Can sustainability-related risks be integrated in the disclosure obligation under the EU Taxonomy Regulation? by Elia Cerrato García

The EU Taxonomy Regulation Sustainable finance: moving towards a forward-looking approach

The EU Taxonomy Regulation, which enters into force on 1 January 2022 contains the action of EU and worldwide legislators to mitigate the worst consequences of climate change. It includes sustainability factors to reshape the economic activities that have adverse impacts on the environment. The ultimate goal of the EU Taxonomy Regulation is to enhance the transparency in order to achieve the goals that the Paris Agreement and the European Green Deal are aiming for. In doing so, the Regulation introduces incentives to encourage private investments to reorient the capital flows towards companies and investments transitioning to or engaged in more sustainable activities. The EU Taxonomy Regulation covers the following six environmental objectives: (1) climate change mitigation; (2) climate change adaptation; (3) the sustainable use and protection of water and marine resources; (4) the transition to a circular economy; (5) pollution prevention and control; and (6) the protection and restoration of biodiversity and ecosystems.

The EU Taxonomy Regulation created a classification system for sustainable investments that intends to enable end-investors to assess whether certain economic activities are “sustainable” by using a common criterion of identification of sustainable activities and reinterpreting the disclosure obligation. The transparency-based efforts of the EU Taxonomy Regulation supplement the rules on transparency in pre-contractual disclosures and in periodic reports, and the sustainability-related disclosures laid down in the  Disclosure Regulation, which conversely affect the non-financial information disclosure set out in NFRD for large corporations. In addition, the Taxonomy Regulation amended certain provisions of the Disclosure Regulation. For instance, under the EU Taxonomy Regulation, the nature of the material information responds to the adoption of a forward-looking disclosure approach, instead of historical information background approach, given that financial market participants are requested to disclose:

  • Where market participants develop an economic activity that contribute to one or more environmental objectives, a statement including information on how, and to what extent, the investments underpinning their financial product support are “environmentally sustainable investments” under the Taxonomy Regulation;
  • Where market participants that do not take the criteria for “environmentally sustainable investments” into account, a statement that they do not take into account the EU taxonomy;
  • Where financial products are marketed as promoting environmental protection in a broad sense, a statement to that end.

The Taxonomy Regulation justifies that forward-looking approach to environmental sustainability is needed due to the systemic nature of global environmental challenges. One of the striking points posed by the EU Taxonomy Regulation in relation to the new disclosure regime is to assess the climate-related risks associated with the forward-looking sustainability considerations without entraining additional inconsistencies in the quantification of those risks.

Assessment of the financial materiality of sustainability-related risks

The Disclosure Regulation sets out that pre-contractual disclosures of financial market participants must include: (1) an assessment of potential impacts of sustainability-related risks on the returns of financial products, either in qualitative or quantitative terms, and (2) how sustainability risks are integrated into the financial market participant’s investment-choices. The EU Taxonomy Regulation takes this idea further to introduce an additional assessment of the potential impact of the transition towards a more sustainable economy, and, as a result of the transition, the risks that certain assets becoming stranded, and the risk of creating inconsistent incentives for investing sustainably. Hence, market participants shall conduct a double assessment of materiality risks: a financial materiality assessment, where financial materiality arises from the economic activity of market player entire value chain, and a sustainability materiality assessment, where social or environmental materiality stems from the external impact of the economic activity on the environment and the communities.

However, approaching the materiality of climate-related or sustainability-related risks differs from the assessment of financial materiality since the latter can be assessed by reference to market-based criteria, whilst the former are more uncertain. On the one hand, the lack of definition of “sustainability materiality” in the existing regulation can challenge the assessment of environmental impact of the financial product and hamper the verification of the due allocation of the proceeds. On the other hand, since not all financial services are likely to be affected on the same way by ESG factors, the particular ESG features of each exposure will affect the assessment of sustainability-related risks. In these circumstances, market financial market will likely engage with “sustainable investments” provided that they do not have to assume inappropriate or excessive risks.

This idea is taken further by the European Supervisory Authorities (ESAs) to encourage market participants and financial advisers to integrate sustainability risks into their overall risk assessment framework, “regardless of the sustainability preferences of the end-investors”. The recent Discussion Paper of the EBA reveals how a high number of credit institutions are concern over their resilience to climate change and working on addressing the materiality of physical and transition sustainability-risks. Nonetheless, the absence of sustainability key performance indicators boosts the use of heterogeneous practices to determine the sustainability risks across institutions.

The financial materiality of sustainability-related risks will need to be carefully assessed by supervisors too. According to the EBA, “ESG factors and ESG risks would also enter into the assessment of the credit institution’s main activities, geographies and market position, particularly into the determination of the materiality of the different exposures and into the identification of the peer group of a credit institution.” The EU Taxonomy Regulation emphasizes that competent authorities of Member States shall monitor the compliance of financial market players and financial advisers with the Requirements of the Regulation, which includes the market players obligation to disclose all sustainability-risks that affect the performance of the business and financial products. In this regard, the EBA proposes the incorporation of long-term business model resilience as a new way to enrich the supervisory analysis given that the existing evaluation process is potentially insufficient in enabling supervisors to understand the longer-term impact of sustainability-related risks on future exposures and financial positions.

The materiality assessment of the environmental impact of an economic activity and the disclosure of not misleading information are subject to technical details that, because they are not covered by the regulation, pose challenges to institutions and supervisors. Therefore, the EU Taxonomy Regulation explains that technical standards need to be adapted to reflect the changes demanded by sustainable economic activities. To that end, the Regulation has requested EBA, ESMA and EIOPA to draft regulatory Technical Screening Criteria (TSC). The ESAs shall jointly draft the TSC for each environmental objective taking into account the differences between financial products. The TSC shall comply with the following requirements: (1) they should identify the minimum requirements necessary to avoid significant harm to other objectives; and (2) they must be based on available scientific evidence.

As regards (1), the EU Taxonomy Regulation states that the Commission should establish granular TSC for the different economic activities where the conditions for ‘substantial contribution’ and ‘significant harm’ should be specified. Nonetheless, where the sustainability indicators enshrined in the Disclosure Obligation are unfeasible, or scientific evidence to determine a risk with sufficient certainty is unavailable, “the precautionary principle should apply in accordance with Article 191 TFEU”, which builds on any minimum requirements laid down pursuant to EU law.

In relation to (2), the EU Taxonomy Regulation recognizes that the environmental and social objectives pursued by the EU Taxonomy Regulation have long been integrated in the TEU and TFEU. The “do no significant harm” principle embedded in the EU Taxonomy Regulation should be read together with Articles 3(3) of the TEU and 11 TFEU. Article 3(3) establishes that the EU shall work on the development of an internal market that protects and improve the quality of the environment and works for a sustainable development based on a balanced economic growth, price stability and a competitive social market economy in Europe. Article 11 states that the design and implementation of EU’s activities and policies must integrate environmental protection requirements with a view to promoting sustainable development.

Connections between the principle of do no significant harm, the materiality assessment of sustainability-risks, and the EU Treaties

The EU Taxonomy Regulation requests the adoption of TSC for each environmental objective. What it means for an economic activity to substantially contribute to an environmental objective is for the investment underlying the financial product to “not to significantly harm any of those objectives”.

The “do no significant harm”, which is a principle of international law, applies, in the context of the EU Taxonomy Regulation, only to those “investments underlying the financial product that take into account the EU criteria for environmentally sustainable economic activities”. The EU Taxonomy Regulation specifies that corporations should adhere to “do no significant harm” principle to qualify as “environmentally sustainable” provided that the economic activity is carried out in alignment of the international standards envisaged in the UN Guiding Principles on Business and Human Rights, OECD Guidelines for Multinational Enterprises, the ILO and the International Bill of Human Rights, and the Charter of Fundamental Rights of the EU. The EU Taxonomy Regulation emphasizes that the EU law may apply more stringent requirements related to the environment, health, or safety. For environmental matters, the requirements embedded in Articles 3 TEU, and 11 and 191 TFEU can serve as “stringent requirements” to the extent that they demand corporations to observe the impact of their activities in the environment, and to EU institutions and authorities to integrate them into their policies and decisions. Some analysis has shown that situations where the EU situations infringe Articles 3 TEU and 11 TFEU can be vulnerable to litigation risks.

The “do no significant harm” principle’s relationship with all the above-mentioned international standards, and the disclosure obligation comes under the EU Taxonomy Regulation: Articles 6 and 25(2)(c) of the EU Taxonomy Regulation evidence that disclosure of sustainable investments’ information shall meet the TSC. Furthermore, the TSC shall be consistent with the principle of “do no significant harm” (Article 25(1)), the objectives that disclosures are to be accurate, fair and not misleading (Article 25 (2)(c)), and the minimum safeguards where the cited international standards are attached (Article 18). Thus, it would be reasonable to expect that the TSC will impose market participants the obligation to make environmental-related risks more apparent through disclosure obligations to ensure that the investment underlying the financial product contributes to the minimum safeguards and causes “no significant harm”. Yet, the integration of sustainability considerations in the disclosure obligations requires great effort to identify regulatory bottlenecks. However, Article 191 TFEU underscores that EU and Member States shall collaborate in the interest of the environment protection. This collaboration will create opportunity to get sufficient technical data and equip the private sector to more efficiently assess and manage climate-risks can encourage a race to the top.


The need to provide a strong and uniform response to the COVID-19 pandemic reinforces the idea of the importance of integrating sustainability considerations in the transition towards a low-carbon economy. As the improvement of disclosure by corporations and institutions increases, the influence of ESG risks can be expected to grow too. Several of the measures adopted have focus largely on addressing information asymmetries in the marketplace through improved disclosure, disregarding other mechanisms that are of relevance to face the challenges posed by sustainable finance. The EU Taxonomy Regulation aims to correct the asymmetries in respect to the integration of sustainability risks in decision-making processes too. Despite the efforts, the 2020 ESMA annual report on corporate disclosures and enforcement shows that although 71% of issuers are providing sufficient disclosure under the current regulatory framework, 10% of issuers provided disclosure in a boilerplate fashion, and the 20% of issuers did not provide any information about policies for addressing climate change-related matters. In this regard, a more assertive integration of sustainability risks as financial risks is required, hence moving beyond a mere reputational risk.

The inequalities of the impact of ESG risks on distinct financing activities constitute an obstacle to comply with the goals reflected in the EU Taxonomy Regulation. It is then important that institutions and supervisors are able to distinguish and form a view on the relevance of sustainability-related risks, following a proportionate, risk-based approach that takes into account the likelihood and the seriousness of the materialization of sustainability-related risks. The EBA’s proposal regarding the integration of long-term business model resilience in the supervisory review process can go a long way toward ensuring efficient verification of the compliance with the obligation to disclose accurate, fair, not misleading information in regard to the “do no significant harm” principle.

In conclusion, there cannot be sustainable and green finance without a serious commitment. Much attention will focus to the implementation of the taxonomy when the TSC have been adopted through delegated acts as well as on other policies in process, like the announcement of the Bank of England to make a path towards mandatory climate-related disclosures across the UK, which can further foster comparable high quality disclosures and provide greater clarity to the financial markets on how to align their reporting.

Elia Cerrato García is a Law Professor at Centro Universitario de Estudios Financieros (CUNEF). She is doing her PhD on sustainable finance regulation at Carlos III University in joint supervision with the University of Bologna. Before starting her PhD, she was a lawyer in a managing company of venture capital entities in Madrid, and she worked as an Assistant Legal Counsel at the Permanent Court of Arbitration.

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