Sustainability in the EU Financial System between Classifications and Disclosures by Bianca Nalbandian

Even before Covid-19 wreaked havoc on the global economy, “sustainable finance” was a much-touted topic already. Beyond being a worldwide catchphrase, sustainable finance amounts to be one of the highest ranked objectives in the EU “green” agenda. Generally, by sustainable finance, green finance or ethical investing one broadly refers, in the financial sector, to incorporating environmental, social and governance (ESG) factors in the investment decision-making process. This necessary calls for a high degree of transparency in the financial industries on risks related to ESG factors that may affect the financial system and the mitigation thereof. Sustainable finance is pivotal for mobilising the capital necessary to meet the European Green Deal’s targets as well as, more broadly, EU’s international commitments on climate change. Indeed, to reach 2030 climate and energy targets and transition to an environmentally sustainable economic model, the European Commission expressily stated that the EU would have to overcome an investment gap of EUR 260 billion a year by 2030.

In this connection, in March 2018 the Commission adopted an Action plan on financing sustainable growth. Such Action plan calls for, inter alia, creating standards for green financial products; incorporating sustainability as part of financial advice; developing sustainability benchmarks; better integrating sustainability into ratings and strengthening the disclosure made by asset managers and financial advisors to their clients. Amongst this array of engagements, the Action plan spells out the need for “[a] shift of capital flows towards more sustainable economic activities [which] has to be underpinned by a shared understanding of what ‘sustainable’ means. A unified EU classification system – or taxonomy – will provide clarity on which activities can be considered ‘sustainable.

A taxonomy, namely a technical framework through which assessing, on a scientific-comparable basis, the sustainable character of an economic activity, might be seen as the foundational brick upon which the whole sustainable finance framework can build up. This is even more so as one of the main hurdles the financial services industry has encountered in engaging in sustainable finance is the lack of a conventional system of reference for evaluating financial products’ sustainability. This, in turn, resulted in a general lack of confidence by investors seeking to turn to sustainable activities and in the rise of so called “green-washing” risks (see below for a definition).

In this last respect, with the establishment of a conventional framework of reference able to watershed what is sustainable from what is not, financial market participants can efficiently disclose the degree of environmental sustainability of their products upon which investors can consequentially operate informed and conscious investment choices. And this is the very point on which the EU seems to have recently taken the lead, potentially becoming a global standard-setter.

The Taxonomy Regulation

On 18 June 2020, the Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment (Taxonomy Regulation or the Regulation) of the EU Parliament and the Council was adopted. The Taxonomy Regulation, which entered into force on 12 July 2020, amends the Regulation (EU) 2019/2088 on Sustainable Finance Disclosure Regulation (Disclosure Regulation) entered into force already in December 2019. Given the Taxonomy Regulation’s foundational character, one might have expected the sustainable finance’s “lingua franca” to be agreed upon before setting ESG factors disclosure requirements to financial market participants. Yet, the Taxonomy Regulation has been object to substantial and lengthy political negotiation, which may explain the prior adoption of the Disclosure Regulation on 9 December 2019.

The Taxonomy Regulation aims at establishing a European classification system defining environmentally sustainable activities. This entails removing barriers to the functioning of the internal market by harmonising Member States’ labelling schemes and classifications of sustainable investments products and activities. Consequently, this would increase capital flows and cross-border investments in truly sustainable activities also reducing green-washing risks, i.e. the practice of “gaining an unfair competitive advantage by marketing a financial product as environmentally friendly, when in fact, basic environmental standards have not been met”.

As for its scope of application, the Taxonomy Regulation refers back to the Disclosure Regulation. Indeed, both the Disclosure Regulation and the Taxonomy Regulation apply to “financial market participants”. Broadly, financial market participants are asset managers and institutional investors. More specifically, the Taxonomy Regulation’s scope of application encompasses: (a) measures adopted by EU Member States (when determining national level rules regarding financial products marketed as environmentally sustainable); (b) financial market participants with products that promote environmental characteristics; (c) financial market participants with products that do not promote environmental characteristics (though their obligations are limited to the making of negative statements); and (d) undertakings which are subject to the obligation to publish a non-financial statement or consolidated non-financial statement as per Directive 2013/34/EU as amended by Directive 2014/95/EU. Under Article 2 of the Disclosure Regulation, financial products includes segregated portfolios, funds (UCITS and AIFs), insurance products, pension schemes, pension products and pan-European personal pension (PEPP) products.

According to Article 3 of the Regulation, for an economic activity to qualify as sustainable, the latter should contribute substantially to at least one of the defined environmental objectives under Article 9. The six-abovementioned environmental objectives are: (a) climate change mitigation; (b) climate change adaptation; (c) sustainable use and protection of water and marine resources; (d) transition to a circular economy; (e) pollution prevention and (f) control and protection and restoration of biodiversity and ecosystems. The objectives are detailed in Articles 10 to 15. Such an economic activity must also not significantly harm any of the environmental objectives and comply with a series of minimum social safeguards (e.g., OECD Guidelines on Multinational Enterprises and the UN Guiding Principles on Business and Human Rights). The Taxonomy Regulation lays down the criteria for “substantial contribution” (Article 15) and “significant harm” (Article 17) for each of the six objectives.

In addition, to be deemed sustainable and considered Taxonomy-aligned, an economic activity has to meet specific performance thresholds (technical screening criteria). These technical screening criteria practically determine which economic activities can substantially contribute or cause significant harm to the objectives and comply with the minimum social safeguards. The technical screening criteria will be set out in delegated acts adopted by the Commission (after consultation of the yet to be established Platform on Sustainable Finance, see Article 20 of the Regulation). At the time of writing, the Commission is assisted by the Technical Expert Group on Sustainable Finance (TEG) in developing criteria for the objectives of climate change mitigation and adaptation, which are intended to be finalised by the end of  2020, with the remaining four objectives due by the end of 2021. The TEG has already released a final Report on the Regulation implementation in March 2020, providing guidance for developing disclosures based on the Taxonomy Regulation as well as a summary of the economic activities covered by the technical screening criteria.

Practically, rather than creating a green labelling system, the Taxonomy Regulation establishes a comparative analysis of the sustainability of economic activities. Indeed, if pared with the disclosure requirements, it will highlight the level of sustainable investments made by an allegedly sustainable product or by a product claiming to promote environmental factors. Then, if the disclosed proportion of sustainable investments is low, the financial product may be rendered unattractive to investors. This analysis is likely to begin with the identification by financial market participants of the various economic activities of a company with a view to identifying those that may be Taxonomy-eligible and against which the other tests can be applied. Once the Taxonomy alignment of individual companies within a portfolio has been identified, the next step envisaged by the Taxonomy is the calculation and disclosure of the percentage of the overall investment portfolio and each individual holding comprised of Taxonomy-eligible activities.

The (Amended) Disclosure Regulation

As mentioned, the Taxonomy Regulation amends the 2019 Disclosure Regulation. The latter lays down disclosure requirements on the integration of sustainability risks, on the consideration of adverse sustainability effects, on sustainable investment objectives, and on the promotion of environmental or social characteristics, in investment decision‐making and in advisory processes. The Disclosure Regulation sets disclosure obligations both at the financial market participant level as well as at the product level (see above for a definition). With regard to adverse sustainability impacts and in respect to both levels of disclosure obligations, financial market participants may opt for not considering principal adverse impacts (unless they exceed specific size). Vis-à-vis sustainability risks, financial market participants may also decide not to consider them relevant to a particular financial product. Nonetheless, in these cases, such firms will have to provide clear reasons for why they do not account for these impacts and risks, including, where relevant, information as to whether and when they intend to consider such adverse impacts, on a “comply or explain” basis.

For financial market participants that promote sustainable investment products, the Disclosure Regulation establishes transparency obligations for the products’ sustainable features. According to the Disclosure Regulation “[s]ustainable products with various degrees of ambition have been developed to date”. That is why the disclosure obligations for financial products that promote environmental or social characteristics are different between from those financial products that have as an objective a positive impact on the environment and society.

The three European Supervisory Authorities (EBA, EIOPA and ESMA, collectively ESAs) are mandated with the task to define with regulatory technical standards (RTS), the content, methodologies and presentation of the information required concerning adverse sustainability impacts and in respect of financial products that promote environmental or social characteristics or that have sustainable investment as their objective. In April 2020, the ESAs published a joint consultation paper setting out draft RTS in respect of each of these. The consultation paper is open to feedback until 1 September 2020. Moreover, in amendment of the Disclosure Regulation (Article 2a), the Taxonomy Regulation establishes that the ESAs will also have to specify in the RTS the exact content and presentation of the information concerning the principle of “do no significant harm”. Such RTS are also currently under development.

The Way Ahead

As noticed by the TEG, the EU Member States are the first actors in the world to create “a cross-market legal obligation” such as the Taxonomy Regulation set of provisions. In the context of the Covid-19 pandemic, this regulatory advancement has become even more crucial for pursuing a resilient recovery by aiming at increasing long-term investments into sustainable economic activities and projects and at reorienting private investments – alongside with public capitals – toward the required transition to a climate-neutral economy. Together, the Taxonomy Regulation and the Disclosure Regulation may be able to provide a higher degree of clarity to investors on the substance underlying purportedly sustainable products.

One the one hand, the Disclosure Regulation would divulge financial market participants’ ESG-risk management for products, provide information on the investment decisions’ negative impacts on sustainability factors and, where applicable, on key features of the product’s sustainability characteristics or objectives. The Taxonomy Regulation, on the other hand, would provide “empirical evidence as to the underlying portfolio’s sustainability” and progressive uniformity at the EU level as per the future development of sustainable finance policies, labels, standards and classifications.

However, one ought to recall that risks of shortcomings can still be detected in the ambitious European project for an ESG classification and disclosure regime. By way of example, in the draft RTS proposed by the ESAs in April 2020, “fossil fuel sector” is defined as only encompassing solid fossil fuels such as coal and lignite leaving out liquid fossil fuels as oil. It has been noticed that such exclusion might bring asset managers and other financial market participants to meet higher disclosure requirements for solid fossil fuels exposure than the ones required for oil and gas company exposure. While this follows the EU’s new classification system for environmentally sustainable investments, which states that solid fossil fuels can never be deemed as green, it however risks creating a false dichotomy between coal products and oil, which can unequivocally hardly be seen as a green. As declared by the director of financial sector strategies at responsible investment group “ShareAction”, the ESAs’ proposal might be seen by some as “like disclosing the amount of fat in a chocolate bar, but conveniently failing to mention the sugar content”. This could potentially mislead investors to think the fossil fuel sectors as applying to the common, wider understanding of fossil fuels resulting in further supports to energy sources not in line with the Paris Agreement’s targets. However, at the time of writing, ESAs are still at the consultation phase, which will close in September. The table may still then turn in favour of a wider definition of fossil fuels category in the final Report.

The Taxonomy and the Disclosure Regulations are not to be seen as a final step. Quite the opposite, they are one important brick in the construction of a European sustainable financial system which will still require further developments. Indeed, as mentioned, these regulations will have to be supplemented by further technical clarifications and reports and have to be read in combination with other EU measures (see, for instance, the Benchmark Regulation). All in all, given the advancement at the EU level and the state of the ongoing global debate, one could even dare to think that, in spite of the pandemic, the years ahead could still be a place and a time for cementing environmental and climate change interests.



Bianca Nalbandian is a Research Fellow at the Max Planck Institute Luxembourg for Procedural Law. She is conducting her Ph.D. on the topic of sovereign wealth funds in international investment law at the University of Luxembourg in joint supervision with the University of Turin.


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