The EU sustainability disclosures regulation: The devil is in the detail

One element of the EU action plan on sustainable finance is that there should be equivalent reporting obligations for asset managers and owners to their clients and beneficiaries, as required by the EU Regulation on Sustainability-related Disclosures in the Financial Services Sector.

But don’t crack open the Champagne just yet. Next to the high-level principles of the law, there is also the small print that could potentially derail the transparency goals the EU seeks.

The small print is the result of arduous political and technical negotiations — “trilogues” in EU-speak — between the three law-making EU institutions. The final text, formally adopted last week, is a compromise agreed by them.

Many proposals, particularly those from the European Parliament, often seen as more ambitious, clashed with the views of the Council of the EU, which represents governments.

Nonetheless, the trilogue agreement has been hailed as a remarkable achievement, one that was unimaginable just a couple of years ago.

The report from the High-Level Expert Group (HLEG) on sustainable finance, the predecessor to today’s Technical Expert Group (TEG), had already raised the issue of clarifying investors’ duties.

Based on a 2016 consultation by the European Commission’s justice department (DG JUST), it was warned that “fiduciary duty was not clear enough and therefore could be used as an excuse for not considering ESG matters in investment decisions”.

The Commission embraced this recommendation and took it further as one of the three legislative initiatives of its Action Plan, alongside the taxonomy and low-carbon benchmarks.

The Commission’s draft focused on the integration of sustainability risks, defined as ESG events or conditions that can financially affect investments, and therefore something that fiduciaries should disclose.

But when the draft landed at the European Parliament’s economic affairs committee (known as ECON), with Dutch MEP Paul Tang as rapporteur, another dimension was introduced.

Tang’s assistant Erik Hormes takes up the story: “Ultimately, the discussion was about sustainability impact, so what [investment] products do to society. And we wanted to have full disclosures for all institutions on that.”

This “dual approach” was a “big innovation” from the Parliament, as Eleni Choidas, ShareAction’s European Policy Manager, points out.

“It was very controversial to introduce it because a lot of financial market participants viewed sustainable finance as [a way of] addressing the impact that sustainability has on their bottom line, but not so much the other way around,” Choidas says.

This dual approach survived in the compromise text, with a sort of distinction between impact of ESG on investments themselves and societal impact of those investments.

It seems to distinguish between disclosures of “sustainability risks” (i.e. ESG impacts on the value of the investment) and disclosures of “adverse sustainability impacts” (i.e. investment decisions impacting “sustainability factors” such as the environment or human rights).

According to the compromise text, if fiduciaries consider their investments have such impacts “a statement on due diligence policies” should be published. Otherwise, the fiduciary has to explain why not.

There is a threshold for this comply or explain obligation based on the headcount of “financial market participants” (the term includes pension providers known as IORPs, asset managers, etc.). Beyond 500 employees, the due diligence statement is compulsory.

Hormes says: “We were also concerned about this threshold because is taken from the Non-Financial Reporting Directive. It isn’t applicable to the financial sector, which can have huge assets under management (AUM) without employing too many people.”Choidas says there was a stalemate on this “issue of proportionality” between the Parliament and Council. In the final wording, she says, the Commission added in a review clause (Article 11) that opens the door to look again at the headcount issue and other ways to measure proportionality.

Hormes says: “We’ve taken this threshold because it was acceptable for the Commission and the Council. But we have an evaluation clause to evaluate whether the existing threshold has to be lowered, so that more [financial market participants] fall under the [compulsory] scope and whether it has to be accompanied by a threshold for AUM.”

Choidas says another contentious issue was that the original proposal was “creating disclosure requirements in a very broad sense” but not ensuring that there “has to be integration and due diligence processes in place prior to disclosure”.

For that due diligence on the impact side of investments, the Parliament report was advocating the adoption of the OECD’s Responsible Business Conduct for Institutional Investors.

“We wanted to have an overarching and mandatory framework for due diligence in line with the OECD guidelines, but we had to give up as Council didn’t want this included,” Hormes says.

These OECD guidelines would have been the framework in which sustainability impacts are managed, according to Hormes. “So, if investors have in place the due diligence framework, this means they have to communicate how they prioritise, mitigate and measure risks.”

Choidas says that the OECD guidelines approach is “very much impact-oriented”, nonetheless the three financial overseers collectively known as the European Supervisory Authorities (ESAs) will take the guidelines into account when they develop regulatory technical standards.

Another compromise was Article 10 of the original draft, which empowered the Commission to adopt delegated acts to ensure that ESG risks were part of the ‘Prudent Person Rule’ under the revised IORP II Directive. [IORP = Institutions for Occupational Retirement Provision.]

Article 10 was supposed to directly amend the IORP directive but has now completely disappeared from the text: Article 9.e jumps straight to article 11 in the compromise text!

Choidas says IORP, which originally came onto the EU statute book back in 2003, predates the current sustainable finance agenda.

“It has relatively weak language on ESG – just that IORPs shall be allowed to take ESG issues into account – so the Commission thought it was an opportunity to strengthen that and bring IORPs up to speed via delegated acts.”

Choidas says that the missing Article 10 was a way to start that conversation with IORPs’ beneficiaries, in the same way as retail investors and others in the chain were already involved.

ABA, the powerful German pension fund association, had advocated excluding IORPs all together from the definition of financial market participant.

And trade body PensionsEurope, of which ABA is a member, did not support Article 10, arguing that it would introduce new and more prescriptive ESG rules. It argued that national supervisors, closer to IORPs’ local governance structures and sustainability preferences, were best equipped to oversee how pension funds manage ESG risks.

Matti Leppälä, CEO of PensionsEurope – which national associations of pension funds — says his organisation welcomes the outcome of the trilogue.

Leppälä says: “Under the agreement, pension funds will report to members how they deal with sustainability risks. This should increase awareness amongst trustees and improve the dialogue with members, while it avoids the prescriptive requirements on the integration of ESG factors in investment decisions initially proposed by the Commission.”

All the relevant content of the overall ESG disclosures that the regulation mentions will be determined by the ESAs. The law just outlines terms such as “brief summaries”, “information on policies” or “reasoned explanations” without much indication of its substance.

The ESAs will have to develop this through regulatory technical standards, or RTS. This was a compromise in which the Parliament’s position prevailed, as the Council’s preference was to do so through non-binding guidelines.

Nonetheless, a sensitive part of the regulation gets deferred to a later stage where the final content of the law will be shaped.

It can take 12 months for climate-related sustainability indicators; and 24 months for social and employee matters, respect for human rights, anticorruption and bribery matters.

Will Martindale, Director of Policy & Research at the Principles of Responsible Investment, says that the development of the regulatory technical standards by the ESAs “will be important to the success of the regulation”.He says: “We expect opportunities for EU member states and investors to contribute their technical experience.”

Likewise, Hormes says: “RTS are going to determine what the ESG factors are, ultimately.”

Asked whether there is still room to water down the regulation and introduce “ESG-washing” provisions, Hormes says that could be a possibility.

However, he adds: “I think it is a strong mechanism because RTS are binding and they are also under Parliamentary scrutiny so there is an element of democratic accountability.”

As three-time Spanish Prime Minister the Count of Romanones said, he didn’t mind MPs making the laws as long as he could implement them. That’s another way of saying that the devil is in the detail.