A Primer on the EU’s ESG Regulations

ESG Regulatory Primer Series - Corporate Finance Institute & Rho Impact

Note: This document is not legal advice; it alludes to the EU’s main ESG regulations and their key concepts. It is not comprehensive to all legal requirements and content updates.

EU Regulatory Landscape

The EU’s legal system has always included laws protecting and advancing environmental, social, and governance issues. However, the introduction of the Non-Financial Reporting Directive (NFRD)[1], in 2014, began a new regulatory era of specific, ESG-focused regulations in the EU.

To understand the developing landscape and the regulations that we will discuss below, it is essential to review two key initiatives: The European Green Deal and the EU Action Plan for Financing Sustainable Growth.

European Green Deal

The European Green Deal[2] is the EU’s comprehensive plan to achieve climate neutrality and promote a sustainable, net-zero economy.

EU Action Plan for Financing Sustainable Growth

The EU Action Plan for Financing Sustainable Growth[3] outlines regulatory and policy measures to integrate sustainability considerations into the financial sector, directing investments toward projects that support the transition to a net-zero economy.

The CSRD, EU Taxonomy, and Sustainable Finance Disclosure Regulation (SFDR) are all key elements supporting the advancement of these two overarching, governmental objectives.

Top Three Regulations to Know

These emerging, ESG-specific laws include the following three regulations that all financial analysts should be aware of:

1. EU Taxonomy for Sustainable Activities

Main Objective

The EU Taxonomy is a classification system (guideline) that provides financial entities with criteria, metrics, and definitions to help determine what activities are “sustainable.”

A sustainable activity is defined as any economic activity, like an investment, that makes a contribution to achieving the EU’s net zero goal by 2050. The Taxonomy acts as a common language for financial entities, providing greater clarity on the sustainability performance and intended impacts of their potential investments.

Who Does This Apply To?

The Taxonomy states guidelines that the following entities must consider when investing:

Financial Market Participants (FMP), such as asset managers, investment firms, pension funds, and insurance companies.

Large public-interest entities with over 500 employees must consider the EU Taxonomy guidelines in their investment due diligence process and disclose the taxonomy parameters that impacted their investment decisions.
Other companies and investors that do not meet the stated criteria above are not obligated to disclose investments under the taxonomy.

Key Concepts and Requirements

The Connection Between The Taxonomy and Overarching EU Policies: The Taxonomy[4] went into force on July 12,  2020. The European Commission realized the criticality of directing investments towards projects that contributed to the European Green Deal’s 2050 Net Zero objectives. The Commission realized that financial market participants needed clear guidance and definitions on what constituted a sustainable project. Hence, the Commission recommended creating a common classification system for sustainable projects and economic activities, the EU Taxonomy.
The Activities That Qualify Under the EU Taxonomy: As mentioned, the Taxonomy helps investors classify if a project or investment is a sustainable activity. The taxonomy provides six categories:
- Climate Change Mitigation: Actions and strategies aimed at reducing or preventing greenhouse gas emissions. For example, renewable energy projects.
- Climate Change Adaptation: Measures and initiatives designed to enhance resilience from the impacts of climate change, such as extreme weather events and drought. For example, building seawalls or flood barriers for coastal infrastructure.
- Sustainable Use and Protection of Water and Marine Resources: Practices and policies that promote water conservation and marine ecosystem protection. For example, reducing agricultural runoff into local waterways.
- Transition to a Circular Economy: Shifting from a linear, “take-make-dispose” economic model to one focused on reusing, recycling, and extending the lifespan of products and resources. For example, textile recycling projects.
- Pollution Prevention and Control: Efforts to minimize or eliminate the release of harmful pollutants into the environment through regulatory measures and pollution reduction technologies. For example, transitioning to electric vehicles and electrifying our transportation system.
- Protection and Restoration of Biodiversity and Ecosystems: Initiatives aimed at safeguarding and rejuvenating ecosystems, species, and habitats to maintain biodiversity and strengthen ecosystem health. For example, reforestation projects and coastal habitat restoration.

Each category outlines technical screening criteria for evaluating the sustainability of economic activities[5]. There isn’t a one-fits-all list of criteria the regulation uses to differentiate sustainable from non-sustainable activities. Rather, the Taxonomy sets different technical screening criteria for sectors and activities (energy, manufacturing, transportation, agriculture, and more).

This technical criteria is developed based on the latest science and expert input, considering issues such as greenhouse gas emissions, resource use, land use, and other environmental topics. The Technical Screening Criteria outlines specific thresholds, benchmarks, and methodologies to assess a specific activity’s environmental impacts.

Key Takeaways

The Taxonomy is Not A Mandatory List – But It’s Mandatory To Consider: The Taxonomy is not a list of investment obligations, but rather a set of guidelines for investing in sustainable activities. While companies are encouraged but not required to follow these guidelines, some entities (see Who Does This Apply To? section above) have a mandatory obligation to:

a. Disclose how their investment products align with the Taxonomy’s criteria

b. Disclose the extent to which they consider the environmental objectives defined in the regulation

Opportunity for Securing Capital – Companies can leverage the Taxonomy to strengthen their fundraising and capital acquisition. As mentioned previously, private and public investors in the EU must disclose their investments and demonstrate that these activities meet the Taxonomy’s criteria. Clearly communicating how your company and/or project meets the Taxonomy criteria for your respective industry can encourage investment from EU capital providers.

Disclosure Is An Obligation – If you are an FMP or a large company (over 500 employees), you must disclose how your investment aligns with the Taxonomy. It’s critical to consider if and how each investment meets this obligation, or one could face legal and reputational consequences. For example, if you are looking to make an investment in the renewable energy industry, part of your due diligence process should include checking if that investment qualifies under the six activity categories mentioned above.

2. The Corporate Sustainability Reporting Directive

Main Objective

The main objective of the Corporate Sustainability Reporting Directive (CSRD) is to increase the quality, comprehensiveness, and transparency of sustainability reporting for companies operating within the EU. The CSRD provides a comprehensive framework for sustainability reporting that complements the existing financial reporting requirements within the EU.

Expanding disclosure requirements to include environmental, social, and governance information aims to promote sustainable business practices and meet the increasing demand for greater transparency on corporate sustainability performance.

Who Does This Apply To?

The CSRD is mandatory for companies with the following characteristics:

Publicly-listed companies on any stock exchanges in the EU.
Large companies that meet two of the following criteria: More than 250 employees, net turnover of more than EUR $40 million, or total assets exceeding EUR $20 million.
Non-EU companies with at least one subsidiary in the EU and a net turnover of more than EUR $150 million.
Banks and financial institutions may be obligated if they have any of the aforementioned characteristics.

Two additional categories are under more restricted obligations:

Financial market participants: Investment firms and other financial market participants that offer investment products are included in the scope of the CSRD for specific, reporting obligations regarding how sustainability issues are incorporated into their investment decision-making.
Issuers of Bonds: Companies issuing bonds on regulated markets in the EU will be subject to certain disclosure requirements under the CSRD, as currently being developed within the scope of the EU Green Bond Standard[6].

Key Concepts and Requirements

1. Reporting Deadlines: Companies that meet the criteria described above must start reporting by the following deadlines:

January 2025 – Companies already subject to the NFRD (based on 2024 fiscal year data).
January 2026 – All Other Companies (based on 2025 fiscal year data).
January 2027 – Listed small and medium enterprises that request an extension (based on 2026 fiscal year data).

2. Reporting Requirements: The specific information that companies need to disclose under the CSRD can include, but is not limited to:

Sustainability Policies and Practices: Companies are required to disclose information about their sustainability policies, strategies, and practices, including how these align with their business model, objectives, and values.
Environmental Impact: Disclosing data on environmental impacts, such as greenhouse gas emissions, energy consumption, water usage, and waste generation.
Social Impact: Reporting on social matters, including employee-related indicators such as workforce diversity, health and safety, employee training, and labor practices.
Governance: Providing information on corporate governance structures, including board composition, executive compensation, risk management, and stakeholder engagement.
Supply Chain Impacts: Disclosing information about their supply chains’ social and environmental impacts, including due diligence efforts to mitigate risks.
Adverse Sustainability Impacts: Reporting on potential adverse impacts on sustainability issues, such as human rights violations, environmental degradation, and social inequalities, and steps to prevent or mitigate such impacts.
Sustainability Targets and Performance: Companies may need to disclose their sustainability targets, progress towards those targets, and the key performance indicators used to assess progress.
Principle Adherence: Companies that follow specific international standards or principles, such as the UN Sustainable Development Goals (SDGs), may need to disclose how they specifically align with these frameworks.

It is important to note that the exact details and requirements for disclosure may vary based on the company’s size, sector, and other relevant factors. The CSRD aims to introduce standardized templates and reporting requirements to enhance comparability and consistency across companies.

3. Comply or Explain: Companies must follow a “comply or explain” approach, which means they must disclose the requested ESG information or explain why they cannot do so. In either case, the statement must be approved by the board of directors and included in the annual financial report. It must also be audited by an independent third party to ensure accuracy and credibility.

Key Takeaways

Directly Impacts Non-EU Companies: The CSRD requires non-EU companies trading on EU stock exchanges or operating in EU member states to comply with these reporting requirements. Even if you’re headquartered outside of the EU, in a country without ESG regulations or disclosure requirements, incompliance with CSRD could result in a range of reputational and strategic challenges within the bloc. Navigating CSRD is a top risk for foreign companies operating or fundraising in the EU.

You Should Consider the CSRD Even if You’re Not Obligated To: The EU has historically been the world leader in promoting environmental and socially responsible business regulations. Given that history, the CSRD has influenced sustainability reporting norms and informed regulatory frameworks in other countries with emerging ESG regulations. Aligning with and operationalizing your approach for CSRD compliance ensures you are prepared for the range of emerging regulations going into effect in other, international markets.

3. The Sustainable Finance Disclosures Regulation (SFDR)

Main Objective

The SFDR provides disclosure requirements for financial market participants (“FMPs”) regarding the sustainability[7] risks, adverse impacts[8], and attributes of their financial products and investments.

Who Does This Apply To?

The SFDR directly applies to financial institutions operating in the EU, which include banks, insurers, asset managers, and investment firms.

Key Concepts and Requirements

Investment Process Transparency: The SFDR aims to ensure that financial market participants provide clear and consistent information about how they integrate sustainability factors into their investment processes, as well as how these factors influence their investment strategies and decisions.
Three Levels of Disclosure
- Level 1 – Mandatory Disclosure Requirements: All financial market participants and financial products are required to comply with Level 1 disclosure requirements. This includes disclosing how they integrate sustainability risks and consider adverse sustainability impacts in their investment decision-making process.
- Level 2 – Product-Level Disclosure: FMPs that sell and manage financial products must also comply with Level 2 disclosure requirements. This involves providing pre-contractual and periodic information about the sustainability characteristics and objectives of their products.
- Article 6, 8, and 9 Products: Under this new classification, a fund strategy must be labeled as either an Article 6, 8, or 9 product. The specific details and nuances regarding each product type include the following:
  - Article 6: Article 6 is considered a “non-sustainable” product. Although they include disclosure on how sustainability issues are integrated into the investment process, article 6 products do not explicitly promote sustainability attributes and could include companies and broader industries that are traditionally thought of as “non-sustainable,” like oil or gambling companies.
  - Article 8: Article 8 refers to a product that promotes environmentally sustainable and socially responsible characteristics, yet does not have a specific sustainable investment thesis or objective. Similar to Article 6, these products could include controversial industries and companies that meet the product’s environmental and social criteria. Article 8 products are referred to as “light green” products.
  - Article 9: Article 9 refers to a product with a specific, sustainable investment thesis or objective. Defined by the asset manager, this product explicitly addresses environmental and/or social objectives, such as climate change mitigation. Article 9 products are referred to as “dark green” products.

Key Takeaways

Indirect Impact on Your Business: Non-EU firms will be impacted indirectly if they have EU subsidiaries, services offered in the EU, and/or are raising capital in the EU. For example, if a non-EU asset management company owns an EU-based subsidiary that sells financial products, the EU subsidiary must comply with SFDR’s disclosure obligations or face the consequences.
Leveraging The SFDR to Secure Financing: One of the main goals of the SFDR is to direct capital toward sustainable activities and companies with positive environmental, social, and governance performance. Financial Market Participants (FMP) in the EU are required to disclose how they integrate ESG factors into their investment decisions. Therefore, by disclosing your company’s ESG information and aligning it with the SFDR’s sustainability goals, EU FMPs are more likely to invest in your company.