Minimum safeguards, maximum confusion: Clarifying the EU Taxonomy social standards for investors
The scope and application of Minimum Safeguards reporting requirements is still the subject of intense debate in the sustainable finance space. Thankfully, the Platform on Sustainable Finance has recently released some important clarifications on this topic.
Dec 10, 2022
Understanding and achieving compliance with Minimum Safeguards is one of the challenges fund managers face while fulfilling their requirements under the EU Taxonomy and the SFDR. Minimum Safeguards ensure that a company not only supports environmental goals, but also adheres to international social standards and guidelines.
Thankfully, the Platform on Sustainable Finance recently clarified some open questions around MS compliance: in this article, we shed light on these new recommendations, and we provide insights from our work on MS compliance.
One of the many challenges that financial market participants (FMPs) face when tackling their obligations under the EU Taxonomy and Sustainable Finance Disclosure Regulation (SFDR) is the availability of data from their underlying investments.
This problem is particularly acute for Private Equity (PE) firms that operate Article 8/8+ or Article 9 funds. Simply put, the regulation requires investors to report on company level data that oftentimes is not publicly available, and depending on the stage of the investment company, might not be available at all. If you are looking for more support to understand the EU Taxonomy and data usability, we have written a free-to-access guide on the topic.
While this issue has been widely discussed for data associated with PAIs (SFDR) and Technical Screening Criteria (EU Taxonomy), there is also increasing market anxiety and confusion around application of the Minimum Safeguards (MS) alignment criteria.
On October 11, 2022 the Platform on Sustainable Finance (PSF) released a report describing best practices in applying the regulation (with a strong focus on data availability and applications).
Importantly, the PSF clarified a number of misconceptions around the MS framework, and provided clear guidelines on how the framework should be applied. Below we unravel the current market guidance, as well as some tips gleaned from our work with a broad range of stakeholders.
Back to basics: What are the Minimum Safeguards?
The EU Taxonomy is not just about measuring the “greenness” of a company, but rather contains mechanisms to ensure that a firm not only supports an environmental objective, but is generally a good corporate actor.
In essence, you can contribute to an environmental objective, but if you aren’t operating your firm under globally recognized social frameworks, your company is not Taxonomy aligned.
The MS framework is the tool that the EU Taxonomy uses to ensure that activities labeled environmentally sustainable adhere to social standards and guidelines.
Although the Taxonomy measures environmental sustainability on an activity level, the PSF clarifies that MS should apply at the entity level. The EU Taxonomy requires companies and FMPs to adhere to international standards, such as the OECD Guidelines for Multinational Enterprises (MNEs), the UN Guiding Principles on Business and Human Rights (UNGPs), International Bill of Human Rights (IBHR), and International Labour Organisation (ILO) Declaration of Fundamental Principles and Rights at Work. Based on these standards and principles, the PSF has distilled these complex topics to four core pillars.
Human rights (including labour and consumer rights)
Bribery, bribe solicitation and extortion (corruption)
The compliance with Minimum Safeguards are distinguished into two steps for each topic:
Implementation of due diligence procedures, internal controls and processes, programmes and strategies, and
Avoidance of negative impacts and legal convictions on any of the substantive topics.
Each Minimum Safeguard topic, therefore, needs to follow a two-step process to identify alignment, as illustrated below:
What if an entity is non-compliant?
The PSF makes it clear that companies and FMPs that are found in breach of any of the MS topics cannot be considered in alignment with the EU Taxonomy. For example, if a company has legally been convicted of tax evasion, this company is not aligned with the MS.
However, the PSF also clarifies that so long as these violations are addressed and measures are implemented to avoid such issues in the future, the company can be considered in compliance, and therefore aligned.
In effect, this means that a negative screening is not enough to determine whether companies are in breach of MS alignment. It is possible that companies with controversies bounce back if they provide proof of amendments in their internal policies and procedures.
Can data proxies be used for MS alignment?
Companies and FMPs can in principle use existing laws and frameworks as proxies to help them align with the minimum safeguards of the EU Taxonomy.
However, the specific laws need to be closely examined to ensure that they align with the requirements described within the UNGPs and OECD MNE Guidelines.
For example, the scope of the Dutch law on due diligence covers only child labor, while the minimum safeguards cover a wider range including human rights and other responsible business conduct.
Similarly, other frameworks can be used for minimum safeguards alignment, as there are overlaps within different EU regulations and frameworks.
For example, the proposed Corporate Sustainability Due Diligence (CSDD) Directive, a regulation of human rights due diligence, could be used as a proxy for MS alignment if it becomes a law.
However, if changes are made to the final law and the overlap with MS requirements are altered, then, it would not be considered as a proxy.
Therefore, companies and FMPs should thoroughly examine the scopes of national and international laws, as well as the frameworks that they want to use as a proxy for alignment to ensure the scope coverage is the same or wider than the published MS.
How is MS relevant for Private Equities?
The MS framework is an integral part of the taxonomy and, therefore, is relevant for any FMP, at entity or product level, that wants to align itself with the EU Taxonomy.
Therefore, PE funds that report according to Article 8 or Article 9 of SFDR and aim to have Taxonomy alignment will have to ensure that their underlying portfolio companies are also aligned on MS.
While the above mentioned proxy assessments could also be applicable for SMEs, they are mainly relevant for larger and publicly traded companies given the maturity of governance structures and internal guiding policies.
How should Private Equities align their SME portfolio companies with MS requirements?
As most SMEs, especially non listed SMEs, will not have considered their business and governance models in line with the MS standards, there is additional complexity for PE firms that need to gather the required information from their portfolio companies.
In the October report, the PSF provides guidelines on how private SMEs should be aligned against the Minimum Safeguards: they recommend that SMEs implement “Guides to human rights for small and medium sized businesses” and use that as a proxy for Minimum Safeguards alignment.
These guides cover commitment to respecting human rights, identifying and assessing risks, as well as facilitating an anonymous complaint mechanism. The comprehensive list of guidelines can be found at the end of this article or here. The PSF suggests that this information can either be published on the SMEs website or self-declared by the company.
Tip: A PE firm can include these guideline points in their contractual agreements with the SMEs to ensure compliance and alignment with the MS. This is a legally compliant, and low impact way to make sure that the investee companies are taking the steps necessary to fall in line with the EU Taxonomy regulation.
Here are the "Guides to human rights for small and medium sized businesses":
There has been a lot of confusion regarding MS and the regulatory reporting implications for Article 8 and Article 9 funds.
To shed some light on the topic, the PSF has released a report with recommendations and best practices for MS reporting.
Taxonomy-aligned Article 8 and Article 9 funds must report on the MS alignment of their portfolio companies
While these requirements also apply to SMEs, the data standard is somewhat different, and can use the “guides to human rights for small and medium sized businesses” (listed above) as a proxy for their alignment
At Briink, we harness Artificial Intelligence to support investors with their SFDR and EU Taxonomy reporting needs, including Minimum Safeguards. If you want to check if your company policies (such as human right, labor, anti-bribery, anti-corruption, and taxation policies) comply with the standards set out by the Minimum Safeguards, you can use our free AI-Powered Policy Screener.
Using it is super simple: all you have to do is drag and drop your policies in the screener, and wait a few minutes for the AI model to process a full MS assessment. In case you are lost, here is a short guide to get started.
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