Transitioning to a more sustainable financial system is paramount to building a sustainable and resilient European economy.
Unfortunately, the proliferation of financial products labeled as “sustainable” exposes investors to greenwashing accusations.
In response to concerns from investors, and as part of an effort to redirect capital towards truly environmentally-friendly economic activities, the EU Commission published its Action Plan on Sustainable Finance. By laying the groundwork for concrete policy initiatives, the Action Plan aims at holding businesses and financial market participants to science-based standards when it comes to the ESG performance of their activities or funds.
The EU Taxonomy Regulation and the Sustainable Finance Disclosure Regulation (SFDR) lie at the core of this legislative effort. Both pieces of legislation aim at increasing transparency for businesses and financial markets participants advancing “sustainability” claims.
However, the relationship between them is still open to debate.
For example, it is not always clear whether funds classified as “green” under the SFDR also need to comply with the criteria defined by the EU Taxonomy. This uncertainty has been exacerbated by a mismatch in the reporting timelines of financial and non-financial institutions.
But what exactly are the EU Taxonomy and the SFDR, and how do they interact with one another?
In this article, we dig deeper into the relationship between so-called “green” funds and the EU Taxonomy.
The EU Taxonomy Regulation provides a classification of economic activities. From 2022, businesses under the scope of the NFRD must report on the EU Taxonomy eligibility of their activities. These reporting obligations will be extended to Taxonomy alignment in 2023.
Aligned - or “environmentally sustainable” activities - make a substantial contribution to one of the EU’s environmental objectives and also respect all other technical screening criteria defined for them in the Taxonomy.
For more details on the Taxonomy Regulation, eligibility and alignment, see our FAQs. We have also recently published a downloadable white paper providing a broader overview on the timeline of EU Taxonomy disclosures.
On the other hand, the Sustainable Finance Disclosure Regulation (SFDR) defines ESG reporting obligations for financial market participants. The "SFDR-classification" labels funds as either “Article 6”, “Article 8” or “Article 9”.
Article 8 (“light green”) funds "promote environmental or social characteristics", while Article 9 (“dark green”) funds constitute "environmentally sustainable investments".
For funds that are neither shade of green, some reporting obligations still apply: in the context of SFDR Article 6, disclosures must be published as to how sustainability risks were integrated in investment decisions. Since March 2021, asset management firms have the obligation to disclose this classification for all of their funds.
The SFDR also created many new financial reporting obligations, applicable to asset managers as well as to credit institutions and insurers. Although they belong to the same regulatory package and share central goals and objectives, how the EU Taxonomy comes into play for SFDR reporting obligations is not entirely clear.
There has indeed been quite a lot of confusion as to how exactly the EU Taxonomy Regulation impacts Article 8 and Article 9 funds disclosures.
The Article 9 or ‘dark green’ label is the one that is most directly connected with the EU Taxonomy, as it implies that every economic activity included in a fund is Taxonomy-aligned.
It falls upon asset managers to verify the Taxonomy-alignment of every single activity their "dark green" funds invest in.
This can be relatively easy if portfolio companies already have to report on their Taxonomy-alignment: asset managers can pull the relevant data from publicly available consolidated management reports. However, some portfolio companies do not have Taxonomy-reporting obligations yet (that is the case of all companies falling out of the scope of the Non-Financial Reporting Directive - NFRD).
In such cases, it is up to asset managers themselves to assess the Taxonomy-alignment of their portfolio companies, or at least to make sure that this assessment is conducted and that they are provided with the required evidence of compliance with Taxonomy criteria. The amount of evidence that needs to be provided will vary based on the size and composition of the fund, but it is usually substantial.
In fact, such evidence has to be provided for every activity the fund invests in, and for every criterion attached to activities in the Taxonomy. In a July 2021 FAQ, the EU Commission specified that Article 9 funds may also include investments for certain specific purposes, such as hedging or liquidity.
In order for these to fit within the dark green label, they have to meet "minimum environmental and social safeguards", so that the fund remains in line with its sustainable investment objective. These safeguards are defined in the Taxonomy: they are the Do No Significant Harm criteria, which are defined at activity-level, and the Minimum Social Safeguards, compliance with which must be assessed at the level of the portfolio company.
The extent to which the activities included in Article 8 or ‘light green’ funds must comply with the criteria outlined in the EU Taxonomy is less clear. According to the SFDR, the activities of Article 8 funds-portfolio companies do not have to be Taxonomy aligned.
However, the Commission made clear that integration of sustainability risks per se was not enough for Article 8 to apply, and that a proportion of the investments included could be ‘environmentally sustainable’ in the meaning of Article 9.
Article 8 funds are therefore hybrid financial products: neither fully Taxonomy-aligned, nor simply integrating sustainability risks, they also have to be composed of investments that “promote” environmental and/or social characteristics.
So when, exactly, can investments qualify as “light green”? The EU Commission has provided some clear guidelines: financial products can fall under the Article 8 category when they comply with certain environmental, social or sustainability requirements laid down by law (including international conventions like the Paris Agreement), and when these characteristics are “promoted” in the investment policy.
The term ‘promotion’ was defined quite broadly by the Commission: it encompasses all of an asset manager’s claims or disclosures related to the product, and how it considers environmental or social characteristics in terms of investment policies and objectives or as a general ambition.
As an example, some Article 8 products may pursue reduction of negative environmental or social externalities caused by their underlying investments.
Claims with regards to the fund’s environmental or social characteristics can be made in a variety of documents, including but not limited to pre-contractual and periodic ones, marketing communications, advertisements, description of investment strategies and asset allocation, factsheets, or use of product names regardless of the form (paper, durable media, websites…).
This implies that asset managers do not have to rely on the EU Taxonomy to make the relevant SFDR disclosures related to their Article 8 products.
However, the EU Taxonomy Regulation can be one of the environmental requirements the fund complies with — for example, a fund could invest in activities that are transitioning to become Taxonomy-aligned. Referring to the Taxonomy benchmarks can help guarantee that the fund is truly green, and actually promotes environmental characteristics.
In summation, the EU Taxonomy can be very useful for asset managers to determine which activities an SFDR-labeled fund they can, and should, invest in. The Taxonomy classification can provide great insights as to which activities, such as enabling or transitional ones, can best fit into funds promoting environmental characteristics.
Beyond investing in eligible activities (the ones listed in the EU Taxonomy), asset managers have to use Taxonomy criteria to assess the alignment of their sustainable investments, in dark green/Article 9 funds. Meanwhile, the EU Taxonomy disclosures in a fund’s prospectus, or even in the firm’s annual or period reports, are great indicators for investors: referring to the Taxonomy for Article 9 and Article 8 funds guarantees that fund labels are not greenwashed, but rather based on concrete efforts to make investments more sustainable.
One of the overarching goals of the Action Plan for Sustainable Finance is to create a unified classification system for sustainable activities. This framework already exists, and it is the EU Taxonomy.
No matter whether you are managing a company or financial assets: EU Taxonomy-alignment is expected to become the north-star metric for determining whether your activities or products are truly sustainable.
At Briink, we are developing a smart AI-powered solution for sustainable finance reporting. It seamlessly integrates Taxonomy criteria for investor-reporting on the EU Taxonomy at scale.
Do you have any questions? Get in touch.