The European Union’s (E.U.’s) Sustainable Finance Framework and Application for Non-E.U. Fund Companies

An overview of the E.U. Taxonomy, Corporate Sustainability Reporting Directive (CSRD) and Sustainable Finance Disclosure Regulation (SFDR)

Background

The European Union (E.U.) passed the Green Deal in 2019. The ultimate objective is to transform the E.U. into a modern, resource-efficient and competitive economy, with the following aims:

1. No net emissions of greenhouse gases by 2050 (i.e., climate-neutrality);
2. Economic growth decoupled from resource use; and
3. No person and no place left behind. 

To help achieve the first aim, the E.U. is aiming for greenhouse gas emissions to be cut by 55% (in comparison to 1990 levels) by 2030.

As part of the Green Deal, the E.U. has outlined the Sustainable Finance Framework, which is intended to help embed sustainability factors at various levels of the economy. 

The three most important elements that comprise the Sustainable Finance Framework are:

1. The E.U. Taxonomy Regulation;
2. The Corporate Sustainability Reporting Directive (CSRD); and
3. The Sustainable Finance Disclosure Regulation (SFDR). 

The three elements are separate, but closely interlinked. While the E.U. Taxonomy provides the classification framework for sustainable activities, the CSRD regulates sustainability reporting and the SFDR defines the disclosure requirements for selling financial products. 

The E.U. Taxonomy Regulation

The E.U. Taxonomy Regulation (“the Taxonomy”) sets criteria to determine whether an economic activity can be considered sustainable. 

The Taxonomy provides companies and investors with appropriate definitions of economic activities that can be considered environmentally sustainable. The aim is to create security for investors, protect private investors from greenwashing, help companies become more climate-friendly, mitigate market fragmentation and help shift investments where they are most needed. ¹

The Taxonomy establishes six environmental objectives:

1. Climate change mitigation;
2. Climate change adaptation;
3. The sustainable use and protection of water and marine resources;
4. The transition to a circular economy;
5. Pollution prevention and control; and
6. The protection and restoration of biodiversity and ecosystems.

It sets out four overarching conditions that an economic activity must meet in order to qualify as environmentally sustainable. According to the Taxonomy, a sustainable economic activity has to be (i) assigned to a defined taxonomy activity, (ii) contribute substantially to one of the six environmental objectives above, (iii) not significantly harm any of the remaining environmental objectives, and (iv) comply with a series of minimum social safeguards.

The Taxonomy has applied to certain, large E.U. companies from 1 January 2021. 

The Taxonomy will apply to non-E.U. companies with a net turnover over €150,000,000 (approx. U.S. $165 million) in the E.U., if they have at least one subsidiary or branch in the E.U. and exceed certain other thresholds. For such companies, the Taxonomy will apply from 1 January 2028, with reports due in 2029.

The Corporate Sustainability Reporting Directive

The Corporate Sustainability Reporting Directive (“CSRD”) establishes a uniform framework for the reporting of non-financial data for companies operating in the European Union.

The CSRD aims to provide greater transparency and more comparable and standardised information on how companies perform from a sustainability perspective. This information is essential for funds and fund managers seeking to integrate ESG considerations into their investment decisions and to comply with their obligations under the E.U. Sustainable Finance Framework.

The CSRD will replace the existing Non-Financial Reporting Directive (NFRD), significantly extending the scope of companies required to report and expanding the range of reporting requirements. Companies will have to cover key ESG areas such as the environment, human rights, social responsibility and diversity in their reports.

A key concept introduced by the CSRD is double materiality. Double materiality means that companies must consider and report on not only the impact of environmental changes on their business, but also on the impact of their operations on the environment (including social and governance issues).

The CSRD is applicable to non-E.U. parent companies which either:

1. Have securities listed on an E.U. regulated market and have more than 500 employees, or
2. Have a qualifying E.U. branch or subsidiary (see below) and generate net turnover of more than €150 million in the E.U. over two consecutive years.

A qualifying E.U. branch is one having net turnover of more than €40 million. 

A qualifying E.U. subsidiary is a large company being one that exceeds any two of: 

1. 250 employees;
2. €40 million net turnover;
3. €20 million total assets;

or a small or medium-sized entity (SME) with securities listed on an E.U. regulated market.

The CSRD will begin to impact the 2024 reporting period for in-scope, E.U. companies. 

For non-E.U. parent companies, CSRD consolidated sustainability reporting requirements on their E.U. operations will be required from their 2028 financial year. However, if the non-E.U. parent company has securities listed on an E.U. regulated market and has more than 500 employees, its individual and consolidated reporting obligations will start from its 2024 financial year.

Sustainable Finance Disclosure Regulation

The Sustainable Finance Disclosure Regulation (“SFDR”) is a set of rules which require financial market participants (i.e., fund managers) to provide information about how they deal with negative environmental and social impacts and risks of their investments.

The disclosure requirements of the SFDR are intended to illustrate to investors and the public the extent to which companies or products meet sustainability benchmarks. Fund managers must disclose how sustainability risks are considered in their investment process, what metrics they use to assess ESG factors and how they consider investment decisions that might result in negative effects on sustainability factors.

The SFDR requires disclosures at the company level as well as at the product level.

In addition, financial companies must disclose their principal adverse impacts (PAIs) on sustainability. PAIs consist of mandatory, core indicators and additional opt-in indicators from the areas of greenhouse gas emissions, energy efficiency, biodiversity, water, waste, social and employee affairs, human rights and corruption. The information on PAIs must be published on in-scope companies’ websites.

At the product level, the SFDR distinguishes three categories of financial products, with different levels of disclosure requirements depending on classification:

• General financial products (“Article 6 funds”);
• ESG financial products with environmental or social characteristics (“Article 8” or “light green funds”); and
• ESG financial products with the aim of sustainable investment (“Article 9” or “dark green funds”).

Mandatory disclosure of sustainability data under SFDR has been in place since 10 March 2021.

Non-E.U. fund managers will be in scope to the extent that they register any of their funds for marketing under national private placement rules in any E.U. member state. They are also potentially in scope to the extent that they manage or advise E.U.-domiciled funds, even if those funds are not privately placed in the E.U.

The three regulatory requirements above are interlinked with some overlap in terms of content. The Taxonomy defines what is considered sustainable under any financial product level information disclosed by investee companies under the CSRD. The reporting provided by the CSRD will be used by fund managers to satisfy the PAI disclosures under SFDR.²

¹https://finance.ec.europa.eu/sustainable-finance/tools-and-standards/eu-taxonomy-sustainable-activities_en
²https://www.eiopa.europa.eu/system/files/2022-11/jc_2022_62_jc_sfdr_qas.pdf 

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• The European Union’s (E.U.’s) Sustainable Finance Framework and Application for Non-E.U. Fund Companies: An overview of the E.U. Taxonomy, Corporate Sustainability Reporting Directive (CSRD) and Sustainable Finance Disclosure Regulation (SFDR)