ESG Regulation: the race has begun

Political, social and investor pressure has led to the introduction of a swathe of new European rules, to be implemented in stages over the next three years, with more to come.

In the October 2019 edition we noted that sustainable finance is now firmly in the regulatory mainstream. The package of legislative proposals issued by the European Commission in May 2018 have all been adopted and further work is now underway under the new European Green Deal.

The first legislative package is aimed at asset managers, investment funds, investing institutions (including insurance companies and pension funds), intermediaries (including banks and insurers) and benchmark providers. It comprises:

1. Harmonised criteria (a taxonomy) for determining whether an economic activity is "environmentally-sustainable" 
2. Disclosure requirements for institutional investors, intermediaries and investment products, and incorporating sustainability factors into investment processes and remuneration policies
3. The creation of new categories of low-carbon benchmarks 
4. Amendments to MiFID II¹ and IDD² rules to integrate sustainability preferences into financial advisers' suitability tests

The core Taxonomy Regulation was the most hotly debated. The nub of the debate was the differentiation between end goals and how to get there (the transition), with different Member State economies more or less dependent on particular energy sources, for instance.

Still to come are the Level 2 rules, which will provide further articulation of some of the criteria. These, too, may experience challenges before adoption - the devil is invariably in the detail. The way in which "adverse impacts" are to be incorporated into the amendments to the MiFID II and IDD delegated acts, for example, has been the subject of much debate with the industry.

The ESAs are charged with producing various technical regulatory standards to underpin the Disclosure Regulation. These will apply to UCITS, all forms of alternative investment funds, occupational pension funds, asset managers, fund intermediaries and insurance intermediaries.

In December, the Commission issued a Communication (PDF 557 KB) that sets out the next set of proposals to tackle climate change and environmental challenges. It includes a section on the pursuit of green finance and investment, and "ensuring a just transition". The Commission estimates that the 2030 targets will require €260 billion additional annual investment (about 1.5% of GDP) and notes that the private sector will be key to financing the green transition.

In autumn 2020, ahead of "UN COP26" in November and as heralded in our report on "EU financial services - a new agenda demands a new approach", the Commission will publish a renewed sustainable finance strategy. It will include three key policy actions:

1. Further embedding sustainability into the corporate governance framework, including a review of the Non-Financial Reporting Directive 
2. Making it easier for investors to identify sustainable investments via labels for retail investment products and by developing an EU green bond standard 
3. Better integrating climate and environmental risks into the EU prudential framework and assessing the suitability of current capital requirements for green assets.

The European Commission's Joint Research Centre (JRC) has issued its Second Technical Report. It now proposes mandatory criteria for determining whether retail financial products (investment funds, insurance-based investment products and savings accounts/deposits) can use the EU ecolabel. The ecolabel will apply to the service provided by the product manufacturer, rather than to the product itself, but can feature on the product's promotional material.

A particular focus of the JRC's recent work has been to find a balance between allowing too many investment products to claim green status and excluding too many existing products that are currently advertised as green. The JRC suggests that bond funds be at least 70%-invested in bonds that comply with the Green Bond Standard, that a "three-pocket" approach be adopted for equity funds (which may be difficult to operate in practice - see box for detail), and that insurance unit-linked products should look through to the underlying funds.

Ahead of any proposed changes to capital requirements, the ECB, EBA, EIOPA and some national regulators (in particular, the UK Prudential Regulation Authority) have set out their supervisory expectations for banks and insurers to incorporate the full panoply of sustainable finance risks and factors in their stress testing exercises.

EBA has issued its own action plan on sustainable finance. It proposes to adopt a sequential approach, starting with key metrics, strategies and risk management, and moving towards scenario analysis and evidence for any adjustments to risk weights. In particular, it encourages banks to set a "green asset ratio".

For the first time, EIOPA's biennial stress testing of occupational pension funds included consideration of ESG factors. The report, issued in December 2019, found that while the majority of the 176 pension funds sampled said they considered ESG factors, only 30% had processes in place to manage ESG risks, and less than 20% assessed the impact of ESG factors on portfolio risks and returns.

The various new rules must be implemented by different deadlines, ranging from 2020 to 2022.

Until the Level 2 rules are finalised, the impact on regulated firms and their services and products cannot be precisely calibrated. It is certain, though, that regulatory and client pressures will be at the forefront from now on. Firms need to incorporate ESG considerations into all aspects of their business.

Moreover, as highlighted in our report (PDF 525 KB) "Impact of ESG disclosures - embracing the future", because the new rules will impact the investment and lending appetites of EU financial institutions, they will have a much wider impact. Coupled with increasing investor demands, there could be a profound impact on non-financial companies' ability to raise capital, within the EU and beyond.

At least 60% of the fund's portfolio must be invested in companies whose economic activities comply with:

• At least 20% of the fund's portfolio must be invested in companies that derive at least 50% of their revenue from green economic activities (as defined by the new Taxonomy Regulation) 
• The remaining 0%-40% must be invested in companies deriving 20%-49% of their revenue from green economic activities.

The remainder of the portfolio must be invested in companies deriving less than 20% of their revenue from green economic activities but not undertaking any excluded activities, or other assets or cash.