ESG Regulatory Round-up
16th June 2023
The ESG space is constantly evolving, and staying up to date with the latest regulations and proposals is crucial for firms. In this ESG Regulatory Round-up, we bring you a comprehensive overview of the recent developments shaping the landscape of sustainability proposals and practices.
Part I: Updates relevant to financial market participants
European Commission proposals to strengthen the EU’s sustainable finance agenda
On 13 June 2023, the European Commission published a new set of proposed measures to enhance and strengthen the EU sustainable finance framework. The purpose of this package is to ensure that the EU sustainable finance framework supports companies and the financial sector while promoting private funding for transition projects and technologies. The proposal includes the addition of new activities to the EU Taxonomy and new rules for ESG rating providers to improve transparency in the sustainable investment market.
This article provides a brief overview of the latest proposed measures focusing on ESG ratings providers and EU Taxonomy Delegated Acts, as well as updates in relation to the European Sustainability Reporting Standards (ESRS) under the Corporate Sustainability Reporting Directive (CSRD), the OECD Guidelines for Multinational Enterprises on Responsible Business Conduct, the Corporate Sustainability Due Diligence Directive and the Regulation on deforestation-free products.
Proposed regulation of ESG ratings providers
The Commission has published a proposal for a Regulation on the Transparency and Integrity of Environmental, Social And Governance (ESG) Rating Activities.
ESG ratings play a vital role in the EU sustainable finance market as they provide information to investors and financial institutions regarding, for example, investment strategies and risk management on ESG factors. According to the Commission, the current ESG rating market suffers from deficiencies and is not functioning properly. Reasons for this are the lack of transparency on the characteristics of ESG ratings, their methodologies and their data sources and the lack of clarity on how ESG rating providers operate.
The proposal does not intend to harmonise the methodologies for the calculation of ESG ratings, but to increase their transparency and ensure increased clarity on operations of ESG rating providers and the prevention of risks of conflict of interest at ESG rating provider level.
The proposed Regulation will require that ESG rating providers offering services to investors and companies in the EU are authorised and supervised by the European Securities and Markets Authority (“ESMA”). This will also ensure the quality and reliability of their services to protect investors and ensure market integrity.
The Commission has also proposed rules for non-EU ESG rating providers. The Regulation provides for three possible regimes for such providers: equivalence, endorsement and recognition.
As a next step, the Commission will now engage in discussions with the European Parliament and Council.
EU Taxonomy Delegated Acts
Following a month-long consultation process by the European Supervisory Authorities (the “ESAs”), the Commission has approved, in principle, a new set of EU Taxonomy criteria for economic activities making a substantial contribution to one or more of the following non-climate environmental objectives:
- sustainable use and protection of water and marine resources;
- transition to a circular economy;
- pollution prevention and control; and
- protection and restoration of biodiversity and ecosystems.
The Commission has also adopted targeted amendments to the EU Taxonomy Climate Delegated Act. The amendments expand on economic activities contributing to climate change mitigation and climate change adaptation that were not included so far – in particular in the manufacturing and transport sectors. The inclusion of further economic activities covering all six environmental objectives, and consequently more economic sectors and companies, will increase the usability and the potential of the EU Taxonomy in scaling up sustainable investments in the EU.
Finally, the Commission has adopted amendments to the EU Taxonomy Disclosures Delegated Act in order to clarify the disclosure obligations for these additional activities.
As soon as the EU Taxonomy Delegated Acts are translated into all EU official languages, they will be adopted and transmitted to the European Parliament and the Council for their scrutiny. This is a four-month period, extendable once by two additional months. Provided that the Parliament and Council do not object, the Delegated Acts are therefore expected to apply as of January 2024.
Proposed changes to the European Sustainability Reporting Standards (ESRS) under the Corporate Sustainable Reporting Directive (CSRD)
Directive (EU) 2022/2464 on corporate sustainability reporting (“CSRD”) introduces an obligation for certain companies1 to report on a broad range of ESG matters. The detailed reporting requirements are set out in European Sustainability Reporting Standards (“ESRS”). The first set of sector-agnostic draft standards comprising twelve draft ESRS were submitted to the Commission on 22 November 2022. The Commission has now issued 12 “near final” ESRS in the form of a Delegated Act for public feedback. These revised draft ESRS contain significant changes compared to those proposed in November 2022.
The 12 draft ESRS consist of 2 general standards applicable to all sustainability topics (the “General Disclosures”) and 10 other standards covering a broad range of ESG topics (the “Other ESG Disclosures”).
Revised ESRS: most significant changes
1. Other ESG Disclosures and Materiality
In the November draft of the ESRS, the General Disclosures and the Other ESG Disclosures were all mandatory. In the updated draft, only the General Disclosures are mandatory. The Other ESG Disclosures will apply based on a self-assessment of materiality by the company. The assessment of materiality is two-fold and consists of impact materiality and financial materiality.
The Other ESG Disclosures include matters such as climate change, pollution, workers in the value chain and business conduct.
Though the reporting burden is eased somewhat as a result of the non-mandatory nature of the Other ESG Disclosures, in-scope companies must now familiarise themselves with the materiality assessment process and apply this to each standard.
The Commission is putting in place an interpretation mechanism to provide formal interpretation of the ESRS. It has also asked the European Financial Reporting Advisory Group (EFRAG)2 to publish additional guidance and educational material, addressing the materiality assessment process and other issues.
2. Phased application of certain reporting requirements and employee threshold
The Commission has introduced a phased-in application of certain provisions in the latest draft ESRS.
It will no longer be mandatory for companies with under 750 employees to provide disclosure on the ‘Own workforce’ standard during the first year. Such companies will also be exempt from reporting for the standards ‘Affected communities’, ‘Workers in the value chain’, ‘Consumers and end-users’ and ‘Biodiversity and ecosystems’ for the first two years of application.
Furthermore, all companies may omit information on anticipated financial effects related to non-climate environmental issues and certain data points related to their own workforce in the first year that they apply the ESRS.
The consultation period remains open until 7 July 2023 and it is expected that the ESRS will be adopted in early August (pending no objections from the European Parliament and Council). The application of the CRSD itself is phased. The first companies must report using the ESRS with reference to the financial year 2024 (i.e., reporting in 2025), therefore, the ESRS must be effective from 1 January 2024 onwards.
European Supervisory Authorities’ common understanding of greenwashing
In November 2022, the ESAs issued a Call for Evidence (“CfE”) on Greenwashing to collect feedback from stakeholders on how to understand the key features, drivers and risks associated with greenwashing and to gather examples of potential greenwashing practices. While the ESAs expect to publish the Final Reports in May 2024, they have now published Progress Reports on Greenwashing in the financial sector.
What is greenwashing?
Based on their analysis of current references, as well as replies received to the CfE, the ESAs understand greenwashing to be “a practice where sustainability-related statements, declarations, actions, or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product, or financial services. This practice may be misleading to consumers, investors, or other market participants”. The ESAs also point out that sustainability-related misleading claims can occur and spread either intentionally or unintentionally and in relation to entities and products that are either within or outside the remit of the EU regulatory framework.
Causes and solutions
The ESAs cite the following factors as drivers of greenwashing:
- challenges in implementing the necessary governance processes and tools that would support high-quality sustainability disclosures and transition efforts;
- difficulties in producing and accessing relevant, high-quality sustainability data;
- a fast-moving regulatory framework that has created implementation challenges for market participants and for national regulators; and
- the complexity of sustainable finance, ESG literacy gaps, as well as a fragmented labelling landscape limit the ability of retail investors to make informed investment decisions and participate in financing the transition according to their sustainability preferences.
To mitigate greenwashing risks, the ESAs state that market participants must make substantiated claims and communicate on sustainability in a balanced manner. Furthermore, the comprehensibility of sustainability disclosures to retail investors needs to be improved, including by establishing a reliable and well-designed labelling scheme for financial products. Finally, the regulatory framework needs to mature further, key concepts need to be clarified and sustainability impact or engagement better integrated.
The ESAs will publish final greenwashing reports in May 2024 and will consider final recommendations, including on possible changes to the EU regulatory framework.
New edition of OECD Guidelines for Multinational Enterprises on Responsible Business Conduct published
An updated edition of the OECD Guidelines for Multinational Enterprises on Responsible Business Conduct (the “OECD Guidelines”) was published on 8 June.
The OECD Guidelines are recommendations addressed by governments to multinational enterprises. They aim to encourage positive contributions enterprises can make to economic, environmental and social progress, and to minimise adverse impacts on matters covered by the Guidelines that may be associated with an enterprise’s operations, products and services. The Guidelines cover all key areas of business responsibility, including human rights, labour rights, environment, bribery, consumer interests, disclosure, science and technology, competition, and taxation.
The 2023 edition of the OECD Guidelines provides updated recommendations for responsible business conduct across key areas, such as climate change, biodiversity, technology, business integrity and supply chain due diligence, as well as updated implementation procedures for the National Contact Points for Responsible Business Conduct.
It is important to note that under Regulation (EU) 2019/2088 (“SFDR”), products that make sustainable investments must indicate how these are aligned with the OECD Guidelines. Financial market participants must therefore familiarise themselves with the latest edition.
Part II: Updates relevant to other corporates
Regulation (EU) 2023/1115 on the Making Available in the Union Market and the Export from the Union of Certain Commodities and Products Associated with Deforestation and Forest Degradation published in the Official Journal
On 9 June 2023, Regulation (EU) 2023/1115 on the Making Available in the Union Market and the Export from the Union of Certain Commodities and Products Associated with Deforestation and Forest Degradation was published in the Official Journal of the European Union (the “Official Journal”).
The Regulation sets mandatory due diligence rules for all operators and traders who place, make available or export the following commodities from the EU market: palm oil, cattle, wood, coffee, cocoa, rubber and soy. The rules also apply to a number of products such as chocolate, furniture, printed paper and selected palm oil based derivates (used for example as components in personal care products).
Operators will be required to trace the commodities they are selling back to the plot of land where they were produced. At the same time, the new rules aim to avoid duplication of obligations and reduce administrative burden for operators and authorities.
The Regulation sets a cut-off date for the new rules on 31 December 2020, meaning that only products that have been produced on land that has not been subject to deforestation or forest degradation after 31 December 2020 will be allowed on the EU market or to be exported from the EU.
The new rules also consider the protection of human rights related to deforestation and a reference was added to the principle of free prior and informed consent of indigenous peoples. The Regulation includes provisions on penalties, which member states should ensure are effective, proportionate and dissuasive.
Fines proportionate to the environmental damage and the value of the relevant commodities or products concerned should be set at the level of at least 4% of the operators’ annual turnover in the EU and include a temporary exclusion from public procurement processes and from access to public funding.
The Regulation enters into force on 29 June 2023.
The European Parliament adopted its position on the Corporate Sustainability Due Diligence Directive
On 1 June 2023, the European Parliament agreed on its position on the Directive on corporate sustainability due diligence (the “CSDDD”).
The European Parliament in its position has proposed a series of amendments to the text of the CSDDD, as proposed by the Commission.
The CSDDD establishes a corporate due diligence duty, meaning that in-scope companies will need to identify, prevent, mitigate and account for human rights abuses and environmental impacts in the company’s own operations, their subsidiaries and their value chains. In addition, certain large companies need to have a plan to ensure that their business strategy is compatible with limiting global warming to 1.5 °C in line with the Paris Agreement. Directors are incentivised to contribute to sustainability and climate change mitigation goals.
The CSDDD also introduces duties for the directors of the EU companies covered, including setting up and overseeing the implementation of the due diligence processes and integrating due diligence into the corporate strategy. When fulfilling their duty to act in the best interest of the company, directors must take into account the human rights, climate change and environmental consequences of their decisions.
As a next step, trialogue negotiations can now commence between the European Parliament, the Council of the European Union and the European Commission. The CSDDD is not expected to be adopted before 2024. EU Member States will then have two years to implement the CSDDD into national legislation.
Please do not hesitate to contact the Zeidler Group ESG legal team should you require further information in relation to the material referred to in this regulatory update.