It is easy to ask: what does sustainable investment mean? The answer is not simple even though a lot rides on it. In the EU climate and energy space alone, the EU estimates that additional sustainable investment will need to rise to €180 billion per annum (on average) between 2021 and 2030. To this should be added huge sums to be spent in other sectors, for instance transport, waste management, real estate and water. To encourage private sector investment in sustainable economic activities, and to do so across EU borders whilst protecting against mis-selling, misrepresentation, greenwashing and the like, the EU seeks to provide investors, markets and other stakeholders with certainty over what constitutes a sustainable investment.
International, national and commercial organisations have been grappling with this over several years. The EU proposed its legislative answer in May 2018, or more accurately it proposed its legislative structure. Below we comment on the EU’s proposal, keeping in mind, of course, that there may be significant changes arising as the proposal moves through the legislative process.
Background at a glance
There has been a huge amount of global and EU work produced over recent years in terms of sustainability and sustainable finance (see here). The EU is not working in isolation of such international work. Broadly there are two main international background drivers. These are the Paris Climate Change Agreement and the UN 2030 Agenda for Sustainable Development. The EU proposal is strongly influenced by these, but otherwise builds upon existing EU legislation, plans and packages.
Sustainability – the environment pillar
There are three pillars to sustainability: economic, social and environment. Whilst the title to the EU’s proposal refers to “sustainable” investment, this is (currently) something of a misnomer as the proposed Regulation relates almost exclusively to the environment pillar. Currently the only non-environment sustainability provision relates to employment safeguards. It could be that subsequent reviews will bring in wider sustainability objectives.
Proposed EU Regulation on the “establishment of a framework to facilitate sustainable investment”
The above proposal is for a regulation rather than a directive. Consequently, as a regulation (if and when implemented) it will have direct effect across the EU and will be binding on all persons, and not just Member States’ governments and emanations of state. It will not require domestic implementing legislation (albeit often Member States bring in related domestic legislation to ease the actual operation of EU Regulations).
For those not familiar with EU legislation, it is important to recognise that EU legislation is to be interpreted purposively. The recitals can be important in this regard. Consistent with other EU legislation, the proposed Regulation has several recitals (indeed, and again this is not unusual, there are numerically more recitals than there are operative provisions).
Ease Pan-EU investment
The proposed Regulation cannot be divorced from the wider work of the EU on sustainable development, particularly in the environment arena. The Regulation is part of a wider EU endeavour to embed environmental, social and governance (ESG) factors into the financial system.
The foundations (and many express terms) of this Regulation are based squarely on existing EU environment law in respect of the likes of energy, pollution, waste, water and the circular economy.
A central aim in this regard is to tackle inconsistent approaches at national level and to provide a pan-EU classification system for determining whether an economic activity is sustainable in environment terms. Part of this intention also is to expose and tackle the scourge of “greenwashing”.
By tackling this current inconsistency and confusion, the EU aims to reorient capital flows to sustainable activities and assist investors more easily to compare green investment opportunities in the various Member States and more confidently invest across internal EU borders and in more than one EU Member State. Likewise, this step seeks to make it easier for sustainable businesses to attract investment from across the EU.
A framework – the detail to follow
In essence, the proposed Regulation sets out a high-level legal framework which will ultimately determine what is an environmentally sustainable economic activity.
It does this first by setting out broad definitions of what can constitute an environmentally sustainable economic activity (an “EU taxonomy”). These definitions (1) restrict sustainability to six environment objectives and (2) identify particular harms which, if caused to any of these objectives, will render the economic activity unsustainable.
It is recognised that the broad taxonomy alone simply will not be enough. Therefore the EU Commission is to supplement the taxonomy over time (see below) with delegated acts (for each environmental objective and related harm to such objective) which will establish the technical screening criteria for determining when economic activities meet the objectives.
The proposed Regulation sets out to establish the criteria for determining whether an economic activity is environmentally sustainable and the degree of environmental sustainability of an investment. The proposed Regulation is to govern (1) any measures at Member State or EU level which set out requirements on market actors in respect of the marketing of financial products or corporate bonds that are marketed as environmentally sustainable, and (2) financial market participants offering financial products as environmentally sustainable investments or having similar characteristics. To this end, to qualify as an “environmentally sustainable investment”, the investment must meet this proposed Regulation and any existing or future labels must comply with this proposed Regulation.
It is to be noted that the focus is on the environment sustainability of economic activities. The focus is not on such sustainability of the legal entity that operates/owns the activity, or of the related asset. However, the EU is hopeful that this work, coupled with disclosure requirements will enable investors to identify separately the degree of environmental sustainability of the legal entity or its portfolio/holdings.
What is an environmentally sustainable economic activity?
Clearly this is a central feature. An economic activity will be environmentally sustainable if it complies with each of the following four criteria:
- It contributes substantially to one or more of six environmental objectives (see below).
- It does not significantly harm any of the six environmental objectives (see further below).
- It is carried out in compliance with minimum safeguards which currently relate to labour (not reviewed further in this article).
- It complies with technical screening criteria (where specified)(see further below).
Six environmental objectives and related substantial contributions
To be an environmentally sustainable economic activity, the activity must contribute substantially to one or more of these six environment objectives. To give markets time to prepare, the operational aspects will be phased in for the different objectives (phased dates in brackets below).
- Climate change mitigation (from 1st July 2020)
This objective requires a substantial contribution to the stabilisation of greenhouse gas concentrations in the atmosphere by avoiding or reducing greenhouse gas emissions or enhancing greenhouse gas removals. This can be via means such as renewable energy, improving energy efficiency, clean transport, switching to renewable materials, carbon capture and storage, phasing out emissions of greenhouse gases, energy infrastructure to enable decarbonised energy, and producing clean and efficient fuels from renewable or carbon neutral sources.
- Climate change adaption (from 1st July 2020)
In this regard, a substantial contribution is required to reducing, or preventing an increase or shift in the negative effects of current and future climate change. This might be via means preventing or reducing location and context specific negative effects of climate change or negative effects posed to the natural or built environment within which the economic activity takes place.
- Sustainable use and protection of water and marine resources (from 31st December 2021)
Here a substantial contribution is required to the good environmental status of waters (an EU environmental water law concept). This can be via means such as aquatic protection against the adverse effects of waste waters, human health protection against pollution of drinking waters, water abstraction protections, improving water efficiency and protection or improvement of water bodies in accordance with the Water Framework Directive, and ensuring sustainable use of marine ecosystem services and the good environmental status of marine waters.
- Transition to a circular economy, waste prevention and recycling (from 31st December 2021)
The list of measures by which a substantial contribution can be made is too long to set out here. Suffice it so say that the measures will be very familiar to those who manage resources, or are involved in the waste management sector. They are centred around improving the efficient use of raw materials, extending the life of products and reuse and recycling of waste materials.
- Pollution prevention and control (from 31st December 2022)
To constitute a substantial contribution to this objective, the economic activity must reduce pollutant emissions (in this case, other than greenhouse gas emissions), or improve air, water or soil quality where the activity takes place, or minimise significant adverse effects on human health or the environment from the production or use of chemicals.
- Protection of healthy ecosystems (from 31st December 2022)
In terms of this objective, a substantial contribution is required from the economic activity in respect of protecting, conserving and enhancing biodiversity and ecosystem services in line with existing EU legislation and non-legislative instruments through matters relating to nature conservation, or sustainable land management, agricultural practices or forest management.
No significant harm to environmental objectives
Of course, in terms of environment protection, there can often be an inherent conflict in that the same activity may be positive from one perspective and negative from another (e.g. an activity that reduces water pollution could at the same time, say, give rise to increased air emissions). The proposed Regulation seeks to address this by setting out what would constitute significant harm to the environmental objectives. Thus if an economic activity on the one hand makes a substantial contribution to one environmental objective, but unfortunately gives rise to significant harm to another environmental objective, then that economic activity will fail to be categorised as an environmentally sustainable activity. These are the harms which will prevent an economic activity from being environmentally sustainable:
- climate change mitigation
an activity which leads to significant greenhouse gas emissions.
- climate change adaption:
an activity which increases negative climate effects.
sustainable use and protection of water and marine resources:
where the activity is detrimental to a significant extent to good, or good environmental, status of waters.
- circular economy, waste prevention and recycling:
where the activity leads to significant inefficiencies in the use of materials in the lifecycle of products, or leads to a significant increase in the generation, incineration or disposal of waste.
pollution prevention and control:
where the activity (compared to the situation before the activity started) leads to a significant increase emissions of pollutants to air, land or water.
protection of healthy ecosystems:
where the activity is detrimental to a significant extent to the good condition of ecosystems.
Technical screening criteria
The provisions (above) relating to what will constitute the required significant contribution to the environmental objectives or the potential significant harms, clearly are very broad. Much more detail will be required to make them workable. The EU’s answer to this (and this type of approach has been adopted in other EU environment law) is that the EU Commission, via delegated acts (the provisions surrounding the legal mechanisms for this are not discussed in this article), will establish technical screening criteria (“TSC”) to provide more substance. The timetable currently envisaged for when TSCs will be adopted and when they will be applicable are:
- TSC by 31st December 2019 for application on 1st July 2020
climate change mitigation
climate change adaption.
TSC by 1st July 2021 for application on 31st December 2021
Circular economy, waste prevention and recycling
Pollution prevention and control
TSC by 1st July 2022 for application on 31st December 2022
Sustainable use and protection of water and marine resources
Protection of healthy ecosystems
A number of things (potentially either or both qualitative and quantitative) are to be taken into account in determining a TSC. These will include scientific evidence and the precautionary principle, identifying the most relevant contributions in the short and longer terms, the impacts of not only the economic activity itself but also the products and services provided by the activity including in production, use and end-of-life and facilitating verification measures. Consideration is also to be given to the risk of distorting market competition, or creating inconsistent incentives or stranded assets. Activities which relate to clean energy and clean transport receive particular mention.
It is anticipated that the proposed Regulation may need to evolve over time. The TSC are to be regularly reviewed and the Regulation itself is to be reviewed on a three yearly basis. Again, this is a common feature of EU environment law.
Platform on Sustainable Finance
To help it in its work, particularly on TSC (but also on capital flows to sustainable investment and potential future need to amend the Regulation), the EU Commission is to set up and chair a platform on sustainable finance. This platform is to be composed of the European Environment Agency, European Supervisory Authorities, the European Investment Bank, the European Investment Fund, experts representing relevant private stakeholders and individual experts with proven knowledge and experience.
The proposed Regulation is potentially very significant given the size of the market for environmentally sustainable investment in the EU and the amount of diverse work currently being undertaken in terms of policy and law on sustainability and ESG in the EU and globally. This endeavour to provide clarity and certainty will no doubt be welcomed by many, albeit it may also disappoint others. The lack of current detail gives rise to a significant number of questions over how the Regulation will work if it is passed. Of course, the proposed Regulation may be subject to amendment (perhaps significant) during its legislative passage (assuming it is passed). We look forward to seeing if it is passed, and if so whether its provisions are altered substantially.