Recent UK, EU and globally significant policy developments and implications for investors, lenders, issuers, and borrowers

• EU Platform on Sustainable Finance final report on minimum social safeguards
• EU Platform on Sustainable Finance report on data and usability as part of taxonomy reporting

Other announcements and publications

Global focus

• The Glasgow Financial Alliance for Net Zero (GFANZ) guide on expectations for real-economy transition plans, and the Net Zero Banking Alliance (NZBA) transition finance guide, get published
• Global baseline sustainability standards will require disclosure of Scope 3 emissions

UK focus

• The Financial Conduct Authority (FCA) propose new disclosure and sustainable investment labelling rules to tackle greenwashing
• UK Green Taxonomy: initial advice published by the Green Technical Advisory Group (GTAG) to the government
• UK launch net zero review
• Thematic feedback published on the Prudential Regulation Authority (PRA) supervision of climate-related financial risk

EU focus

• Final report published on disclosures for fossil gas and nuclear energy investments under EU Sustainable Finance Disclosure Regulation (SFDR)
• European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) publish their work programmes for 2023, prioritising sustainability and ESG risk management topics
• ESMA publish final report and revised guidelines on MiFID II suitability requirements related to sustainability
• EBA publish report on the integration of ESG risks in the supervision of investment firms

What to look out for, for the rest of 2022 and Q1 2023

• COP27 in Egypt and COP15 in Montreal
• UK’s revised green finance strategy and amended net zero strategy
• European Financial Reporting Advisory Group’s (EFRAG) first batch of EU ESG reporting standards

EU Platform on Sustainable Finance reports

The Platform for Sustainable Finance (‘the Platform’) published two reports regarding the EU Taxonomy. The Platform is an advisory body to the EU Commission and the recommendations from these reports can be ignored, amended, or adopted by the EU Commission.  One report focuses on the data and usability in the reporting and the other one on the application of ‘minimum social safeguards’ requirements of the EU Taxonomy.

A key theme in both reports is around aligning the EU Taxonomy requirements with other key pieces of EU legislation, such as the Non-Financial Reporting Directive (NFRD), Corporate Sustainability Reporting Directive (CSRD), Sustainable Finance Disclosure Regulation (SFDR), Corporate Sustainability Due Diligence Directive (CSDD), and the EU’s Low Carbon benchmark rules. Specifically, the usability report calls out that there is a need for a common terminology or set of definitions or metrics across the different legislations and allow for use globally where possible

In the data and usability report, the Platform highlights more than 60 recommendations for the European Commission to consider. These include providing additional Taxonomy-alignment reporting guidelines and creating an online platform for industry participants to suggest revisions to Taxonomy criteria when facing usability issues. The report also includes areas where it thinks the Platform should focus on in the future, especially on implications for smaller and medium-sized companies and the treatment of derivatives in reporting as well as the use of trading book metrics in green assets ratios (GARs) for banks.

Additionally, a significant focus of the usability report has been placed on the ‘do no significant harm’ (DNSH) criteria. The report states that “in its current form, some of the DNSH testing criteria create substantial interpretation and usability challenges. If left unaddressed, this could impact the goal of generating complete, comparable, and reliable disclosure.” The report states that the currently used options for reporting on DNSH as ‘equivalent’ information may not truly align to the criteria. For example, using proxies such as ‘environmental controversies’ are not sufficient as they are typically at the extreme end of environmental standards and set DNSH at a lower bar than the Climate Delegated Act (e.g., breaching metric-based thresholds would not be registered as a ‘controversy’). Similarly, there are concerns with using local regulatory compliance or environmental scores if the standards are lower than the DNSH criteria.

The report on minimum safeguards (MSS) advises companies, investors, and auditors on how they can determine if they are complying with the requirements in line with the Taxonomy Regulation. The report states that disclosures around the MSS should encompass impacts generated throughout the lifecycle of production, use, and disposal of product or provision of services and continuously identify, prevent, mitigate, track, and account for actual and potential adverse impacts on human rights.

The report also includes recommendations for where the Commission should tighten rules on non-compliance to minimum safeguard requirements. For example, when a company provides “inadequate or non-existent” due diligence reporting on human rights or does not respond to allegations, such instances should be specified as not complying with the minimum safeguard requirements.

Key considerations for sustainable finance market participants

Issuers / Borrowers

The EU Taxonomy has implications for issuers both in terms of their corporate reporting of Taxonomy-aligned revenues, capex and opex, and to potentially be used for identifying projects for Green Use of Proceeds (UoP) bonds. Both reports cover areas that are perceived to be challenging for issuers to implement. Therefore, these recommendations may impact on how issuers report information to be assessed on their overall ESG performance by investors as well as what disclosures they produce using the EU Taxonomy in green and/or sustainability financing frameworks and related reporting.

The Platform’s recommendation for adapting the Taxonomy for global application would support issuers in using the EU classification system for their financing frameworks covering global projects outside the EU in the future. The Platform does state that the technical screening criteria (TSC) for significant contribution to environmental objectives is the most readily applicable element of the Taxonomy for use outside the EU. However, although it can often be used to define project eligibility, there are some criteria that rely on EU-specific concepts or standards (e.g., net zero energy building for green buildings). From a corporate reporting perspective, the Platform recognises that non-EU equivalence would still need to be developed for these types of criteria and adopted by jurisdictions outside the EU to ensure the interoperability of different legislative and regulatory regimes.

The report on the MSS provides helpful recommendations on reporting, which can also be considered as part of disclosures within green/sustainability financing frameworks that intend to align with the EU Taxonomy and as part of the respective green/sustainability finance reports. The report explains that these requirements cover companies’ own operations, subsidiaries, supply chains, and other business relationships. Therefore, this type of comprehensive disclosure could also be applied to EU Taxonomy-aligned financing frameworks and reporting. In the frameworks, issuers can point to these disclosures as evidence that they can uphold the MSS and, where relevant detail is available, show how these steps apply to the eligible projects. Issuers should expect that investors will scrutinise them on these points and the report does provide examples for how companies can claim they have adhered to MSS on different sectors and social and human rights-related topics.

Investors / Lenders

The implications for investors and lenders would largely mirror those for issuers/borrowers where the finance providers act as users of information provided by companies receiving finance. Availability of granular and reliable information on ESG risk and factors has been a long-standing issue for the financial industry to enable decision making and own compliance obligations with regard to EU Taxonomy and connected legislation.

Additionally, the Platform recommends the inclusion of all use-of-proceeds financial instruments (loans and bonds issued by SMEs, large corporates and by SSAs) in all numerators and denominators throughout all legislative texts. For example, currently, the calculation of a Green Asset Ratio (GAR) under the EU Taxonomy Article 8 rules scopes out any exposures to sovereigns and SMEs even where EU Taxonomy aligned financing can be provided to these types of issuers. If adopted, such a change could help facilitate the consistency of GAR and other KPI reporting by finance providers also allowing them to take the full credit for any Taxonomy-aligned capital provided.

The Platform recommends a careful approach when using estimated or approximated data in reporting. For example, for the purpose of Taxonomy-alignment estimations, the Platform would caution against the use of carbon estimates in determining substantial contribution by third parties. Financial institutions may therefore need to reconsider their existing or intended policies on Taxonomy reporting to balance the use of “real data” vs proxies.

With regard to public financing, the Platform recommends the development of a framework, including a set of principles for the use of the Taxonomy in public spending, when it is intended to protect the environment, that determine for which types of expenditures these investments may deviate from it, why and how. It also encourages the European Commission and member-states to explore the use of the Taxonomy to define their green procurement practices. Such a framework would benefit SSA issuers and respective investor group by providing clarity on what Taxonomy alignment would mean for the public sector. We would add that multilateral development banks would benefit from a separate framework too considering their specificity dictated by the presence and role in a range of markets, including developing and emerging markets.

The GFANZ guide on expectations for real-economy transition plans, and the NZBA transition finance guide get published

Whilst not constituting a specific legislative or regulatory development, several important industry-led publications have taken place recently, including the Glasgow Financial Alliance for Net Zero (GFANZ) guide on Expectations for Real-economy Transition Plans and the Net Zero Banking Alliance (NZBA) Transition Finance Guide. It is likely that both guides will contribute to the evolution of laws and regulations on the net-zero transition in the near future.

The GFANZ workstream on real-economy transition plans is co-chaired by NatWest, and the main purpose of the report was to provide a practical guide for companies in the real economy when preparing transition plans and disclosing progress against them – including to meet growing expectations from financial institutions. GFANZ has identified five transition plan themes comprising a total of ten components – disclosure of which would provide relevant information for financial institutions when evaluating a company’s transition plan for credibility and alignment to net zero goals, as well as tracking progress in implementation (Table 1).

Table 1: Components of real-economy transition plans relevant to financial institutions

The NZBA Transition Finance Guide is also complementary to the earlier released GFANZ’s Recommendations and Guidance on Financial Institution net zero transition plans. It provides a summary of key tools available, as well as an overview of some of the approaches and frameworks currently leveraged by market participants, to accelerate the shift of capital towards low-carbon activities. This guide also highlights potential inter-operability (and gaps) between such frameworks and suggests policy responses to scale up transition finance globally.

Global baseline sustainability standards to require disclosure of Scope 3 emissions

The International Sustainability Standards Board (ISSB) has voted to require disclosure of Scope 3 greenhouse gas emissions, in its international sustainability reporting standards, to be published in early 2023 (Environmental Finance subscription required). For such disclosures, the ISSB will aim to work with countries on ‘safe harbour’ provisions, which could enable companies to provide such information and reduce associated potential legal or regulatory risks. Additionally, the definition of materiality is set to be aligned with the accounting definition established by the International Accounting Standards Board (IASB), removing the reference to “enterprise value”. The ISSB also confirmed that the Task Force on Climate-Related Financial Disclosures (TCFD) framework will become the basis for its standards. Some disclosures and language in relation to transition plans will be amended to facilitate alignment with proposed corporate sustainability reporting standards in the EU.

FCA proposed new disclosure and sustainable investment labelling rules to tackle greenwashing

In a bid to clamp down on greenwashing, the FCA has released a proposal on Sustainability Disclosure Requirements (SDR) and investment labels that includes new measures and restrictions on how terms like ‘ESG’, ‘green’ or ‘sustainable’ can be used. The measures are among several potential new rules which will aim to protect consumers and improve trust in sustainable investment products. The work forms part of the commitment made in the FCA's ESG Strategy and Business Plan to build trust and integrity in ESG-labelled instruments, products, and the supporting ecosystem. The FCA’s consultation (CP22/20) is open until 25 January 2023, and the regulator intends to publish final rules by the end of the first half of 2023.

The FCA’s proposal has similar objectives to the EU SFDR, which when it introduced its rules set a baseline for investors introducing new sustainable funds.  The FCA’s proposal, also seeks to provide specific requirements for the designation of investment labels, which to the EU SFDR may have effects for issuers to provide the required evidence for inclusion, such as:

• Sustainable focus: products with an objective to maintain a high standard of sustainability in the profile of assets by investing to (i) meet a credible standard of environmental and / or social sustainability; or (ii) align with a specified environmental and/ or social sustainability theme. At least 70% of a ‘sustainable focus’ product’s assets should meet a robust, independently assessed, evidence-based and transparent standard of environmental and / or social sustainability or align with a specified environmental and/or social sustainability theme.
• Sustainable improvers: products investing in assets to improve the environmental or social sustainability over time, including in response to stewardship. Criteria for this category emphasise that the firm must disclose clearly where the product will and will not invest and describe its asset selection and stewardship policies. Disclosures must use a clear and measurable target for improvements in the sustainability profile of assets.
• Sustainable impact: products with an explicit objective to achieve a positive, measurable contribution to sustainable outcomes. These are invested in assets that provide solutions to environmental or social problems, often in underserved markets or to address observed market failures.

Please look out for a more detailed analysis of the proposal in the November edition of our ESG Policy and Regulation round-up newsletter.

UK Green Taxonomy – initial advice published by GTAG to the government

The Green Technical Advisory Group has published ‘part one’ of its independent advice to government on implementation of the UK’s ‘green taxonomy’.

The paper provides a summary of the first stage of analysis undertaken by the GTAG and the policy recommendations provided to date to the government. They cover the following areas:

• UK’s approach to onshoring the EU’s taxonomy
• International interoperability
• ‘Do no significant harm’ principle
• The taxonomy’s ‘use-cases’ and policy links

The paper notes that a distinctly different UK taxonomy to that of the EU would lead to additional costs for investors, particularly those managing global assets. This conclusion is also helpful for issuers with UK and wider European operations, as the limited difference between the taxonomies is important when considering required disclosures and issuing use of proceeds bonds for taxonomy-related projects.

The paper recommends that:

• Limited revisions will be needed to the EU’s TSC, specifically for those economic activities where the references and metrics will not be usable in the UK context, such as buildings.
• There are activities that the GTAG believes could be more comprehensively incorporated into the UK’s taxonomy, such as agriculture.
• A review will be considered by GTAG on the UK’s approach to the DNSH principle. It is being considered how to potentially streamline DNSH to make the taxonomy more usable for investors and companies.

The advice also indicates that the GTAG plans to further analyse how international interoperability can be more fully embedded in the taxonomy, how the taxonomy can support the development of climate transition plans, and the UK’s approach to the remaining four environmental objectives (water and marine resources; pollution prevention and control; biodiversity and natural ecosystems; and circular economy).

Under the EU Withdrawal Act, the UK is legally required to have implemented the TSC for the taxonomy’s first two objectives in law by 1 January 2023. Public consultation on the draft criteria has been delayed several times – most recently due to the ongoing changes in the UK’s government and political landscape. Uncertainty remains as to whether the draft criteria will be released before the end of 2022 for feedback.

UK launches net zero review

Former Energy Minister Chris Skidmore MP has been asked to lead the review of the UK’s government’s net zero Strategy focusing on carbon neutrality by unlocking £90 billion in investment into fighting climate change. This review which was announced in September 2022 emphasises on examining ways to reach the legally binding targets by supporting businesses and growth that will foster a green industrial revolution.

Mr Skidmore has a mandate to submit the recommendations by end of 2022, taking into consideration views from various key stakeholders such as consumers and investors. The review is a response to the rapidly changing political and economic environment in the last year that has led to high inflation and global energy prices.

Thematic feedback published on the PRA's supervision of climate-related financial risk

Sam Woods, Chief Executive of the UK PRA, has written to bank CEOs setting out thematic feedback from the Climate Biennial Exploratory Scenario (CBES) stress test. The letter measures firms’ progress against the PRA’s supervisory expectations as set out in SS3/19 and complements firm-specific feedback. Woods noted that firms’ compliance with SS3/19 will be assessed on an ongoing basis and firms should continue to demonstrate effective management of climate risks through regular supervisory engagements and reviews. Those judged not to have made sufficient progress in embedding regulatory expectations should expect to be asked to provide a roadmap explaining how they intend to overcome the gaps, with the possibility of further supervisory action.

Final report published on disclosures for fossil gas and nuclear energy investments under EU SFDR

The three European Supervisory Authorities (the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA)) have delivered to the European Commission their Final Report with draft Regulatory Technical Standards (RTS) regarding the disclosure of financial products’ exposure to investments in fossil gas and nuclear energy activities under the EU Sustainable Finance Disclosure Regulation SFDR. The ESAs propose to add these specific disclosures (which will need to be provided in pre-contractual documents, on websites and in periodic reports) to give transparency around investments in taxonomy-aligned gas and nuclear economic activities and they will help investors make informed decisions.

The European Commission will scrutinise the draft RTS and endorse them within three months of their publication also clarifying the application date.

ESMA and EBA published their work programmes for 2023 prioritising sustainability and ESG risk management topics

The European Securities and Markets Authority and the European Banking Authority have both released their work programmes for 2023. The common trend for both programmes is that sustainability and ESG considerations will continue to play a key role within European financial markets. The work programmes describe key strategic areas for both European agencies as well as related activities and tasks to ensure stability within the European banking and securities industries.

The EBA will continue to focus on running EU-wide stress tests while also implementing the European ESG agenda in its regulatory and risk assessment mandates as well in its own organisation and will further develop its ESG risk monitoring framework to monitor ESG risk for the European banking sector and the developing green financial markets. The agency will gradually increase its use of relevant external ESG data for its ESG risk monitoring framework, with a focus on climate-change-related risk data.

ESMA’s work programme sets deliverables in several areas for 2023, including on sustainable finance issues such as:

1. Enabling sustainable finance: develop remaining technical standards under the Sustainable Finance Disclosure Regulation and work to better understand and fight against greenwashing.
2. Investors and issuers: coordinate a Common Supervisory Action (CSA) regarding sustainability, covering the risk of greenwashing in the fast-growing area of sustainable investment products. ESMA also expects to be mandated to support the regulatory framework for sustainable finance, under the Corporate Sustainable Reporting Directive, the proposed regulation for EU Green Bonds and the SFDR.

ESMA published final report and revised guidelines on MiFID II suitability requirements related to sustainability

ESMA published its final report on the guidelines of the MiFID II suitability requirements, a framework which seeks to strengthen investor protection and enhance the functioning of financial markets. The report incorporates sustainability factors that investment firms must consider while providing services to clients.

The key amendments to the MIFID II Delegated Regulation include 1) explaining differences to clients between sustainability and non-sustainability features without using technical jargon; 2) collecting data on the extent of client investment preferences in sustainability products; 3) assessing the clients’ sustainability preferences; and 4) training workforce on sustainability topics. The report also highlights that avoiding greenwashing is not enough and fund managers must avoid “green-bleaching” wherein investments are made into sustainable activities but not disclosed due to the fear of facing challenges with data gaps arising from disclosure scrutinisation.

EBA published Report on the integration of ESG risks in the supervision of investment firms

The EBA published a Report on how to incorporate ESG risks in the supervision of investment firms falling in the scope of the Investment Firms Directive (IFD). This Report builds on and complements the EBA recommendations on management and supervision of ESG risks for credit institutions and investment firms published in June 2021. This Report, addressed to national competent authorities covers: (i) business model analysis, (ii) assessment of internal governance and risk management, and (iii) assessment of risks (risk to capital and liquidity risk).

Acknowledging the current limitations related to data and methodologies in the assessment of ESG risks, the EBA recommends that the integration of ESG aspects in the supervisory process could follow a gradual approach, prioritising the recognition of ESG risks in investment firms’ strategies, governance arrangements and internal processes, and later incorporating them in the assessments of risks to capital and liquidity. However, competent authorities are also expected to monitor and encourage further developments in the data and methodologies allowing more accurate measurement and management of ESG risks by investment firms.

• COP27 (UN Climate Change Conference) to be held in Sharm El Sheikh, Egypt during 7-18 November with the role of finance for climate and development being discussed and COP15 (UN Biodiversity Conference) to be held in Montreal, Canada, during 7-19 December.
• UK government is expected to publish a new green finance strategy as well as an amended net zero strategy. In May 2022 the UK government launched a call for evidence to support the update of its 2019 green finance strategy. The new strategy was targeted to be published before the end of 2022 however it may be delayed into Q1 2023 considering the current political instability in the country. The strategy will aim to take stock of progress so far and set out how the UK can better ensure the financial services industry is supporting the UK’s energy security, climate, and environmental objectives. The UK government also has an obligation to amend its net zero strategy in response to the High Court decision. As a reminder, in June the English High Court determined the net zero strategy to be "unlawful" and "inadequate" with a view to meeting the UK's 2050 net zero ambitions and ordered that the strategy be refined and reissued by the end of March 2023.
• EFRAG is expected to publish the first batch of EU ESG Reporting standards for the European Commission to adopt. The European Financial Reporting Advisory Group (EFRAG) has already published the initial draft of the European Sustainability Reporting Standard for public feedback. This draft sets out the proposed requirements for companies to disclose on sustainability-related risks, impacts, and opportunities under the incoming sustainable reporting directive. EFRAG has been working on finalising the first set of standards to deliver to the European Commission for adoption.

Tonia Plakhotniuk, Vice President, Climate & ESG Capital Markets

Daniel Bressler, Vice President, Climate & ESG Capital Markets, Corporates

Tyler Mayzes, Analyst, Climate & ESG Capital Markets, Corporates