The rising popularity of green politics has led investors to demand more sustainable investment options and increased transparency regarding their money’s whereabouts and usage. Consequently, financial intermediaries are introducing “green” financial products. These products are undergoing regulatory development by the European Commission, aiming to direct capital towards sustainability and clarify what defines a sustainable investment.
In 2018, the European Commission tasked a group of specialists from social, financial, and academic fields to formulate a sustainable finance strategy. This strategy aims to integrate environmental, social, and governance (ESG) factors into investment choices and ensure clients receive accurate information.
To execute this strategy, the European Commission proposed several measures: a regulation establishing a framework for sustainable investment (Taxonomy Regulation), a regulation on disclosing sustainable investments and sustainability risks (Disclosure Regulation), and a regulation amending the benchmark regulation (Low Carbon Benchmark Regulation). This article examines each regulation, outlining the criteria for labeling a product as “green,” and discusses regulators’ initiatives toward sustainability.
The Taxonomy Regulation
The Taxonomy Regulation sets standardized criteria for classifying an economic activity as environmentally sustainable and eligible for a “green” label. Financial intermediaries offering green funds must specify the degree to which these criteria were employed. This measure prevents capital being raised for “green” endeavors with no clear environmental benefit.
This regulation applies to the European Union, its member states, and financial market participants, including UCITS and AIF managers, EuVECA and EuSEF managers, insurers, and pension product providers, collectively referred to as “participants” in this article.
Environmentally sustainable investment
An investment is considered environmentally sustainable if it finances one or more economic activities that significantly contribute to at least one environmental objective, don’t significantly harm any of these objectives, and adhere to minimum safeguards and technical screening criteria.
These environmental goals, as defined by the Taxonomy Regulation, encompass: mitigating and adapting to climate change, sustainably using and protecting water and marine resources, transitioning to a circular economy, preventing and recycling waste, controlling and preventing pollution, and protecting healthy ecosystems.
These activities must comply with Article 12 of the Taxonomy Regulation, which determines if an economic activity significantly harms any environmental objective.
Minimum safeguards
Economic activities must respect minimum social and governance standards, adhering to the principles and rights outlined in the International Labour Organisation’s declaration on Fundamental Rights and Principles at Work. This ensures that financial intermediaries don’t neglect social factors while promoting environmentally sustainable products.
Technical screening criteria
Economic activities must also meet the technical screening criteria detailed in Article 14 of the Taxonomy Regulation. These criteria involve identifying significant potential contributions to the environmental objective (considering both short and long-term impacts), specifying minimum requirements to avoid harm to other objectives, and utilizing qualitative and/or quantitative thresholds whenever feasible. They also stipulate building upon existing EU labeling and certification schemes, methodologies for assessing environmental footprint, and statistical classification systems.
Further criteria mandate using conclusive scientific evidence, high-quality research, and market experience, considering the economic activity’s life cycle and its nature and scale, and accounting for potential market liquidity impacts. Additionally, the criteria address the risk of asset stranding due to value loss during the transition to a sustainable economy and the risk of creating conflicting incentives.
Lastly, they emphasize covering all relevant economic activities within a sector and ensuring equal treatment for activities that contribute equally to environmental objectives, thereby preventing market distortion. Criteria should also facilitate compliance verification whenever possible.
An investment is eligible for the “green” and EU-compliant label if it supports one or more environmental objectives without significant harm, adheres to minimum safeguards, and meets technical screening criteria. However, the Taxonomy Regulation currently focuses solely on environmental factors. Social and governance-related investments are expected to be regulated under separate legislative proposals.
The Disclosure Regulation
While the Taxonomy Regulation defines environmentally sustainable activities, the Disclosure Regulation outlines how managers must provide information to enhance investor clarity and transparency.
Websites
Participants must publish and regularly update policies on their websites detailing how sustainability risks are integrated into investment decisions. The website must include: a description of the sustainable investment target, information on methodologies used to assess, measure, and monitor the impact of sustainable investments (including data sources, screening criteria for underlying assets, and relevant sustainability aspects), an index or target as needed, and the information included in periodic reports (discussed below). Investors should have easy access to methodologies used for index and benchmark calculations.
Pre-contractual disclosures
Pre-contractual disclosures must describe: procedures for integrating sustainability risks into investment decisions, the anticipated impact of sustainability risks on financial product returns, and alignment of participant remuneration policies with sustainability risk integration and the financial product’s sustainable investment target, when applicable.
Financial products with an index
For financial products targeting sustainable investments with an designated index as a reference benchmark, disclosures must include: information on the index’s alignment with the target and an explanation of any discrepancies between the index’s weighting, constituents, and a broad market index.
Financial products with no index
For similar products without a designated index, disclosures must explain how the sustainability target is achieved.
Periodical reports
Periodic reports (annual or interim) must include: the financial product’s overall sustainability impact, measured through relevant indicators, and for products with a designated index, a comparison between the product’s overall impact, the designated index, and a broad market index, in terms of weighting, constituents, and sustainability indicators.
The Low Carbon Benchmark Regulation
The Low Carbon Benchmark Regulation introduces a new benchmark category: low-carbon and positive carbon impact benchmarks. This provides investors with clearer information on their investments’ carbon footprint.
A low-carbon benchmark comprises assets selected for having lower carbon emissions than a standard capital-weighted benchmark, while a positive carbon impact benchmark includes assets whose carbon emission savings surpass their carbon footprint.
Due to the rise of ESG benchmarks, the Low Carbon Benchmark Regulation requires disclosing how the methodology for each benchmark or family of benchmarks incorporates ESG factors, enabling informed investor decisions.
Technical report on the Taxonomy
The European Commission formed a technical expert group (TEG) to create a unified classification system called a Taxonomy. In 2019, the TEG released a report proposing technical screening criteria for 67 activities across various sectors (agriculture, forestry, manufacturing, energy, transportation, water, waste, ICT, and buildings) that can significantly contribute to climate change mitigation. The report also includes methodologies, examples, and guidance for evaluating substantial contributions to climate change adaptation.
The TEG’s mandate was extended to refine the proposed criteria and provide further implementation guidance. To avoid burdening participants, the Taxonomy will be implemented only after achieving stability and maturity. Fund managers must thoroughly analyze each activity they consider for investment to ensure compliance with the Taxonomy’s criteria.
Financial regulators’ initiatives towards sustainability
While some countries monitor the EU’s green finance regulations, others have enacted domestic legislation to protect investors in green products. This will be analyzed alongside initiatives in third countries like China and Hong Kong, which are actively contributing to a greener economy.
EU Member States
France
France is at the forefront of sustainability. Article 173-VI of France’s Law on Energy Transition for Green Growth (LTECV) requires asset management companies and institutional investors to disclose the social and environmental impacts of their activities, including effects on climate change, social factors, the circular economy, food waste reduction, discrimination, and diversity promotion. However, a “comply or explain” principle allows for flexibility if valid reasons for non-compliance are provided.
In 2019, France’s financial regulator, the Autorité des Marchés Financiers (AMF), established the Climate and Sustainable Finance Commission, composed of experts tasked with improving the collective understanding of sustainability challenges.
The AMF is reviewing KIIDs and prospectuses of French-authorized funds to ensure clear, accurate, and non-misleading information from asset management companies regarding their investment strategy and climate-related risks. The PACTE Law further reinforced the AMF’s supervisory authority in this area.
United Kingdom
The United Kingdom’s Financial Conduct Authority (FCA) released a Discussion Paper on Climate Change and Green Finance in 2018. The FCA intends to hold firms accountable for misleading information regarding their “green” activities and will take necessary actions (e.g., issuing policies and guidance) to prevent consumer deception and align UK regulations with EU regulations.
The UK’s exit from the EU is not expected to affect its compliance with EU legislative proposals. The Taxonomy Regulation, the Disclosure Regulation, and the Low Carbon Benchmark Regulation were included in the Financial Services (Implementation of Legislation) Bill 2017-2019 as pending EU legislation to be adopted domestically. These regulations will likely be integrated into UK law during the UK’s withdrawal from the EU and throughout any transition period.
Italy
Italy’s financial regulator, the Commissione Nazionale per le Società e la Borsa (CONSOB), recently formed a Steering Committee to monitor EU proposals, studies, research, and analyses on sustainable finance.
Regarding domestic legislation, the Regulation implementing Legislative Decree no. 58 of February 24, 1998 (Decree 58) requires intermediaries to provide accurate information on products and services labeled “ethical” or “socially responsible.” This includes information on objectives, characteristics, selection criteria, voting rights policies, and generated income. This information must be published on the firm’s website and disclosed annually.
Non-EU Member States
China
In 2017, the China Securities Regulatory Commission (CSRC) introduced standards for semi-annual and annual reports from listed companies, requiring them to report on ESG matters. These standards are mandatory for major polluters and apply on a comply-or-explain basis for other listed companies. By 2020, the CSRC plans to mandate environmental risk disclosure for all listed companies and bond issuers.
China’s guidelines for a green financial system encourage securities regulators to increase penalties for listed companies and bond issuers that misrepresent environmental information.
Hong Kong
The Securities and Futures Commission of Hong Kong (SFC) issued a circular concerning SFC-authorized funds that consider ESG factors in their investment objectives or strategies. Consequently, offering documents for these funds must provide sufficient information for investors to make informed decisions, including investment focus, green or ESG criteria, and principles. Green fund managers are obligated to regularly monitor underlying investments to ensure alignment with the fund’s investment objective and the SFC’s circular.
The SFC is developing a centralized, publicly available database of green funds that meet the criteria outlined in the SFC’s circular, expected to launch by the end of 2019.
Conclusions
Managers offering “green” financial products must understand the European Commission’s proposals. These products need to meet the Taxonomy Regulation’s criteria, and participants must provide clear and accurate information to empower investors to make well-informed choices. The Taxonomy Regulation, applicable to climate change mitigation and adaptation activities from July 1, 2020, requires financial intermediaries to adapt if their funds invest in these economic activities.
The European Commission allows EU member states to implement domestic legislation on green products, potentially enabling the establishment of national frameworks that facilitate sustainable investments, such as special tax regimes for green funds.
However, the International Organization of Securities Commissions (IOSCO) identified inconsistencies in national sustainable finance legislation, potentially undermining investor confidence. The European Securities and Markets Authority (ESMA) highlights the need for international coordination and the promotion and implementation of sustainability by global regulators. Consistent measures across jurisdictions would encourage marketing green funds globally, boosting capital flow toward sustainability.
The Taxonomy presents a viable solution for a unified classification system, but further action is required to enhance investor confidence. Other regulators should consider the SFC’s dedicated webpage for ESG-compliant funds, as this could positively impact green fund investments.
EU regulators could consider the CSRC’s initiative to mandate requirements and penalize misleading information. Mandating EU requirements and penalizing non-compliant financial intermediaries would strengthen investor protection and discourage marketing funds as “green” without clear environmental benefits.
Further reading:
European commission, Green Finance: Overview. Available at https://ec.europa.eu/info/business-economy-euro/banking-and-finance/green-finance_es.
FCA, Discussion Paper (18/8) on Climate Change and Green Finance.
Barnard & Peers: chapter 23
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