Application of the EU Taxonomy Regulation for Financial Market Participants

Since 2020, the EU has adopted several new environmental, social and governance (ESG) regulations. For financial market participants (FMP), the EU Taxonomy Regulation (EU Taxonomy 2020) and the Sustainable Financial Disclosure Regulation (2021) are most relevant as many FMPs start complying with the EU’s developing sustainable finance framework.

The EU Taxonomy establishes a common classification system for sustainable activities by setting out four criteria that a sustainable investment must meet: (1) make a substantial contribution to at least one of the six environmental objectives, (2) do no significant harm to any of the other five objectives, (3) comply with minimum safeguards, and (4) comply with the technical screening criteria set out in the EU Taxonomy delegated acts.

Meanwhile, the Sustainable Financial Disclosure Regulation (SFDR) imposes mandatory ESG disclosure obligations for FMPs, including on how they consider sustainability risks in the investment decision-making and on any adverse impacts of their investment decisions on sustainability.

Increased Disclosure Obligations Under New ESG Regulations

While the EU’s implementation of these ESG regulations has been gradual, the obligations arising from these regulations—particularly when measuring and disclosing the sustainability of their activities—are already significant for FMPs.

Firstly, at the organizational level, FMPs must consider ESG requirements in multiple processes. Notably, firms must implement policies on the integration of sustainability risks into their investment decision-making. Secondly, under ESG regulations, FMPs must assess the alignment of their business activities with the EU Taxonomy in a comprehensive four-step process:

• Identify the activities covered by the EU Taxonomy. FMPs must pinpoint which activities fall under their purview and are included in the Climate Delegated Act (CDA) and the Complementary Climate Delegated Act (CCDA). 
• Assess whether the activities meet the technical screening criteria. The activities are delineated in the EU Taxonomy and further detailed in the CDA and CCDA, namely the “Do No Significant Harm” and substantial contribution criteria. 
• Check compliance with the minimum safeguards. This step evaluates whether the firm is in conformity with the guidelines set out by the Organization for Economic Co-Operation and Development (OECD) and the United Nations (UN) guiding principles on business and human rights.
• Apply relevant reporting rules. Firms must disclose alignment with the EU Taxonomy, including within prospectuses and periodic reports.

The Challenge of Compliance

Assessing alignment with the EU Taxonomy and abiding by the reporting requirements can be challenging and resource intensive. Firms are required to implement an ESG framework, including designing and implementing ESG policies and procedures, screening their activities to see which need to be assessed, collecting data on the alignment of these activities with the EU Taxonomy, and disclosing the degree of alignment in regular reporting.

Recent studies have pointed to a lack of disclosure by FMPs, often due to the absence of data on selected adverse sustainability impact indicators and, more broadly, insufficient corporate disclosures. This lack of data makes it hard for FMPs to report to investors on EU Taxonomy alignment. Moreover, FMPs must keep up with frequent regulatory changes, which impact how and when they report, to ensure that they do not fail to comply with ever-evolving regulatory requirements.

What types of challenges do FMPs face when implementing an ESG framework, keeping up with regulatory changes and dealing with challenges relating to collecting data?

Case Study 1

An asset management company operating in the EU was looking to market its Article 8 funds in France. Where funds are marketed to retail investors, local requirements demand enhanced frameworks and additional disclosures. The French regulator L'Autorité des marchés financiers guidelines 2020-03 state that information provided to investors must be proportionate to how extra-financial characteristics are considered.

Kroll assisted the firm with developing its ESG framework by conducting a gap analysis against regulatory requirements and updating ESG policies, processes, pre-contractual documentation, periodic reports and its website. Kroll also advised the firm when exchanging and submitting documents to the French regulator.

Kroll’s support ensured that the pre-contractual documentation, periodic reports and the website complied with the applicable national regulatory requirements as well as the SFDR/EU Taxonomy framework. Kroll can also conduct regulatory audits on ESG frameworks to ensure that firms comply with the applicable requirements and provide relevant training to ensure key staff members are aware of the key requirements posed by the regulation. 

Case Study 2

An investment firm in Europe was looking to invest in a renewable energy company in Central Asia, which it deemed to qualify as a sustainable investment under EU Taxonomy. The EU Taxonomy makes clear that this investment will not be “taxonomy-aligned” unless it complies with “minimum safeguards,” or procedures implemented by an undertaking to ensure compliance with standards set by the OECD Guidelines for Multinational Enterprises (OECD Guidelines) and the UN Guiding Principles on Business and Human Rights (UN Guiding Principles) related to human rights, bribery, taxation and fair competition.

The investor instructed Kroll to conduct due diligence on the company and a risk analysis of the country’s renewable energy industry and political environment more broadly to help them assess whether the undertaking complied with minimal safeguards by avoiding and addressing any negative impacts and having the appropriate due diligence procedures in place.

Through public record research, Kroll identified serious violations of labor laws and allegations of corruption related to land purchases and permits by the company and its management. Furthermore, discreet inquiries with well-placed sources, including renewable energy experts, country specialists and former employees, identified specific human rights risks inherent to the business model of the undertaking and known human rights controversies related to the country’s renewable sector that the undertaking needed to address in the due diligence processes. 

Kroll’s due diligence helped the investor identify human rights breaches, while its country and industry risk analysis helped inform the investor’s assessment of whether sustainability risks were addressed in the undertaking’s human rights due diligence processes.

Conclusion

As the EU looks to drive investment toward more sustainable business and increase transparency on sustainability, FMPs are increasingly obliged to evaluate and report on the sustainability of their activities. To comply with these ESG regulations and to make the EU objective of climate neutrality a success, Kroll can help FMPs implement ESG frameworks and align their activities with the EU Taxonomy and SFDR through compliance and regulatory support and human rights due diligence.