While firms have had to prioritise responding to the Covid-19 outbreak over recent months, attention is refocusing on the EU’s ESG legislative package as the year goes on and a number of deadlines approach. In this Q&A we concentrate on the Disclosure Regulation and the Taxonomy Regulation and discuss what firms will be required to do under these regulations and when the measures come into force. Many of the requirements are not straightforward and there will be difficult judgments to be made. The scope of the regulations is wide, and firms will be impacted regardless of whether they have ESG products/strategies within their range. Further, there are aspects of the measures that will impact firms based outside the EU.

We have also asked Tamara Cizeika and Emma Danforth of Allen & Overy LLP for practical insights on what they have been seeing when advising asset management clients in interpreting the new ESG requirements.

Q What is the Disclosure Regulation?

A The Disclosure Regulation focuses on integrating sustainability into the investment and decision-making processes of financial market participants (including AIFMs, Ucits ManCos and investment firms providing portfolio management) and financial advisers. It includes disclosure requirements that apply at both a firm and product level. The bulk of the Disclosure Regulation will apply from 10 March 2021 and it is expected that preparation for the new regime will be a focus for many firms in 2020. That said, with most of the regulatory technical standards (RTS) only expected by the end of January 2021, there will be a tight timeframe for firms to ensure they are ready. In April 2020, the European Supervisory Authorities (ESAs) issued a consultation paper on the RTS which sets out extensive detail on the content, methodologies and presentation of the required disclosures. The scope of the information to be included and level of granularity is likely to require significant efforts on the part of firms.

Q What firm and product-level disclosures will be required?

A At an entity level, firms will need to disclose certain information on their websites, including on: integration of sustainability risks into investment decision-making processes; how remuneration policies are consistent with integration of sustainability risks; whether/how the principal adverse impacts of investment decisions on sustainability factors have been considered. The practical application of this requirement depends on the size of
the firm.

The purpose of these disclosures is to facilitate market-wide transparency on each firm’s ESG profile and capabilities and enable investors to make informed decisions. Note that these obligations will apply to all EU firms, not only ESG-focused ones.

At a product/strategy level, firms will need to include information evidencing how sustainable objectives are met and how environmental and social characteristics and principal adverse impacts are considered in their pre-contractual and website disclosures and ongoing reporting. Certain of these requirements will apply to all product types, including those that do not have a sustainable investment objective or promote environmental or social characteristics.

Q Is there an impact on non-EU firms/products?

A Non-EU firms managing EU products, either directly or on a delegated basis, will need to consider the requirements set out above. For example, non-EU managers that have a Ucits in their structure may need to provide data to assist the Ucits ManCo with making the required disclosures.

In addition, non-EU firms will be impacted when actively marketing their products in the EU, even where the fund is a non-EU fund. The Disclosure Regulation sets out that the requirements in respect of pre-contractual disclosures shall apply to the disclosures referred to in Article 23(1) of the AIFMD. Non-EU AIFMs marketing by means of a member state’s national private placement regime route are required to comply with the disclosure requirements of Article 23.

Emma Danforth: A key issue facing firms is when, and how much, to engage with the requirements, particularly in light of concerns about the dicslosure of the necessary underlying data. We’ve seen some firms really engage as they view this as an opportunity to distinguish themselves from their competitors, whereas others are waiting to see whether the industry will develop market-standard disclosure. We also find that given the breadth of the definition of ‘sustainability’, firms are struggling to find the right balance between their ESG obligations and the fiduciary duties owed to their clients – e.g. to what extent should returns be reduced to mitigate sustainability risks?

Tamara Cizeika: The issue of data is one that comes up time and time again. Indeed, in the recent RTS consultation paper, the ESAs acknowledged that data constraint is one of the biggest challenges when it comes to the provision of sustainability information to investors. However, the ESAs indicated that they are to press ahead notwithstanding data issues, although note that some flexibility may be necessary. This will be an area that firms will be watching closely.

Q What is the Taxonomy Regulation?

A The Taxonomy Regulation sets out categories of economic activities that are considered environmentally sustainable and is based on six environmental objectives1. The intention behind the taxonomy is to create a set of criteria to classify whether or not an activity is ‘green’. Implementation will be staggered, with the first obligations applying from 31 December 2021.

The regulation sets out that an activity can be considered to
be environmentally sustainable where it:

• “Contributes substantially” to one or more of the six objectives or is a transitional or enabling activity.
• Does not “significantly harm” any of the objectives.
• Complies with various international, social andgovernance standards.
• Complies with additional specific Technical Screening Criteria.

It also includes certain disclosure/reporting requirements that are in addition to the requirements in the Disclosure Regulation. The extent to which these apply depends on whether or not the financial products promote environmental characteristics.

The Taxonomy Regulation will be subject to review and it is expected that the criteria for environmentally sustainable activities will be updated to reflect the fast-changing nature of science and technology. Firms will therefore need to be adaptable and keep up to date.

Tamara Cizeika: Firms need to recognise the weight the EU places on the Taxonomy Regulation. The European Commission considers the taxonomy to be a fundamental step in its programme for greening the EU on the basis that a shift towards more sustainable economic activities has to be underpinned by a shared understanding of what ‘sustainable’ means.

Emma Danforth: Historically, few clients had ESG policies so firms would often agree to comply with the ESG policies of those that did if requested. As more firms and clients develop individual and broader ESG policies, firms are struggling to find a way to continue to accommodate these bespoke requests without it becoming too time consuming or restrictive for the firm. A related difficulty is how to manage the increasing number of conflicts
between the ESG policies of two or more clients or of the firm and its clients.

Q What are the timing implications?

A One particular issue that firms must consider is keeping on top of staggered compliance obligations and tight timeframes as the new regulations come into force in a piecemeal and overlapping way over the next two years. For example, firms will need to reassess systems and procedures put in place to comply with the Disclosure Regulation and check whether these are also compliant with the disclosure requirements introduced at a later date by the
Taxonomy Regulation. Firms will also need to watch deadlines in case of any delay or changes as the regulators consider their work priorities in light of Covid-19.