A new regulation will detail how financial market participants and financial advisors must incorporate ESG risks and opportunities in their procedures.

By Paul A. Davies and Michael D. Green

The European Union (EU) is committed to being the global leader in fighting climate change and implementing the Paris Agreement. Since climate change is increasingly viewed as a risk factor with respect to financial stability, the EU is now focusing on the financial sector in its efforts to implement the Paris Agreement and improve the sustainability and competitiveness of the EU economy.

Background

In May 2018, the European Commission (EC) took steps toward a plan to develop a cleaner and greener economy. In particular, the EC proposed (as part of the EU Action Plan on Sustainable Finance) new measures to establish criteria to objectively determine the sustainability of financial products.

The proposals included: harmonised criteria to determine whether an economic activity is environmentally sustainable; consistent rules for the integration of environmental, social, and governance (ESG) factors into financial services; and the introduction of low carbon benchmarks operating as low carbon versions of standard indices. These proposals would allow more investment to be channelled into sustainable activities.

The Disclosure Regulation

In March 2019, following the May 2018 declaration, the European Parliament and EU Member States reached an agreement to publish new rules on disclosure requirements for sustainable investments and sustainability risks via a “disclosure regulation”. The disclosure regulation will detail how financial market participants and financial advisors must incorporate ESG risks and opportunities in their processes, procedures, and policies. In addition to the Paris Agreement, the disclosure regulation also supports the broader framework of the 2012 United Nations Sustainable Development Goals and the EU’s sustainable development and carbon neutrality agendas.

The widespread adoption of ESG reporting has been variable, and many firms have either failed to report on the financial impacts of ESG risks or have reported any ESG risks inconsistently. The disclosure regulation encourages uniformity by establishing a consistent set of rules on how financial market participants inform investors on the integration of ESG risks and opportunities. These rules are designed to provide stakeholders with valuable information regarding the potential risks of ESG events on the value of investments and clearly delineate the financial impacts of those risks. Sustainability is given a high profile, with requirements to disclose adverse impacts on ESG matters. For example, investments in assets that pollute, or harm biodiversity, must be disclosed.

In short, investors must disclose procedures that integrate ESG risks into their investment and advisory processes, the extent to which those risks may impact the profitability of investments, and information on how environmentally friendly strategies are implemented. The new rules are intended to enable better-informed choices to ensure that invested capital is used responsibly and supports sustainability.

Three Pillars of the Regulation

The disclosure regulation is supported by three pillars:

  1. Elimination of greenwashing. “Greenwashing” is the provision of unsubstantiated or misleading claims regarding the sustainability characteristics and benefits of an investment product. The disclosure regulation aims to eliminate greenwashing and in parallel raise market awareness of sustainability.
  2. Regulatory neutrality. The disclosure regulation provides a disclosure toolkit to be applied in a uniform manner by different financial market operators. The European Banking Authority, the European Securities and Markets Authority, the European Insurance and Occupational Pensions Authority, and the Joint Committee of the European Supervisory Authorities will all monitor harmonisation of disclosures in all concerned sectors.
  3. Level playing field. The disclosure regulation covers investment funds, insurance-based investment products, private and occupational pensions, individual portfolio management, insurance advice, and investment advice.

These structural foundations are intended to allow Europe’s financial system to work towards mitigating the impact of climate change and position itself as a global destination for investments in green technologies and green financial products.

Towards a Greener Future

The disclosure regulation (and other related proposals) offer strong evidence of the EU’s focus on and commitment to its Action Plan on Sustainable Finance.

EU ambassadors must now endorse the political agreement in order for the EU to publish the disclosure regulation. The European Parliament and Council are expected to adopt the regulation after the required legal and technical input has been provided.

Latham & Watkins will continue to follow and report on developments in this area.

This post was prepared with the assistance of Martin Cassidy in the London office of Latham & Watkins.