European Commission’s sustainable finance package on ESG ratings, the EU Taxonomy and transition finance

At a glance:

• On 13 June, the European Commission published a sustainable finance package, representing its final significant piece of work on its sustainability agenda during this legislative mandate.
• The main elements of the package comprised:
  - A proposal for an “ESG Rating Regulation”, with the objective of enhancing transparency around ESG rating methodologies and improving governance and             conflicts management in ESG ratings providers.
  - The adoption of two delegated acts on the Taxonomy to set the technical screening criteria for the remaining four of the six environmental objectives under the   Taxonomy, and to provide further clarification on economic activities not covered by the Taxonomy to date.
  - A recommendation on transition finance, creating a formal definition of transition finance and providing examples of how the existing sustainable finance framework can be used to facilitate the transition.

• This package brings together a range of policy proposals to deepen the impact of the EU Green Deal. However, there is still significant work to do to improve data around sustainability and how firms assess the sustainability of their investments. We expect the work to continue in the next legislative mandate.
• ESG ratings providers in the EU will need to be authorised and meet new regulatory requirements, which will require them to review and disclose rating methodologies and ensure their business models meet rules on conflicts of interest.
• Issuing the technical screening criteria for the remaining four objectives in the Taxonomy is a key milestone for the Commission and should drive firms to action with Taxonomy implementation.
• Guidance on how to make a substantive difference to the real economy through transition finance should give firms plenty to focus on in terms of sharpening and expanding their climate change strategy.

Relevant to: CEOs, Chief Sustainability Officers, CFOs, CROs, CCOs, and those working on sustainability projects, and in Risk and Compliance, across banking, insurance, and investment management; and users of financial services and ESG ratings.

On 13 June, the European Commission published a sustainable finance package, intended to build on and strengthen the EU sustainable finance framework and boost investment for a sustainable future. The published package represents the final significant piece of work from the Commission on its sustainable finance agenda during this legislative mandate.

The sustainable finance package comprised:

• a Communication providing an overview of the package and setting out progress achieved by the EU on its sustainable finance agenda to date, concluding that “early evidence” shows its agenda is “working on the ground”;
• a proposal for a Regulation on ESG ratings which aims to enhance transparency around ESG ratings;
• final Delegated Act(s) & Annexes (technical screening criteria) under the Taxonomy Regulation, namely: (1) the Environmental Delegated Act (annex 1, annex 2, annex 3, annex 4, annex 5, annex 6, annex 7) and (2) the amending Climate Delegated Act (annex 1, annex 2); Commission Notice on the interpretation and implementation of certain legal provisions of the Taxonomy Regulation and links to the Sustainable Finance Disclosure Regulation (SFDR) (FAQs); and a usability guide on the Taxonomy Regulation;
• Recommendation on facilitation finance for a transition to a sustainable economy (and Annex).

This blog provides our analysis of the main elements contained in the sustainable finance package.

ESG ratings

The EU Commission proposed the ESG Ratings Regulation to improve the quality and transparency of ESG ratings and address the risks posed by opaque methodologies.

Under the proposal, EU entities providing ESG ratings in the EU would need to be authorised by ESMA. The proposed rules will not apply in certain circumstances, including where ESG ratings are not for public disclosure, or where EU financial undertakings are using them for internal purposes.  Third country ESG ratings providers wishing to provide ESG ratings in the EU would only be able to do so following an equivalence decision, after a process of “recognition”, or through “endorsement” by an authorised EU ESG ratings provider in the same group.

Under the proposed rules, ESG ratings providers would be required to publish the methodology, models and assumptions used in their ESG ratings. Additional information would need to be disclosed not only to users of ratings but also the entities being rated. Governance and conflicts of interests are also key themes – a “separation of business and activities” section states that ESG ratings providers would not be allowed to provide any service which may pose a conflict of interest related to the entities they rate, including consulting, developing and distributing credit ratings and benchmarks, providing auditing services, or engaging in investment, banking, insurance or re-insurance activities. This may have a significant impact on firms that currently provide both credit and ESG ratings from the same legal entity - in future they may need to set up separate entities in order to continue providing ESG ratings, with associated legal and operational costs.

If negotiations go smoothly, the Regulation could enter into force in about Q3 2024, and apply six months later. ESG ratings providers already providing ratings in the EU would need to notify ESMA within three months of the application date and apply for authorisation within six months of the application date. Small and medium-sized undertakings would have 24 months from date of application of the regulation. We expect the new requirements to be a significant change for ESG ratings providers. Whilst the EU Commission is clear that it does not want to harmonise ESG rating methodologies in order to allow room for innovation, firms will need to review their methodologies annually and be subject to significant disclosure requirements. Methodologies, models and key assumptions will need to be disclosed alongside details of which aspects of double materiality the rating considers. Firms will need to ensure that they are able to explain their assumptions and set out their methodologies in a way that is not overly technical and can be understood by a wide group of end users. New processes will need to be put in place to address the new governance requirements and firms will need to dedicate time and resources towards assessing potential current or future conflicts of interests.

Concerns about lack of transparency in ESG ratings are not limited to the EU. HMT in the UK recently consulted on bringing ESG ratings providers into the regulatory perimeter and the FCA’s Data and Ratings Working Group (DRWG) has published in July a draft voluntary Code of Conduct for ESG ratings and data product providers. The DRWG’s Code of Conduct also contains principles for ESG ratings providers on transparency, governance and conflicts of interests alongside further principles emphasizing the importance of robust systems and controls.

EU Taxonomy

As anticipated, the Commission has now adopted the Taxonomy Environmental Delegated Act, setting out the technical screening criteria for the remaining four of the six environmental objectives. However, there is still work for the Commission to do as the Delegated Act does not cover the full range of economic activities that were originally expected. For example, there has been criticism from some MEPs about the failure to include technical screening criteria for some industries, such as textiles, fishing and agriculture. Instead, the Commission has prioritised those sectors where it can have the most impact due to the availability of more technical data and/or where it could agree criteria within the short timeframe. Work will continue on additional technical screening criteria through the European Sustainable Platform. However, the immediate emphasis is on identifying any conflicts between sustainable finance legislation and other EU measures, along with looking at what firms need to do to evidence “significant contribution” to an environmental objective under Taxonomy alignment.

The package recognises that demonstrating Taxonomy alignment is challenging for firms. The Commission has renewed its commitment to publish further guidance where necessary and engage with firms to help them understand how to use the Taxonomy to inform transition plans and investment strategies. There is also a commitment to make further additions and refinements to the Taxonomy as data, regulatory expectations and technological advancements evolve. There are also plans to expand the Taxonomy Calculator and Taxonomy Compass on the Taxonomy Navigator website to cover the activities under the remaining four objectives.

At the same time, the Commission has produced some FAQs to help firms understand links between minimum social safeguards under Article 18 of the Taxonomy Regulation and principal adverse impacts (PAIs) under the SFDR. On a practical level, firms need to consider PAIs under due diligence procedures that might affect meeting the “minimum safeguards” requirement to align with the OECD Guidelines for Multinational Enterprises and UN Guiding Principles on Business and Human Rights.

The addition of the new screening criteria is a key milestone for the Commission. Firms now have the detail they need to determine whether their activities are aligned to the Taxonomy. We expect the Delegated Acts to apply as of January 2024. As firms determine their Taxonomy-alignment, they may want to adjust their business models and/or sustainability strategy ahead of disclosing under the SFDR and reporting under the Corporate Sustainability Reporting Directive (CSRD) from 2025 (application on a phased basis), where in scope of these rules.

Transition finance

The Commission’s recommendation on transition finance, while not setting out any new policy, has initiated the discussion on the role of transition finance in the EU. The Commission’s recommendation sets out a formal definition of “transition finance” – the “financing of climate and environmental improvements to transition to a sustainable economy, at a pace that is compatible with the climate and environmental objectives of the EU”.

The Commission’s recommendation clarifies how EU firms can voluntarily use the existing regulatory framework as a means for facilitating transition finance. For example, companies can use the criteria for Taxonomy-alignment as a reference point for setting targets and reporting on taxonomy-aligned capital expenditure.

The Commission encourages financial services firms to provide transition-related financing solutions, linked to climate or environmental targets, and encourages the ESAs and Member States to continue to raise awareness of transition finance. The Commission did not, however, provide an update on the possible implementation of the Platform on Sustainable Finance’s Extended Environmental Taxonomy (also known as the Transition Taxonomy), which included a red/amber/green framework. This may now be picked up in the next Commission five-year term, due to begin in November 2024.

Financial services firms may want to compare their own internal definitions of transition finance with that set out by the Commission, and consider whether they need to update their own approach to take full advantage of transition finance opportunities. Equally, firms should continue to ensure that they highlight (to the ESAs or their National Competent Authority) any outstanding regulatory obstacles to providing transition finance.

Conclusion and next steps

The sustainable finance package represents the final significant piece of work from the Commission on its sustainability agenda during this legislative mandate. While the main elements of the EU’s sustainable finance framework are now “in place”, the framework will continue to be developed and refined.

As announced in December 2022, the Commission will consult on the SFDR in Autumn 2023. In terms of the Commission’s broader sustainable finance framework, the Commission will also provide practical guidance to market players and seek to address gaps, usability concerns and uncertainties, with specific focus on reducing the burden on SMEs and making the framework more usable and inclusive for them.

An additional priority will be to continue work on facilitating transition finance, including by better integrating the Taxonomy, and the EU Platform on Sustainable Finance will assess new economic sectors and activities to be added to the Taxonomy.

None of the EU’s sustainable finance initiatives are easy or quick to implement. Firms will need to review their reporting, disclosure, and data frameworks to ensure that they are Taxonomy compliant. ESG ratings providers will need to be authorised and meet new requirements. But beyond compliance, firms will need to consider how the regulatory requirements will affect their sustainability and investment strategies. Firms should also play close attention to the opportunities that may arise from transition finance, a subject that is gaining increasing regulatory and industry attention globally.