Navigating ESG in times of regulatory and market uncertainty

In recent years, the European Union has introduced legislation on sustainable finance, including the Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD). These laws aim to help the EU transition towards a more sustainable economy, in line with the objectives of Europe’s Green Deal, whilst also protecting the health and competitiveness of its financial and economic markets. In this blog, we introduce four main pieces of legislation and discuss how investors can navigate the topic of ESG in times of regulatory (and market) uncertainty.

The SFDR – the transparency regulation

The Sustainable Finance Disclosure Regulation (SFDR) is a European regulation designed to promote sustainable investment and increase transparency in the financial sector. Financial Market Participants (FMPs) must disclose how they take sustainability into account in their investment decisions and report on the ESG strategies and impacts of their financial products.

EU Taxonomy – the classification tool

The EU Taxonomy works as a classification tool. It defines when an economic activity can be regarded as sustainable. The EU Taxonomy lists activities and the criteria that need to be fulfilled for the activity to be considered (environmentally) sustainable. The EU Taxonomy sets out three overarching conditions that an economic activity must meet in order to be considered sustainable:

1. make a substantial contribution to at least one of the six environmental objectives
2. ‘do no significant harm’ to any of the other five environmental objectives
3. comply with minimum safeguards

The SFDR, like the CSRD, cross-references with the EU Taxonomy and the criteria listed in the EU Taxonomy are used by FMPs to calculate the share of taxonomy-aligned investments in the portfolio. In effect, these two regulations are one package serving the same goal – to create transparency about the sustainability of investment portfolios. Ultimately, the intention is to steer more investments towards sustainable portfolios.

Completing the picture: CSRD and CSDDD

The Corporate Sustainability Reporting Directive (CSRD) has been in force since January 2023 and applies to all economic sectors, going beyond the financial sector. It requires all large companies to report extensively on their sustainability profile and performance. The directive is linked to the EU Taxonomy and requires companies to disclose their share of activities aligned to the Taxonomy (similar to SFDR). The Corporate Sustainability Due Diligence Directive (CSDDD) will complement the CSRD and will require large companies to identify, assess, mitigate and remediate adverse human rights and environmental impacts in the supply chain. The CSDDD currently remains at proposal stage. It is expected that both directives will complement the SFDR and the EU Taxonomy (and vice versa), so that increased transparency on sustainability performance is established in both the real and financial economy.

The interplay of SFDR, EU Taxonomy and CSRD: challenges and uncertainties

Although the regulatory landscape for ESG is evolving, there are still many uncertainties regarding the specific requirements. On SFDR and Taxonomy alone, the European Commission (EC) and the European Supervisory Authorities (ESAs) have published multiple Q&As since the regulations came into force to provide much-needed guidance for FMPs. Despite this, the application of SFDR concepts such as ‘sustainable investment’, the existing categorisation of financial products (Art 6, 8 and 9), or the taxonomy criteria (e.g. on climate change adaptation) remains challenging. This is also the case for overarching concepts, such as ‘do no significant harm’ (DNSH), which does not seem to be fully in line with the SFDR and the EU Taxonomy. This is further complicated by the fact that the current first ‘version’ of the SFDR is currently under review by the European Commission, with possible changes ranging from minor adjustments to a complete overhaul of the SFDR and its fundamental workings. As for the EU Taxonomy, it remains incomplete, with more criteria for environmental contributions to be added in the future and a taxonomy for social objectives yet to be defined. How well the CSRD will complement the two regulations through provision of company disclosure on sustainability remains to be seen upon its first application in 2024.

In the midst of all this, the EU is currently attempting a balancing act between (1) publishing legislation in time (to speed up the transition) and with sufficient level of ambition (to realise the EU Green Deal) and (2) making laws that complement each other and include realistic and feasible requirements for FMPs, and that therefore work well in practice (and not only in theory).

How to navigate as an investor

The current ESG environment also presents challenges for FMPs. Ensuring compliance with sustainable finance legislation is a must, but already proving difficult given the stated uncertainty and a lack of guidance. The fact that only very limited ESG data is available at the portfolio and investment level (and when it is available, it is difficult to compare) makes it even harder to comply with existing disclosure requirements. Moreover, many FMPs manage different types of financial products, making it challenging to implement a one-size-fits-all ESG approach. This leads some FMPs to adopt a rather conservative and cautious ‘let’s wait and see’ approach towards their ESG ambitions, sticking to the minimum disclosure requirements until the regulatory landscape matures.

However, the truth is that, all regulation aside, the pressure on investors to play an active role in the sustainability transition is rising. Whilst in the past ESG was widely seen (and approached) as a ‘tick-the-box exercise’, this is now changing. Stakeholders increasingly expect investors to embrace the paradigm shift, ‘really’ deal with ESG, commit serious resources to the topic and take meaningful action, backed with quality data to support their performance. While many FMPs have taken the first steps by developing a proprietary ESG approach (often with an aversion to existing legislation, claiming that it takes awareness and resources away from a better, more normative approach), many of these investors will, in the future, have to level up their efforts and revise / improve their strategies and methodologies. Other FMPs have not implemented any activities yet and will be required to commit considerable time and energy to the topic of ESG in order to maintain their ‘licence to operate’.

Investors need to think strategically about ESG, demonstrating real commitment and meaningful progress, whilst maintaining regulatory compliance and avoiding greenwashing at all costs. Working with our clients and talking to peers and partners, we have observed useful practices that help market participants achieve this balancing act. We have summarised some of these below:

1. Materiality

   Materiality is a key concept within ESG. It means that, rather than reporting and working on all different sorts of ESG aspects (e.g. all of the 17 Sustainable Development Goals), organisations should give priority to those ESG aspects that are most important for them, given their business model, geographical context, size (and a number of other factors). Limiting your ESG approach to a few select aspects with the highest priority is reasonable and legitimate. Often, when ESG feels too big, materiality can help make it a little smaller.

2. Proportionality
   

   Sustainable finance regulations, although demanding, emphasise the principle of proportionality. Not all organisations are expected to invest the same amounts of time, money, and energy. Investigating what ‘proportionate’ means for your organisation and why (and communicating this to your stakeholders) can help you find a progressive but feasible approach to ESG.

3. Intended purpose
   

   While grey areas and room for interpretation remain, the overall purpose of laws like the SFDR and CSRD is clear. When in doubt about specific requirements and their implementation, go back to the intended purpose of these laws to help guide you. A good rule is: principle first, compliance second.

4. Legislation as a vehicle, not the basis
   

   Sustainable finance legislation can provide some direction for how to set up and organise your ESG efforts, i.e. around the requirements that need to be complied with. However, it does not help you in defining why you do ESG and how it connects to your business, which needs to be the foundation for a good ESG approach. It is therefore advisable to use legal requirements as a frame or vehicle, but not as the basis for your ESG approach.

5. Involve portfolio companies, and give them room
   

   It has proven useful for investors to involve their investments as much as possible in the conversation, and to provide some room for the company to develop their own view on and approach to ESG. An example is the facilitation of workshops or roundtables with representatives of all portfolio companies on specific ESG topics or requirements. While standardised requirements (e.g. on data collection or installing policies) have their place, investments need to be encouraged to define their own set of material ESG aspects and activities to be implemented.

6. Prepare for CSRD and CSDDD early on
   

   These two directives ask a lot of organisations. This is true especially for the CSDDD, which goes beyond transparency rules and requires companies to take action on sustainability topics in their supply chain. Even though these rules may apply to your organisation (or your investments) only in future years, it is likely that much time will be needed to prepare for them. Starting early is important.

7. Involve legal and market perspectives
   

   While legal opinion is necessary for questions of compliance (and will often have the last word), it is important to involve market perspectives as well. Especially when dealing with grey areas and room for interpretation, looking at peers and partners can help find a solution that is not only sound from a legal point of view, but that is also viable and receives acceptance in the market.

8. Make use of phase-ins
   

   Lastly, business sustainability and ESG are here to stay. That said, no organisation should be doing it all or should aspire to do it perfectly from the start. Legislation includes phase-ins for many requirements and it can be wise to take advantage of them.