On 18 June 2020, the European Parliament adopted a new EU1 Regulation on the establishment of a framework to facilitate sustainable investment (the Taxonomy Regulation). The Taxonomy Regulation was published in the EU Official Journal on 23 June 2020.
The adoption of the Taxonomy Regulation follows the entry into force of the Sustainable Finance Disclosure Regulation (the SFDR) in December 2019.
This Update discusses the impact of the SFDR and the Taxonomy Regulation on asset managers, including non-EU managers who market their funds into the EU. Please see the penultimate section of this Update for the status of these new regulations in the UK following its exit from the EU (Brexit). Please also see our other Update, EU Advances ESG Related Reforms to Financial Services Regulations, for a general overview of the EU’s ESG reforms.
Many of the disclosure requirements that apply to asset managers start to apply from 10 March 2021.
Scope — Application to EU and Non-EU Asset Managers
The SFDR and the Taxonomy Regulation apply to “financial market participants,”2 a term that includes (among others) MiFID3 investment firms that provide portfolio management, alternative investment fund managers (AIFMs), and UCITS4 (or their management companies). The regulations set out requirements relating to financial products made available by financial market participants. The term “financial products” includes (among other things) portfolios managed by MiFID managers and alternative investment funds (AIFs) managed by AIFMs.
As explained in greater detail below (under SFDR), the disclosure obligations include disclosures at the product (AIF) level, in particular disclosures made to investors, as well as disclosures at the entity (AIFM) level, in the form of public disclosures on the entity’s website.
The definition of “financial market participant” clearly includes AIFMs authorized under the Alternative Investment Fund Managers Directive (AIFMD), that is, EU AIFMs. As for non-EU AIFMs, there is some ambiguity in the text of the legislation. However, according to a recent FAQ document published by the European Commission and the Technical Expert Group on Sustainable Finance, the disclosure obligations for financial market participants in the Taxonomy Regulation, which build on the respective obligations in the SFDR, are meant to apply to anyone offering financial products in the EU, regardless of where the manufacturer of such products is based. It thus seems clear that the disclosure obligations in the Taxonomy Regulation and in the SFDR will apply to non-EU AIFMs that market their AIFs in the EU pursuant to the national private placement regimes under Article 42 of AIFMD.
In addition, the product-level requirements described below may also indirectly affect non-EU asset managers that act as delegates of EU financial market participants (such as EU AIFMs or UCITS management companies), as such EU firms are likely to require the information from the non-EU delegate to comply with their own regulatory obligations. That is, a non-EU manager might not have a direct regulatory obligation to prepare the disclosures but might be contractually required by the delegating EU manager to do so.
The disclosures required under the SFDR consist of entity (e.g., AIFM)-level disclosures and product (e.g., AIF or portfolio)-level disclosures. As noted above, the disclosures must be made variously in pre-contractual information to investors, in periodic investor reports and publicly on firms’ websites. The majority of the disclosure requirements under the SFDR apply from 10 March 2021.5
Entity (AIFM)-level disclosures
At an entity (AIFM) level, a financial market participant is required to disclose
- information on its website about its policies on the integration of sustainability risks in its investment decision‐making process
- information on its website regarding the consideration (or not) of principal adverse impacts of its investment decisions on sustainability factors
- information in its remuneration policies and on its website as to how its remuneration policies are consistent with the integration of sustainability risks
Product (AIF)-level disclosures
At a product (AIF) level, a financial market participant is required to disclose
- information in its pre-contractual disclosures to investors and periodic reports about the manner in which sustainability risks are integrated into its investment decisions and the likely impacts of sustainability risks on the returns of the financial product
- information as to whether, and if so how, the particular financial product considers principal adverse impacts on sustainability factors
In respect of both the entity-level and product-level disclosures, financial market participants may determine not to consider principal adverse impacts (unless they exceed certain size tests under which they have more than 500 employees). At a product level, financial market participants may determine that sustainability risks are not relevant to a particular financial product. However, in each case, such firms must provide clear reasons as to why they do not take these into account, that is, a “comply or explain” approach.
Disclosures for sustainable investment products
For financial market participants that promote sustainable investment products, the SFDR provides a common framework for disclosures as to the products’ sustainable features. However, the SFDR acknowledges that sustainable products “with various degrees of ambition” have been developed to date. Accordingly, the disclosure requirements distinguish between financial products that promote environmental or social characteristics and those financial products that have as an objective a positive impact on the environment and society.
Where a financial product promotes, among other characteristics, environmental or social characteristics (provided that the companies in which the investments are made follow good governance practices), the information to be disclosed shall include information on how those characteristics are met and, if an index has been designated as a reference benchmark, information on whether and how this index is consistent with those characteristics.
Where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark, the information to be disclosed shall be accompanied by information on how the designated index is aligned with that objective and an explanation as to why and how the designated index aligned with that objective differs from a broad market index.
Where a financial product with sustainable investment as its objective does not designate an index as a reference benchmark, the information to be disclosed shall include an explanation on how that objective is to be attained. Where a financial product has a reduction in carbon emissions as its objective, the information to be disclosed shall include the objective of low carbon emission exposure in view of achieving the long‐term global warming objectives of the Paris Agreement.
For products falling within these categories, a financial market participant must also publish the information under Articles 8 or 9 (as applicable) of the SFDR on its website, alongside additional information regarding the methodologies used to assess, measure and monitor the environmental or social characteristics or the impact of the sustainable investments selected for the financial product, including its data sources, screening criteria for the underlying assets and the relevant sustainability indicators used to measure the environmental or social characteristics or the overall sustainable impact of the financial product. The website must also include the information mandated for the financial products’ periodic report under Article 11 of the SFDR.
The content, methodologies and presentation of the information required in relation to principal adverse sustainability impacts and in respect of financial products that promote environmental or social characteristics or that have sustainable investment as their objective will be set out in regulatory technical standards (RTS) developed by the European Supervisory Authorities (ESAs). In April 2020, the ESAs published a joint consultation paper setting out draft RTS in respect of each of these. The consultation paper is open to responses until 1 September 2020. The draft RTS propose a requirement to use a mandatory reporting template for the presentation of pre-contractual and periodic disclosures. According to the consultation paper, the ESAs saw merit in providing mandatory disclosure templates for the purpose of harmonised and comparable disclosures. However, the ESAs have delayed the drafting of these templates until the consultation period has completed and there is greater certainty regarding what must be disclosed under the pre-contractual disclosure requirements.
As discussed above, the product (AIF)-level disclosures will apply to non-EU AIFMs marketing AIFs in the EU under the AIFMD national private placement regime. The product (AIF)-level disclosures are required to be made in the pre-investment disclosures and annual report for the AIF being marketed.
However, it is somewhat less clear how the entity (AIFM)-level disclosures will apply to a non EU AIFM that may have only one AIF (of its many AIFs) registered for marketing under AIFMD. This matter may be settled by guidance from regulators or by market convention over time.
As for non-EU AIFMs that promote sustainable investment products, the common disclosures set out in the SFDR may prove to be a useful framework by which firms can highlight the impact of their products to prospective investors, both in the EU and globally.
At a high level, the Taxonomy Regulation establishes a framework for a harmonized classification system (i.e., a taxonomy) to define environmentally sustainable economic activities. The Taxonomy Regulation outlines six environmental objectives, including climate change mitigation and climate change adaptation, and provides that for an economic activity to be environmentally sustainable, the activity must make a “substantial contribution” to at least one of these six objectives and not cause any significant harm to any of the others.6
The taxonomy is designed to enable the development of future EU policies in support of sustainable finance, including EU-wide standards for environmentally sustainable financial products and the eventual establishment of labels that formally recognise compliance with those standards across the EU or other future economic and regulatory measures. Uniform legal requirements for determining the degree of environmental sustainability of investments, based on uniform criteria for environmentally sustainable economic activities, are considered necessary as a reference for future EU law aiming to facilitate the shift of investment toward environmentally sustainable economic activities or to mobilise investment that pursues climate-related or other environmental objectives.
Given its foundational nature, it would have been preferable for the Taxonomy Regulation to have been agreed before the SFDR; however, owing to the time taken to reach a political agreement between the Parliament and the Council, the initial text of the Taxonomy Regulation was not agreed until 18 December 2019. Accordingly, the originally enacted form of the SFDR, which was published in the Official Journal on 9 December 2019, was unable to refer to the Taxonomy Regulation. To deal with this timing issue, and so that disclosures made under the SFDR can refer to investments that are “environmentally sustainable” as defined under the Taxonomy Regulation, the Taxonomy Regulation introduces a number of amendments to the SFDR.
The amendments supplement the disclosure obligations relating to products that have sustainable investment or a reduction in carbon emissions as their objective (under Article 9 of the SFDR) or that promote environmental or social characteristics (under Article 8 of the SFDR) and that, in each case, invest in an economic activity that contributes to an environmental objective under the Taxonomy Regulation.
The Taxonomy Regulation does not itself set out a “green labeling” regime, but if an investment product purports to have a sustainable investment objective or promotes environmental or social characteristics, then it must disclose the percentage of the investments underlying the financial product that qualify as environmentally sustainable economic activities (although not the percentage of investments with a social objective, as the Taxonomy Regulation is addressed only to environmental sustainability).7 For other products, the Taxonomy Regulation requires the financial market participant to include a statement that the investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities.
The Taxonomy also adds a new provision (Article 2a) to the SFDR, which requires the ESAs to develop RTS to further specify the details of the content and presentation of the information in relation to the principle of “do no significant harm.” The SFDR otherwise refers to this principle without definition. The Taxonomy Regulation also refers to it within the specific context of assessing harm to the environmental objectives for the purposes of determining whether an investment is environmentally sustainable, for which RTS will also be developed by the ESAs.
As noted above, the Taxonomy Regulation does not set out a green labelling regime, but the disclosure requirements will highlight the level of sustainable investments made by a product that purports to be sustainable. Where the proportion of sustainable investments is low, this may make the product unattractive to an environmentally conscious investor.
The text of the Taxonomy Regulation was subject to significant political negotiation, and the final version includes a number of changes compared with the original draft proposed by the European Commission in May 2018. EU institutions had to overcome political disagreement before the Taxonomy Regulation could be introduced. In particular, there was disagreement as to whether the Taxonomy Regulation should specify a taxonomy for “brown” (i.e., carbon-based, harmful) economic activities.
The Taxonomy Regulation does not specify a brown taxonomy but recognizes three different types of environmentally sustainable economic activities:
The Taxonomy Regulation specifically excludes power generation activities from solid fossil fuels (such as coal or lignite) but does not exclude oil- or gas-related economic activities. Nonetheless, the development of the technical screening criteria8 for environmentally sustainable economic activities may be calibrated in such a way that activities relating to oil and gas are effectively excluded. The consequence for non-EU asset managers investing in such economic activities would be that the proportion of their investments qualifying as environmentally sustainable would decrease.
Brexit: Status of the SFDR and Taxonomy Regulation in the UK
The UK left the EU on 31 January 2020, but an implementation period runs until 31 December 2020, during which EU law continues to apply in the UK. As a general rule, EU law that is ‘operative’ before 31 December 2020 will continue to apply in the UK on 1 January 2021.
As the disclosure obligations in the SFDR do not apply until March 2021, and the disclosure obligations in the Taxonomy Regulation do not apply until 2022 (for climate-related environmental objectives) and 2023 (for the other environmental objectives), the disclosures will not form part of ‘retained EU law’ in the UK from 1 January 2021. As such, it will be for the UK government to decide whether to apply the disclosure obligations to firms which offer financial products in the UK. At the time of writing, the UK government has expressed an intention to monitor the EU’s progress regarding its sustainable finance initiatives and, in particular, the final detailed rules under the SFDR and the Taxonomy Regulation, before it decides whether to align with the EU.
Notwithstanding the above, the broader framework established by the Taxonomy Regulation (i.e., other than the disclosure obligations) does form part of retained EU law in the UK, as the remainder of the Taxonomy Regulation will apply from the date of its entry into force (being 12 July 2020). According to a letter published by HM Treasury , the UK government intends to use its powers under the European Union (Withdrawal) Act 2018 (as amended by the European Union (Withdrawal Agreement) Act 2020) to address any deficiencies in the "onshored" version of the Taxonomy Regulation to ensure its operability from the end of the Brexit implementation period. However, the UK government will need to decide whether to adopt the detailed technical screening criteria, which are currently being developed by the EU, or whether the UK wishes to set out its own criteria for environmentally sustainable activities.
Notwithstanding the uncertainty in respect of the UK’s position, it is expected that non-EU AIFMs that market their funds under the NPPRs of any EU member state will be required to comply with the disclosure obligations from March 2021.
Nonetheless, many non-EU AIFMs register their AIF for marketing in the UK first, before expanding to other jurisdictions. If the UK adopts a different approach to the EU in respect of the need for, or form of, sustainability disclosures, this could result in overlapping (or possibly conflicting) disclosure requirements, which would further add to the costs of compliance for such non-EU AIFMs.
In addition, if the UK adopts substantially different technical screening criteria, this could result in a divergence between economic activities that will qualify as environmentally sustainable under the EU rules, versus the UK rules, which would have broader implications beyond the disclosure requirements set out above.
It is possible that financial market participants that are active in both the UK and the EU may simply adopt the more onerous of the two (UK or EU) standards in order to manage this process.
In the medium to longer term, the effect of the SFDR and the Taxonomy Regulation may be felt by non-EU asset managers even without a direct EU nexus, as has been the case with certain aspects of MiFID II (notably, the unbundling of investment research) that have made their way across the Atlantic. The EU has sought to position itself as a global leader with regard to the use of sustainable finance to tackle climate change and other environmental issues, and the SFDR and the Taxonomy Regulation may become the minimum standard, which an increasingly environmentally and socially conscious investment community comes to expect from asset managers.