Sustainable finance regulations respond to the sustainability agenda

The sustainability agenda has evolved over millennia, ever since the ancient Egyptians invented the concept of crop rotation and declared that “a person would not travel to eternity should he pollute the Nile”. Whilst sustainability has continued to evolve its purpose remains as essential as ever.

As early as 1912 it was reported that burning coal contributes to the warming of the planet, with potentially devastating consequences. Despite this knowledge, we have failed to respond accordingly:

• The last nine years have been the warmest on record and ocean temperatures broke record highs every day for over a year.
• Fossil fuels still represent 82% of the energy market, down by a mere 3% (from 85%) over the 30 years of the climate crisis.
• 1 million species are under threat of extinction.

Sustainable finance regulations respond

It is for this reason that the EU has stepped up and established a comprehensive sustainable finance regulatory framework, seeking to encourage and empower investors to support EU carbon neutrality goals. Other countries are following suit with 29 taxonomies in development globally.

The key tools, which are proving to be highly effective, are outlined below. They are designed to drive capital towards sustainable investment by

• providing a clear understanding of climate risk
• defining sustainable activities
  
• ensuring transparency.

IFRS S2 – identifying, measuring and disclosing climate risk

IFRS S2 has integrated the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and requires investors to understand and disclose climate-related risks and opportunities.

The requirements are broad, covering assets and organisations, physical and transitional risk, the quantification of risk as well as the processes and policies. IFRS S2 also includes metrics that organisations need to manage for cross-industry and industry‑specific climate-related risks and opportunities as set out in the graphic below.

The EU taxonomy – defining sustainability activity

The EU taxonomy, developed as part of the EU’s Sustainable Finance Action Plan, is a comprehensive classification system to facilitate sustainable finance and investment activities. It sets out what economic activities can be considered sustainable to drive investment, promote sustainable economic growth, mitigate climate change, and protect the environment.

Each economic activity has its own sustainability criteria. For example, existing buildings built before 2021 may only be considered aligned with the EU taxonomy (or ‘sustainable’) if they have an EPC A rating or if they are within the top 15% of energy performers in their local market and have carried out a climate risk assessment. The EU Taxonomy goes further by requiring those activities to meet minimum social safeguards.

The EU SFDR – driving transparency

The EU’s Sustainable Finance Disclosure Regulation (SFDR) was introduced to drive transparency. It requires financial market participants (eg asset, investment and fund managers) to disclose how they integrate ESG factors into their investment decisions and provide detailed information on their impacts. Investors must classify their financial products according to their ‘sustainable investment objective’:

• If a fund makes sustainable investments with an environmental objective, it is an Article 9 Fund.
• If a fund promotes environmental or social characteristics, it is considered an Article 8 Fund.
• Other funds (without sustainable investment objectives) are considered Article 6 Funds.

Under the SFDR, investors are also obligated to report on their alignment with the EU taxonomy, disclose up to 64 environmental indicators (known as Principal Adverse Impacts) and incorporate information on how sustainability risks and impacts are considered and integrated into investment decisions.

How to navigate the sustainable investment landscape?

Although the new regulatory landscape is influencing design standards, due diligence processes, and valuations across the EU and beyond, we have yet to see it pick up the pace of change that’s needed. It is important to consider the challenges of navigating the sustainable investment landscape in order to meet stakeholder expectations and deliver impact.

Read more about how investors can best navigate the challenging sustainable investment landscape.