ESG – A Sustainable Finance Journey beyond the EU Taxonomy
Sustainable Finance a key focus under the EU Green Deal
The European regulatory landscape has been characterised by a period of profound change and development over the last decade. More recently, one of the main priorities of the European authorities and policy makers is sustainable finance.
Sustainable finance is expected to play a vital role in meeting the EU’s policy objectives under the European Green Deal, aiming to make Europe the first climate-neutral continent by 2050. It will also enable the EU to meet its international commitments on climate change under the Paris agreement and the sustainability objectives as part of the UN 2030 Agenda for Sustainable Development.
The EU Green Deal action plan is the EU’s response to tackle climate change and environmental degradation. In fact, it has been estimated that the European Green Deal investment plan will mobilise more than €1 trillion of sustainable investments over the next decade, channelling public and private investments in the transition to a low-carbon economy.
One of the biggest challenges is the evolving nature of the regulatory landscape. The lack of harmonisation between different regulatory frameworks creates a significant obstacle for the market. Moreover, the lack of synergies has, in the past, brought inconsistencies in interpretations and overlaps between various pieces of legislation.
Another important challenge is the robustness and reliability of information provided under the various legislations. Currently, information disclosed is far from a satisfactory level of standardisation, consistency, and comparability.
The European Commission (EC) Action Plan on Financing Sustainable Growth was the first essential step towards establishing a sound regulatory framework on sustainable finance. The renewed sustainable finance strategy and implementation of this action plan lay out the EC’s strategy to further connect finance with sustainability.
The importance of high-quality, standardised ESG data
European DataWarehouse (EDW) is closely monitoring regulatory developments in sustainable finance with regard to disclosure requirements and contributes to the various relevant public consultations based on its expertise with regulatory data reporting and templates.
A fundamental factor for the achievement of these goals is the collection and disclosure of high-quality, standardised ESG data. Data plays a key role for financial markets, and is essential for achieving the desired real-economy transition.
Data availability, comparability, and quality are among the most commonly identified challenges in this transition to sustainability. The challenges that need to be addressed can be summarised as follows:
- Existence of multiple regulatory disclosure frameworks and different timelines (currently, there are three key EU regulations on sustainability disclosure: the Sustainable Finance Disclosure Regulation, the Non-Financial Reporting Directive, and the Taxonomy Regulation)
- Lack of ESG data standardisation and metrics
- The absence of a centralised publicly accessible data space for companies’ ESG information, combining data reported under the various EU regulatory frameworks.
CHALLENGE #1: Existence of multiple regulatory disclosure frameworks and different timelines
There are currently three key EU regulations on sustainability disclosure:
1. Sustainable Finance Disclosure Regulation (SFDR)
In December 2019, the SFDR was published in the Official Journal (OJ) and came into force on 10 March 2021. This regulation introduces sustainability disclosure obligations for financial market participants (FMP) and financial advisers with respect to adverse impacts on sustainability matters at both entity and financial product level.
The European Supervisory Authorities (ESA) have been mandated to develop Regulatory Technical Standards (RTS) on the content, methodology, and presentation of the relevant information to be disclosed under this regulation. The final RTS were submitted to the EC in February 2021 and they will apply from 1 January 2022. This regulation aims to address some of the existing challenges, including the lack of transparency and comparability.
2. Non-Financial Reporting Directive (NFRD) – Corporate Sustainability Reporting Directive
In December 2019 the EC announced its intention to review the NFRD as part of its strategy to strengthen the foundations for sustainable investment. Under the NFRD, public interest entities (PIE) with more than 500 employees were required to disclose non-financial information. This includes, reports on their policies regarding social responsibility and treatment of employees, respect for human rights, anti-corruption and bribery, as well as diversity on company boards.
More recently, on 21 April 2021, the EC published its proposal for a Corporate Sustainability Reporting Directive (CSRD) which aims to revise and strengthen the rules of the NFRD and bring it into alignment with other disclosure requirements, in particular the Sustainable Finance Disclosure Regulation (SFDR) and the Taxonomy Regulation. More specifically, the purpose is to reduce complexity and to avoid any duplication of reporting requirements.
The CSRD significantly broadens the scope of the NFRD by extending the reporting requirements to all listed EU companies (excluding micro entities), and large non-listed companies. Non-listed SMEs could also report on a proportional and voluntary basis. This means that 50,000 companies in the EU would be subject to sustainability disclosures compared to 11,000 previously under the scope of the NFRD.
3. EU Taxonomy Regulation
The Taxonomy Regulation (TR) plays a major role in this transition by establishing a classification system for environmentally sustainable economic activities and amends both the SFDR and the NFRD.
The former is amended by requiring FMPs to disclose information on “how and to what extent” the activities funded by these products are taxonomy-aligned. For those that are not taxonomy-aligned a statement is required confirming that they do not consider the EU taxonomy.
The TR mandates the ESAs to develop RTS specifying the details and the information to be made available in this respect. Currently the ESAs are consulting on taxonomy related product disclosures . To avoid duplication of reporting, the ESAs proposed amending the existing RTS under the SFDR by also incorporating the taxonomy related disclosures. The consultation closed on 12 May 2021 and the relevant delegated act supplementing Article 8 of the EU Taxonomy Regulation was adopted by the EC on 6 July 2021.
The latter is also amended based on the Article 8 of the TR, which requires financial and non-financial companies in the scope of the CSRD (former NFRD) to include information on “how and to what extent” their activities are aligned with environmentally sustainable economic activities. Article 8 also requires non-financial companies to disclose the share of their turnover derived from products aligned with environmentally sustainable economic activities.
The new disclosure requirements will apply from 1 January 2022 with regard to the climate change mitigation and climate change adaptation environmental objectives. From 1 January 2023 they will also apply with respect to the other four environmental objectives.
Finally, other regulations are also amended to integrate sustainability factors or to disclose sustainability-related information, for example, the Securitisation Regulation (EU) 2017/2402.
As per the transparency requirements of the Simple, Transparent, and Standardised (STS) framework, reporting entities should make environmental performance data available for assets financed by residential mortgage loans and auto loans & leases, provided such information is available to the originator.
EDW, as a registered Securitisation Repository under this regulation, collects information on the EPC certificate and the EPC certificate provider name for those securitisations.
Following the publication of the Capital Markets Recovery Package in the OJ on 6 April 2021, the Securitisation Regulation has been further amended to include the disclosure of sustainability-related information:
- Art. 22 (4) states that originators may decide to publish such information and, at the same time, the ESAs shall develop an RTS on the content, methodologies, and presentation of the above-mentioned information.
- Art. 45a specifies that the ESAs shall publish a report on the development of a sustainable securitisation framework by 1 November 2021. Moreover, such a report should be submitted to the European Parliament and to the Council together with the report on the functioning of the Securitisation Regulation as per Article 46.
Thus, it is evident that ESG data is also broadly applicable in the context of securitisation. In particular regarding climate change risks related to the assets financed by the underlying exposures, social factors in relation to potential discriminatory practices in underwriting and servicing, and governance issues with respect to the legal framework of a specific transaction.
CHALLENGE #2: Lack of ESG data standardisation and metrics
ESG data providers typically rely on either corporate self-assessments or on ESG datasets provided by data collectors. Currently, the primary source of ESG data is the corporate sector via self-assessed corporate and integration reports. Secondary sources include public statistics and datasets and industry surveys. The activity of financial organisations and data providers is therefore highly affected by the quality and consistency of data and, as a result, a vast industry has emerged to serve the need for ESG information. This requires disclosing parties to interact with various stakeholders: data collectors, investors, and data providers.
ESG data stakeholders are highly interdependent, hence, the lack of consistency and verification which may lead also to diverging ESG ratings. This constitutes an issue given that a significant number of financial institutions do not have the resources to analyse ESG data and, consequently, rely heavily on external providers.
In light of this, EDW joined forces with the Joint Research Committee (JRC) of the EC and the University of Cagliari for a research project on the need for a targeted disclosure and financial risk assessment framework to classify and include ESG metrics.
Specifically, the project aims at developing and testing a first-generation matrix that would capture the overall ESG risk exposure of European banks both at individual- and banking system-level.
The first step is represented by the ongoing analysis of ESG scores and methodologies from the most important data providers such as Bloomberg, Vigeo Eiris, S&P, and Sustainalytics. Once the ESG exposure matrix is designed, it will be tuned according to the results of a recently launched, sector-specific survey involving the major European banking institutions.
The ESG survey closes on 20 August 2021 and the results will be presented at the International Risk Management Conference in Cagliari, Italy, on 1-2 October 2021.
The ESG scoring landscape has been the subject of critics also in academic literature. In fact, a prominent study from MIT Sloan School of Management showed that the correlation between different ESG score providers is generally poor, the worst case being that of governance factors (see Fig. 1).
Figure 1. Correlations between ESG Ratings (Berg, Koelbel and Rigobon, 2019, Aggregate Confusion: The Divergence of ESG Ratings)
CHALLENGE #3: Absence of a common centralised publicly accessible data space
Currently, investors and other stakeholders have difficulties accessing, comparing, and using companies’ financial and sustainability-related information due to fragmentation. One of the first recommendations in the final report of the High-Level Forum on the Capital Markets Union (HLF) is the establishment of a European Single Access Point (ESAP) for company information.
Based on the recommendation of the HLF, the EC published a consultation in January 2020 aimed at collecting general and technical views on how to establish a ESAP for companies’ financial and sustainable investment-related information. It was a detailed questionnaire which included assessing the scope of data.
An ESAP would not only facilitate access to such information but would also further contribute to the harmonisation and standardisation of the information, and represents an important step toward better comparability, increased transparency, lower barriers and costs, as well as assisting FMPs to prepare the data.
The ESAP should be set up as an EU-wide platform offering easily accessible and digitally usable information based on a minimum common reporting standard with respect to the IT format and technology used.
On 6 July 2021, the EC adopted a package of measures aimed at facilitating the flow of money towards financing the transition to a sustainable economy.
The package consists of three building blocks:
- Strategy for financing the transition to a sustainable economy
- Proposal for an EU Green Bond Standard (EUGBS)
- Delegated act supplementing Article 8 of the EU Taxonomy
The EC’s new sustainable finance strategy proposed actions in the following key areas: transition finance, inclusiveness, resilience and contribution to the financial system, and global ambition.
The second pillar aims at setting a voluntary “gold” standard for green bond issuers with the objective of demonstrating that financing is flowing towards EU-Taxonomy aligned green projects and reducing the risk of greenwashing by allowing comparison of investments against a recognised standard.
The EUGBS framework is built on the following key principles:
- Inclusive: all EU and non-EU issuers can issue European green bonds
- Voluntary: it is a voluntary standard
- Alignment with the EU Taxonomy: the use of proceeds should be fully allocated to projects that are EU taxonomy aligned.
- Transparency: yearly allocation reports of the bond proceeds and impact report at least once after the full allocation of proceeds
- External review: it will be subject to external review to ensure that they are compliant with the EUGBS Regulation
- Supervision of the reviewers by the European Securities and Markets Authority (ESMA): the external reviewers will be registered and supervised by ESMA
The Delegated Act intends to enhance transparency and mitigate the risk of greenwashing by making available information to investors with respect to the environmental performance and economic activities. This act specifies the content and methodology regarding the disclosure of information by financial and non-financial entities within the scope of the NFRD.
The evolution of the sustainability disclosure framework
This report demonstrates the highly complex nature of the sustainability disclosure framework which is expected to continue evolving over the years to come thanks to the development of global standards via the engagement of international bodies such as the IFRS Foundation and IOSCO.
In light of this, it is desirable that regulators continue working on the alignment of the various sustainability disclosures and that financial and non-financial companies, subject to the sustainability disclosure obligations, develop efficient methodologies to address common disclosure requirements.
In order to achieve high-quality data, the disclosure process needs to be streamlined with timelines as a key aspect. The establishment of a ESAP is also critical in this process.
Provide your input
European DataWarehouse is currently conducting a survey on behalf of the Joint Research Centre of the European Commission to collect industry feedback on the criticality of ESG factors within banks’ risk and investment management frameworks.
The data will be analysed as part of a project on modelling the ESG risk exposures of European banks from both a micro and macro-prudential perspective and will be crucial in identifying key features that a bank’s ESG assessment models should include.
Please click below to provide your input. The survey will close on 20 August 2021. If you have any questions, contact our team via ESG@eurodw.eu.