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First published April 20, 2020 and updated on November 18, 2020 and on November 30, 2020
What is the law/regulation?
In December 2019 the European Council and the European Parliament reached political agreement on the text of a proposed Regulation on the Establishment of a Framework to Facilitate Sustainable Investment – the so-called "Taxonomy Regulation.” The Taxonomy Regulation1 was published in the Official Journal of the EU on 22 June 2020, following its adoption by the European Parliament on 18 June 2020 and entered into force on 12 July 2020.
What is its scope and impact?
The Taxonomy Regulation establishes an EU-wide classification system or ‘framework’ intended to provide businesses and investors with a common language to identify to what degree economic activities can be considered environmentally sustainable. It aims to “provide clarity and transparency on environmental sustainability to investors, financial institutions, companies and issuers thereby enabling informed decision-making in order to foster investments in environmentally sustainable activities.”2
While the majority of the Taxonomy Regulation will impact asset managers who make available a “financial product” which either (a) has environmental sustainability as its objective or (b) promotes environmental characteristics, the Taxonomy Regulation also states that financial market participants3 who do not take into account the criteria for environmentally sustainable investments should provide a statement to this end, meaning that all asset managers are, effectively, in scope.
In defining “financial product,” the Taxonomy Regulation refers to the definitions embedded in the Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector (the Disclosure Regulation):
The Taxonomy Regulation provides a definition of “environmentally sustainable” economic activities. An economic activity is environmentally sustainable if:
The disclosure obligations in the Taxonomy Regulation supplement the rules on sustainability-related disclosures in the Disclosure Regulation. Together, the Taxonomy and Disclosure Regulations will require firms to disclose the degree of environmental sustainability of funds and pension products that are promoted as environmentally friendly, and include disclaimers where they do not (articles 8 and 9 of the Disclosure Regulation). In addition, firms which are subject to the Non-Financial Reporting Directive (NFRD)9 will be required to disclose, in their financial statements, information on the proportion of their activities that are classified as environmentally sustainable according to the Taxonomy Regulation, such as the proportion of their turnover derived from products or services associated with economic activities that qualify as ‘environmentally sustainable’.10
The Taxonomy Regulation contemplates that asset managers will use the technical screening criteria to assess a company’s economic activities and determine whether each activity does or does not meet the taxonomy criteria – then aggregate the percentage of taxonomy alignment at investment and product level.11 The Taxonomy Regulation will be supplemented by delegated acts containing detailed technical screening criteria for determining when an economic activity can be considered sustainable, and hence 'Taxonomy-aligned'. The percentages of taxonomy alignment will then help firms to explain their strategies in a way that is consistent and easily comparable. To ensure consistency between the Taxonomy Regulation's concept of “do no significant harm” and the Disclosure Regulation's concept of “adverse impact indicators”, the Taxonomy Regulation amends the Disclosure Regulation, mandating that the ESAs12 jointly develop regulatory technical standards relating to content and presentation of information relating to the principle of do no significant harm.
On 20 November 2020, the European Commission launched a public consultation on a draft delegated regulation. This contains the first two sets of technical screening criteria for determining which economic activities can qualify as contributing substantially to climate change mitigation or climate change adaptation, and for determining whether that economic activity causes ‘no significant harm’ to any of the other environmental objectives. The draft delegated regulation is based on Articles 10(3) and 11(3) of the Taxonomy Regulation. The consultation is open for feedback until 18 December 2020. The European Commission will consider the feedback received before finalising the delegated act. It will then be subject to scrutiny by the European Parliament and the Council and will apply from 1 January 2022.
What is the timeline?
The Taxonomy Regulation was published in the Official Journal of the EU on 22 June 2020 and entered into force on 12 July 2020.
The Taxonomy Regulation states that to give sufficient time to the relevant actors to familiarise themselves with the criteria for environmentally sustainable economic activities13 set out in the Regulation and to prepare for their application, the obligations set out in this Regulation should become applicable, for each environmental objective, 12 months after the relevant technical screening criteria have been adopted.
The Taxonomy Regulation contemplates a phased implementation, with certain rules applying from different dates:14
What are the key considerations for asset managers?
The aim of the Taxonomy Regulation is to provide a common language to identify environmentally sustainable activities and financial instruments to be used by investors, financial institutions, companies and issuers.
As a piece of EU legislation, its impact will be felt in the EU by entities such as AIFMs, UCITS management companies, MiFID investment firms providing portfolio management or investment advice. These entities will need to use the ‘framework’ taxonomy when making disclosures in prospectuses, portfolio management agreements, annual reports, non-financial statements, and on websites. The need to conform investment practices to these disclosures means that the Taxonomy Regulation could also influence the way that many firms incorporate ESG into their investment processes.
The Taxonomy Regulation will also impact non-European asset managers offering financial products into the EU. For example, (i) a non-EU manager that operates a UCITS may need to assist the UCITS ManCo with making disclosures by providing it with information relating to environmental sustainability which takes account of the framework taxonomy; or (ii) a non-EU manager marketing its funds in the EEA under Article 23 of AIFMD will need to refer to the framework taxonomy when making sustainability disclosures. Given the size of the EU market, and because the taxonomy is the most comprehensive attempt yet to set regulatory standards for ESG, the taxonomy may also influence ESG disclosures and practices outside the EU.
The impact of Brexit
The UK formally left the EU on 31 January 2020 and entered into a transition period which (at the time of writing) is scheduled to end at 11pm on 31 December 2020, after which EU law will cease to apply in the UK.
Although the Taxonomy Regulation entered into force on 12 July 2020, the key operative requirements (e.g. disclosure obligations) only apply after 31 December 2021. Therefore, these requirements will not form part of retained EU law in the UK though the UK may choose to incorporate them into its domestic legislation. Consequently, there may be a bifurcation of requirements depending on the location of the asset manager, with asset managers in the EU and the UK being subject to different requirements.
The UK government says that it cannot yet comment on the extent to which the UK will align with the EU on this regulation because the delegated legislation containing technical standards has not yet been published, so it does not have clarity as to the exact requirements that it would be agreeing to. The UK will continue to monitor the EU’s legislative process as it considers the UK's approach.
The Taxonomy Regulation is notably focused on the environmental aspects of ESG. An investment can be branded as sustainable as long as it meets one of the six specified environmental objectives and does not significantly harm any of the remaining objectives. Following recent statements made by the head of the sustainable finance and financial technology unit at the European Commission, it seems that there is a move to explore whether the Taxonomy Regulation should be extended to cover social issues as well as a wider range of environmental factors, ahead of the publication of a new sustainable finance action plan next year. As yet there are no further details.