Measures aim to establish consistent criteria for sustainable investments, as well as clear market standards for investors.
The European Commission (EC) has set out its first proposal for “concrete actions” to help the EU financial sector take the lead in establishing a greener economy and supporting the Paris Agreement. These legislative proposals, which were published on 24 May 2018, follow the release of the EC’s Action Plan on sustainable finance on 8 March 2018 (more information on the Action Plan is available in this Latham blog post).
If the changes are adopted, they would be implemented through a series of delegated acts to establish the environmental taxonomy, followed by a fitness check of EU legislation on public corporate reporting and amendments to non-binding guidelines on non-financial reporting. The EC would also adopt a prospectus for green bond issuances and would publish a comprehensive study on sustainability ratings and research. Finally, the EC would create ecolabels for financial products and explore possible measures to see how climate and environmental risks can be incorporated into banks’ risk management policies aligning with the EU taxonomy.
The EC’s proposed regulation would both:
(1) Impose new transparency duties on “financial market participants,” meaning certain institutional asset managers and investors
(2) Establish criteria regarding environmentally sustainable activities that would apply to: (a) financial market participants with sustainability-themed funds; and (b) Member States establishing national rules for financial products or corporate bonds that are marketed as environmentally sustainable.
New Transparency Obligations on Financial Market Participants
The new duties aim to improve transparency and communication between the financial market participants and their customers. Certain of these duties apply to all financial market participants, including duties in respect of providing advice on how the financial market participant incorporates environmental, social, and governance (ESG) factors into its internal processes. Other duties only apply if the financial market participant is seeking investors in a fund with a sustainability theme or target, in which case the proposed regulation would impose new duties and classifications for how that theme or target is described, measured, and reported.
The focus of the EC’s proposed regulation on financial market participants is notable in that it does not directly address companies that would seek to borrow funds using sustainable finance products. The EC’s proposed regulation does not, for example, address any securities law risks associated with labelling a bond a “green bond”, provide any fiscal incentives for investment in sustainable bonds or loans, or clarify when such labels will be deemed appropriate. Indirectly, the EC’s proposed regulation would likely affect the primary issuance and borrowing market because it would limit what type of sustainability targets or themes a financial market participant could use. However, the financial market participant will be left to decide whether a particular bond or loan fits those regulated criteria.
New Criteria for Financial Market Participants and Member States
Two choices inherent in the EC’s proposed criteria are worth mentioning. First, the EC chose to defer to national regulation in relation to the green bond and sustainable finance primary market. Member States remain free to establish rules for what types of bonds and loans can bear a green label. While the EC’s proposed criteria limit Member State flexibility in terms of assessing environmental sustainability of a certain activity, Member States will be free to create divergent standards around the other elements of sustainable finance (such as the connection between the financing and the underlying environmentally sustainable activity, the detail provided on project selection, and management of proceeds and the reporting required). In a slight departure from that approach, the EC’s proposed criteria seemed to contemplate a concept analogous to “green striping” (as described further in this Latham blog post). The EC’s proposed criteria notes specifically that investments can be characterized as environmentally sustainable as a matter of degree.
The second notable choice inherent in the EC’s proposed criteria is that the EC opted to prioritize environmental sustainability rather than provide equal weight to social or governance factors. The criteria do impose certain minimum safeguards in respect of labour standards (including rights in respect of collective bargaining), but do not impose any “do no harm” rules or apply to social bonds.
The EC’s rationale for proposing concrete actions is that climate change represents a serious risk both to financial stability and to economic loss caused by natural disasters, such as flooding and land erosion. For example, the EC cites that insurance-covered losses relating to catastrophe have peaked at €110 billion. Further, the EC cites that investments made today will lose their entire value in the years to come if climate change risks remain unmitigated.
Jyrki Katainen, the EC Vice-President for Jobs, Growth, Investment and Competitiveness, pointed out that: “[t]o achieve the EU’s 2030 climate targets, we need around €180 billion a year of additional investments in energy efficiency and renewable energy. Mobilising private capital to fund sustainable investment is essential. The European Fund for Strategic Investments (EFSI) is already incentivising private investments to achieve these goals. Today’s proposals will increase transparency of sustainable finance and the investment opportunities it offers, so that investors have reliable information available to enable the transition to a low-carbon, resource-efficient and circular economy.”
The key legislative measures to implement the EC’s Action Plan include
1. A unified EU classification system (‘taxonomy’): This measure establishes consistent criteria for deciding if an economic activity / investment qualifies as environmentally sustainable. These criteria are to be applied by financial market participants marketing sustainability-themed funds and by Member States setting out national rules on labelling investment products.
Based on this criteria, the economic activity must:
(a) Contribute substantially to one or more of the environmental objectives, which are: (i) climate change mitigation; (ii) climate change adaptation; (iii) sustainable use and protection of water and marine resources; (iv) transition to a circular economy, waste prevention, and recycling; (v) pollution prevention and control; and (vi) protection of healthy ecosystems
(b) Not significantly harm any of the environmental objectives set out above
(c) Be carried out in compliance with the specified minimum safeguards
(d) Comply with the following technical screening criteria, if instructed by the EC: (i) being qualitative and/or quantitative, with thresholds if possible; (ii) building upon existing frameworks, such as EU labelling and certification schemes, EU methodologies for assessing environmental footprint, or EU statistical classification systems; (iii) being based on conclusive scientific evidence; (iv) comprising life cycle analysis; (v) avoiding market distortions; and (vi) facilitating verification of compliance
2. Codified investors’ duties and disclosures: The regulation, followed by delegated acts with more precise obligations, will set out clearly and consistently how institutional investors and asset managers must integrate ESG factors into their decision-making process. The institutional investors and asset managers will also have to show how their investments correlate to their ESG targets and explain how they comply with these
3. Low-carbon benchmarks: The EC is proposing new rules to create a new category of low-carbon / ‘decarbonising’ benchmarks. This new market standard will help investors measure the performance of their investments, and then choose how to allocate their assets
4. Better advice to clients on sustainability: The EC’s ultimate objective is to amend the Delegated Acts Financial Instruments Directive (MiFID II) and the Insurance Distribution Directive. The EC has started a consultation in order to understand the most effective way for investment firms and insurance distributors to incorporate ESG factors into the advice they give to individual clients, which should be provided according to the proposed rules. This should diversify the groups of investors to whom sustainable investments are available.
Latham will continue to monitor the progress of the new measures.
This post was prepared with the assistance of Olivia Featherstone in the London office of Latham & Watkins.