Unpacking the EU Commission’s sustainable finance package

In June 2023, the European Commission announced a package of reforms targeting the financial sector, with the aim of increasing its alignment with the European Green Deal objectives.

The package clarifies previous conflicts between the SFDR and Taxonomy Regulation, proposes the European Securities and Markets Authority (ESMA) as a regulator for ESG ratings providers, and elevates the European Sustainability Reporting Standards as compliant with global standards.

The Commission observed a lack of legal clarity leading to a surge of managers downgrading their Article 9 or 8 funds in wake of the SFDR. Fabio Ranghino, partner and head of sustainability and strategy at Ambienta, comments: “While intended as a disclosure regime, the SFDR has been increasingly used as a labelling regime and, as a consequence, as a competitive tool used by GPs to distinguish themselves.”

In response, the regulator has introduced safe harbour clarifications, such as investments in “environmentally sustainable economic activities” under the Taxonomy Regulation now automatically qualifying as an SFDR “sustainable investment”. Additionally, funds that passively track an EU climate benchmark fall under the scope of Article 9 with sustainable investment as their objective.

“This is a very welcome development,” says Andrew Henderson, a partner in Goodwin’s financial regulation practice. “A lot of the amendments seek to address shortcomings of the original texts. These should help firms to develop best practice standards in response.”

But alignment might not come without causing further challenges. “Particularly important can be the alignment between the SFDR and the Taxonomy Regulation when it comes to the principle of ‘do no significant harm’ (DNSH) with respect to environmental aspects,” highlights Ranghino. “Here, the European Supervisory Authorities (ESAs) are hinting in a recent consultation at the possibility of using DNSH Taxonomy principles for sustainable investment tests. This could increase the complexity of SFDR implementation, particularly for private market GPs, if it were to go forward.”

While a few optimistic players, like FAP Group, upgraded their investment vehicles to Article 9, the industry’s lack of confidence in the legislation keeps it cautious. That’s conflicting, as LPs are increasingly looking to cut off capital allocations to funds with subpar ESG performance.

Fighting fire with fire
Objective benchmarking could prove an asset to inspire confidence. As part of the reforms, the European Commission is looking to introduce a supervisory regime for ESG rating providers under the watchful eyes of ESMA. Regulation means recognition and legitimacy – a positive development, says Henderson: “A market regulator cannot underwrite a particular rating agency and its ratings. Nevertheless, a regulatory licence signals that the ratings process will follow a certain baseline standard. While this does not remove the risk that a rating is incorrect, the regulation of service providers to regulated firms, such as asset managers, points to a maturity of the industry, which will surely have a positive impact.”

To further align and heal wounds of fragmentation in the legislature, the Commission has declared the ESRS as defined in the Corporate Sustainability Reporting Directive (CSRD) will be deemed compliant with global standards.

While this sounds like good news in theory, industry experts are holding their breath: “The overarching aim of the CSRD was to bring sustainability reporting to the same level as financial reporting, which has significantly increased the range of companies impacted by the regime,” explains Bettina Denis, head of sustainability at Revaia. “It was an urgent step in the right direction, but has presented challenges, especially for smaller businesses. Often, due to their maturity or sector, they perceive many of the reporting criteria as not relevant to them.

“Therefore, from their point of view, the recent revision to ESRS is a positive move, as it will require companies to report only on criteria they assess as material. However, this revision introduces inconsistency with the other EU regulations requirements (such as SFDR), meaning that, due to contrasting requirements, financial investors could still require their investees to report on criteria that they deem non-relevant.

“If we want to avoid the burden of reporting overtaking the urgency of the actions, regulators need to act and find a way for regulations to operate in a more coherent way.”

In an echo of Denis’s words, the European Fund and Asset Management Association (EFAMA) responded to the recent joint consultation of the ESAs with a statement demanding the SFDR’s PAIs align with the ESRS as laid out in the CSRD.

Ranghino concurs and stresses that “ESRS should not become an addition but rather address the fragmentation of reporting standards”.

Solving problems often creates new ones and regulation is no exception. Alignment between the SFDR and Taxonomy Regulations, while possibly empowering firms to develop best practices, might do so out of necessity rather than prudence. While regulating the providers of ESG ratings might ease the tension on GPs as they will be able to rely on the companies they outsource to, the standard to be set is more likely a minimum baseline. And the ESRS’s elevation to global compliance might still further complicate what is already a fragmented framework.

Nevertheless, the regulator has demonstrated that it hears the industry’s concerns and aims to address them. Neither the SFDR nor the Taxonomy Regulation have been in effect for long compared to other legislative texts, and any kinks will need to be worked out over time.