ESG: the EU Taxonomy Regulation, SFDR and CSRD
Unlocking the Path to Sustainability
To facilitate the transition of the European Union's economy and achieve its ambitious climate-neutrality target, the EU relies not only on public investment, but also on private investment. As an integral component of the European Green Deal, the EU has introduced the Sustainable Finance Framework, designed to integrate sustainability considerations across different sectors of the economy. This framework incorporates EU regulations aimed at enhancing corporate transparency and promoting sustainable investments, with the three key regulations being:
the Taxonomy Regulation (EU) 2020/852 (the “Taxonomy Regulation”)
the Sustainable Finance Disclosure Regulation (EU) 2019/2088 (the “SFDR”), and
the Corporate Sustainability Reporting Directive (EU) 2021/0104 (the “CSRD”) which will soon replace the Non-Financial Reporting Directive 2014/95/EU, (the “NFRD”).
This legislative package represents a groundbreaking development for sustainable finance, sustainable investment, and ESG reporting. By providing a clear classification system and comprehensive criteria, the Taxonomy Regulation aims to combat greenwashing and guide investment flows towards environmentally sustainable activities. The disclosure and reporting obligations accompanying the Taxonomy Regulation, as well as those found in the SFDR and CSRD, which are interlinked, enhance transparency and enable stakeholders to make informed decisions. Companies, especially those that are new to reporting, should proactively prepare for the disclosure and reporting requirements set forth by the regulations to ensure a seamless implementation process.
The Taxonomy Regulation
The Taxonomy Regulation, introduced in 2020, provides a harmonised framework across the EU Member States aimed at providing clarity and fostering confidence in sustainable investments. It establishes a comprehensive pan-European classification system (or taxonomy), enabling financial market participants to identify and report to what degree their economic activities can be considered as environmentally sustainable thus allowing them to make well-informed decisions when making investments.
What is its scope?
The Taxonomy Regulation applies to:
(a) “financial market participants” who make available “financial products” which either (i) have environmental sustainability as their objective or (ii) promote environmental characteristics; and
(b) undertakings which are subject to the obligation to publish a non-financial statement or a consolidated non-financial statement pursuant to Directive 2013/34/EU, known as the Accounting Directive.
Pursuant to the SFDR, “financial market participant” means:
an insurance undertaking which makes available an insurance‐based investment product (IBIP);
an investment firm which provides portfolio management;
an institution for occupational retirement provision (IORP);
a manufacturer of a pension product;
an alternative investment fund manager (AIFM);
a pan‐European personal pension product (PEPP) provider;
a manager of a qualifying venture capital fund registered in accordance with Regulation (EU) No 345/2013;
a manager of a qualifying social entrepreneurship fund registered in accordance with Regulation (EU) No 346/2013;
a management company of an undertaking for collective investment in transferable securities (UCITS management company); or
a credit institution which provides portfolio management;
and, “financial products” means:
a portfolio managed in accordance with Article 4(1) of Directive 2014/65/EU (MiFID II);
an alternative investment fund (AIF);
an Insurance-based Investment Product;
a pension product;
a pension scheme;
an Undertaking for Collective Investment in Transferable Securities (UCTIS) fund; or
a Pan-European Personal Pension Product.
Defining Sustainable Economic Activities
At the core of the Taxonomy Regulation lies the definition of a sustainable economic activity. To qualify as sustainable, an activity must meet two key criteria.
Firstly, it must make a substantial contribution to at least one of the six environmental objectives specified in the Taxonomy Regulation. These objectives include:
(a) climate change mitigation,
(b) climate change adaptation,
(c) sustainable use and protection of water and marine resources,
(d) transition to a circular economy,
(e) pollution prevention and control, and
(f) protection and restoration of biodiversity and ecosystems.
Secondly, a sustainable economic activity must "do no significant harm" (DNSH) to any environmental objectives, while respecting basic human rights and labour standards. This principle ensures that an activity does not undermine the overall sustainability goals and avoids negative impacts on the environment or society. Further, the activity should be carried out in compliance with minimum safeguards and adhere to certain technical screening criteria established by the EU Commission.
Financial market participants are required to disclose how and to what extent they utilise these criteria to determine whether their investments are environmentally sustainable.
Technical Screening Criteria (the “TSC”) and Compliance
To determine whether an activity meets the criteria for sustainability, the Taxonomy Regulation relies on Technical Screening Criteria (TSC). These criteria define specific requirements and thresholds that an activity must meet to be considered a significant contribution to a sustainability objective. The TSCs are developed through Delegated Acts, which provide detailed guidance on the assessment of activities.
The concept of "do no significant harm" is a crucial element of the Taxonomy Regulation. It sets thresholds for environmental performance, ensuring that an activity does not cause significant harm to any of the objectives. Compliance with the DNSH principle is essential for an activity to be classified as sustainable.
Enabling and Transitional Activities
The Taxonomy Regulation distinguishes between enabling activities and transitional activities. Enabling activities are those that directly enable other activities in making a substantial contribution to the Taxonomy Regulation’s environmental objectives. These activities must have a substantial positive environmental impact throughout their lifecycle and should not lead to a “lock-in” of assets that hinder long-term sustainability goals.
Transitional activities, on the other hand, are those that contribute to climate change mitigation and support the transition to a low-carbon economy. These activities may not meet all the criteria for sustainability but play a crucial role in the transition process. To qualify as transitional, an activity must not have technologically or economically feasible low-carbon alternatives, it shall demonstrate the best performance in terms of greenhouse gas emissions within its industry, avoid hindering the development and deployment of low-carbon alternatives and does not lead to a lock-in of carbon-intensive assets.
Disclosure Obligations for Financial Market Participants
The Taxonomy Regulation goes beyond being a mere classification system. It also imposes new disclosure obligations on financial market participants. These obligations aim to enhance transparency and enable investors to assess the degree of alignment of their investments with the Taxonomy Regulation.
The main disclosure obligation imposed on financial market participants under the Taxonomy Regulation is the requirement to disclose how and to what extend they use the criteria for environmentally sustainable economic activities to determine the environmental sustainability of their investments. However, the Taxonomy Regulation goes even further and extends this obligation to financial market participants which do not take into account the criteria for environmentally sustainable investments. Such financial market participants are required to provide a statement to this end.
The Taxonomy Regulation supplements the above-mentioned disclosure obligations by imposing additional mandatory disclosure obligations under the NFRD and the SFDR. Under the NFRD, which will be replaced by the CSRD and will remain into force until companies have to comply with the CSRD, in scope companies must disclose information on the extent to which their activities are associated with environmentally sustainable activities. This includes disclosing the proportion of turnover derived from activities falling under the Taxonomy Regulation, as well as the proportion of capital and operating expenditure associated with these activities.
The Sustainable Finance Disclosure Regulation (the “SFDR”)
The Taxonomy Regulation goes beyond being a mere classification system. It also imposes new disclosure obligations on financial market participants. These obligations aim to enhance transparency and enable investors to assess the degree of alignment of their investments with the Taxonomy Regulation.
The main disclosure obligation imposed on financial market participants under the Taxonomy Regulation is the requirement to disclose how and to what extend they use the criteria for environmentally sustainable economic activities to determine the environmental sustainability of their investments. However, the Taxonomy Regulation goes even further and extends this obligation to financial market participants which do not take into account the criteria for environmentally sustainable investments. Such financial market participants are required to provide a statement to this end.
The Taxonomy Regulation supplements the above-mentioned disclosure obligations by imposing additional mandatory disclosure obligations under the NFRD and the SFDR. Under the NFRD, which will be replaced by the CSRD and will remain into force until companies have to comply with the CSRD, in scope companies must disclose information on the extent to which their activities are associated with environmentally sustainable activities. This includes disclosing the proportion of turnover derived from activities falling under the Taxonomy Regulation, as well as the proportion of capital and operating expenditure associated with these activities.
The Corporate Sustainability Reposting Directive (the “CSRD”)
The CSRD, which is due to replace the NFRD, strengthens and expands the scope of existing reporting requirements as it estimated to put into scope nearly 50,000 EU companies, a substantial increase from the previous count of around 11,000 companies. Adopted in January 2023, EU Member States have until 6 July 2024 to transpose the CSRD into national law. The CSRD establishes a harmonised framework across the EU for the reporting of non-financial data such as companies' environmental practices, human rights considerations, social responsibility initiatives, diversity efforts, and more. Most importantly, the CSRD will apply the so-called ‘double materiality’ principle as it will require companies to disclose information on sustainability matters that affect the company, as well as the impacts of the company on sustainability matters. The CSRD will apply in the following four stages:
(a) large undertakings which are ‘public-interest entities’ (those already subject to the NFRD) and public-interest entities which are parent undertakings of large groups, both having more than 500 employees reporting in 2025 on financial year 2024;
(b) all other large companies (not currently subject to the NFRD) reporting in 2026 on financial year 2025;
(c) listed public-interest SMEs (except micro undertakings), small and non-complex institutions and captive insurance undertakings reporting in 2027 on financial year 2026; and
(d) non-EU undertakings with (i) an EU-established large subsidiary or a listed SME subsidiary or (ii) a large EU branch reporting in 2029 on financial year 2028.
The impact on stakeholders
The Taxonomy Regulation, the SFDR and the CSRD have far-reaching implications for various stakeholders, including companies, investors, and policymakers.
For companies, they present an opportunity to demonstrate their commitment to sustainability and attract investors seeking environmentally friendly investments. They also provide a framework to align their activities with the EU’s sustainability goals and incorporate environmental considerations into their business strategies.
Investors will benefit from the transparency and clarity that these legislations uphold, allowing them to identify and invest in sustainable assets with confidence. The disclosure requirements will enable investors to assess the environmental sustainability of financial products, making it easier to compare investment options and align their portfolios with their sustainability objectives.
Policymakers will have a tool to guide and direct investments towards environmentally sustainable activities. By providing a common language and framework, they will facilitate the implementation of the European Green Deal and support the transition to a sustainable and climate-neutral economy.
Looking ahead: the future of the Taxonomy Regulation
The Taxonomy Regulation is a significant step towards achieving the EU’s sustainability goals. However, its current focus is primarily on environmental objectives. There is ongoing discussion about expanding the Taxonomy Regulation to include social objectives and a broader range of environmental factors. This could result in an even more comprehensive framework for sustainable investment.
Furthermore, the Taxonomy Regulation could serve as a benchmark for other EU policies and initiatives. For example, the EU Green Bond Standard is expected to align with the Taxonomy Regulation, creating a direct link between sustainable investments and capital markets. Additionally, the EU Ecolabel for retail financial products is being developed with reference to the Taxonomy Regulation, further integrating sustainability considerations into financial product labelling.
As the Taxonomy Regulation continues to evolve, it will shape the future of sustainable finance, guide investment decisions, and contribute to the transition to a more sustainable and resilient economy.
Upcoming: new legal package
A new package of measures aimed at strengthening the EU sustainable finance framework has recently been put forward by the EU Commission. By doing so, companies will be better supported in their transition towards sustainability while also contributing further to the objectives of the European Green Deal.
The package includes:
a new Environmental Delegated Act which will establish TSC for activities that can make a substantial contribution to the following environmental objectives: (a) sustainable use and protection of water and marine resources; (b) the transition to a circular economy; (c) pollution prevention and control; and (d) protection and restoration of biodiversity and ecosystems;
amendments to the Climate Delegated Act which will include economic activities that make a substantial contribution to the environmental objectives of (a) climate change mitigation and (b) climate change adaptation;
a proposal for a Regulation on ESG rating activities aimed at increasing the reliability and transparency of ESG rating providers. This will include the need for ESG rating providers to acquire authorisation and be supervised by the European Securities and Markets Authority (ESMA), the requirement to adopt policies and procedures relating to, among other things, their independence, conflicts of interests and complaint handling. Further, ESG rating providers will be required to disclose the methodologies, models and key rating assumptions used in their ESG ratings, as well as refrain from providing certain activities such as consulting to investors and shall not outsource any of their important operational functions. Failure to comply with such obligations will result in hefty fines and penalties;
an EU Commission Notice in the form of Frequently Asked Questions (FAQ) on the Taxonomy Regulation and the Sustainable Finance Disclosure Regulation relating to minimum safeguards and sustainable investments; and
an EU Commission Recommendation offering practical suggestions and guidance to market participants on how they can transition to climate neutrality and environmental sustainability, which will further strengthen their competitiveness within their market.
More information
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