The European Union's Sustainable Finance Framework - What Financial Market Participants Need to Know

Josef Bergt

2023

Introduction

The transition to a sustainable and climate-neutral economy is an imperative that has been gaining traction in both public discourse and legislative action. The financial market plays a pivotal role in this transformation, serving as both a conduit and a catalyst for change. Financial market participants, ranging from product providers to institutional investors, have the potential to significantly mitigate the impacts of climate change and facilitate the transition to a more resilient and sustainable economy. This article aims to elucidate the intricate regulatory frameworks and initiatives, particularly within the European Union, that are designed to steer capital flows towards sustainable investments and to enforce measures that address financial risks arising from climate change, natural disasters, and social issues.

European Commission's Action Plan and the Green Deal

The European Commission's Action Plan for Sustainable Finance and the Green Deal serve as the foundational pillars for the legal framework concerning sustainable finance, falling under the purview of the national competent supervisory authorities. These initiatives aim to integrate Environmental, Social, and Governance (ESG) aspects into the regulatory and supervisory framework, thereby redirecting capital flows towards sustainable investments and enhancing transparency and long-term planning in financial and economic activities.

Taxonomy Regulation (TR)

The Taxonomy Regulation (EU 2020/852) serves as a central legal act in European regulation concerning sustainable finance. It establishes criteria for determining whether an economic activity can be classified as environmentally sustainable. The regulation sets forth specific environmental objectives and provides a legal definition for environmentally sustainable economic activities. Financial market participants must also adhere to transparency requirements concerning sustainable investments, as stipulated in Articles 5 to 8 of the Taxonomy Regulation.

It provides a legal definition for ecologically sustainable economic activities, specifying criteria that contribute to various environmental objectives such as climate protection, adaptation to climate change, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention, and biodiversity and ecosystem restoration. The regulation also outlines transparency requirements for financial market participants, particularly in pre-contractual information and regular reports concerning ecologically sustainable investments. 

Sustainable Finance Disclosure Regulation (SFDR)

The SFDR (EU 2019/2088) creates a harmonized legal framework for financial market participants and financial advisors regarding transparency in the incorporation of sustainability risks and the consideration of adverse sustainability impacts in their processes. It mandates disclosures on websites and in pre-contractual documents, varying depending on whether the financial product promotes ecological or social characteristics or aims for a sustainable investment.

Effective since March 10, 2021, the regulation mandates key disclosure obligations, including website disclosures on sustainability risk strategies, adverse sustainability impacts at the corporate level, and the consideration of sustainability risks in remuneration policies. It also requires transparency in pre-contractual documents concerning sustainability risks and adverse impacts at the financial product level. The regulation differentiates between financial products that promote ecological or social characteristics ("light green" products) and those targeting sustainable investment ("dark green" products). Delegated Regulation (EU) 2022/1288 further specifies technical regulatory standards, including content, methodology, and presentation of sustainability-related information, and introduces reporting templates for Principal Adverse Impacts (PAI) and reports under Articles 8 and 9. Effective since January 1, 2023, the competent national supervisory authorities have in geeral been designated as the authority responsible for enforcing these disclosure obligations.

Benchmark Regulation (BR) and Other Regulatory Amendments

The Benchmark Regulation (EU 2019/2089) introduces EU benchmarks for climate-related changes and sustainability-related disclosures for benchmarks. Additionally, amendments to delegated legal acts in securities and insurance supervision law (Solvency II, IDD, MiFID II, AIFMD, UCITSD) have been published, focusing on the integration of sustainability risks and factors.

Corporate Sustainability Reporting Directive (CSRD)

The CSRD significantly modifies existing sustainability reporting requirements, extending the obligation to all large companies and listed small and medium-sized enterprises. It introduces mandatory standards for sustainability reporting and mandates external verification of sustainability reports.

The directive expands the scope to include all large companies, regardless of stock market listing, and publicly listed small and medium-sized enterprises, with some exceptions for the latter. Micro-enterprises are exempt. The directive introduces mandatory sustainability reporting standards and requires the inclusion of the sustainability report in the management report, eliminating the option for a separate report. It also mandates external verification of the sustainability report. The European Financial Reporting Advisory Group (EFRAG) is responsible for the technical development of the European Sustainability Reporting Standards (ESRS). The CSRD will be applicable for fiscal years starting on or after January 1, 2024, with staggered applicability based on company type. Legislative implementation on a national level is expected in 2023.

Source: FMA Austria on Sustainable Finance

Executive Summary:

  • The European Commission's Action Plan and the Green Deal serve as the bedrock for sustainable finance regulations.
  • The Taxonomy Regulation provides a legal framework for classifying environmentally sustainable economic activities.
  • The SFDR mandates sustainability-related disclosures for financial market participants.
  • Amendments to existing regulations like Solvency II, IDD, MiFID II, AIFMD, and UCITSD integrate sustainability risks and factors.
  • The CSRD expands and strengthens sustainability reporting requirements.