Legal development

ESMA publishes explanatory notes on sustainable finance framework

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    What has happened?

    On 22 November 2023, the European Securities and Markets Authority (ESMA) published three helpful explanatory notes covering key aspects of the EU sustainable finance framework:

    1. the concept  of "sustainability" and its use across the EU sustainable finance framework, including in the EU Taxonomy Regulation (EU TR) and the EU Sustainable Finance Disclosure Regulation (EU SFDR);

    2. the "do no significant harm" principle that forms an integral part of the EU TR, the EU SFDR and the EU Benchmarks Regulation (EU BMR); and

    3. the concepts of "estimates" and "equivalent information".

    The notes are described by ESMA as "purely factual presentations" of relevant legal provisions found in EU legislation and associated guidance. They do not constitute official guidance or provide additional information over and above what is already available. However, they are useful as reference documents, particularly for those looking at the European sustainable finance regime for the first time. 

    In this briefing, we summarise the content of the ESMA notes that focus on the concepts of "sustainability" and "do no significant harm", or DNSH. We also explore the note on the use of "estimates" in sustainability reporting. 

    Background

    The EU's sustainable finance legislative framework is notoriously fragmented, with interrelated provisions spread across a patchwork of legislative instruments, guidelines, and other materials. ESMA's notes explain the fundamentals of the three core principles described above, and will help market participants locate the materials that they need to fully understand the regime's requirements.

    However, ESMA is clear in the publications that they do not add to, interpret, replace or provide guidance on any legislation or materials. Rather, they summarise factual information relating to the applicable concepts, and are intended to facilitate users' navigation and understanding of the legislative framework. Consequently, there is no new content here, just a helpful summary and consolidation of the prevailing position.

    Paper 1: "Sustainability" in the EU sustainable finance framework

    The first note, "Concepts of sustainable investments and environmentally sustainable activities", addresses the concept of sustainable investments and the use of that term throughout the EU's sustainable finance framework. It focuses in particular on how the concept is used in the EU TR and the EU SFDR. Unfortunately, these Regulations are not aligned, which has led to confusion in the past, particularly when they first entered into force. 

    "Environmentally sustainable investment" under the Taxonomy Regulation

    The note addresses the EU TR first, and begins by setting out the EU TR definition of "environmentally sustainable investment":

    "an investment in one or several economic activities that qualify as environmentally sustainable […]" (our emphasis).

    The note goes on to list the criteria that need to be satisfied under the EU TR for an economic activity to be considered "environmentally sustainable" (sometimes also referred to as "taxonomy-aligned"). These include that:

    • the activity contributes substantially to one or more of the six environmental objectives identified under the EU TR; 
    • the activity does not significantly harm any of those environmental objectives (the concept of DNSH is discussed further below in the context of ESMA's second note); and
    • the activity complies with sector-specific, science-based technical screening criteria (TSC) established under the EU TR for each environmental objective.

    Environmental objectives

    The six environmental objectives established under the EU TR are:

    1. climate change mitigation;
    2. climate change adaptation;
    3. sustainable use and protection of water and marine resources;
    4. transition to a circular economy; 
    5. pollution prevention and control; and 
    6. protection and restoration of biodiversity and ecosystems.

    "Enabling" and "transitional" activities can also be categorised as environmentally sustainable if they meet applicable EU TR criteria.

    Technical screening criteria and disclosure obligations

    Compliance with the "substantial contribution" and "do no significant harm" criteria described above is assessed in terms of alignment with the TSC for the applicable objective. TSC are only currently in force for the objectives of "climate change mitigation" and "climate change adaptation", with TSC for the remaining four climate objectives entering into force next year. 

    The EU TR also imposes disclosure obligations relating to how and to what extent certain entities' activities are associated with "environmentally sustainable" economic activities. 

    As a result, the information needed to determine whether an investment is an "environmentally sustainable investment" under the EU TR, and to comply with related disclosure obligations, is scattered across several pieces of legislation and supplemented by a number of additional guidance and other materials. ESMA's note attempts to (i) simplify the framework by explaining the fundamental principles of the taxonomy framework and related disclosure requirements, and (ii) reference, with links, relevant legislation, applicable provisions, and related guidance. It is therefore a useful starting point for anyone grappling with the EU TR.

    "Sustainable investment" under the EU SFDR

    Next, ESMA's note turns to the definition of "sustainable investment" under the EU SFDR, summarising this as:

    • an investment in an economic activity that contributes to an environmental or social objective; 
    • which investment does not significantly harm any environmental or social objective; and
    • in respect of which investee companies follow good governance practices in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance.

    ESMA also lists a number of additional materials that are relevant when determining whether an investment is a "sustainable investment" under the EU SFDR, and highlights the fact that, if the "good governance" limb above is not satisfied, the relevant product would be in breach of Article 8 or Article 9 (as applicable) of the EU SFDR.

    Article 8 and Article 9 products

    In the note, ESMA summarises the EU SFDR's so-called Article 8 products and Article 9 products, named after the articles in the Regulation that impose disclosure obligations in respect of certain product types. It summarises the product types as:

    • Article 8 products: "financial products that promote environmental or social characteristics provided that the companies in which the investments are made follow good governance practices."; and
    • Article 9 products: "financial products that have sustainable investment as their objective".

    ESMA then summarises the key disclosure obligations applicable to Article 8 and Article 9 products, referencing the legislation that sets out the specific disclosure obligations for each product type, as well as signposting additional disclosure obligations under the EU TR. 

    ESMA also:

    • references and provides a link to the Q&As published by the European Supervisory Authorities (ESAs);
    • draws out the European Commission's clarification that "sustainable investment" can be measured at company level as well as at activity level; and 
    • highlights the fact that the EU SFDR does not prescribe how key parameters of the "sustainable investment" definition – including DNSH – should be measured, noting that market participants need to perform their own assessments in this area, disclosing any assumptions underlying the analysis.

    Finally, ESMA (i) explains that, while market participants may define their own criteria and create their own framework for sustainable investments under the EU SFDR, they must not interpret the definition of "sustainable investment" differently for different products, and (ii) summarises two sustainable investment "safe harbours":

    • financial products that passively track Paris-aligned Benchmarks or Climate Transition Benchmarks are automatically deemed to be making sustainable investments; and
    • investments in "environmentally sustainable economic activities" under the EU TR can automatically qualify as "sustainable investments" for product level disclosure purposes under the EU SFDR.

    A comparative table provided by ESMA to show the differences between the concept of "sustainability" under the EU TR and the EU SFDR is replicated at Annex I to this briefing. This is a particularly useful reference. 

    Paper 2: "Do no significant harm" or DNSH

    The second note, "Do No Significant Harm" definitions and criteria across the EU Sustainable Finance framework, explains the principle of "Do no significant harm", or "DNSH", which is a central component of the EU TR, the EU SFDR, and the EU BMR. In the note, ESMA addresses each of these regulations in turn.

    "Do no significant harm" under the EU Taxonomy Regulation

    The note addresses the EU TR first. 

    As discussed above, an economic activity cannot be classed as "environmentally sustainable" under the EU TR if it significantly harms any of the six established environmental objectives. This is explained further in the EU TR's recitals as "causing more harm to the environment than the benefits it brings". 

    ESMA's note explains that, for each economic activity that could potentially be categorised as "environmentally sustainable", the activity will need to be assessed to determine (i) whether it substantially contributes to one or more objectives, and (ii) whether it significantly harms any of the other objectives. 

    ESMA also highlights in this section that the DNSH assessment also to be included in the EU SFDR product disclosures discussed above.

    This section of the note contains links to relevant materials, including draft Commission Notices relating to the interpretation of various provisions within the sustainable finance framework.

    "Do no significant harm" under the EU SFDR

    In the next section of the note, ESMA explains that the DNSH concept is one of the three key elements against which investments are to be assessed in order to determine whether they can be deemed sustainable investments under the EU SFDR. The note also explains that the concept is relevant for disclosure in relation to both Article 8 and Article 9 products, but only to the extent that those products make sustainable investments.

    ESMA also summarises disclosure requirements at both entity and product level, explaining the concept of Principal Adverse Impact indicators1 (PAIs) and highlighting that (i) use of PAIs is mandatory when demonstrating DNSH compliance, and (ii) disclosing market participants must explain how PAIs are taken into account for DNSH purposes. ESMA also confirms that entity-level disclosure is on a "comply or explain" basis.

    Finally, ESMA draws readers' attention to various clarifications made by the ESAs in relation to disclosure under the EU SFDR, including the fact that there are two types of disclosure, each of which applies independently of the other: 

    (i) DNSH disclosure for financial products that make sustainable investments, which must take into account PAIs when demonstrating that the investment does not significantly harm any environmental or social objective; and 

    (ii) separate PAI disclosures at both entity and product level for all investments.

    "Do no significant harm" under the EU BMR

    In the final section of this note, ESMA considers the DNSH concept as it applies to the EU BMR. Under the EU BMR, DNSH is reflected in requirements to exclude certain underlying assets from the applicable benchmark portfolio. For example, a benchmark cannot constitute an EU Paris-aligned Benchmark unless the activities relating to the underlying assets do not significantly harm ESG objectives. A similar restriction applies in respect of EU Climate Transition Benchmarks.

    A comparative table provided by ESMA to show the differences between the "DNSH" concept EU TR, the EU SFDR, and the EU BMR is replicated at Annex II to this briefing.

    Paper 3: Concept of estimates across the EU sustainable finance framework 

    The final document published by ESMA explains how key sustainable finance legislation deals with the use of "estimates" and "equivalent information" and the conditions under which these are allowed as sources of data to prepare mandatory ESG metrics for regulated entities' compliance with their obligations. This is an important summary as for many firms obtaining relevant data has been a challenge.

    Different pieces of the EU sustainable finance framework impose requirements for the calculation and/or disclosure of various ESG metrics or sustainability indicators by financial market participants (FMPs). Such disclosures and/or calculations perform a key role under the EU TR, EU SFDR and EU BMR, as described above. 

    For each of these regimes, there could be exceptional situations where firms cannot reasonably obtain the relevant information, for example to determine the alignment with the TSC or report under the PAIs. ESMA notes that, in those cases, stakeholders should be allowed to use information from other sources to make complementary assessments. The use of estimates that would relate to limited and specific parts of the data elements and produce a prudent outcome should also be allowed. 

    Under the EU SFDR, ESMA notes that, where information is not readily available from public disclosures by investee companies, FMPs should explain details about whether they obtained "equivalent information" directly from investee companies or from third-party providers. The notion of "equivalent information" in the EU SFDR is explicitly linked to disclosures in relation to investments in economic activities that are environmentally sustainable (i.e. taxonomy-aligned).

    The paper also clarifies that under the EU SFDR it would be good practice for FMPs to disclose for each PAI indicator the proportion of investments for which data was obtained directly from investee companies and the proportion of investments for which data was obtained by carrying out additional research, cooperating with third party data providers or external experts or making reasonable assumptions.

    A comparative table provided by ESMA to show the differences between the concept of use of estimates under EU TR, the EU SFDR, and the EU BMR is replicated at Annex III to this briefing.

    Commentary

    As discussed above, ESMA's notes do not provide any additional information for market participants, or (thankfully) introduce further obligations. They are intended to act purely as factual summaries, signposts, and consolidations of existing information and materials, and to help guide overwhelmed market participants through the twists and turns of this convoluted and confusing regime. 

    It is a welcome sentiment from ESMA, and explanatory material of this nature can only help improve general understanding of the regime. However, whether these publications enhance market understanding to the extent that ESMA hopes will be for readers to determine.

    1. A set of climate, environment-related, social and employee, respect for human rights, anti-corruption and anti-bribery matters indicators listed in Annex I of EU Regulation 2022/1288.

    Annex I - Overview of SFDR sustainable investments and Taxonomy environmentally sustainable activities 

      Taxonomy Regulation (TR)Sustainable Finance Disclosures Regulation
    (SFDR)

    Which stakeholders should apply the concepts of a) Taxonomy environmentally sustainable activities; and b) sustainable investment? The concept of environmentally sustainable economic activities is applied by financial and non-financial undertakings which fall within scope of TR Article 8, to assess whether an economic activity is environmentally sustainable, i.e. Taxonomy-aligned. This assessment is carried out as part of the non-financial reporting of these
    undertakings.
    FMPs that fall within scope of the SFDR to assess whether investments of Article 8 and 9 financial products can be deemed as ‘sustainable investments’.
    What does the application of these concepts entail?An economic activity is deemed environmentally sustainable (taxonomy – aligned), when the following requirements are met: a) substantial contribution to one or more of the TR environmental objectives; b) do not significantly harm any of those objectives; c) compliance with certain minimum safeguards; and d) compliance with the TSC for substantial contribution and DNSH. An investment is deemed as ‘sustainable’ when it meets the following requirements: a) it is in an economic activity contributing to an environmental or social objective; b) the investment does not significantly harm any environmental or social objective; and c) the investee companies follow good governance practices.
    Does the framework contain specific criteria for the application and disclosure of the concepts of SFDR sustainable investments and Taxonomy environmentally sustainable activities?The Commission developed sector-specific and science-based criteria (i.e. the TSC in accordance with the TR). These are set out in the Climate Delegated Act and the Complementary Climate Delegated Act for the two climate environmental objectives and the ‘Environmental Delegated Act’ for the remaining four environmental objectives.The SFDR framework does not set out specific criteria, thresholds or targets for the assessment of sustainable investments. Nevertheless, specific disclosures are prescribed for products disclosing under Article 8 or 9 that make sustainable investments. These disclosures include, amongst others; a) a description of how the sustainable investments contribute to a sustainable investment objective; b) explanations on how the SFDR DNSH principle is complied with by showing how the PAI indicators have been taken into account; c) how the sustainable investments are aligned with the OECD Guidelines for Multinational Enterprises and the Guiding Principles on Business and Human Rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work and the International Bill of Human Rights; and d) the good governance practices of investee companies.
    Do the relevant criteria refer to specific targets or thresholds?The EU Taxonomy TSC for substantial contribution and DNSH refer to specific targets or
    thresholds or specific requirements which should be met when the economic activity is carried out.
    The SFDR framework does not prescribe specific targets or thresholds for the assessment of sustainable investments; however sustainable investments must at least abide by the three criteria of Article 2(17): contribution, DNSH and good governance.
    What is the scope of application of the two concepts? The notion of environmentally sustainable investments is applied at the economic activity level and relates to economic activities that are taxonomy-eligible i.e. economic activities for which TSC regarding substantial contribution and DNSH have been developed. Moreover, environmental sustainability under the TR relates to the ‘E’ aspect of ESG. Sustainable investments can be measured at the level of economic activity or that of a company. Additionally, sustainable investments in the SFDR framework can be in economic activities that contribute to either environmental or social objectives.

     

    Annex II - Overview of the DNSH principle under TR, SFDR and BMR

     

      Taxonomy Regulation (TR)Sustainable Finance Disclosures Regulation (SFDR)Benchmarks Regulation (BMR) 
    Who should apply the DNSH principle? Financial and non-financial undertakings which fall within scope of TR Article 8, i.e undertakings required to publish a non-financial statement.FMPs making available financial products making sustainable investments within scope of the SFDR.Administrators of EU Climate Transition Benchmarks (CTBs) and EU Paris-aligned Benchmarks (PABs).
    In which situations should the DNSH principle be applied?

    The DNSH principle is applied when assessing whether an economic activity is environmentally sustainable (‘taxonomy-aligned’).

    As part of this assessment undertakings need to determine whether an economic activity does not significantly harm any of the environmental objectives set out in TR.

    Undertakings also should adhere to the SFDR DNSH principle when implementing the procedures to ensure that an economic activity is carried out in compliance with minimum safeguards.

    FMPs apply the DNSH principle when assessing whether sustainable investments of financial products comply with DNSH principle enshrined in the definition of 'sustainable investment'.The DNSH principle relates to the criteria for excluding underlying assets from the benchmark portfolio of EU CTBs and EU PABs.

    In addition, PABs administrators are required to ensure that the activities relating to the underlying assets do not significantly harm other ESG objectives.
    What does the application of the DNSH principle entail?To apply the DNSH principle undertakings are required to assess that the DNSH TSC for that economic activity are met. The DNSH principle entails assessing whether an investment in an economic activity that contributes substantially to an environmental or social objective does not significantly harm any environmental or social objectives. This is done by taking into account the PAI indicators in Table 1 of Annex I of CDR 2022/1288 and any relevant PAI indicators in Tables 2 and 3 of Annex I of CDR 2022/1288.The exclusion of underlying assets (as well as their selection and weighting) should result in CTB benchmark portfolios that are on a decarbonisation trajectory and PAB benchmark portfolios that are aligned with the objectives of the Paris Agreement.
    Does the framework contain specific criteria for the application of the DNSH principle?The Commission developed sector-specific and science-based criteria, i.e. the TSC in accordance with the TR.

    These are set out in the Climate Delegated Act and the Complementary Climate Delegated Act for the two climate environmental objectives and the ‘Environmental Delegated Act’ for the remaining four environmental objectives.
    With regards to sustainable investments FMPs should disclose how those investments do not cause significant harm to any environmental or social sustainable investment objective. In this context, they should disclose how the indicators for adverse impacts on sustainability factors have been taken into account as well as how the sustainable investments are aligned with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.

    The ESAs specify that the use of PAI indicators is mandatory to demonstrate that an investment qualifies as a sustainable investment. The PAI indicators cover
    environmental and social sustainable objectives.
    For PABs the companies that should be excluded are the ones that operate in sectors that do not have measurable carbon emission reduction targets with specific deadlines that are aligned with the objectives of the Paris Agreement. These sectors are specified in CDR 2020/1818.

    For CTBs the exclusions that apply relate to companies involved in a) controversial weapons; b) tobacco cultivation and production; c) violations of UNGG and OECD Guidelines for Multinational Enterprises

    Companies that are found or estimated to significantly harm one or more of the environmental objectives in the TR are excluded from both CTBs and PABs.
    Do the DNSH criteria refer to specific targets or thresholds?The DNSH TSC refer to specific targets or thresholds or specific requirements which should be met when the economic activity is carried out. The PAI indicators that are used for the application of the DNSH principle are not associated with specific targets. The criteria refer to the exclusion of companies operating in specific sectors or violating specific international conventions
    What is the scope of application of the DNSH principle?The DNSH principle is applied at the economic activity level and should cover all economic activities that are taxonomy-eligible,i.e. economic activities for which TSC have been developed. The DNSH principle applies to any sustainable investments.The exclusions are applied to the underlying assets of the benchmark portfolio, i.e. at company level.
    Are there situations where the DNSH criteria in the three sectorial legislations (TR, SFDR,
    BMR) interact?
      The Commission clarified that investments in ‘environmentally sustainable’ economic activities under the TR can be automatically qualified as ‘sustainable investments’ in the context of the product level disclosures under SFDR. This means that investments in specific economic activities can be considered to be sustainable investments.

    However, for investments in an undertaking with some degree of taxonomy-alignment through a funding instrument that does not specify the use of proceeds, FMPs would still need to check the SFDR DNSH principle.

    In the case of financial products disclosing under Article 9(3) SFDR which
    passively track PABs or CTBs the Commission explained in a Q&A that
    those products are deemed to be making sustainable investments and as such would not be required to apply the SFDR DNSH requirements.
     

     

    Annex III -  Overview of the concepts of estimates and equivalent information 

     

      Taxonomy Regulation (TR) Sustainable Finance Disclosures Regulation (SFDR) Benchmarks Regulation (BMR) 
    Which stakeholders may apply the concept of estimates / equivalent information?  The concept of ‘estimates’ is applied by financial undertakings which are required to publish a non-financial statement. FMPs that fall within scope of the SFDR may apply the concepts of ‘equivalent information’ and estimates in specific situations

    Equivalent information is data received directly from investee companies or third parties in relation to investments in economic activities that are environmentally sustainable.

    Estimates relate to data on PAI indicators that were obtained by carrying out additional research, cooperating with third party data providers or external experts or making reasonable assumptions.
    The concept of estimates is relevant for benchmark administrators, including administrators of EU Climate Transition Benchmarks (‘CTBs’) and EU Paris-aligned Benchmarks (‘PABs’).
    In which situations may these concepts be applied?
     The use of estimates is possible in the following situations:

    a) For the purpose of assessing Taxonomy-alignment of exposures in third-country investee companies except for the DNSH criteria.

    b) To assess taxonomy eligibility of financial undertakings and report the information voluntarily.
     The use of ‘equivalent information’ is permitted where publicly reported data concerning exposures to non-NFRD/CSRD investee companies is unavailable. In these cases, FMPs are allowed to use ‘equivalent information’,i.e. data that have been
    obtained either directly from investee companies, or from third parties.

    The use of estimates is permitted where some data points for the PAI indicators require the use of estimates.

    Also, for investee companies that either are not in scope or do not yet report under the CSRD/TR framework the use of complementary assessments and estimates is permitted.
     Benchmark administrators are required to disclose the data sources used and whether data is estimated or reported.
    Does the framework contain specific requirements for the situations when these concepts can be applied? The use of estimates is related to voluntary reporting, which should be disclosed separately from mandatory disclosures. Such voluntary reporting should not contradict or misrepresent mandatory information and it should not be more prominent than mandatory disclosures. Supporting detail should be added to set out the basis for this disclosure, the methods used for its preparation, and a clear explanation of how it differs from mandatory reporting.  In Q&A VII.11 the ESAs explain the basic principles that should be met when the concept of'equivalent information’ is applied.

    Moreover, as a good practice it is recommended for FMPs to disclose for each PAI indicator the proportion of investments for which data was obtained by carrying out additional research, cooperating with third party data providers or external experts or making reasonable assumptions.

    Lastly, the Commission FAQ explains when using complementary assessments and estimates FMPs should clearly explain the reasons for such assessments and estimates and the basis for their conclusions. These estimates should relate to limited and specific parts of the data and produce a prudent outcome.
     With regards to the methodology for the calculation of ESG factors, administrators should disclose the standards and the source of data used. These standards could include, inter alia, the main assumptions and the precautionary principles underlying the estimations; and the percentage of reported vs estimated data used for the calculation.

    For administrators of EU CTBs and EU PABs there is a requirement to disclose the research methodology to estimate missing, unreported, or underreported GHG emissions.

     

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.

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