By Saga L Eriksson, PhD Candidate
The European Commission introduced the first sustainable finance measures in its 2018 Sustainable Finance Action Plan. The Action Plan has the aim of fostering “stability, transparency and long-termism” in the EU economy and “reorienting” private finance towards achievement of the low carbon transition. The measures are part of the EU Green Deal and focus on better defining sustainable investments and more accurate reporting of climate risks. This blog post discusses the key pillars of the framework, how they interact with each other and what remains to be addressed.
The mechanism of sustainable finance
Sustainable finance as a concept looks at investing and lending that interacts with economic, social and environmental issues[1]. In literature, the finance lever is seen as a possible alternative to carbon taxes, compensating for the difficulties in achieving global agreement on a price for carbon.[2] The underlying logic of both measures is the same, the accurate pricing of emissions, in the hope that market forces guide economic activities away from the production of goods with negative environmental impacts. In the case of sustainable finance, it is expected that transparency around company activities and their climate risks will make it harder for worse performing companies to raise funding. Alternatively, where the need for transition finance is significant, such measures make it easier for investment to be steered towards achieving emission reductions, particularly in sectors where impact is largest. EU sustainable finance measures are an ambitious effort to push for more formalized standards for what is meant by sustainable economic activities, and more rigorous verification of this, as a further development to largely voluntary international schemes.
Taxonomy as the baseline standard
The first pillar introduced by the Commission Action Plan is the Taxonomy Regulation, which offers an overarching definition of environmentally sustainable economic activities. To be considered Taxonomy aligned, activities need to make a substantial contribution to at least one environmental objective, do no significant harm to any of the other objectives, comply with minimum social safeguards, and comply with thresholds set out in Technical Screening Criteria (TSC) specific to the economic activity in question. The six environmental objectives, set out in Article 9, are climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, the transition to a circular economy, pollution prevention and control, the protection and restoration of biodiversity and ecosystems.
The requirement of reporting the proportion of operating and capital expenditures meeting the TSC supports the use of the Taxonomy as a tool for investors to help them compare investment opportunities. The hope is that this reporting will incentivise companies to make their business models more environmentally sustainable through transparency around their engagement with sustainability themes as well as their direction of travel and strategy.
While the Taxonomy requires company level disclosures, the TSC are set out in terms of economic activities, with included sectors divided into (1) green activities, (2) enabling activities, and (3) transition activities. For enabling activities, the expectation is to avoid lock-in of assets that undermine long-term environmental goals while having a substantial positive environmental impact. For ‘transitional’ activities greenhouse gas emissions need to correspond to the best performance in the relevant sector or industry, not hamper the deployment of low carbon alternatives, and avoid lock-in of carbon intensive assets.
To ensure the biggest impact, the Commission puts emphasis on the Taxonomy being a classification system for ‘green’ economic activities. This does not necessarily imply that activities that do not fall in scope are automatically polluting. There was debate while the measures were being drafted on the idea of also a ‘brown’ Taxonomy, that would explicitly indicate activities not considered sustainable. This would have extended the framework to cover activities that may improve current levels of environmental performance, but do not reach a level of substantial contribution. However, even under the current framework, for activities that do not meet the TSC, financing with a view to improvement can be considered aligned if it is part of an implementation plan to meet the threshold within in a period of 5 years.
Such choices however bring forth the political nature of the Regulation. While the Taxonomy is very much branded as scientific and robust, some of the choices made on which economic activities to include, and how much flexibility to give have come under scrutiny from scientists. Differences arise on what emphasis should be put on phasing out certain activities altogether versus transitioning them towards lower emissions. This was brought to light with the inclusion of nuclear and gas, a decision challenged by environmental campaigners. Emphasis overall is on the transition, and the EU is very keen to avoid being seen to ‘pick winners’. This has led to a reluctance to label activities outside the Taxonomy as automatically ‘brown’, while also wanting the framework to be ambitious and focus on activities with the biggest impact. Nevertheless, the focus on technological neutrality brings with it certain trade-offs that can be damaging to credibility.
Building on the Taxonomy – further investor and company disclosures
Following from the introduction of the Taxonomy, additional disclosure requirements are set out in the Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD). These pieces of legislation set out reporting requirements for financial market participants in the former, and non-financial entities of a certain size in the latter. These include reporting on environmental sustainability, with reference to Taxonomy alignment, as well as other social and governance aspects.
The SFDR brings transparency to the integration of sustainability risks and impact in financial products. This is to provide better information to end investors about how environmental and social characteristics are accounted for. Previous voluntary reporting schemes have been considered by the Commission as inadequate, making it difficult to compare financial products on their environmental and social characteristics. SFDR mandates disclosure on entity websites about how relevant sustainability risks are integrating into the investment decision making process of the organisation, as well as information on how financial entities’ remuneration policies are consistent with the integration of sustainability risks.
Organisations also need to report on adverse sustainability impacts at the entity level, specifying any negative effects they have on sustainability factors as well as undertaking product level disclosures. These depend on the extent to which the financial product offered engages with sustainability themes. Article 6 products are ones that have not set specific sustainability goals and disclose only how sustainability risks are accounted for and how this impacts returns. Article 8 products look to either promote environmental or social characteristics, and Article 9 products have an intentional sustainability objective.
For Article 8 products, the extent to which these characteristics are achieved, and the methodology used to assess this must be disclosed. For Article 9 products, disclosures include an indication of how the relevant sustainability objective is achieved and explanation of how this differs from a traditional market objective. Crucially, neither product type entails a minimum threshold for sustainability, meaning it is not intended as a label for financial products. Entities carry out their own assessments and disclose planned asset allocations and the minimum share of sustainable investments, but there is not set minimum share required.
CSRD complements SFDR in ensuring that investors have all the necessary information from investee companies to carry reporting. CSRD intends to help investors better understand the risks and impacts of investments and make it easier for civil society organisations to hold companies to account for their environmental and social impact. CSRD revises and extends the scope of the Non-Financial Reporting Directive (NFRD), and the evolution of terminology away from using ‘nonfinancial’ in favour of ‘sustainable’ reflects the Commission’s view that sustainability information should be considered financially relevant.
This is to address the previous separation of the two and elevate the status of sustainability reporting, reflected in the CSRD’s double materiality approach. This means entities need to not only report on the risks they are exposed to, but also their own impact on the environment and society around them. While previous approaches were largely focused on whether sustainability triggers financial effects, including also impact necessitates a bigger role for entities in mitigating potential negative consequences of operations.
In many ways the aims of the Taxonomy and CSRD interact in that they both aim to harmonise standards and give investors better information on company performance to facilitate access to capital. However, CSRD is focused on company level reporting on a variety of factors that integrate environmental, social and governance (ESG) concerns, while the Taxonomy is only for alignment with specific environmental thresholds. On environmental factors, reporting under CSRD corresponds directly to the six environmental objectives in the Taxonomy.
While companies will need to report on their Taxonomy alignment, CSRD reporting also includes other aspects such as minimum social and employee matters, respect for human rights, anti-corruption and bribery matters. The areas included pertain to the business model and strategy of the organisation and resilience to sustainability related risks. While CSRD specifies who needs to report and on what, the accompanying European Sustainability Reporting Standards (ESRS) outline how the reporting needs to be done. The ESRS includes three categories of disclosures divided into cross-cutting, topical (ESG) and sector-specific considerations, to be introduced gradually. Efforts have also been made to align the ESRS with global standards such as the Global Reporting Initiative (GRI).
Open questions and potential inconsistencies in the framework
While the Taxonomy, SFDR and CSRD are designed to work together, there are factors around the timeline of implementation and the definitions of sustainability that challenge their ability to form a coherent whole. Measures are phased in with Taxonomy reporting having started in January 2022 for non-financial undertakings. This is when entities have been required to report on their Taxonomy eligibility i.e. whether their activities are covered by the Taxonomy. From January 2023 the reporting has extended to Taxonomy alignment meaning whether Taxonomy eligible activities comply with the TSC. From January 2024 onwards, Taxonomy reporting extends to financial undertakings who will need to report on several KPIs including green asset ratios.
The first SFDR disclosures for financial undertakings began in 2021, whereas the first CSRD disclosures for undertakings previously in scope of the NFRD start from January 2024. Extension of CSRD to further EU entities including SMEs follows in January 2025 and January 2026, and reporting for third country entities begin in January 2028. Some of the requirements were further adjusted in 2023, with changes to the thresholds for inclusion in the Accounting Directive, impacting which companies must file reports under CSRD. This was part of the Commission’s efforts to reduce overall reporting burden, announced in October 2023.
Due to the sequencing of reporting, there are questions to be asked on how well the measures can work together. For example, in the case of SFDR and CSRD, financial institutions have had to begin disclosing the sustainability of their products before the majority of companies have been mandated to give investors information about their operations. This has led to a lack of data and need for estimation, something the financial industry has raised as an issue. However, it can also be viewed as an intentional move to ensure the adoption of CSRD. If financers are already asking for the information, companies have an incentive to adopt CSRD as quickly as possible.
Another key question around the complementarity of measures concerns diverging definitions of sustainability. While the CSRD definition of sustainability derives directly from SFDR, due to this information being specifically aimed at financial market participants, there is no similar equivalence between SFDR and the Taxonomy. The definition of sustainability within the Taxonomy is limited to the environmental objectives included, while SFDR adopts a broader definition. Under SFDR sustainable investment can include, but is not limited to, investment in economic activities that contribute to an environmental objective in the Taxonomy. The SFDR definition also includes social objectives, while sustainability risk is recognised as “any environmental, social or governance event or condition that causes a negative material impact of the value of the investment”. Therefore, SFDR can be seen to engage with all aspects of ESG, while the Taxonomy so far is limited to only cover environmental elements.
This has created a discrepancy between the meaning of a sustainable investment and a Taxonomy-aligned investment, even though one of the guiding purposes of the Taxonomy is to set out the overarching standard for what counts as sustainable. To address this issue, a recent Commission Notice clarified that investments in Taxonomy-aligned environmentally sustainable economic activities could be automatically qualified as sustainable investments under SFDR. While there is a reason for the duplication of a separate Taxonomy and SFDR definition for sustainability, namely that using purely the Taxonomy definition only covers certain economic activities, it may still present a conceptual problem that such divergence exists. Particularly in relation to usability of the framework and clarity of reporting, this could present challenges if the definition of sustainability is in fact not uniform as a Taxonomy would suggest.
Another divergence concerns adverse impacts, only used as a reporting tool in SFDR with no minimum performance level required. The Taxonomy on the other hand sets a high level of ambition in identifying the most sustainable activities in each sector linked to the Paris Agreement and the EU Climate Law. Such inconsistencies on adverse impacts could create further confusion on how reporting relates to the achievement of broader, high-level environmental goals. This is already evidenced in the fact that industry has tended towards treating SFDR as a labelling scheme, presenting the danger of making financial product descriptions seem more definitive or ambitious than they are. This in turn creates potential problems with greenwashing, which the Taxonomy is meant to deter through a scientifically robust definition. However, this may be too much to expect if the Taxonomy only covers a limited amount of ESG aspects and sectors.
The Commission considered the Taxonomy Regulation as the most urgent measure when establishing its own scheme of sustainability reporting. All other reporting and disclosure measures were assessed to be contingent on standards and criteria in the Taxonomy, but whether this occurs in practice is perhaps undermined by the fact the Taxonomy does not extend to cover all aspects of the reporting required in its complementary pieces of legislation. There is no social or governance Taxonomy so far, although there has been some discussion of a possible social taxonomy. The logic of EU policymakers is that all aspects of ESG cannot be considered equal, therefore environmental concerns deserve to take precedence. However, this creates an interesting dynamic between the Taxonomy, on the one hand, and SFDR and CSRD, on the other. While they are meant to build upon and complement each other, it can be argued they are all missing elements either in scope, ambition, or speed of implementation.
Photo by Maryna Yazbeck on Unsplash
[1] Dirk Schoenmaker and Willem Schramade, Principles of Sustainable Finance (Oxford University Press 2019)
[2] Bolton, Patrick, and Marcin Kacperczyk. “Global Pricing of Carbon-Transition Risk” National Bureau of Economic Research Working Paper 28510 (February 2021) https://www.nber.org/papers/w28510.