Addressing the challenges of the new sustainable finance regulations

Tue 13 Oct 2020

As the world gears up for the transition to net-zero, the European Union is setting ambitious targets with respect to its own environmental footprint. For instance, by 2030 the EU is looking to reduce European greenhouse gas emissions by at least 55% compared to 1990 levels; increase the share of renewables within Europe’s total energy consumption to 32%; and achieve energy savings of at least 32.5%, compared to the EU’s ‘business-as-usual’ scenario.

The investment gap is estimated at €260 billion a year by 2030 and achieving these goals represents an investment challenge that cannot be met by the public sector alone – the financial sector must play a role in raising the private capital needed. The European Commission is well aware of this reality and adopted an Action Plan for Sustainable Finance in March 2018, which sets out a comprehensive strategy to mobilise private sector finance towards sustainability.

Significant investment required

Now, as the need for private capital has become increasingly apparent, the Action Plan has once again risen to the fore. The Green Deal, announced in December 2019, significantly increased the EU’s climate action and environmental policy ambitions with Europe aiming to become the first carbon-neutral continent by 2050. The Green Deal will mobilise at least €1 trillion over the next decade and the financial sector will be instrumental in achieving this. In addition, the Covid-19 crisis showed the urgent need to improve the resilience of our societies and economies.

As significant investment will be required to meet the challenges of resilience, sustainability and carbon-neutrality, the European Commission announced in early April a Renewed Sustainable Finance Strategy which will build on the ten actions put forward in the Commission’s 2018 Action Plan.

EU Action Plan overview

The Action Plan outlines ten reforms^[1] in three key areas. These include reorienting capital flows towards sustainable investment, in order to achieve sustainable and inclusive growth; mainstreaming sustainability into risk management; and fostering transparency and long-termism in financial and economic activity. To support its Action Plan, the Commission adopted a package of regulatory measures in May 2018, including a proposal for an EU taxonomy regulation, plus regulation on sustainability disclosures and on developing low-carbon benchmarks.

Through comprehensive disclosure requirements aimed at the financial industry, the main objective of these regulations is transparency. In-scope financial institutions and companies will need to provide clearer, more standardised information to those investors looking to engage in sustainable investing.

In addition, the Commission is consulting on a voluntary EU Green Bond Standard (EU GBS) for issuers of bonds or other capital market debt instruments. This consultation runs until October 2020 and the EU GBS may be subject to a legislative proposal in the coming months.

To read our analysis of the EU Commission action plan on sustainable finance, click here.

Three key legislative proposals

First, the EU Sustainable Finance Disclosure Regulation (SFDR) will complement the Non-Financial Reporting Directive (NFRD) by introducing disclosure requirements for asset managers and institutional investors as from 10 March 2021. This legislation aims to standardise disclosures on investments and sustainable products across the EU. In-scope firms will need to publish information on investments, such as details on due diligence, adverse sustainability impacts mitigation and remuneration, to be disclosed on firm’s website no later than 30 June 2021. Information should also be published on products. This should include details on the sustainability impact of the product and how this has been measured, to be disclosed in both the annual report and pre-contractual disclosures by 30 December 2022.

Secondly, the Taxonomy Regulation came into force on 12 July 2020 and is an EU-wide classification system providing businesses and investors with a common language to identify whether an economic activity is environmentally sustainable. This framework aims to facilitate sustainable investment. The Regulation also amends the SFDR introducing new additional disclosure obligations for a wide range of entities.By the end of 2021, financial market participants offering financial products in the EU will have to justify in their pre-contractual and periodic disclosures on how, and to what extent, they have used the Taxonomy providing actual figures.

Large non-financial companies and financial institutions already required to provide a non-financial statement under the NFRD will, during the course of 2022, have to disclose once a year in their NFRD reporting how and to what extent their activities are associated with Taxonomy-aligned activities.

Finally, the Low-Carbon Benchmark Regulation that came into force on 10 December 2019 is intended to provide investors with a user-friendly tool for comparative analysis of low-carbon benchmark methodologies. It amends the Benchmark Regulation to create two EU climate benchmarks, and as at 30 April 2020 requires all benchmark administrators to provide ESG disclosures explaining how ESG factors are reflected in key elements of the benchmark methodology and in each benchmark.

As from 31 December 2021, benchmark administrators must disclose on how their methodology aligns with the target of carbon emission reduction or attains the long-term targets of the Paris Climate Agreement. By 1 January 2022, all benchmark administrators should also “endeavour” to market one or more climate benchmarks.

Preparing for implementation

Complying with the new sustainable finance regulations will be time consuming, raise challenges particularly around data gaps and modelling, and require coordinated action from multiple stakeholders. Below are several steps that financial institutions should take:

1. Initial walkthrough: read and understand the requirements within the various regulations. Identify key stakeholders needed for implementation. This includes both internal stakeholders including, for example, Finance, Risk, Compliance, Front Office, and Sustainability functions and external stakeholders, such as accountants, depositary and portfolio companies.
2. State of play: understand if and to what extent the institution is concerned by the regulation, and on what grounds. For example, is it a financial adviser or is it an investment manager? Is it exposed through direct holdings or investments through other structures? Review existing portfolios and classify assets according to whether or not they promote ESG matters. Assess the availability of data regarding assets.
3. Impact assessment: create a data template with the required information for all portfolios. Start to populate this template and identify missing data.
4. Objectives definition: set specific, measurable, attainable, relevant, and time-bound (SMART) objectives. A first objective can be complying with the regulation at the given deadline. A second objective can be refining data on a longer-term horizon for better disclosures.
5. Strategy definition: set a strategy to achieve the objectives defined. Assess the effort needed to source data, benchmark ESG data providers, and estimate the costs and financing sources needed for the implementation.

The EU’s ambitious targets with respect to its own environmental footprint and the mobilisation of the private sector finance in reaching these targets presents a challenging agenda going forward. Implementation of the new sustainable finance regulations should, therefore, be planned well ahead to ensure a compliant strategy is established.

^[1] The ten actions are the following: (1) Establishing an EU classification system for sustainability activities, (2) Creating standards and labels for green financial products, (3) Fostering investment in sustainable projects, (4) Incorporating sustainability when providing investment advice, (5) Developing sustainability benchmarks, (6) Better integrating sustainability in ratings and research, (7) Clarifying institutional investors and asset managers’ duties, (8) Incorporating sustainability in prudential requirements, (9) Strengthening sustainability disclosure and accounting rule-making, (10) Fostering sustainable corporate governance and attenuating short-termism in capital markets