Environmental, social and governance (ESG) reporting requirements for companies and mandatory disclosures by financial services firms are expanding rapidly. 

Firms need to prepare to make more disclosures and to use the information disclosed by others. They must also be able to substantiate their sustainability claims, at entity- and product-level, to regulators, investors and consumers. Independent assurance requirements are being introduced in some areas.

The 2021 status report of the Task Force on Climate-Related Financial Disclosures (TCFD) indicates that the TCFD's recommendations are being adopted in an increasing number of jurisdictions and by more companies, with Europe leading the way. But significant progress is still needed, with a worldwide average of only one in three companies reviewed making TCFD-aligned disclosures.  

The proposed EU Corporate Sustainability Reporting Directive (CSRD) heralds a significant expansion in the range of entities required to report and what those disclosures must cover. It adds to the new requirement under the Non-Financial Reporting Directive (NFRD), which was introduced via Article 8 of the Taxonomy Regulation and requires around 11,000 large companies to disclose proportions of turnover and expenses relating to environmentally sustainable activities. CSRD will:

  • Extend the scope of NFRD to all large companies and all companies listed on regulated markets (except listed micro-enterprises), with future capture of non-listed entities
  • Require the audit (assurance) of reported information
  • Introduce more detailed reporting requirements and a requirement to report according to mandatory EU sustainability reporting standards
  • Require companies to add a digital tag to the reported information, to feed into the European “single access point” envisaged in the Capital Markets Union action plan

The proposed Green Bond Standard is also being debated, but work on criteria for an EU Ecolabel for retail investment products has been put on hold until the Level 2 rules on climate change mitigation and adaptation under the Taxonomy Regulation are completed.

There are more rules to come on product disclosures. The ESAs have submitted to the Commission draft rules for SFDR Article 8 and 9 products to underpin the additional requirements introduced into SFDR via the Taxonomy Regulation. Precontractual and periodic disclosures must identify the environmental objectives to which the product contributes and show how and to what extent the product's investments are Taxonomy-aligned. These will take the form of graphs and changes to the existing SFDR mandatory templates. In addition, independent assurance will be required.

The UK government has issued “A roadmap to sustainable investing”, which covers phase 1 of the government's three-phase plan for greening the financial system: informing investors and consumers, acting on the information, and shifting financial flows. In addition to work on a UK taxonomy (see ESG taxonomies article), rules to be developed will require financial services firms and real economy corporates to report consistent information on sustainability.

The new regime will streamline existing disclosure requirements (e.g. TCFD-aligned) with new requirements, including on reporting environmental impact. Investment products will need to make consumer-focused disclosures showing the impact, risks and opportunities of the activities they finance. This will be accompanied by a consumer-facing label, to be developed by the FCA. Moreover, asset managers, asset owners and investment products will be required to substantiate their sustainability claims.

Making existing rules work

ESMA's 2022 work programme (PDF 590 KB) says the priority will be to support building new sustainability disclosure rules and to lead common approaches in national regulators' supervisory practices. ESMA notes that extensive work will be required to build consistent application of rules and effective approaches. It will prepare a supervisory briefing to assist national regulators in supervising investment products with sustainability features and will develop further its own sustainability risk identification methodology.

The EBA recognises that the proposed Green Asset Ratio is imprecise in its current iteration but believes it will improve through use and experience. Final Pillar 3 proposals are expected to be approved by end-2021. As part of its 2022 work programme (PDF 1.25 MB), the EBA will monitor the effective implementation of ESG disclosure standards and gradually expand the scope of disclosure reflecting the development of the EU taxonomy and data availability.

In July, the FCA published guiding principles and key considerations on the design, delivery and disclosure of UK sustainable investment funds. The principles take the form of a “Dear Chair” letter. They are a statement of the FCA's expectations for retail funds that incorporate ESG attributes and include interpretative guidance and examples to help firms.

SFDR — a little more clarity, perhaps

In January 2021, with less than eight weeks before the first March 2021 SFDR implementation deadline, the ESAs wrote to the Commission highlighting several important areas of uncertainty in the interpretation of SFDR that needed urgent clarification and with which firms had been struggling. In July, the Commission published its long-awaited Q&A (PDF 602 KB), which is helpful in some areas, but in others simply repeats the ESAs' questions or cites sections of the SFDR text, without providing clarification on interpretation or practical implementation. In brief:

1. Does the provision of SFDR apply to non-EU AIFMs1 and registered AIFMs?

EC: No to non-EU AIFMs (but product disclosures may apply if funds are marketed in the EU); yes to registered (i.e. sub-threshold) AIFMs

2. How should you apply the 500-employee threshold for principal adverse impact reporting at entity level to parent undertakings of a large group? Should it include both EU and non-EU entities, and should the due diligence statement include impacts of the parent undertaking only or include the impacts of the group at a consolidated level?

EC: The headcount is linked to the parent undertaking being a “financial market participant” (FMP) under SFDR. If it is, any subsidiaries beneath it are caught. If it is not, its own headcount is not included. Instead, the headcount is focused on the employees of the subsidiary undertaking that is the FMP.

3. What is the meaning of “promotion” in the context of products `promoting' environmental or social characteristics (Article 8)?

EC: Integration of sustainability risks (per SFDR Article 2(22)) is not sufficient for Article 8 to apply. Promotion “encompasses, by way of example, direct or indirect claims, information, reporting, disclosures as well as an impression that investments pursued by the given financial product also consider environmental or social characteristics in terms of investment policies, goals, targets or objectives or a general ambition”. These disclosures may appear in a wide range of documents or media.

4. How should you apply Article 9 of SFDR?

EC: Article 9 products may invest in a wide range of underlying assets, provided they qualify as sustainable investments under SFDR Article 2(17). In order to meet requirements in accordance with prudential, product-related sector-specific rules, an Article 9 product may include investments for certain specific purposes such as hedging or liquidity, but these must also meet minimum environmental or social safeguards to be in line with the sustainable investment objective.

5. How should you apply SFDR disclosure rules to MIFID portfolios and other tailored products? And if they apply at the portfolio level, how is it possible to maintain client confidentiality obligations?

EC: Confidentiality and data protection requirements under EU and national laws owed to the individual client may prevail over the requirement to disclose information pursuant to SFDR Article 10 on a public part of the FMP's website. Depending on the FMP's jurisdiction and the applicable statutory level of protection, this may require the portfolio manager mandate to include strong language as to confidentiality owed to clients.

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1Alternative Investment Fund Managers