The package focuses on material sustainability reporting and disclosure obligations, as the EU looks to direct capital toward sustainable activities.
On 21 April 2021, one day prior to Earth Day and a US-led global climate summit, the European Commission adopted a much-anticipated package of measures as part of its policy to help direct capital towards sustainable initiatives and to help the European Union reduce its greenhouse gas emissions by at least 55% by 2030 compared to 1990 levels and reach its 2050 carbon neutrality goal.
The package of measures include:
- A proposed Corporate Sustainability Reporting Directive (CSRD), which would amend the existing reporting requirements under the Non-Financial Reporting Directive (NFRD) and seek to ensure that companies provide consistent and comparable sustainability information
- The EU Taxonomy Climate Delegated Act, which aims to identify the economic activities that best contribute to climate change mitigation and adaptation
- Six Delegated Acts on fiduciary duties, investment, and insurance advice, which aim to ensure that financial firms (e.g., advisers, asset managers, or insurers) include sustainability in their procedures and investment advice to clients
Corporate Sustainability Reporting Directive
In March 2021, the Sustainable Finance Disclosure Regulation (SFDR) came into force and imposed extensive environmental, social, and governance (ESG) disclosure requirements on in-scope EU institutional investors responsible for major capital flows. After much lobbying from financial institutions on the need for investee companies to elevate their ESG disclosures, the European Commission has concluded that the current level of information reported by companies under the NFRD does not meet the needs of investors and stakeholders and raises concerns about the ability of investors to meet their own disclosure requirements under the SFDR.
The CSRD introduces a number of changes, including the following material highlights:
- The existing NFRD captures companies with 500+ employees and financial instruments listed on an EU regulated market, EU Banks and EU Insurers. The CSRD extends the scope of reporting on sustainability matters to all large private companies and to all companies listed on EU regulated markets (removing the employee threshold but excluding listed micro-enterprises). Under the CSRD, nearly 50,000 companies would need to follow detailed sustainability reporting standards, compared to the 11,000 companies that are currently subject to the NFRD.
- CSRD introduces more detailed sustainability reporting requirements, in particular, a requirement to report according to mandatory EU sustainability reporting standards that are to be developed by the European Financial Reporting Advisory Group (EFRAG) in collaboration with relevant international initiatives. The first draft of standards is set to be adopted by October 2022.
- There would be a requirement for companies to digitally “tag” reported information so that it is machine-readable and feeds into the European single access point envisaged in the Capital Markets Union Action Plan (for which the European Commission will put forward a proposal later this year).
- The CSRD would introduce an assurance obligation with respect to the sustainability disclosures. This obligation would introduce, for the first time, a general EU-wide audit (assurance) requirement for reported sustainability information. At the initial stages, the assurance obligation would be “limited”, as the European Commission notes that it will need to adopt a progressive approach. However, over time, the assurance obligation would likely reach a “similar level” to the one for financial reporting. The European Commission also notes that it may be possible for sustainability assurance to be undertaken by auditors other than the typical financial assurance auditors.
Pursuant to the CSRD, companies would have to report on sustainability matters (including their plans to ensure that their business model and strategy are consistent with limiting global warming to 1.5oC), in accordance with the EU sustainability reporting standards.
EFRAG will set out the EU sustainability reporting standards in more detail. However, key points to note include:
- The standards must take account of global standard-setting initiatives (such as the Task Force on Climate-related Financial Disclosures or TCFD). Further, EFRAG is to consider the proposals of the International Financial Reporting Standards Foundation to create a new Sustainability Standards Board, together with the work carried out by initiatives including the Global Reporting Initiative, the Sustainability Accounting Standards Board, the International Integrated Reporting Council, the Climate Disclosure Standards Board, and CDP. For more details on the convergence of global disclosure standards, see this Latham blog post. While alignment with the TCFD (the most commonly adopted global standard) is helpful, it is important to flag that TCFD focuses on climate risk whilst the reporting under the CSRD would extend significantly beyond this to cover a full spectrum of ESG risks.
- The standards should include reporting on the risks arising from global supply chains, including forced labour and child labour. Additionally, the standards should be consistent with internationally recognised principles and frameworks such as the International Labour Organisation Declaration on Fundamental Principles and Rights at Work.
- The CSRD would aim to ensure consistency between reporting requirements under the EU Taxonomy Regulation and company sustainability reporting. Article 8 of the EU Taxonomy Regulation requires companies falling within the scope of the NFRD, and additional companies brought under the scope of the proposed CSRD, to report certain indicators on the extent to which their activities are sustainable as defined by the EU Taxonomy Regulation. These indicators will be specified in a separate delegated act.
The next step for the CSRD is for the European Parliament and the Member States in the Council to negotiate final legislative text. The European Commission anticipates that in parallel, EFRAG will work on a first set of draft EU sustainability reporting standards. According to the timetable provided by the European Commission, the earliest that companies would apply the standards would be in reports published in 2024, covering financial year 2023.
Multinationals should pay particular attention to the differing materiality thresholds for reporting within the CSRD, compared to other global standards such as the TCFD. Specifically, the CSRD would require a double materiality lens, obliging undertakings to report on both how sustainability matters affect the undertaking and the external impacts of the undertaking’s activities on people and the environment. This is a significant distinction from the single (financial) materiality lens of the TCFD, which aligns with a materiality threshold for other (financial impact) disclosures a company may make.
EU Taxonomy Climate Delegated Act
The EU Taxonomy Regulation captures all companies in scope of the NFRD (and will likely be extended to CSRD in-scope companies) in addition to other EU financial market participants, such as fund managers and financial advisors. The EU Taxonomy Climate Delegated Act (the DA), set to apply from 1 January 2022, aims to support sustainable investment by defining technical screening criteria for disclosures mandated under the EU Taxonomy Regulation. For more information on the EU Taxonomy Regulation, see this Latham blog post.
The technical screening criteria have been developed based on scientific work carried out by the EU’s Joint Research Centre, the EU Technical Expert Group, and experts on the Platform for Sustainable Finance.
The DA lists a number of economic activities in sectors covering 80% of EU carbon emissions (e.g., manufacturing, transport, energy, and buildings) and sets criteria to determine whether each activity can be considered to make a substantial contribution to climate change mitigation and adaptation, and to do no significant harm to environmental objectives.
While the College of Commissioners reached a political agreement on the text of the DA on 21 April 2021, it will be formally adopted only once it has been translated in all EU languages at the end of May.
The DA leaves out technologies such as gas and nuclear, which the European Commission will cover in a complementary Delegated Act of the EU Taxonomy Regulation alongside agriculture and certain manufacturing activities. This complementary Delegated Act will cover nuclear energy subject to the results of a review process underway based on the independent report published in March 2021 by the Joint Research Centre. Natural gas and related technologies are set to be covered as transitional activity if they fall within the limits of Article 10(2) of the EU Taxonomy Regulation.
By way of consequential amendments to a plethora of existing EU regulation triggered primarily by the standards in SFDR, six delegated acts propose the following changes, expected to apply from October 2022:
- Sustainability amendments of rules on fiduciary duties: these amendments clarify the obligations on a financial firm when assessing its sustainability risks, such as the impact of floods on the value of investments. The amendments will apply to UCITS management companies, AIFMs, insurance and reinsurance companies, and MiFID Conflicts policies will need to be adapted to identify when a firm’s activities might conflict with the sustainability preferences of individual clients.
- Suitability assessments: when assessing a client’s suitability for an investment, advisors will need to discuss the client’s sustainability preferences. These assessments will apply to MiFID firms and insurance distributors. ESMA is separately considering whether to extend this obligation to appropriateness assessments for non-advised services.
- Product governance rules: sustainability factors and sustainability-related objectives will have to be taken into account in the product oversight and governance process. These rules will apply to product manufacturers and advisers.
The European Commission hopes that these six delegated acts will empower retail investors to decide where and how their savings should be invested and increase the demand for financial instruments and products with sustainable investment strategies and those that consider adverse impact on sustainability.
The elements of this sustainability finance package are the latest policy efforts from the European Commission to give effect to the European Green Deal and to provide a comprehensive framework to assist companies in transforming their business models via enhancing the reliability and comparability of sustainability information.
In the run-up to COP26, countries are setting ambitious climate targets, and there is an increased appetite for sustainable finance products as well as a growing focus on the global convergence of standards. The European Commission is clearly hoping that its new sustainable finance package will establish the EU as a global standards leader.
Latham & Watkins will continue to monitor developments in this area.
This post was written with the assistance of Aleksandra Dulska in the London office of Latham & Watkins.
https://ec.europa.eu/finance/docs/level-2-measures/taxonomy-regulation-delegated-act-2021-2800_en.pdf https://ec.europa.eu/finance/docs/level-2-measures/taxonomy-regulation-delegated-act-2021-2800-annex-1_en.pdf https://ec.europa.eu/finance/docs/level-2-measures/taxonomy-regulation-delegated-act-2021-2800-annex-2_en.pdf
 EU Regulation 2020/852 dated 18 June 2020.
 Undertakings for the Collective Investment in Transferable Securities (UCITS) falling under the scope of Directive 2009/65/EC.
 Alternative Investment Fund Managers (AIFMs) falling under the scope of Directive 2011/61/EU.
 Markets in Financial Instruments Directive (MiFID) firms are investment firms falling into the scope of Directive 2014/65/EU of the European Parliament and of the Council (MiFID II).