The Commission’s further guidance on the Taxonomy Regulation and SFDR

Among the documents published by the Commission on 13 June 2023 as part of its ESG package (see our report here), we thought the Commission’s Notice (the Notice) was worth flagging with a separate note.

The Notice was published on 12 June 2023 and, as its title makes clear, it deals with “the interpretation and implementation of certain legal provisions of the EU Taxonomy Regulation and links to the Sustainable Finance Disclosure Regulation”.

Taking the questions in a slightly different order from in the Notice:

Can Taxonomy-aligned investments qualify as ‘sustainable investment’ under the SFDR?

Perhaps the most important clarification in the Notice is in question 4, in the section headed ‘Interactions with the SFDR’.

Recital 19 of the Taxonomy Regulation confirmed that ‘sustainable investments’ under the SFDR include investments into ‘environmentally sustainable economic activities’ within the meaning of the Taxonomy Regulation.

As to what is required for an activity to be considered as ‘environmentally sustainable’, Article 18(2) makes a link between the Taxonomy Regulation and the SFDR via compliance with minimum safeguards.

Where an undertaking discloses activities as ‘environmentally sustainable’ under the Taxonomy, it is deemed that the social elements of the ‘do no significant harm’ (DNSH) principle are met at entity level.

The DNSH principle and the requirement to ensure that an investee company follows good governance practices are taken as being fulfilled for investments in Taxonomy-aligned economic activities since these comply with the Taxonomy’s minimum safeguards.

Accordingly, such investments in Taxonomy-aligned ‘environmentally sustainable’ economic activities can be automatically qualified as ‘sustainable investments’ as far as product level disclosure requirements under the SFDR are concerned.

Put another way: investments in specific economic activities can be considered to be sustainable investments.

The Notice does flag, though that if a FMP invests in an undertaking with some degree of taxonomy-alignment through a funding instrument that does not specify the use of proceeds, the FMP would still need to:

• check whether the rest of the economic activities of the undertaking comply with the environmental elements of the SFDR DNSH principle; and
• assess whether she/he considers the contribution to the environmental objective sufficient.

in order to consider the whole investment in that undertaking as being a ‘sustainable’ investment.

What is the role of minimum safeguards in the Taxonomy Regulation?

An economic activity can only qualify as environmentally sustainable under the taxonomy Regulation where (as well as meeting the other requirements of Article 33) it is carried out in compliance with the minimum safeguards laid down in Article 18.

These safeguards are an integral part of the Taxonomy Regulation and form one of the four Article 3 criteria which must be met before an economic activity can be considered environmentally sustainable.

The purpose of the minimum safeguards under the Taxonomy Regulation is to prevent activities and investments from being regarded as ‘sustainable’ where they:

• involve breaches of key social principles and human and labour rights or
• do not align with minimum standards for responsible business conduct.

How are minimum safeguards defined under Article 18 of the Taxonomy Regulation?

Article 18 of the Taxonomy Regulation lays down specific requirements for minimum safeguards.

Article 18(1) - international standards of responsible business conduct.

The Notice clarifies that Article 18(1) minimum safeguards are to be understood as “due diligence and remedy procedures” which are implemented by a company carrying out an economic activity in order to ensure alignment with:

• the OECD’s Guidelines for Multinational Enterprises – these also recommend that enterprises apply good corporate governance practices, including due diligence as set out in the OECD Principles of Corporate Governance; and
• the UN Guiding Principles on Business and Human Rights - these include the principles and rights set out in eight of the ten fundamental conventions identified in the International Labour Organization Declaration of the on Fundamental Principles and Rights at Work and the International Bill of Human Rights.

Article 18(2) - the DNSH principle under Article 17 of the SFDR.

The link in Article 18(2) to the DNSH principle is intended to ensure that minimum social standards are defined at an EU level with consistency within EU legislation. Details of the SFDR’s DNSH principle are set out in the SFDR Level 2 RTS.

According to the RTS, as well as disclosing whether a sustainable investment is aligned with the OECD and UN guidelines above, implementing DNSH requires the consideration of a list of principal adverse indicators (PAI).

In the view of the Commission, the link between the minimum safeguards and the DNSH principle should be understood, as a minimum, through the SFDR PAIs for social and employee matters, respect for human rights, anti-corruption and anti-bribery matters – see Table 1 of Annex I of the SFDR Level 2 RTS.

Key expectation for undertakings under Article 18 of the Taxonomy Regulation.

Undertakings which disclose their alignment with the Taxonomy must assess their compliance with the Taxonomy’s minimum safeguards requirements under Articles 18(1) and 18(2) of the Taxonomy Regulation.

Under Article 18(1), the key requirement is that the undertaking must implement appropriate procedures, including those to “continuously identify, prevent, mitigate or remediate the relevant actual and potential adverse impacts connected with their own operations, value chains and business relationships in order to ensure their activities are carried out in line with these standards”.

On occasions, an undertaking cannot address certain risks or eliminate certain negative impacts, despite implementing all appropriate procedures. Provided the undertaking has clearly disclosed these potential impacts and explained what it did to identify, prevent, mitigate or remediate them and why it could not eliminate certain impacts, it can still comply with the minimum safeguards.

As part of the due diligence and remedy procedures, Article 18(2) requires companies to consider the SFDR PAIs related to social and employee matters, respect for human rights, anti-corruption and anti-bribery matters.

The only issue covered by Article 18(2) not explicitly covered by Article 18(1) is that of PAI relating to the exposure to controversial weapons (as defined in the SFDR Level 2 RTS).

Article 18(2) requires undertakings to ensure that their due diligence and remedy procedures allow for the identification, prevention, mitigation or remediation of any actual or potential exposure to the manufacture or selling of controversial weapons.

Beyond these Article 18(2) provisions, the Taxonomy Regulation contains no further considerations relating to weapons or defence-related equipment and technologies in the assessment of minimum safeguards.

However, the Notice makes clear the Commission’s view that the defence industry is a “crucial contributor to the resilience and security of the Union, and therefore to peace and social sustainability”.

The Notice also notes that the list of SFDR indicators related to social and employee matters, respect for human rights, anti-corruption and anti-bribery may change in future revisions of the SFDR Level 2 RTS, so undertakings will have to consider any issue that the SFDR’s adverse indicators may address in the future in accordance with Article 18(2).

Reporting in line with the Corporate Sustainability Reporting Directive (the CSRD) will help companies assess their compliance with Article 18 and will help investors obtain the necessary information from investee companies.

Since Article 18 requires no additional disclosures, there is no duplication with the CSRD reporting requirements.