As ESG reporting framework matures, so does the information overload for investors. Specialist jargon, such as “taxonomy” or “does not significantly harm”, are often not understood, especially at the retail level.
One can even argue that subtle distinctions between:
- “sustainable investments” (as defined in the Sustainable Finance Disclosure Regulation - SFDR) and
- investments that are “taxonomy-aligned” (as defined in the Taxonomy Regulation)
are more suitable to be debated within academic discourse rather than practically applied in a day-to-day business practice.
Nevertheless, the requests for the legislative alignment - to the greatest extent possible - of SFDR and Taxonomy Regulation “sustainability” definitions have not been efficient so far.
“Sustainable investment” under the SFDR, should ideally be aligned with “environmentally sustainable economic activities” as defined in the current environmental taxonomy (and potentially in the future social taxonomy), as different scopes and definitions used by the SFDR and Taxonomy Regulation are counterintuitive and confusing for consumers.
Efforts should be made to ensure alignment between various ESG disclosures related initiatives, such as between the entity-level Article 8 Taxonomy Regulation disclosures with the product-level Article 5 and 6 Taxonomy Regulation disclosures since the latter will be built on the former.
It is also noteworthy, that OpEx of underlying non-financial investee companies as one of the possible ways to calculate the KPI for the disclosure of the extent to which investments are aligned with the taxonomy has met negative views of market participants.
They suggested that OpEx offers little value, introduces difficulties in the context of accounting and suffers from lack of data. OpEx is not defined in IFRS or US GAAP and this could lead to less comparable figures. In exchange, turnover and CapEx disclosures were proposed as sufficient.
A few asset managers noted that the proposed pre-contractual disclosures seem to be based on the fact that data on the assets of the financial product already exist. However, for some financial products, e.g. portfolio management services, no product exists when the pre-contractual documentation is established. This information can therefore not be provided.
As follows from some regulatory analyses, instititions are aware of the confines set by the Level 1 legislation.
Nevertheless, some stakeholders are extremely worried by the complexity that results from the piecemeal introduction of different pieces of legislation and the use of concepts that are close to one another although not identical to one another.
The SFDR Regulatory Technical Standard (RTS) of 6 April 2022 recognises environmentally sustainable activities (Taxonomy Regulation) as a subset of the SFDR Article 8 and 9 products.
Although this an almost inevitable consequence of the present status of the Level 1 legislation, it will have as unfortunate consequence to increase the complexity to the end investors.
Blatant examples of the said complexities are, in particular:
a. The SFDR refers to (environmental and social) “characteristics” (Article 8 - so-called "light green products"), alongside “objectives” (Article 9 - so-called "dark green products").
The Taxonomy Regulation refers to “environmentally sustainable activities”. For an activity to be environmentally sustainable, it should contribute substantially to one or more of the environmental “objectives” of the Taxonomy Regulation. Investments into environmentally sustainable activities can be a subset of both Article 8 and 9 products.
However, at the same time the RTS requires that the precontractual information for Article 8 products should state: “the financial product promotes environmental or social characteristics, but does not have as its objective a sustainable investment” (Article 26(1)). These subtilities transform sustainable investing into intellectual high-tech.
Unless the investor fully understands the different concepts, it will be very difficult to understand why a product which indicates a minimum share of environmentally sustainable activities at the same time carries warning: “this product does not have as it objective a sustainable investment.”
b. Also, at present, the focus of the Taxonomy Regulation is on environmental objectives. On the other hand, the SFDR includes, alongside environmental objectives, also social objectives and governance requirements. To understand all this, the investor should not only understand the difference between ESG-characteristics (art 8) and ESG objectives (art 9), but also the subtle differences between environmental objectives in terms of the Taxonomy Regulation, environmental objectives other than those mentioned in the Taxonomy Regulation and ESG-objectives in general.
It is also often argued that discrimination against sustainable investments outside the scope of the taxonomy (i.e. not taxonomy-aligned) should be avoided, in particular, investors should not imply that sustainable investments which are not (yet) within the scope of the Taxonomy Regulation are any less sustainable.
c. SFDR uses the concept of “principal adverse impact”. The Taxonomy Regulation uses the notion of “minimum safeguards” and “does not significantly harm”.
The notion of “minimum safeguards” in the Taxonomy Regulation, is smaller than the notion of “principal adverse impact” of the SFDR. For example, board gender diversity, which is a principal adverse impact indicator, is not a minimum safeguard for taxonomy alignment. Also, its application is limited to environmentally sustainable activities as defined by the Taxonomy Regulation.
The “does not significantly harm” principle of the Taxonomy Regulation focuses on the six environmental objectives recognized by the Taxonomy Regulation. The “principal adverse impact indicators” of the SFDR have a broader scope, ranging from environmental indicators to social and employee, respect for human rights, anti-corruption, and anti-bribery matters.
As was noted in the regulators’ Final report of 22 October 2021, the taxonomy is based on three categories, i.e.:
- transitioning and
but, by defining only two of these categories, the third category will not be visible to the customer.
It was doubted that it would be feasible for products committing to a certain share of sustainable investments in line with the taxonomy to specify minimum proportions of transitional and enabling activities in the pre-contractual documents.
The commitment to a minimum share of taxonomy-aligned investments that would need to be met and monitored on a continuous basis was considered a challenge in itself and only a few products were believed to be able to make commitments on a more granular level.
Therefore, it was expected that it would be possible to disclose a zero minimum share of transitional and enabling activities in the pre-contractual documents and to explain to investors that this is due to the lack of feasibility to make binding commitments, but that the actual share of investments in transitional and enabling activities would be disclosed in the periodic report.
So, many shortcomings of the European ESG prototype legislative construct are visible at this stage, nevertheless maximum effort seems necessary to fully understand all interdependencies and cross-references.
Detailed reporting and transparency of companies’ actions are envisioned, thus potential errors will be on entrepreneurs’ account, not legislators.
ESA’s Final report of 22 October 2021 on taxonomy-related product disclosure RTS with regard to the content and presentation of disclosures pursuant to Article 8(4), 9(6) and 11(5) of Regulation (EU) 2019/2088, JC 2021 50
SMSG advice to the ESA’s Joint Consultation Paper on Taxonomy-related sustain-ability disclosures (draft regulatory technical standards with regard to the content and presentation pursuant to Article 8(4), Article 9(6), Article 11(5) of Regulation (EU) 2019/2088.