NFRD, SFDR, Taxonomy... Are There Too Many ESG Regulations?

To ignite a real ecological and inclusive progress, companies have to identify, quantify and share their extra-financial impacts. To activate their transformative power, the European Union has been setting up new regulations aimed at making transparency requirements more systematic and thorough for all economic actors.

Compared to now, NFRD was (almost) bliss!

Up until 2020, extra-financial reporting was essentially based on the Non-Financial Reporting Directive (NFRD) – Grenelle’s younger sibling –, which compelled listed and large-sized corporations (500+ collaborators) to communicate information on the social and environmental repercussions of their activities.

This text was a laudable world premiere, but it has one shortcoming: the indicators (about 150) are not normalized. Each company is therefore free to select its information and calculation methods on each theme imposed by the regulation. On jobs, for example: a company could communicate the total number of employees, the number of full-time equivalents, or the number of employees with permanent contracts. It could also choose the average headcount per month, or even the global headcount on Dec. 31st … This example – a simplifying one, sure – shows how complicated it is to compare the extra-financial performance of one company to another. The Corporate Sustainability Reporting Directive, currently being revised to apply to a larger pool of companies (250+ collaborators), should hopefully include elements to standardize indicators.

Taxonomy vs greenwashing

Since the NFRD was deployed, two major texts were added to strengthen Europe’s anti-greenwashing regulation: the EU Taxonomy for sustainable activities and the Sustainable Finance Disclosure Regulation (SFDR).

The EU Taxonomy is a framework to classify economic activities based on their sustainability. This text’s goal is to channel movements of capital towards businesses which contribute to the fight against climate change and the achievement of the Paris Agreement. Companies will have to indicate how much of their revenues or financial products are eligible to and aligned with the taxonomy.

This Taxonomy allows for a very detailed and thorough analysis. Eurazeo, for example, has developed a thematic fund dedicated to the ecological shift of the maritime sector, called Eurazeo Sustainable Maritime Infrastructure (ESMI). ESMI will finance harbor and maritime infrastructures whose CO2, Nox and Sox emissions will be much lower than current. Maritime transportation is eligible to the Taxonomy, as it is considered to contribute to the fight against climate change. For each project financed by ESMI, it is necessary to determine whether it is green or not, based on:

• Technical criteria of environmental performance: CO2 emissions, fuel consumption…
• DNSH criteria (“Does not cause significant harm”): water consumption, Nox and Sox, other discharges…

For more efficiency and coherence in the fight against climate change, the technical criteria will become more and more demanding in time, and the eligibility principle applied to boats has a major caveat: the vessels dedicated to fossil fuel transport are not eligible, although they answer all the other requirements.

The text is still under development – only 2 out of 6 environmental goals have been published – and a social taxonomy is on its way. This example indicates the level of precision and granularity which is going to be implemented to examine and compare companies’ activities and financial products. It also shows how much work and effort will be needed to collect and verify information, lead evaluations and eventually align any given activity with the European taxonomy.

SFDR: good idea or real puzzle?

There is more good news: to the EU Taxonomy was recently added the Sustainable Finance Disclosure Regulation (SFDR), twin to the NFRD for financial products.

The SFDR makes it mandatory for financial companies to communicate extra-financial information on each of their products and to classify them according to such a typology:

• “Article 6” products do not factor in ESG aspects (or very lightly);
• “Article 8” products imply an obligation of means such as deploying an exclusion policy, doing an ESG due diligence before investment, measuring ESG impacts of underlying assets…
• “Article 9” products have a formalized goal, which therefore makes them the most rigorous and virtuous products on ESG aspects. An “Article 9” fund can have set goals on decarbonation or contribution to a Sustainable Development Goal.

At Eurazeo, a vast majority of assets under management are classified as “Article 8” by design, because ESG has been fully integrated into the investment process for almost 15 years now. In this regard, this new framework consolidates the integrated approach we have developed on ESG, which is also why about 80% of our funds (at raising and management stages) are Article 8 or 9-compliant.

In addition to this ranking, companies also have to share more information on environmental and social aspects in the form of Regulatory Technical Standards (RTS). Some are normalized with calculation methods (I will have to pick up math class), others allow for more creativity… There again, the ultimate goal is to standardize extra-financial data regarding financial products and make it comparable.

Added layers of regulation restrain efficiency

Besides the need to normalize indicators which I just mentioned, there is still one major limit to the efficiency of those regulations, which lies in their layering. The intricacy of these multiple frameworks makes it very hard to understand and execute them in context.

I speak from experience: answering the NFRD (including changes brought by CSRD), all the while deploying the Taxonomy and SFDR is absolutely dizzying. And because France enjoys having its own regulations too, we also have to integrate the complex demands of the Article 173 of the law on Energy Transition and the Article 29 on Energy and Climate, which apply to funds over 500 M€, in addition to the varying recommendations of several financial centers on how to apply these texts correctly.

Making those texts converge is virtually impossible: application perimeters vary from one to another, deadlines vary too, indicators add up to reach preposterous figures (300? 400? 500?). Nobody really knows how much data will be needed or produced in those operations. One thing is for sure: this situation is completely at odds with the (happy ?!) sobriety advocated by sustainable development philosophers.

Let’s stay optimistic … and brave!

In spite of the imperfection of this regulatory construction, clients of financial products have quickly understood the value of Article 8 and 9 products. Those adequately answer the requests of their mandators and make it easier to avoid stranded assets – the companies which have lost value because they didn’t embark on the ecological and social transformation, such as those operating in coal or plastic for example. We are currently witnessing a strong appetite for financial products combining financial and extra-financial value. The European regulations are providing some useful tools of understanding, which were previously missing.

Organizing the combination of multiple regulations, harmonizing methods to create comparable, qualitative data, and simplifying requirements to focus on the most important ones: that’s what’s at stake in the coming months. Let’s all stay optimistic and brave: this regulation is an ambitious work-in-progress, and its current complexity should not obliterate its real usefulness. Considering the ticking clock of the climate and social crisis we are in, it has already had a big positive impact by making us accelerate.