KEY ESG experts explain how the EU taxonomy work with SFDR

SFDR Blog Series: How does the EU taxonomy work with SFDR?

Published: 26 Jul 2022 · Last updated: 30 Sep 2022

What is the EU Taxonomy?

The EU Taxonomy is a detailed legislative classification system. It provides a common language for a range of European sustainable finance regulations, including Sustainable Finance Disclosure Regulation (SFDR).

Introduced at the start of 2022, the EU Taxonomy reflects the aims of the European Green Deal (2020). This legislation takes action to tackle greenwashing in European markets and beyond. The EU Taxonomy creates a list of commonly understood objective truths. These truths allow managers to make direct comparisons on environmental performance across a range of asset classes and regulations.

Six core environmental objectives make up this legislation, covering topics ranging from ecosystem and biodiversity protection to pollution prevention. Regulations for two of the six objectives were enforced at the start of 2022. The remaining four objectives are expected to be implemented at the start of 2023. The two enforced objectives of the EU Taxonomy focus on climate-related issues: climate change mitigation and climate change adaptation. For each of these objectives, technical screening criteria have been established to set out exactly which activities can be considered as “taxonomy-aligned”.

It is worth noting that there is no requirement for firms to invest in economic activities that are considered taxonomy-aligned. This applies to both SFDR and the EU Taxonomy regulations. This touches on a broader misconception in the market, which posits that these regulations are classification systems and standards. In reality, they are disclosure-based systems aimed at improving transparency.

How does the EU Taxonomy work with SFDR?

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Level 1 SFDR regulation was introduced back in March 2021. Among other firm-wide policy disclosures, Level 1 regulation required fund managers to classify their funds according to Articles 6, 8, or 9. This classification was dependent on fund sustainability performance.

Level 2 SFDR regulation, which is expected to come into force at the start of January 2023, requires fund managers to justify these classifications. This will predominantly be justified through disclosure of the principal adverse impact indicators (PAIs), discussed in an earlier blog from this series. However, Level 2 SFDR also requires fund managers to disclose information regarding the taxonomy alignment of certain funds. These disclosures are based on classifications according to Articles 6, 8, or 9.

The Level 2 SFDR legislation draft was published in October 2021. This publication was meant to clarify the relationship between the EU Taxonomy and SFDR, but there were still unanswered questions. Subsequent publications from the European Commission (EC), most recently in June 2022, have clarified how the EU Taxonomy regulation applies to firms complying with SFDR Level 2.

Under what circumstances do fund managers complying with SFDR need to worry about taxonomy disclosures?

Taxonomy-related disclosures are only applicable to select Article 8 and 9 funds. An Article 8 fund is a fund that promotes environmental or social characteristics. Any Article 8 fund that promotes environmental characteristics which contribute to an environmental taxonomy objective is subject to taxonomy disclosures.

Article 9 funds have sustainable investment or the reduction of carbon emissions as their goal. Taxonomy disclosures apply to Article 9 funds characterised by environmental objectives, but they can also apply to Article 9 funds characterised by social objectives, provided the fund also contributes to an environmental objective in some manner.

Despite these clarifications from the EC, the different thresholds for Article 8 and 9 funds still leave room for interpretation. This will likely cause initial confusion for fund managers.

Given that these are public disclosures, it is advisable that fund managers examine typical practice of other investment firms. This will help them to gain a better understanding of the best practices for their sector.

What is involved in these taxonomy disclosures?

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For firms complying with SFDR Level 2 regulations, taxonomy disclosures are required for the funds detailed above in both pre-contractual and periodic documentation.

Disclosures centre around the minimum proportion of taxonomy-alignment within a particular fund, specifying the objective the aligned turnover relates to. Pre-contractual disclosures require the minimum taxonomy-alignment of a fund to be presented in the form of a pie chart. This taxonomy-alignment is usually expressed through turnover. However, fund managers can also use capital expenditures (capex) or operational expenditures (opex) if they are deemed more appropriate. Periodic disclosures require minimum taxonomy alignments based on all three financial figures (turnover, capex, and opex), expressed in the form of a bar chart. This taxonomy-alignment assessment must be carried out on a regular basis for each portfolio for the purposes of periodic reporting. Pre-contractual disclosures must also be updated if there is a change in alignment.

What is ‘minimum alignment’?

Taxonomy legislation emphasises the use of the term “minimum alignment”. This is because regulators seek to make it clear that taxonomy-alignment should be exclusively based on reliable data sources. This means that the taxonomy-alignment of a fund may be higher than reported. However, only alignment that can be reliably reinforced should be publicly disclosed.

To put it simply, taxonomy-alignment is automatically zero for Article 8 and 9 funds if there is no access to reliable data. Furthermore, fund managers are not allowed to publish statements justifying the low taxonomy-alignment of funds based on a lack of sufficiently high-quality data. The regulation does not allow this because it implies that, if this data were available, taxonomy alignment would be higher.

Estimates cannot be used in lieu of reliable data. However, when reliable reporting data is unavailable, fund managers can use equivalent information, either directly taken from portfolio companies or third-party data providers. Currently, the definition of “equivalent” is open to interpretation, and market bodies are calling on the EC for further clarification.

Difficulty with regulatory timelines

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As it stands, fund managers disclosing the taxonomy alignment of certain funds presents a huge data challenge to the portfolio companies. Until now, these companies would not have been required to disclose this information and gathering the relevant information is a significant undertaking. The inconsistent timelines of SFDR and the EU Taxonomy respectively makes this even more challenging.

Regulations for the first two environmental objectives of the EU Taxonomy were enforced on 1st January 2022. Part of this regulation required fund managers to disclose the taxonomy alignment of select Article 8 and 9 funds. SFDR Level 2 regulation provides the relevant methodology that enables fund managers to calculate their portfolio taxonomy alignment. However, as a result of multiple regulatory delays, this is not due to be enforced until 1st January 2023.

Operating during the interim period between the enforcement of these two pieces of regulation has led to confusion amongst fund managers. However, despite SFDR Level 2 not yet being enforced, the final draft documentation has been published as of April 2022. This draft provides guidance and templates for fund managers seeking clarity on disclosing their portfolio alignment.

How KEY ESG can help

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At KEY ESG, we keep up to date with the latest regulatory developments regarding SFDR so that you don’t have to.

Our software enables fund managers to easily track and manage the data submissions of their funds across a range of ESG regulations. This allows you to take control of your processes and act to ease the transition as new legislation emerges.

We help you to plan your strategy and meet ESG requirements, all while substantially simplifying the data burdens placed on portfolio companies. Portfolio companies often don’t know where to start, and so our software provides guidance to support the first steps in providing the correct data.

To find out more, take a look at some of the articles on our Learning Hub or get in touch with a member of the team to request a free demo.

The SFDR Blog Series continues...

  • Establishing the differences between Articles 8 and 9

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