Sustainable Investments. Taxonomy Regulation and SFDR Regulation

In her opening speech at the online conference organized on 25 January by the Institute for Law and Finance in Frankfurt on Green Banking and Green Central Banking, ECB President Christine Lagarde spoke about the harmful effects of climate change on the environment, the need to develop an orderly transition toward a zero-carbon economy in order to avoid the detrimental consequences of climate change, and how this requires an economic and industrial transformation of the countries involved, one that must also ensure the social inclusion of the entire process—one that must not be delayed, interrupted, or developed in a disorderly fashion.

For these reasons, President Lagarde emphasized how the phenomenon of climate change is at the heart of many projects managed by the ECB, including those related to its monetary policy strategy. Indeed, the role of the ECB and of European central banks becomes central when one considers that the effects of climate change represent a threat to the stability of the global financial system and, consequently, that central banks must manage the risks associated with climate change in accordance with their institutional mandate.

However, the quantification of these risks is characterized by deep uncertainty regarding the magnitude of the physical and transition risks’ effects on the economy, the policies to mitigate them, the simultaneous and broader adaptive capacity of the entire productive and socio-economic system, as well as the fact that assessing climate effects requires a longer time horizon compared to the much shorter timeframes of monetary policy and financial stability.

Today, central banks must face two trends: on the one hand, the more tangible effects of climate change on the European financial system, and on the other, an acceleration in the transition of policies. Both trends have macroeconomic and financial implications and impact the maintenance of price stability, financial stability, banking supervision activities, as well as the balance sheet of the Eurosystem. Climate change also affects the primary mandate assigned to the ECB—price stability—as it can create short-term volatility in output and inflation due to extreme weather events and, if not addressed in a timely manner, can have lasting effects on growth and inflation.

Similarly, transition policies and innovation can have a significant impact on growth and inflation. All these factors could potentially influence the inflation expectations of households and businesses. According to a recent estimate by the European Systemic Risk Board, a disorderly transition could reduce loans to the private sector by 5% in real terms. Climate change can also have adverse effects on monetary policy instruments.

Sudden, persistent, and high-intensity climate variations could lead to an increase in short-term volatility and the acceleration of structural change, such that central banks may be unable to correctly identify the shocks relevant to medium-term inflation prospects, making it more difficult to assess the most appropriate direction to give to monetary policy.

The ECB is currently assessing, without prejudice to the primary objective of price stability, how it can contribute to supporting the Union’s economic policies, as required by the Treaty. The active role played by the ECB can influence the development of specific market segments; in fact, the ECB holds about one-fifth of the volume of green bonds in circulation. Since the beginning of this year, bonds with coupon structures linked to specific sustainability performance targets have been accepted as collateral for Eurosystem credit operations and for outright purchases for monetary policy purposes. In 2020, the ECB increased the share of green bonds in its fund portfolio by 3.5% and plans to increase it further in anticipation of the significant growth of this market in the coming years.

It is also important to note that in recent years, central banks have been engaged in developing specific climate stress tests to identify the main risk factors and how they spread within their respective financial systems, with particular reference to the banking and insurance systems, or to assess the adoption of prudential risk mitigation policies, by encouraging lending, reducing capital requirements for banks (or, alternatively, increasing such requirements for financial intermediaries excessively exposed to carbon-intensive sectors, a so-called “brown penalty”), in order to encourage green investments and loans through the introduction of a green supporting factor (for example, high energy-efficiency mortgages, the purchase of electric cars, investments in SMEs or high-quality infrastructure projects), also in line with the speech by the Vice-President of the European Commission, Valdis Dombrovskis (“Greening finance for sustainable business”) of September 2017.

Central banks, in their role as investors, can integrate environmental factors into the management of their portfolios and assess the feasibility of specific ESG investments, or through the publication of their exposures and climate risk management strategies based on the recommendations of the Task Force on Climate-related Financial Disclosures.

The European Union Emissions Trading System (ETS)

The first development dimension indicated by the ECB is the inclusion of the true social and environmental cost of carbon in the prices paid by all sectors of the economy, which can be achieved through the application of direct taxes or via “cap and trade” schemes that reverse the taxation system by imposing a limit on the maximum amount of emissions allowed in a given period of time, in such a way that reductions will be certain, while the price per ton will vary depending on how easily the economy can meet those limits.

The ETS was introduced by the European legislator with Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003, which amends Directive 96/61/EC of 24 September 1996 on integrated pollution prevention and control, subsequently amended by Directive 2009/29/EC of the European Parliament and of the Council of 23 April 2009, aimed at improving and extending the Community scheme for greenhouse gas emission allowance trading.

The legislation necessary to implement specific aspects of the ETS directive – for example, the relocation of carbon emission allowances (carbon leakage), the auctioning of allowances, and international credits – is adopted by the European Commission following approval by the intergovernmental committee of experts on climate change and consultation with the European Parliament.

Each year, each Member State reports to the Commission on the state of implementation of the ETS directive, and the Commission monitors the carbon market and presents its findings in its annual carbon market report.

The Union’s cap-and-trade emissions trading system (ETS) implies that, within said cap, companies can buy and sell emission allowances according to their needs and offers companies the flexibility they need to reduce the cost of emissions in the most cost-effective way.

To date, the European ETS system covers around 11,000 power stations and manufacturing plants in the 27 Member States plus Iceland, Liechtenstein, and Norway, as well as aviation activities in the same countries.

Overall, about 45% of the Union’s total greenhouse gas (GHG) emissions are regulated by the ETS system which, covering over three-quarters of international carbon trading, represents the world’s largest emissions trading market.

In July 2015, the European Commission presented a legislative proposal on the revision of the ETS system for the next phase (2021–2030, 4th trading period), in line with the EU climate and energy policy framework set for 2030, aimed at reducing EU ETS emissions by 43% compared to 2005. In this regard, it is likely that the effective carbon price will increase if the targets set by the Union for emission reduction are to be achieved.

Based on estimates by the OECD and the European Commission, it has emerged that, at present, it is necessary to maintain the effective carbon price within a range of €40–60.

Decision (EU) 2015/1814 of the European Parliament and of the Council of 6 October 2015, amending Directive 2003/87/EC, established a Market Stability Reserve in 2018 (operational from 2019) within the Union’s emissions trading system for GHG allowances, aimed at increasing the resilience of the ETS system to imbalances between supply and demand and enabling it to operate in an orderly market.

Most recently, Directive 2018/410/EU of the European Parliament and of the Council of 14 March 2018, which amends Directive 2003/87/EC and Decision 2015/1814, aims to support a more cost-effective reduction of emissions and to promote investment in low-carbon technologies.

It is important to highlight that emission allowances represent the currency of the European ETS system, the value of which derives from the cap placed on their overall number available. Each allowance, usable only once, entitles the holder to emit one tonne of CO₂, the main greenhouse gas, or an equivalent amount of two other powerful greenhouse gases, nitrous oxide (N₂O) and perfluorocarbons (PFCs).

Companies must return one allowance for each tonne of CO₂ (or the equivalent amount of N₂O or PFCs) covered by the European ETS system that they emitted in the previous year. In this regard, very heavy fines are foreseen for companies that fail to deliver enough allowances to match their emissions. Companies may receive some allowances for free from governments, but to cover the remainder of their emissions they must purchase additional allowances or use any surplus allowances saved in previous years. Companies that emit less than the number of allowances they have received may sell the surplus allowances. Within certain limits, they may also accumulate credits from participating in specific types of projects recognised under the Clean Development Mechanism of the Kyoto Protocol, aimed at effectively reducing GHG emissions. The ETS system, by allowing companies to purchase international credits, is channelling significant investments aimed at promoting clean technologies and low-carbon development strategies in developing countries and economies in transition.

The European ETS system can become a fundamental component for the development of an international carbon market. National or regional systems already operate in China, South Korea, Canada, Japan, New Zealand, Switzerland, and the United States. It is hoped that the international carbon market will develop through the bottom-up harmonisation of compatible systems; in this regard, the harmonisation of the European ETS system with other solid equivalent systems would facilitate the reduction of costs associated with emission abatement, increase market liquidity, stabilise the carbon price, create a level playing field, and foster global cooperation on climate change.

It is evident that the European ETS system, by requiring companies to purchase or draw on their reserves of allowances and credits, creates a permanent incentive for them to reduce their emissions and invest in more efficient environmentally sustainable technology or in energy sources with lower carbon intensity. Since 2013, auctioning has been the default and most transparent method for the allocation of emission allowances and puts into practice the “polluter pays” principle. A company with its own allowance holding account in the Union Registry may buy or sell allowances, regardless of whether or not it is a company covered by the European ETS system. Trading can be carried out directly between buyers and sellers, through various organised exchanges or through intermediaries active in the carbon market. The production price; in a series of support mechanisms that help industry and the energy sector face the innovation and investment challenges of the transition to a low-carbon economy; in the establishment of two new funds: the innovation fund (which extends support for the development of innovative technologies in industry) and the modernisation fund (which facilitates investments in the modernisation of the energy sector and, more generally, strengthens energy efficiency in 10 low-income Member States); in the availability of free allowances to modernise the energy sector in these low-income Member States.

Corporate Social Responsibility

The second dimension indicated by the ECB is greater transparency in the communication of non-financial information by companies. With Directive 2014/95/EU, the European legislator required large companies, including unlisted companies, to prepare a non-financial statement (NFS), which must contain a brief description of the business model, a description of the policies applied by the company and the related results, including due diligence procedures, the main risks connected to the company’s activities, also in reference to its relationships, products, and business services (including the entire supply chain), which may have negative repercussions on the environment, and the key non-financial performance indicators relevant to the specific activity of the company. See article published in Il Sole 24 Ore on 26 March 2021. (Impact of companies’ activities on the environment and of negative repercussions on companies as a result of climate change.)

The European Commission’s Action Plan to Finance Sustainable Growth

In its March 2018 Action Plan to finance sustainable growth, the European Commission defined a Union-wide strategy on sustainable finance and a roadmap for future actions that will impact the entire financial system. Already in December 2016, the Commission had established a group of twenty high-level senior experts (HLEG) drawn from civil society, the financial sector, academia, and observers from European and international institutions. Their task was to advise the Commission on how to effectively channel public and private capital flows toward sustainable investments, how to identify measures that financial institutions and supervisory authorities should adopt to protect the stability of the financial system from environment-related risks, and how to implement these policies on a pan-European scale.

The recommendations of the High-Level Expert Group on Sustainable Finance, summarized in the final report of January 2018, form the basis of the Action Plan on sustainable finance adopted by the Commission in March 2018. The Commission’s Action Plan on sustainable finance aims to integrate ESG criteria into financial services and support sustainable economic growth by increasing the awareness and transparency of financial actors regarding the need to mitigate ESG risks, particularly considering the long-term nature of such risks and the uncertainty surrounding their assessment and pricing.

With the March 2018 Action Plan, the Commission aims to redirect capital flows toward a more sustainable economy, integrate sustainability into risk management, and promote transparency and long-term vision.

In the Action Plan on sustainable finance, the Commission outlines the following ten actions it intends to adopt to steer the capital market toward a sustainable development model.

European Commission Action Plan

Taxonomy for Climate Change Mitigation and Adaptation. Obligations for Companies.

The offering of financial products that pursue environmentally sustainable objectives is an effective way of directing private investments towards sustainable activities. The requirements for marketing financial products or corporate bonds as environmentally sustainable investments—including the requirements imposed by Member States and the Union to allow financial market participants and issuers to use national labels—aim to increase investor confidence and raise awareness of the environmental impacts of such financial products or corporate bonds.

In this context, it is useful to highlight the recent adoption by the European Union of Regulation (EU) 2019/2088 of 27 November 2019 (Sustainable Financial Disclosure Regulation or SFDR) and Regulation (EU) 2020/852 (Taxonomy).

The SFDR, which came into force on 10 March 2021, constitutes one of the fundamental pillars of ESG disclosure in financial services, as it introduces a harmonised regime for financial market participants and financial advisers regarding the integration of sustainability risks. It imposes the obligation on recipients of the regulation to provide pre-contractual and ongoing disclosures related to sustainability and concerning financial products intended for end investors.

Sustainability risk is defined as an environmental, social, or governance event or condition that, if it occurs, could cause a significant negative impact on the value of the investment. The subjective scope of application of the SFDR regulation includes two macro-categories of recipients of the new obligations.

SFDR Regulation – Recipients

The SFDR regulation provides disclosure obligations (transparency rules) both at the entity level and at the product level

To complement the SFDR, with regard to the description of negative sustainability impacts, the European Commission has not yet published the delegated acts, based on the proposed RTS (Regulatory Technical Standards) released last February by the ESAs (EBA, EIOPA, ESMA), which are expected to enter into force in January 2022.

Regulation (EU) 2020/852, which entered into force on 12 July 2020, aims instead to create the first list of sustainable investments—a classification system designed to establish a common language that investors and companies can use when investing in projects and economic activities that have a substantial positive impact on the climate and the environment.

The Taxonomy Regulation applies to:

• measures adopted by Member States or by the Union that establish obligations for financial market participants or issuers in relation to financial products or corporate bonds made available as environmentally sustainable;
• financial market participants making financial products available;
• companies subject to the obligation to publish a non-financial statement or a consolidated non-financial statement pursuant to Article 1 of Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014, amending Directive 2013/34/EU of the European Parliament and of the Council of 26 June 2013.

On the obligations for large companies to publish a non-financial statement, see the article published in Il Sole 24 Ore on 26 March 2021 (Impact of company activities on the environment and negative repercussions on companies due to climate change).

If it is true that with Decision 1386/2013/EU of 20 November 2013, the European Parliament and the Council urged Member States to encourage greater private sector participation in financing environmental and climate-related expenditures by introducing incentives and methodologies that would encourage businesses to measure environmental costs, it is equally true that achieving the three dimensions of sustainability—economic governance, social, and environmental—outlined in the new global sustainable development framework adopted by the UN in September 2015 (Agenda 2030), requires that capital flows be directed towards sustainable investments. This must be done by integrating the system with financial products and services that pursue environmentally sustainable objectives.

The requirements for marketing financial products or corporate bonds as environmentally sustainable aim to achieve the Union’s desired sustainable development, to increase investor confidence in such products, and to prevent companies from unfairly gaining a competitive advantage by marketing a financial product as environmentally sustainable when it does not, in fact, meet the sustainability criteria set out in Regulation (EU) 2020/852 (greenwashing). Such practices undermine the principle of fair competition and hinder the orderly development of the market.

It is clear that the criteria for determining whether an economic activity is, in practice, environmentally sustainable should be harmonized at the Union level to avoid fragmenting the internal market. Such fragmentation, characterized by information asymmetries and different conformity criteria, would increase costs and discourage cross-border investments within the Union.

In this regard, the European Commission is exploring the possibility of developing a voluntary standard for European green bonds, as well as implementing an EU ecolabel for retail investment products, which could possibly be extended to financial products by the third quarter of 2021.

Regulation (EU) 2020/852 establishes the criteria for a sustainable activity: first, it must substantially contribute to at least one of the six environmental objectives (climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources; transition to a circular economy; pollution prevention and control; protection and restoration of biodiversity and ecosystems); second, it must not cause significant harm to any of the other environmental objectives (do no significant harm); third, it must meet minimum social safeguard requirements; and finally, it must comply with technical screening criteria based on the sustainability indicators proposed by the European Parliament in its resolution of 29 May 2018 on sustainable finance and later transposed into Directive (EU) 2019/2088.

Furthermore, the Commission recommends that large non-financial undertakings disclose certain key climate-related performance indicators, such as the share of turnover, capital expenditures, and operating expenses associated with environmentally sustainable economic activities. Regulation 2020/852 also provides negative definitions of environmentally sustainable economic activities: an economic activity cannot be considered environmentally sustainable if it causes more harm than benefit to the environment, and the technical screening criteria should indicate whether such activity causes significant harm to other environmental objectives; economic activities should be considered environmentally sustainable only if they are conducted in line with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights. See article published in Il Sole 24 Ore of 18 March 2021 on the New Global Sanctions Framework of the European Union regarding serious violations and abuses of human rights (Nuovo quadro sanzionatorio globale dell’Unione Europea in tema di gravi violazioni e abusi dei diritti umani).

Furthermore, Regulation 852/2020 has amended the SFDR Regulation by introducing supplementary obligations relating to the alignment of transparency requirements with the environmental taxonomy. In fact, Article 5 provides for aligning the transparency required for products that include a share of sustainable investments, indicating how such sustainable investments contribute to environmental objectives. As it stands, the Commission has been tasked with presenting technical screening criteria through “delegated acts” to further develop the taxonomy and to enrich the regulation with concrete technical criteria, supplemented by an equivalent taxonomy for high-carbon-intensity activities.