A busy month for European sustainability regulation

A regular briefing for the alternative asset management industry.

Followers of European sustainability regulation have had a busy month. Although it is hard to remember a time when developments didn't come thick and fast, the last few weeks have been particularly intense.

Many of the recent announcements have been long-awaited, and, in some cases, merely aim to mitigate problems caused by over-hasty and poorly drafted initial rules.

For example, a consultation issued last week by the European Supervisory Authorities on further changes to the SFDR's implementing rules would, if adopted in their current form, require many firms to change their processes and procedures, again. The ESAs' proposals include amendments to the disclosure templates, website disclosures, and the list of principal adverse impact (PAI) indicators. Although these revised PAI indicators are largely consistent with emerging corporate reporting standards, no proper assessment has yet been made of the costs and benefits of the existing indicators. It seems that policymakers' faith in the power of extensive disclosures to effect real economy change is undiminished.

Also last week, the European Commission (finally) answered some fundamental questions on the interpretation of the SFDR. The Commission is of course constrained by the law, meaning that the answers have provided only partial assistance. In particular, firms have been left with some discretion to determine what constitutes a "sustainable investment" – a crucial question for an Article 9 ("dark green") fund. That flexibility will now embolden more firms to launch Article 9 funds (even though there has been no change to the earlier guidance that requires all the investments in an Article 9 fund to qualify as "sustainable").

The Commission has tacitly acknowledged that the lack of clarity in the rules exacerbates greenwashing risks. They have suggested that firms should self-regulate this risk by exercising "increased responsibility towards the investment community" in classifying investments. That seems like an unstable solution, and it is welcome that a more fundamental review of the SFDR is underway – although substantial changes will probably take years rather than months.

"It seems that policymakers' faith in the power of extensive disclosures to effect real economy change is undiminished."

More positively, further draft EU Taxonomy rules were issued at the beginning of April. These technical criteria – which had been expected last year – define the tests for determining whether an activity that contributes to one of the EU Taxonomy's non-climate related objectives qualifies as Taxonomy-aligned. The rules run to over 100 pages (including some proposed changes to the existing climate-related rules) and firms have until 3 May to comment on them.

The drafts are controversial in some respects, as is the Taxonomy project as a whole, but at least they can be counted as progress. The Taxonomy may be a slow burn – and some of the inevitable political compromises are already being challenged in the courts – but it is likely to have very important capital allocation consequences in the years to come.

Meanwhile, in the UK, there was also much for the market to absorb. Even though most large companies, asset managers and asset owners will soon have to produce detailed reports on their climate-related risks and opportunities in accordance with TCFD recommendations, the UK remains behind the EU on a more general disclosure and labelling framework, and on a Taxonomy.

The UK regulator has been consulting on disclosures and labels for regulated firms, but has been taken aback by some of the feedback received from the market. It is clear that it will need more time to reflect on the consultation responses if it is to avoid some of the mistakes made by the SFDR. The FCA's announcement that it is delaying the introduction of the regime until the third quarter of this year was not entirely surprising and is evidence that the regulator wants to get the rules right before they are launched.

The FCA published another discussion paper in February, although it made no concrete proposals. The paper could be important, though, as it may herald more prescriptive requirements for UK-regulated firms to integrate sustainability considerations into their governance, remuneration and required competences. The UK's proposed new offence of failure to prevent fraud, announced in February but confirmed last week, is also likely to create compliance work for firms.

And then, at the end of March, the UK government made a series of announcements on so-called "Green Day". These included a re-confirmation of the UK's commitment to become the world's first net zero-aligned financial centre – although many were disappointed by the lack of committed public financing. There was certainly nothing on the scale of the US's Inflation Reduction Act, nor even a commitment to match the EU's draft Net Zero Industry Act, also published in March.

The UK announcements did confirm that progress continues to be made on a green taxonomy, with a consultation scheduled for the Autumn. However, the government is treading carefully: there will be an initial "testing period … for at least two reporting years" before taxonomy reporting will be made mandatory, to ensure the information is accessible, reliable and useful.

We also had confirmation that international sustainability reporting standards (rather the EU ones) will form the basis for any economy-wide disclosure regime, and a pledge to consider adoption of the TNFD – the natural environment's equivalent of climate's TCFD. There was also a commitment to work with interested parties to clarify a pension trustee's fiduciary duty (or ability) to take account of certain ESG factors.

The UK has a lot still to do if it is to match its warm words with concrete policy initiatives, while the EU continues to press on with extensive (and costly) disclosure regimes in the hope that they will deliver real world benefits. Although regarded by many as a second-best solution, and not without political difficulties, such a policy prescription is likely to be politically expedient – and therefore here to stay. That means there will be a lot more for firms – and their advisers – to read, interpret and apply in the years ahead.