SFDR

On 20 October 2023, the European Commission issued:

• the notice C/2023/267 (the “Notice”) on the interpretation and implementation of certain legal provisions of the EU Taxonomy Climate Delegated Act (the “Climate Delegated Act”) establishing technical screening criteria for economic activities that contribute substantially to climate change mitigation or climate change adaptation and do no significant harm to other environmental objectives.

In the Action Plan on Financing Sustainable Growth (2018), the Commission committed to establishing a clear and detailed EU classification system for sustainable economic activities. This unified EU classification system was implemented by the Taxonomy Regulation, which sets the framework to facilitate sustainable economic activities and imposes transparency obligations on financial and non-financial entities with respect to those activities.

Subsequent delegated acts adopted, such as the EU Taxonomy Climate Delegated Act (applying as of 1 January 2022) and its amendments (applying as of 1 January 2023), set out a list of technical screening criteria for Taxonomy-aligned activities and energy activities being considered as contributing substantially to climate change mitigation or climate change adaptation and do no significant harm to other environmental objectives.

It is noteworthy that the FAQs contained in the Notice do not cover the rationale for the choice of criteria; rather, the purpose is to clarify the technical screening criteria and facilitate the effective application of the Climate Delegated Act, thus, to assist financial and non-financial undertakings in the implementation of the relevant legal provisions.

• a second notice C/2023/305 (the “Second Notice”) providing guidance on the interpretation and implementation of legal provisions within the Disclosures Delegated Act under Article 8 of the EU Taxonomy Regulation.

The Disclosures Delegated Act, adopted in July 2021, outlines disclosure obligations for undertakings regarding the Taxonomy-eligibility and alignment of their activities under Article 8. Three sets of guidance were published by the EU Commission on the content of the Disclosures Delegated Act.

Non-financial undertakings are set to begin reporting Taxonomy key performance indicators (“KPIs”) as from 1 January 2023. The Second Notice aims to provide interpretative and implementation guidance, presented in the form of FAQs to assist these undertakings. Financial undertakings will commence reporting their Green Asset Ratio/Green Investment Ratio as from 1 January 2024. A separate notice for financial undertakings may be adopted in the future.

The Disclosures Delegated Act requires financial undertakings to use KPIs disclosed by their counterparties (e.g., non-financial undertakings) when calculating their Green Asset Ratio/Green Investment Ratio. Also, the SFDR requires financial market participants to utilise KPIs based on turnover, capital expenditure (“CAPEX”) and operating expense (“OPEX”), disclosed by investee companies for assessing the environmental performance of marketed financial products.

The FAQs contained in the Second Notice clarify existing legislative provisions and aim to assist non-financial undertakings in implementing those legal requirements.

On 25 October 2023, the CSSF published a communication with regard to the launch, on 3 October 2023, by ESMA of a common supervisory action (the “CSA”) with the NCAs on the integration of sustainability preferences in firms’ suitability assessment and product governance requirements.

One will recall that MiFID II requires investment firms to gather information on clients' knowledge, financial situation, and investment objectives. This includes assessing clients' expertise in relevant financial areas, their ability to bear losses, and their risk tolerance, to ensure that investment firms recommend suitable services and financial instruments aligned with clients' profiles.

The CSA follows ESMA’s recent update of two sets of guidelines (the “Guidelines”) on (i) the MiFID II suitability requirements and (ii) MiFID II product governance requirements, issued on 3 April 2023 and 3 August 2023 respectively, both of which entered into force on 3 October 2023.

Those Guidelines are driven by the significance of suitability assessment for investor protection within the MiFID II framework for investment firms to provide suitable recommendations or decisions to clients.

The key amendments introduced in the above-mentioned Guidelines encompass:

• Mandatory specification of sustainability-related objectives: Firms are now obliged to explicitly outline any sustainability-related objectives associated with a product. Notably, the Guidelines allow the alignment of these objectives with the definition of "sustainability preferences" outlined in Article 2(7) of the amended MiFID II Delegated Regulation
• Clustering approach for target market identification: A novel provision permits the identification of the target market based on clusters of products rather than individual products. This "clustering approach" facilitates the application of a unified strategy for products sharing sufficiently comparable features.
• Alignment of distribution strategy with target and for complex products: Firms engaged in the distribution of intricate products through non-advised sales are required to ensure that the distribution strategy aligns with the target market of the product. This may involve refining the distribution strategy as identified by the manufacturer.
• Proactive information sharing by distributors: Distributors are now required to proactively furnish manufacturers with relevant information to support periodic product reviews. This obligation extends beyond responding to requests, adhering to the proportionality principle.

The aim of the CSA is to determine:

• how firms gather information about their clients' sustainability preferences;
• what mechanisms firms have implemented to accurately identify and classify investment items based on sustainability characteristics in order to perform a suitability assessment;
• how firms apply a “clustering approach to guarantee the sustainability of an investment, and
• how firms ensure that a target market assessment of the investment product aligns with sustainability-related objectives.

Please note that the CSSF implemented the ESMA Guidelines on MiFID II product governance requirements in the Circular 23/840 issued on 14 September 2023. As part of this CSA, the CSSF will contact a selection of regulated entities for compliance purposes.

On 25 October 2023, ESMA published a summary of the results of a fact-finding exercise on corporate reporting practices under the Taxonomy Regulation (the “Fact-Finding”).

The Taxonomy Regulation requires, in Article 8, undertakings subject to an obligation to publish non-financial information including information on how, and to what extent, their activities are associated with economic activities that qualify as environmentally sustainable.

The Disclosures Delegated Act specifies the information to be disclosed as well as the timing for the disclosure. For non-financial undertakings within the scope of these requirements, 2023 was the first year of reporting.

ESMA collected information from European non-financial undertakings listed in regulated markets. The primary objective of the Fact-Finding was to assess the quality of the disclosures and how the reporting requirements had been addressed.

The Fact-Finding reveals notable trends. For instance, a large part of the issuers (96%) disclosed the key performance indicators (KPIs) relating to alignment with the Taxonomy Regulation, but concerns arise with the reporting templates, as 30% were modified or incomplete – impacting the compatibility and hindering data access for users.

Moreover, the Fact-Finding shows that over 40% of issuers lacked adequate or provided insufficient mandatory qualitative information on transparency compliance, and the operating expenditure alignment of the key performance indicators such as OPEX was frequently not reported or stated as zero.

Therefore, the Fact-Finding highlights a need for enhanced consistency and transparency in corporate reporting practices on avoiding double counting, screening activities against a single climate objective. ESMA emphasises the importance of issuers providing both quantitative and detailed qualitative information as required by the Disclosures Delegated Act and prompts issuers to leverage available resources for more robust disclosures.

On 21 November 2023, the Official Journal of the European Union published the Commission Delegated Regulation (EU) 2023/2485 of 27 June 2023 (the “2485 Delegated Regulation”) amending Delegated Regulation (EU) 2021/2139 (the “Taxonomy Climate Delegated Act”). The 2485 Delegated Regulation amends the Taxonomy Climate Delegated Act by setting forth the technical screening criteria for climate change mitigation and climate change adaptation for economic activities not yet covered in the Taxonomy Climate Delegated Act. This includes some manufacturing activities in relation to key components for low carbon transport and electrical equipment, which can help achieve greenhouse gas emissions savings in other target activities.

Published on the same day was the Commission Delegated Regulation (EU) 2023/2486 supplementing the Taxonomy Regulation by establishing the technical screening criteria for determining the conditions under which an economic activity qualifies as contributing substantially to the sustainable use and protection of water and marine resources, to the transition to a circular economy, to pollution prevention and control, or to the protection and restoration of biodiversity and ecosystems and for determining whether that economic activity causes no significant harm to any of the other environmental objectives, and amending Commission Delegated Regulation (EU) 2021/2178 (the “Taxonomy Disclosures Delegated Act”) as regards specific public disclosures for those economic activities was published in the Official Journal of the European Union.

The two delegated regulations entered into force on the twentieth day following their publication in the Official Journal of the European Union, i.e., on 11 December 2023.

On 22 November 2023, ESMA released three explanatory notes, addressing crucial aspects of the Sustainable Finance Disclosure Regulation (SFDR), the Taxonomy Regulation (TR), and the Benchmark Regulation (BMR). These notes specifically delve into (i) defining sustainable investments and activities; (ii) implementing the 'do no significant harm' (DNSH) requirements; and (iii) the use of estimates. It is important to note that these explanatory notes do not introduce new information, interpret existing texts, or serve as replacements, instead they may serve as an aide for stakeholders in navigating the complex landscape of the European sustainable finance framework.

(i) the definition of sustainable investments and activities: the note defines the "environmentally sustainable investment" as an investment in one or several economic activities that qualify as environmentally sustainable. It highlights the need for market participants to assess key parameters independently and provides "safe harbours" for certain products. The note concludes with a comparative table summarising the differences between sustainability concepts in the EU TR and EU SFDR.

(ii) the ‘Do No Significant Harm’ definitions and criteria: the note highlights that an economic activity should not qualify as "environmentally sustainable" under the EU TR if it significantly harms any of the six established environmental objectives. DNSH is a key element for assessing sustainable investments under the EU SFDR relevant for both Article 8 and Article 9 products making sustainable investments.

(iii) the use of estimates: the note elucidates how key sustainable finance legislation addresses the use of "estimates" and "equivalent information" for mandatory ESG metrics under the EU TR, EU SFDR, and EU BMR. It advocates good practice for FMPs under EU SFDR to disclose data sources for PAI indicators, distinguishing between direct company data and information obtained through research or third-party collaboration.

On 4 December 2023, the ESAs published their final report to amend the draft RTS to Commission Delegated Regulation 2022/1288 supplementing the SFDR. The fast-evolving ESG markets and the growing demand for ESG investments has been accompanied by an increased demand for high-quality sustainability information. Mandated by the European Commission in April 2022, the ESAs aimed to enhance transparency and comparability in sustainability impact reporting for financial products available in the market.

The ESAs have suggested alignment with the draft European Sustainability Reporting Standards (ESRS), in respect of social indicators for the disclosure of the PAIs of investment decisions in light of the data challenges raised by FMPs, in view of increasing consistency and accountability of information in accordance with the Corporate Sustainability Reporting Directive (CSRD). In addition, the ESAs have suggested additional mandatory and opt-in indicators which are not, for the time being, reported under ESRS.

Regarding amendments to pre-contractual and periodic disclosures of greenhouse gas (GHG) emissions reduction targets, the ESAs aimed to enhance transparency due to an expected increase in products featuring climate change mitigation strategies. The ESAs rejected a simple yes/no question on GHG targets, favouring basic information in financial product templates, supplemented by detailed disclosures on the product's website.

Concerning the design of the Do No Significant Harm (DNSH) test for sustainable investments, the ESAs expressed concern about the current wide discretion given to fund managers.

On 14 December 2023, ESMA issued a public statement (the “Statement”) on its consultation on guidelines on funds’ names using ESG or sustainability-related terms launched on 18 November 2022 (the “Consultation”) . Following the feedback received from market participants to the Consultation, ESMA has decided to postpone the adoption of the guidelines and to introduce new amendments.

The key modifications include:

• Deletion of the additional 50% threshold for sustainable investments for funds using sustainability-related terms in their names. Instead, such funds must have a minimum of 80% of investments aligning with their sustainability characteristics or objectives, adhere to Paris-aligned Benchmark (PAB) exclusions, and substantially invest in sustainable investments, as defined by SFDR.
• Introduction of a new category for transition-related terms. Funds with transition-related terms in their names should, in addition to the minimum 80% threshold referred to above, apply Climate Transition Benchmark (CTB) exclusions.
• Segregation of environmental, social, and governance terms. Funds using environmental terms in their names should apply PAB exclusions. Funds combining E, S, and/or G terms in their names should follow the guidelines cumulatively, except for those using a combination of environmental and transition terms, which should apply CTB exclusions instead of PAB exclusions.
• Measurability for transition and impact-related terms. Funds using these terms in their names should ensure that the minimum proportion of investments specified earlier also contributes to generating positive and measurable social or environmental impact or demonstrates a clear and measurable path to social or environmental transition.

ESMA intends to adopt the guidelines shortly after the entry into force of the amended AIFMD and UCITS Directive. The guidelines will be applicable three months after their publication on ESMA’s website.

Managers of new funds will be expected to comply with the guidelines immediately following their publication whereas managers of existing funds will have six months to comply following their publication.