Progress Since Paris: Sustainable Policy in Europe in 2020 and Beyond
January 11, 2021
Following the celebration of the five-year anniversary of the Paris climate conference (COP21) in December 2020, Europe stands out as one of the leaders in developing policies that support the goals of the Paris Agreement, providing frameworks for companies and investors alike to redirect capital flows toward environmentally sustainable activities, as well as various mechanisms to alleviate the social impact of the transition to a greener economy.
Although Europe has long demonstrated its commitment to sustainability, ranging from the adoption of its emissions trading system in 2003 to its 2009 climate and energy package to its 2014 framework on non-financial reporting, the approach considerably accelerated in 2020. This is largely due to the momentum following the European Commission’s December 2019 announcement of its Green Deal, a comprehensive roadmap seeking to make Europe the first climate-neutral continent by 2050, as well as various calls from companies, business leaders and civil society organizations to place health, well-being and the protection of the environment and wildlife at the heart of the EU’s post-pandemic recovery.
In addition to the Green Deal, which includes a broad scope of funding measures, regulatory reform and policy proposals affecting the energy, transportation, agriculture, construction and financial sectors, the European Commission has further advanced in the last year in developing policy to implement its sustainable finance action plan. The plan is designed, on the one hand, to maximize opportunities and tools for corporates, financial firms and retail investors to “finance green” and, on the other hand, to further integrate sustainability considerations into financial institutions’ governance and risk management frameworks, thereby “greening finance.”
This “greening” requires developing new areas of policy, most notably the new EU Taxonomy Regulation for the classification of sustainable activities, intended to provide certain businesses and investors with a common language to identify the extent to which economic activities (and, by extension, investments) can be considered environmentally sustainable or “green.” Under the Taxonomy Regulation, an economic activity will be deemed to be “environmentally sustainable” if it contributes substantially to, and does not significantly harm, climate change mitigation, climate change adaptation, sustainable use of water and marine resources, the transition to a circular economy, pollution prevention and control and the protection of biodiversity and ecosystems. First disclosures with regard to the Taxonomy Regulation’s climate change mitigation and climate change adaptation objectives will be due in January 2022, while disclosures with respect to the remaining four environmental objectives will be due in January 2023.
In addition, under the EU Sustainable Finance Disclosure Regulation (SFDR), new disclosure obligations will be required for certain financial services firms – including, in particular, asset managers and fund managers – with respect to website disclosures, pre-contractual disclosures (including descriptions of sustainability risks and information on how sustainability criteria are analyzed in fund prospectuses) and periodic reporting to investors. The extensive requirements are expected to drive firms to review how sustainability risks are incorporated into their investment decision-making processes and, potentially, to make internal strategic changes as to how they operate their business, both for purposes of achieving compliance with the SFDR and (re-)positioning themselves in the financial market. This process will in turn require significant engagement with investee companies to inform decision-making and understand a fund’s overall sustainability footprint (as well as with investors or other intermediaries who may themselves be subject to the requirements) and ongoing due diligence and portfolio monitoring.
Furthermore, since 2017, under the Non-Financial Reporting Directive (NFRD), publicly listed companies, banks, insurance companies, and such other companies designated as public-interest entities by national authorities are required to publish, in the context of their ongoing public reporting, on the policies they implement in relation to environmental protection, social responsibility and the treatment of employees, respect for human rights, anti-corruption and bribery, and board diversity. In 2019, the European Union went a step further by issuing guidance on disclosure of climate-related information in line with the recommendations of the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures.
Each of these legislative developments requires extensive drafting, debate, consultation with stakeholders and review of expert opinions, leading to significant changes that will take effect in phases over 2021, 2022 and beyond. In the meantime, EU Member States are working on transposing approved frameworks into national law and providing guidance to companies and banks on how they intend to interpret and enforce the requirements. Certain policy measures have also been subject to diverging positions among the European institutions themselves, as was seen with the EU Parliament’s recent vote to increase green-house gas reduction targets to at least 60% by 2030 (whereas the Commission had previously proposed 55%). While a cohesive approach to many policy areas is being defined in Brussels, each Member State will need to apply the various frameworks in a way that appropriately takes into account the interests of its own domestic constituents.
Another policy area that has developed considerably more at the Member State level over the last year is mandatory human rights and sustainability due diligence frameworks. Certain Member States, such as France, have already adopted their own national legal frameworks while others are currently in parliamentary negotiations. In the wake of this momentum, the Commission has committed to introduce legislation for mandatory human rights and environmental due diligence on global supply chains by 2021. In general, these frameworks define human rights broadly, including not only concepts such as civil and political rights, but also more modern interpretations, such as the right to a clean environment and various implications of the right to privacy in the digital age.
None of this precludes global organizations and financial institutions from continuing their voluntary sustainability-related projects in the interim, whether relating to sustainable sourcing and procurement, efficient energy consumption, carbon offset schemes or recycling programs. Moreover, in the wake of the COVID-19 outbreak, many companies are taking stock of their sustainability footprint, which may include investing in technology, R&D and innovation projects and divesting from activities that are unlikely to ever be classified as sustainable. In fact, while different regulators work through statutory and other regimes, many companies are already far ahead in their thinking with robust programs and strategies on sustainability and will have to adapt those programs to various regulatory regimes going forward.
It is almost universally acknowledged that the absence of a common global approach to measuring sustainability efforts and ESG criteria has hindered the development of sustainable investing (notwithstanding its significant growth in recent years). The multiplicity of competing reporting standards (the so-called alphabet soup of goals, initiatives, frameworks and guidelines) has made accurate comparisons difficult and facilitated greenwashing.
It would be impossible to address this through uncoordinated actions at the level of individual nation states and in any case some of those that might have provided leadership in this area have been distracted by domestic politics in recent years. Therefore, it is not surprising that not only has the EU become the main driver of harmonization efforts that go beyond the voluntary guidelines and take the form of binding rules, but that a number of countries outside the EU are emulating the European approach, either openly or implicitly.
One example is the United Arab Emirates: a nation built with petrodollars is now leading the regional charge toward the sustainable diversified economies of the future. In January 2020, the country’s regulatory authorities published their “Guiding Principles on Sustainable Finance,” aimed at increasing implementation and integration of sustainable practices among the UAE’s financial entities. The second of the three voluntary principles emphasizes the importance of adopting minimum eligibility requirements for what constitute “sustainable” financial products and signals the authorities’ intention to adopt an appropriate taxonomy in the UAE in due course. Until such adoption, the UAE authorities intend to rely on internationally recognized taxonomies for guidance and explicitly refer to (among others) the European Commission’s 2018 Action Plan and “associated regulatory proposals” (i.e., the Taxonomy Regulation).
Many jurisdictions seem content to allow the EU to do the heavy lifting on ESG harmonization. Given that international investors based in their own markets will need to comply with the EU rules in any event, in the same way as EU-style competition and antitrust regimes have multiplied around the world in recent decades, and data protection rules modelled on the GDPR have started to appear on the global regulatory horizon, it seems reasonable to anticipate regional and national sustainable frameworks similar to the EU’s Green Deal and Action Plan and the regulations and directives adopted under them. Given the change in administration, a key question for 2021 is the extent to which the U.S. approach will diverge from the European one in the coming years. For additional information on the U.S. approach to sustainability, please see Corporate Sustainability: Moving Faster and Faster to the Center of Strategy and Shareholder Value in this memo.
U.S. boards should be looking at regulation in Europe when considering green finance, their own sustainability and other ESG reporting and disclosure and human capital and supply chain considerations, especially as a Biden administration will likely itself look to Europe as it considers its own efforts toward climate and sustainability regulation. Against this backdrop, the first quarter of 2021 would be a good time for companies to revisit the overall sustainability outlook for the near- and medium-term and determine whether ESG factors have been appropriately reflected at all levels of the organization, whether relating to disclosure, board and management composition, operations, capital-raising, acquisitions or managing relations with employees and stakeholders, particularly with a view toward mitigating enforcement or disputes risks. In building these considerations into their broader business strategy, organizations can better ensure that projects undertaken today will be aligned with the standards that will drive investment decisions tomorrow.