation (TR), the Sustainable Finance Disclosure Regulation (SFDR) and the Benchmark Regulation (BMR). These concepts apply to (i) businesses (financial and non-financial undertakings) that report under the Non-Financial Reporting Directive (NFRD) and its successor, the Corporate Sustainability Disclosure Directive (CSRD), and under the TR; (ii) financial market parties in scope of SFDR; and (iii) benchmark administrators in scope of BMR. These parties grapple with inconsistencies across the various legal instruments. The EU authorities have sought to clarify such issues in the application of the Sustainable Finance framework by publishing guidance and Questions & Answers. The ESMA statements specify that they are not legally binding and do not constitute guidance. Nonetheless, they are useful for a proper understanding of the EU Sustainable Finance framework. We provide a short overview of ESMA's explanatory notes in this blog.

The rules under the TR, SFDR and BMR rely on appropriate availability and quality of ESG data to the entities in scope of such regulations in order for them to provide ESG disclosure. Where ESG data are not available, the rules allow the use of estimates or equivalent information. How can such estimates or equivalent information be used to satisfy requirements under the TR, SFDR and BMR?

Estimates and equivalent information are two different concepts that have different implications and requirements under the relevant regulations. Estimates are approximations or assumptions based on available data or methodologies, while equivalent information is alternative or proxy data that can be used to fulfil the same disclosure objective as the original data. The use of estimates and equivalent information is subject to specific conditions and limitations, depending on the relevant regulation and the context.

Under the Taxonomy Regulation (TR), entities in scope of sustainable finance regulations determine which economic activities can be considered ‘environmentally sustainable’, based on (i) a substantial contribution to one of six environmental or climate objectives; (ii) doing no significant harm (DNSH) to any of these objectives; and (iii) compliance with minimum social safeguards, to be determined in accordance with specific technical criteria. Under certain circumstances, the TR allows the use of estimates on the basis of other sources of information to determine the alignment with the technical screening criteria established under the TR, e.g. where data is not available or reliable (for example where companies are not required to include sustainability reporting under NFRD/CSRD). Further details on this principle are set out in the Disclosures Delegated Act, which provides that financial undertakings may use estimates to assess taxonomy alignment of their exposures in third-country investee companies. However, estimates are not allowed for the DNSH criteria. ESMA explains that estimates (used to assess a substantial contribution) should relate to limited or specific data and produce prudent outcomes, meaning that they should not overstate the sustainability of an economic activity. Moreover, financial undertakings should disclose the methodology and proportion of estimates used for assessing the taxonomy alignment of their exposures.

Under the Sustainable Finance Disclosure Regulation (SFDR), financial market participants (FMPs) are required to disclose information on integration of sustainability risks and opportunities into their investment decisions and advice. For the purposes of disclosure of taxonomy aligned investments at product level, FMPs should primarily rely on publicly reported information from investee companies. Where such information is not readily available from public disclosures, FMPs should explain details about why and whether they obtained and used 'equivalent information' directly from investee companies or from third party providers. In addition, to measure the negative effects of investments on environmental and social factors (e.g. the DNSH requirement), the SFDR provides for principal adverse impact (PAI) indicators. It is recognised that such assessment may require the use of estimates. This may be particularly true prior to the application of the CSRD, while limited information may be available. The European Supervisory Authorities noted that it would be good practice for FMPs to disclose for each PAI indicator "the proportion of investments for which data was obtained directly from investee companies and the proportion of investments for which data was obtained by carrying out additional research, cooperating with third party data providers or external experts or making reasonable assumptions."

Under the Benchmark Regulation (BMR), benchmark administrators are required to disclose the data sources used in the administration of the relevant ESG benchmarks and the extent to which data is estimated, as well as the standards and controls for ensuring the quality and reliability of the data. The BMR requires administrators of EU Climate Transition Benchmarks (CTBs) and EU Paris-aligned Benchmarks (PABs) to disclose the methodology for estimating the greenhouse gas emissions of the underlying assets, when such data is missing or incomplete, and to ensure that the estimates are consistent and conservative.

As we can see, the EU Sustainable Finance framework does leave room for a practical approach to bridging data gaps and enhancing the comparability and consistency of sustainability information. However, the use of estimates and equivalent data (used where reported ESG data are not available) does come with limitations as to transparency of methodology and of estimated or equivalent data and as to outcomes being prudent and conservative.

Application of Do No Significant Harm (DNSH) requirements

As discussed above, the 'Do No Significant Harm' (DNSH) principle applies under the Taxonomy Regulation (TR) for determining the environmental sustainability of an economic activity (‘taxonomy alignment’), as well as the sustainability of investments under the Sustainable Finance Disclosure Regulation (SFDR). It also features in the Benchmarks Regulation (BMR). However, the DNSH principle is not applied in the same way across the different components of the EU Sustainable Finance framework and there are some variations and nuances that market participants should be aware of, as explained by ESMA.

The TR applies the DNSH principle at the level of economic activities, and sets out technical screening criteria for each activity that specify the thresholds and indicators for assessing whether no significant harm is caused to any of the environmental or climate objectives, which then determines taxonomy alignment of the economic activity. This principle also applies under the SFDR: the DNSH principle is one of the elements to be assessed in order for an investment to qualify as a sustainable investment under the SFDR. In addition, the SFDR requires DNSH disclosures for financial products that make sustainable investments, e.g. how the DNSH principle was applied in investment selection and due diligence processes, and how impacts and risks of investments are monitored and measured.

Under the BMR, the DNSH principle serves to exclude assets from the benchmark portfolio that significantly harm any of the six environmental or climate objectives under the TR, based on the technical screening criteria of the TR, from any EU Climate Transition Benchmarks (CTBs) and the EU Paris-aligned Benchmarks (PABs).

Summarising the above;

  • the TR applies DNSH at the level of the economicactivity: each economic activity within a company or a financial product must meet DNSH requirements in order to be considered ‘taxonomy aligned’;
  • the SFDR applies DNSH at the level of investments: an investment must meet DNSH requirements in order to be able to be considered a ‘sustainable investment’ and the overall impact of the financial product on the environment and society must be considered; and
  • the BMR uses DNSH to exclude certain underlying assets from the portfolio of EU Climate Transition and Paris-aligned Benchmarks, based on measurable carbon emission reduction targets aligned with the Paris Agreement.

The definition of sustainable investments

ESMA also clarifies the interplay between the concept of ‘sustainable investments’ under the SFDR and the ‘environmental sustainability’ of economic activities under the TR. These concepts resemble each other, but are not identical.

As seen above, the TR focuses on the environmental dimension of sustainability, and provides a detailed and granular classification system for economic activities that contribute to environmental or climate objectives.

According to the SFDR, a sustainable investment is an "investment that: contributes to an environmental or social objective, as measured by key indicators or a reference benchmark; does not significantly harm any of the environmental or social objectives; ensures that the investee companies follow good governance practices, such as respect for human rights, anti-corruption and anti-bribery measures, and sound management structures."

If financial products promote environmental or social characteristics (Article 8 products) or have sustainable investment as their objective (Article 9 products), specific information on sustainability aspects and objectives must be disclosed, including certain disclosures provided for in Articles 5 and 6 of the TR.

In our earlier blog about the Sustainable Finance Package 2023, we already discussed that the European Commission has clarified, as part of the EU Sustainable Finance Package 2023, that investments that are ‘taxonomy aligned’ also qualify as ‘sustainable investments’ within the meaning of Article 9 of the SFDR.