EU Sustainable Finance Package

The Environmental Delegated Act introduces the technical screening criteria relevant for determining whether the relevant economic activity contributes substantially to one of the four remaining environmental objectives under the EU Taxonomy Regulation and whether the activity causes no significant harm to the other objectives.  The four remaining environmental objectives covered by the Environmental Delegated Act are:

• 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.

The technical screening criteria adopt the format used for the first two environmental objectives (climate change mitigation and adaptation), and are set out in granular detail in four annexes to the Environmental Delegated Act:

• Annex I: Sustainable use and protection of water and marine resources;
• Annex II: Transition to a circular economy;
• Annex III: Pollution prevention and control; and
• Annex IV: Protection and restoration of biodiversity and ecosystems.

The Environmental Delegated Act also makes some related changes to the EU Taxonomy Disclosures Delegated Act largely to incorporate the additional four environmental objectives in Annexes V, VI and VII. 

The Environmental Delegated Act will now be subject to scrutiny by the European Parliament and Council of the European Union and is expected to come into force on 1 January 2024. 

There are, however, some transitional provisions with the effect that the key performance indicators relating to the additional technical screening criteria under the Environmental Delegated Act (as well as the additional technical screening criteria under the EU Taxonomy Climate Delegated Act – see below) will only need to be disclosed by non-financial undertakings as from 1 January 2025 and financial undertakings as from 1 January 2026.

The Commission has also issued a Delegated Regulation amending the EU Taxonomy Climate Delegated Act which includes the technical screening criteria for the environmental objectives of climate change mitigation and adaptation.

The changes include, in Annex I, additional technical screening criteria for climate change mitigation focussing on the transport and manufacturing sectors.  These include:

• Cars and other vehicles:
  • Manufacture of automotive and mobility components;
• Rail:
  • Manufacture of rail rolling stock constituents;
• Electricity:
  • Manufacture, installation and servicing of high, medium and low voltage electrical equipment for electrical transmission and distribution that result in or enable a substantial contribution to climate change mitigation;
• Aircraft:
  • Manufacturing of aircraft;
  • Leasing of aircraft;
  • Passenger and freight air transport; and
  • Air transport ground handling operations.

There are also some targeted amendments to address technical and legal inconsistencies in the existing technical screening criteria.

Additional technical screening criteria for climate change adaptation are also included in Annex II.   These include:

• Desalination;
• Software enabling physical climate risk management and adaptation; and
• Consultancy for physical climate risk management and adaptation.

There is also a new section on Disaster Risk Management including emergency services and flood risk prevention and protection infrastructure.

As with climate change mitigation, there are also some targeted amendments to address technical and legal inconsistencies.

These changes are expected to apply as from 1 January 2024 (subject to the transitional arrangements mentioned above).

Proposal for a Regulation on ESG rating providers

The proposed Regulation on ESG rating providers and Annex introduce a new regulatory regime for entities providing ESG ratings in the EU. 

It applies where ESG ratings (broadly opinions or scores on the ESG characteristics, profile, risks or impact of an instrument or undertaking based on an established methodology and defined ranking system) are disclosed publicly or distributed to EU financial undertakings, entities falling within the EU Accounting Directive or EU public authorities.  There are some exceptions such as where the rating is provided privately or used for internal purposes.

Under the proposed Regulation, EU entities providing ESG ratings will need to be authorised by ESMA or, subject to conditions, will be able to endorse ESG ratings provided by a non-EU affiliate.  Non-EU entities will only be able to provide ESG ratings in the EU if they are able to benefit from an equivalence decision covering their jurisdiction (and certain other requirements are met) or, in the case of certain entities with low levels of ESG rating activities (broadly below €12 million) have been subject to a recognition decision by ESMA.  ESMA will maintain a register of ESG ratings providers.

ESG ratings providers will need to comply with a number of organisational requirements.  These include limitations on the other services that they can provide. In particular, they will not be able to provide certain consulting services, develop benchmarks or carry on investment or banking activities.

ESG ratings providers will also have to adopt a wide range of policies and procedures aimed at ensuring the independence of their ratings activities as well as the quality of the ESG ratings provided.  There are also strict requirements in respect of conflicts of interest including requirements to take measures to prevent and mitigate conflicts of interest, requirements to disclose conflicts to ESMA and powers to ESMA to require the ESG ratings provider to take action to address conflicts of interest.  Complaints-handling and outsourcing requirements also apply.   

ESG ratings providers will also be required to ensure that fees charged to clients are fair, reasonable, transparent, non-discriminatory and based on costs.  They will also have to make certain disclosures to the public (including on the methodologies used) and to subscribers of the ESG ratings and rated entities.

It is not yet known when the Regulation will come into force but it is unlikely to be before the end of 2024.  The regulation of ESG ratings providers is also being considered in the UK by HM Treasury.

The Commission Notice includes some commentary from the Commission on the minimum safeguards under the EU Taxonomy Regulation.  This is not intended to have the force of law but is provides a useful indicator of how undertakings should interpret the relevant requirements.

The Notice includes guidance that when implementing the minimum safeguards and the principle of do no significant harm in SFDR, at a minimum, the principal adverse impact indicators for social and employee matters, respect for human rights, anti-corruption and anti-bribery matters in the SFDR Delegated Regulation should be considered.  These (currently) are:

• violations of UN Global Compact principles and OECD Guidelines for Multinational Enterprises;
• lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD Guidelines for Multinational Enterprises;
• unadjusted gender pay gap;
• board gender diversity; and
• exposure to controversial weapons (anti-personnel mines, cluster munitions, chemical weapons and biological weapons).

There is also helpful acknowledgment that an undertaking is not prevented from being considered to comply with the minimum safeguards if it is unable to address certain risks or eliminate certain negative impacts (including in its value chain) despite implementing all appropriate procedures.   In such a case, the undertaking should clearly disclose the potential impacts and explain what it did to identify, prevent, mitigate or remediate them and why it could not eliminate certain impacts.

Finally, the Commission also confirms that investments in economic activities which qualify as "environmentally sustainable" under the EU Taxonomy can automatically qualify as SFDR "sustainable investments".  However, where a financial market participant invests in an undertaking with some degree of taxonomy-alignment through a funding instrument that does not specify the use of proceeds, such as a general equity or debt, the financial market participant would still need make sure that this meets the requirements under SFDR to be a sustainable investment including that the remaining economic activities of the undertaking do no significant harm and contribute to the environmental objective.