In October 2014, the European Commission set an ambitious economy-wide target of at least 40 per cent greenhouse gas emission reduction for 2030 (as compared to the levels in 1990), as well as renewable energy and energy efficiency targets of at least 27 per cent. This target was agreed in 2015 through the Paris Climate Agreement.
The UK’s pledge to reduce emissions was made as part of a joint pledge with members of the European Union set out in the Paris Climate Agreement (and the UK’s decision to leave the EU does not absolve it of the commitments it has made to date).
To achieve the target set out in the Paris Climate Agreement, a High Level Expert Group (HLEG) on Sustainable Finance was appointed by the European Commission and in January 2018 HLEG published a report offering a sustainable finance strategy for the EU.
HLEG’s recommendations formed the basis of an action plan on sustainable finance adopted by the European Commission and published in March 2018 (Action Plan).
Proposed legislative changes arose from the Action Plan, including:
- Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment, and amending regulation (EU) 2019/2088 (often referred to as the Taxonomy Regulation);
- Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial sector (often referred to as the Disclosure Regulation or the SFDR); and
- Regulation (EU) 2019/2089 amending regulation (EU) 2016/1011 as regards EU Climate Transition Benchmarks, EU Paris-aligned Benchmarks and sustainability-related disclosures for benchmarks.
As part of the Action Plan, the European Commission has also published, and is consulting on, six draft delegated acts which amend MiFID II, AIFMD, the UCITS Directive, Solvency II and the IDD. In-scope firms will need to consider sustainability factors across their organisations, including organisational requirements, product and service offerings and product governance processes.
We have set out overleaf a summary of the Taxonomy Regulation and the Disclosure Regulation.
The Taxonomy Regulation introduces an EU-wide classification system of environmentally sustainable activities, aiming to provide more clarity for investors concerning financial products which purport to invest in sustainable activities or promote environmental objectives.
To qualify as environmentally sustainable, amongst other things, an activity has to contribute to at least one of the following environmental objectives:
- climate change mitigation;
- climate change adaptation;
- sustainable use and protection of water and marine resources;
- transition to a circular economy, waste prevention and recycling;
- pollution prevention and control; and
- protection of healthy ecosystems.
The Taxonomy Regulation entered into force on the 12th of July 2020, however, many of the key provisions will not apply until after the adoption of delegated acts which establish the screening criteria for each environmental objective. The provisions relating to each environmental objective will become applicable six months after the technical screening criteria are established (with the aim to give firms sufficient time to prepare).
In June 2020, the UK government described its intended approach to the Taxonomy Regulation. John Glen MP said that the UK would retain the taxonomy framework, including high-level environmental objectives but as to the details to be set out in delegated acts supplementing the Taxonomy Regulation, the UK Government would not at this stage confirm the extent to which the UK will align with EU law in this area.
The Disclosure Regulation
The Disclosure Regulation will apply at both the firm and product level, irrespective of whether a firm or product has an environmental, social and governance (ESG) focus.
The Disclosure Regulation applies to investment firms and credit institutions that provide portfolio management (amongst others). It also applies to firms that provide financial advice.
The products that the Disclosure Regulation applies to are numerous, including portfolios managed under MiFID II, AIFs and UCITS.
The key requirements on firms in the Disclosure Regulation include:
- publishing information on their website about their policies on the integration of sustainability risks in their investment decisions-making process;
- publishing and maintaining on their website a statement on due diligence policies relating to the principal adverse impacts of investment decisions on sustainability factors where those are considered or, where those are not considered, publishing and maintaining clear reasons why they do not consider these and whether they intend to do so in the future;
- including in their remuneration policies information on how those policies are consistent with the integration of sustainability risks, and publishing that information on their websites;
- including in pre-contractual disclosures the way sustainability risks are integrated into investment decisions or investment advice and the results of the assessment on the likely impacts of sustainability risks on the returns of the financial products they make available or advise on; and
- including in pre-contractual disclosures clear and reasoned explanations on whether and how a financial product considers principal adverse impacts on sustainability factors. If principal adverse impacts are considered, a statement should be included in the disclosure that information on principal adverse impacts on sustainability factors is available in the financial product’s periodic report, and
where principal adverse impacts are not considered, a statement to that effect and the reasons for this.
The Disclosure Regulation also sets out particular requirements in relation to sustainable investments and products promoting environmental and social characteristics. Here, the Disclosure Regulation and the Taxonomy Regulation are closely connected. For example, they share certain concepts such as the “do no significant harm” principle (DNSH).
While the Disclosure Regulation is expected to apply from the 10th of March 2021, the detail of the Taxonomy Regulation is still being developed, including an RTS on the DNSH concept. Some firms have expressed concern that the RTSs under the Taxonomy Regulation, helpful in understanding concepts stated in the Disclosure Regulation, will not be developed before their disclosure obligations kick in.
At the moment, we expect that the Disclosure Regulation will be on-shored into UK domestic law at the end of the transition period but that the UK may decide to depart from some of the requirements in the draft regulatory technical standards that supplement the Disclosure Regulation.
Additional developments in relation to sustainability
In December 2019, under increased global pressure to act on climate change, the EC presented a growth strategy aiming to make Europe the first climate neutral continent by 2050. Separately, the UK has also set itself the target to bring greenhouse gas emissions to net zero by 2050.
The European Commission has recently consulted on its renewed strategy on sustainable finance. The consultation closed in July and we await a follow-up publication from the European Commission confirming its future strategy.
In the UK, the PRA and FCA formed the Climate Financial Risk Forum which has recently published a guide to help industry address climate-related risks. The guide covers management, scenario analysis, disclosures and innovation along with case studies which firms should use to inform their approaches to managing climate-related risks.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, September 2020