key points for private fund managers

On 13 June the European Commission (the Commission) published a new package of measures to bolster the EU sustainable finance framework. 

Its aim is to: “ensure that the EU sustainable finance framework continues to support companies and the financial sector, while encouraging the private funding of transition projects and technologies.”  

Highlights

These are the highlights we think of most interest (also discussed further below):

• The Commission indicates that a consultation on assessing the Sustainable Finance Disclosure Regulation (SFDR) will be launched in autumn 2023 (which in due course may lead to ‘SFDR II’).
• There are some useful points of clarification in the Commission’s new FAQ:
  • Investments in ”environmentally sustainable economic activities” pursuant to the EU Taxonomy Regulation (Taxonomy) automatically qualify as SFDR “sustainable investment.”
  • This complements the Commission’s response in its April 2023 Q&A, that funds that passively track an EU climate benchmark fall within Article 9(3) and are deemed to have sustainable investment as an investment objective.
  • The Taxonomy criteria for when an economic activity can qualify as environmentally sustainable include compliance with minimum safeguards, which links to the SFDR’s principle of “do no significant harm” (DNSH).
  • Reporting by a company in accordance with the EU’s sustainability reporting standards (ESRS) will be deemed compliant with global standards.
• There are various new EU economic sectors and activities that make a substantial contribution to the climate change objectives.
• The Commission notes that investors and asset owners, as for financial intermediaries, can contribute to the financing of the transition by reflecting transition financing objectives in their lending or investment strategy.

Reasons for the measures 

The Commission states that early evidence shows that the sustainable finance framework is beginning to work as intended to facilitate a more sustainable economy – for example, companies are applying the Taxonomy and starting to communicate their sustainable investments based on it (albeit that, for the purposes of this assessment, only certain listed market data is referenced). 

It also notes that any policy developments under the wider framework will aim to enhance regulatory consistency and simplify implementation, among other objectives. There is also a commitment to facilitate cooperation at the international level. In our  view there is still the challenge and opportunity to be able to secure the coherence and effectiveness of the wider sustainable finance framework. 

Many of the points made in the Sustainable Finance Package either reinforce recent updates and guidance or pave the way for future developments. This short briefing sets out some features from the package that will be of interest to private fund managers.  

The measures in more detail 

We have outlined below the various limbs of the measures.

• Approval of EU Taxonomy Delegated Acts (including amendments to the Climate Delegated Act and Environmental Delegated Act) on activities and associated criteria for the six taxonomy environmental objectives. In addition to expanding on the economic activities that substantially contribute to the objectives of climate change mitigation and adaptation, the Commission sets out new criteria for economic activities making a substantial contribution to one or more of the non-climate environmental objectives (namely sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control and protection and restoration of biodiversity and ecosystems). Following the European legislative process, these will enter into force and apply from January 2024.
• Adoption of a proposal for a regulation to improve the reliability, comparability, and transparency of environmental, social, and governance (ESG) rating providers, who provide ESG information and analytics for investment strategies, risk management and rating activities. This market will now be brought under the remit of the European Securities and Markets Authority, to ensure the integrity of ESG rating providers’ operations and prevention of risks of conflicts of interests at the provider level.
• Recommendation on how transition finance interplays with the existing sustainable finance framework and how companies, investors and intermediaries can voluntarily use it to finance their transition to a climate-neutral and sustainable economy. This draft non-binding guidance supports awareness (including of member states and supervisory authorities) of those interested in raising or providing transition finance and how the various tools can be used for both investing in transition and managing climate change risks. The Platform on  Sustainable Finance and European Supervisory Authorities (ESAs) will be helping inform developments in this area.
• Staff working document that provides an overview of the key pillars of the EU sustainable finance framework and sets out five recent measures taken in order to enhance its usability and practical application (these also feed into the FAQ).  The key pillars are:
  • Taxonomy (including the Delegated Acts)
  • disclosures e.g. under SFDR, the Corporate Sustainability Reporting Directive (CSRD), Benchmarks Regulation, Markets in Financial Instruments Directive (MiFID)  suitability preference rules and European Single Access Point Regulation
  • tools for market participants and intermediaries to develop sustainable investment solutions, e.g., EU climate benchmarks and the European green bonds standards initiative
• FAQs on the application of the Taxonomy criteria and disclosure requirements for eligibility and alignment reporting

Our highlights in more detail

As we note above, these are the highlights we think of most interest for those in private funds.

• The Commission indicates that a consultation on assessing SFDR (which in due course may lead to SFDR II) will be launched in autumn 2023. This is in recognition of various shortcomings of the current regulatory framework, including the fact that SFDR has been mistakenly applied as a labelling (instead of disclosure) regime and there are inconsistent market interpretations. The review will focus on how to improve SFDR’s legal certainty and enhance its usability and role in mitigating greenwashing. This potential overhaul is also likely to affect other related sustainable finance legislation, such as the Taxonomy, Benchmark Regulation, MiFID and Alternative Investment Fund Managers Directive (AIFMD) supplemental legislation and the CSRD. However, these pending wholesale changes do not impinge on progress related to the ESA consultation on revising level 2 SFDR (see our April 2023 client alert for more information), with the Commission still expecting the ESA’s report on this in the autumn (following the 4 July 2023 deadline for public feedback). Neither should they impinge on the safe harbours covered below.
• Some useful points of clarification in the Commission’s new FAQ and recent measures, as set out below.
  • Investments in “environmentally sustainable economic activities” pursuant to the Taxonomy automatically qualify as an SFDR “sustainable investment.” This is likely to be of particular help for real estate projects , because where there is any development or transition, the assets are unlikely to fall in the SFDR “sustainable “definition as (i) no energy performance certificate (EPC) rating is available until a project is completed; and (ii) anything EPC C or below is “inefficient” and cannot be “sustainable.”  However, an effective safe harbour is now available where a fund’s activities align with the Taxonomy. The position differs for an investment through a funding instrument that does not specify the use of the proceeds, such as a general equity or debt, where the manager would have to check additional SFDR elements to ensure the whole investment in that undertaking is considered “sustainable.”
  • The above “safe harbour” is in addition to that confirmed in the Commission’s April 2023 Q&A – that funds that passively track an EU climate benchmark fall under scope of Article 9(3) SFDR and are deemed to have sustainable investment as an investment objective. The Commission notes that the lack of legal clarity in this area had been causing uncertainty, leading many funds to declassify to Article 8 in Q4 2022. It is worth noting that the position is different where a fund has a reduction in carbon emissions as its objective (also under Article 9(3) SFDR) and no such tracking, in which case the manager will still have to comply with the Article 2(17) SFDR “sustainable investments” test.
  • The Taxonomy criteria for when an economic activity can qualify as environmentally sustainable include compliance with minimum safeguards, which links to the SFDR’s DNSH principle. This is to be understood, as a minimum, through the SFDR principal adverse impact indicators for social and employee matters, respect for human rights, and anti-corruption and anti-bribery matters, and noting that this will include any future changes to these indicators (as set out in Table 1 of Annex I SFDR).  The Commission states that there should be no duplication with Taxonomy and CSRD reporting requirements.
  • Article 8 funds that promote environmental characteristics  must disclose the degree to which the fund’s investments are in economic activities that are Taxonomy-aligned in pre-contractual disclosures, regardless of whether or not the fund commits to investments in environmentally sustainable investments. The Commission confirms that complementary (i.e., additional) assessments and estimates can be used to assess the Taxonomy alignment of companies out of scope or not yet reporting under the Taxonomy.
  • Reporting by a company in accordance with the EU’s ESRS will be deemed compliant with global standards. The Commission has been working with the International Sustainability Standards Board and the Global Reporting Initiative to strive to ensure a high level of interoperability between the different sets of standards.
• There are various new EU economic sectors and activities (for example, on the themes of transport, services, buildings, manufacturing and ICT and data solutions) that make a substantial contribution to the climate change objectives and which are likely to be helpful for those using the Taxonomy as a base reference point for investments that are recognised as environmentally sustainable but that were not previously referenced.
• The Commission notes that investors and asset owners, as for financial intermediaries, can contribute to the financing of the transition by reflecting transition financing objectives in their lending or investment strategy. This may be an opportunity to engage with clients and investee undertakings on specific transition objectives, including through specific financing solutions and portfolio level targets.

To discuss the contents of this alert, please contact the authors or your usual Goodwin contact.