Climate risk disclosure regulations have grown in number as international financial regulators try to maintain financial stability in the face of climate chaos.
While the UK, New Zealand, and now Switzerland model their disclosure requirements on the Task Force on Climate-related Financial Disclosures (TCFD) recommendations, the European Union has additional regulations you should be aware of.
Stateside, the United States Securities and Exchange Commission (SEC) has enforced penalties for misleading claims from ESG funds at its highest levels ever in 2023.
In spite of increased stringency, US regulations remain far less prescriptive than the sustainable finance regulatory approach of the EU. Could that change in the future?
We explore the similarities and differences between the US and EU regulatory outlook for climate risk and ESG-linked sustainable finance regulations.
Snapshot of the EU’s Sustainable Finance Action Plan in 2023
In 2018, the EU outlined its long-term Sustainable Finance Action Plan (SFAP) with three main aims:
- Direct capital flows towards sustainable investments.
- Manage climate, environmental and social financial risks.
- Improve transparency and long-termism for the finance sector and the broader economy.
The EU has since adopted a range of regulations to meet the aims of the plan. Here are several of the core regulations:
The EU Taxonomy Regulation is a cross-sector classification system for defining which commercial activities can be considered “environmentally sustainable.” Its aim is to provide clear guidelines for investors and reduce greenwashing.
Companies should demonstrate how their activities, products, and/or services contribute to at least one of six environmental objectives defined in the taxonomy, without doing harm to the others. These are: climate change mitigation, adaptation, sustainable water, circular economy, pollution, and biodiversity.
They should also comply with the taxonomy’s sector- and/or activity-level criteria that applies to their activities, products, or services and a set of minimum social safeguards to be classified as “green.”
Financial market participants should use the information reported by companies on the EU alignment to disclose their products’ sustainability information and their sustainability approach.
The first version of the regulation entered into force on 12 July 2020, however additional work to describe the environmentally sustainable activities came later. These details were published in the first and second Climate Delegated Acts enforceable on January 1, 2022 and January 1, 2023, respectively.
The Sustainable Finance Disclosure Regulation (SFDR)
Effective as of March 10, 2021, the Sustainable Finance Disclosure Regulation (SFDR) is a set of reporting requirements for ESG-linked disclosures by financial market participants. It includes reporting requirements for both those that self-identify as “sustainable” as well as those that do not.
Recent updates within the regulation include:
- The final Regulatory Technical Standard (RTS) went into effect on January 1, 2023.
- Its quantitative Principle Adverse Impact Indicators (PAI) for entity-level reporting are slated to be published on June 1, 2023.
Current points of confusion center on Article 8 and 9 definitions. While all funds have to disclose their ESG data, funds that market sustainable finance products are classified as either Article 8 or Article 9 funds. Article 8 funds do not claim sustainability as a core investment objective while Article 9 funds do.
In the latest RTS, Article 9 funds by definition should comply with a “Do No Significant Harm” (DNSH) criteria and contain 100% sustainable assets. In practice, it’s unclear how funds will treat the inclusion of economic activities such as nuclear energy, which are labeled sustainable in the EU Taxonomy, but may contradict the DNSH requirement. The language of the RTS has caused many ESF funds to downgrade their status from from Article 9 to Article 8 funds, as our CEO Patrick Reed has discussed.
MifID II Amendment
Two amendments to the second Markets in Financial Instruments Directive (MiFID II), one of the main investment service regulations in the EU, will place new requirements on sustainable finance fund managers and advisers.
Effective as of August 2, 2022, the amendment requires financial advisers and asset managers to ask about their participants’ sustainability preferences. They can choose from the following approaches:
- EU Taxonomy alignment
- The percentage of sustainable investments outlined (disclosed via SFDR)
- Quantitative or qualitative PAIs
On November 22, 2022, fund managers should integrate sustainability objectives and factors into their product governance.
Read our MifID II guide to prepare for this regulation.
This regulation establishes two climate benchmarking labels and includes ESG disclosure requirements. The two benchmarks are:
- European Climate Transition Benchmark (EU CTB), which benchmarks a portfolio to a decarbonization path that limits climate and market risks ; and
- European Paris-Aligned Benchmark (EU PAB), which limits the benchmark portfolio’s emissions to a global temperature rise of 1.5C° from pre-industrial levels.
In 2020, the EU published the minimum specifications for each of the climate benchmarks in its Delegated Regulations. The additional ESG disclosure requirements for the benchmarks are outlined in the delegated regulation.
EU Green Bond Standard
This is a voluntary standard with a label and rules for the green bonds market.
See this timeline for a more granular overview of the updates.
Points of US/EU alignment
A parallel effort to minimize greenwashing from funds is underway in both the US and the EU. The US SEC issued a record number of ESG-related enforcements in 2022 and the wave of fund downgrades from Article 9 to Article 8 in the EU reflect both jurisdictions’ increasing stringency.
Whereas the EU requires funds to meet a certain set of guidelines to classify as “sustainable,” the US typically penalizes misleading ESG claims. In a recent example, the SEC charged Goldman Sachs Asset Management (GSAM) a penalty of $4million for failing to align its investments with its stated ESG policies. However, a new draft of an EU law suggests member states could soon adopt penalties as a strategy to crackdown on greenwashing, too.
Both the US SEC and the European Securities and Markets Association (ESMA) are requesting comments on similar proposals for fund names. Both propose 80% alignment between a fund’s name and its investments.
The SFDR requires fund managers to outline their sustainability objectives as part of their reporting, Similarly, the SEC has proposed a rule for enhanced ESG disclosures that would require certain investment companies and advisers to report on their ESG objectives.
Points of US/EU non-alignment
In general, the EU’s approach tends to be more prescriptive than that of the US, which likely aims to limit the administrative burden on its market participants.
While the SEC is reviewing comments for its proposed Climate Risk Disclosure rule, it is likely to be more aligned with the UK, which focuses directly on climate-related risks similar to the recommendations from the TCFD. This narrower focus doesn’t specify social requirements, which are outlined in both the SFDR and EU Taxonomy.
Currently, there is no taxonomy proposed in the US, but other countries such as Canada and the UK are in the process of developing taxonomies. It is not likely for the US to develop a taxonomy as rigorous as that of the EU, but the SEC could enhance its definitions to provide clarity on sustainable finance investments.
For sustainable fund advisers and asset managers, SFDR data is a critical tool to enhance your products and services.
Download our free SFDR data library to review detailed data on SFDR-aligned ESG metrics and PAI coverage.