Travers Smith's Sustainability Insights: The EU's sustainability challenge

A regular briefing for the alternative asset management industry.

The European Commission's renewed Sustainable Finance Strategy, adopted in July 2021 and building on a 2018 Action Plan, was certainly ambitious. Indeed, the Commission has rightly credited the EU with "global leadership in setting international standards". But blazing a trail in a complex and novel regulatory field is a double-edged sword: there are bound to be missteps and – as asset managers will testify – the EU's rules have given rise to a number of challenges. Understanding and applying the complex and (in places) poorly drafted rules is, perhaps, the main challenge for firms (although final proposed versions of the Sustainable Finance Disclosure Regulation's (SFDR's) implementing rules – published this week – will help), while regulators and NGOs have expressed concern that the disclosure regime might actually exacerbate "greenwashing". The Taxonomy – a centrepiece of the EU's sustainable finance strategy – is narrow in scope and is clearly only a starting point. Emerging rules on corporate disclosures will be burdensome, while a proposal on sustainability due diligence has come in for significant criticism.

It is to be expected, therefore, that the European Commission will have to amend, evolve and clarify its new rules in some important respects in the coming years. ESMA, the pan-EU supervisor, recently explained how it is going to help – and its Sustainable Finance Roadmap offers alternative asset managers some clues about what is likely to change in the near future.

ESMA's roadmap, published in February and building on the Commission's own priorities, points out that it must respond to "copious legislative activity" and "strong investor demand for sustainable products". Combating greenwashing and promoting transparency is clearly regarded as a central part of ESMA's mission – and the SFDR's de facto labels are identified as part of the problem. The European Commission has already announced that it will develop minimum standards for "Article 8 products" – those that promote environmental and/or social characteristics – and ESMA plans to support the Commission's work in this regard.

The lack of minimum standards is perhaps not surprising in a disclosure regime, but baseline criteria would seem to be a prerequisite for a label. In fact, ESMA has been adamant on a number of occasions that the SFDR is not a labelling regime, and the supervisor is aware that – if it is seen as such by investors – it could result in investors being misled.

But there is also a recognition among policymakers that – whether intended or not – the SFDR's categories are being used as labels, and moving to underpin them with some minimum standards is now the inevitable response. That view is shared by a group of NGOs and consumer organisations, who issued recommendations for minimum criteria in February.

The NGOs' view is that Article 8 products should be required to avoid harm, while an Article 9 designation should be reserved for funds having positive and measurable impact. Products should, according to these recommendations, include some exclusions – so that, for example, an Article 8 product could not invest in fossil fuel or nuclear energy generation – and have a minimum level of alignment with the EU Taxonomy.

But blazing a trail in a complex and novel regulatory field is a double-edged sword: there are bound to be missteps and – as asset managers will testify – the EU's rules have given rise to a number of challenges.

Any such minimum standards would seem to require an amendment to the SFDR itself, so it is not a quick process, but the industry will need to engage with ESMA as they develop proposed minimum standards. Even if not applied retrospectively to products marketed under the existing rules (which would be wrong in principle), investors are unlikely to stop demanding Article 8 products because the criteria have changed. Many firms will be forced to adopt whatever minimum criteria end up being applied.

Another aspect of the SFDR that has come in for some criticism is the choice of "principal adverse impact" (PAI) indicators that are specified in the implementing rules that were published this week. Firms who are currently aligning their data collection processes with those indicators should take note that ESMA is already planning to review them.

Meanwhile, a supervisory statement issued by ESMA and other supervisors in late March confirmed that asset managers must start issuing a quantitative taxonomy-alignment score for certain products, even though that data is not yet widely available. The supervisors confirmed that estimates may not be used and that additional information (other than information on how the data was obtained) should not be provided. However, the statement also confirms that firms may engage directly with investee companies to gather the data if needed. There still seems to be no obligation for an alternative asset manager to collect data from companies that are not themselves reporting taxonomy-alignment: instead, they could classify the company as 0% aligned. But EU-based investors are likely to want alternative asset managers to perform their own taxonomy assessments. Given the complexity in making a taxonomy-alignment determination, especially for non-EU assets, that will be an ongoing challenge.

Those taxonomy determinations are also not likely to get easier, even if consultancy solutions do emerge. That's because the taxonomy will grow. Not only is a social taxonomy in development, but recent announcements suggest that enhancements to the green taxonomy are also likely. The Platform on Sustainable Finance argues in its latest report for an extended environmental taxonomy, suggesting a traffic light system that allows all economic activities to be classified according to their environmental impact.

The EU's ambition to be the global leader in sustainability standards shows no sign of abating – even though the UK and the US are now playing catchup. For market participants getting to grips with the existing EU sustainability rules, some clarity is gradually emerging and, in particular, reporting templates and final SFDR reporting requirements seem to be settled for the time being (unless the co-legislators object to the Commission's proposed version). But new challenges are undoubtedly also on their way as European rule-makers build on what they have accomplished so far.

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