ESG Regulations in the European Union

The 2014 Non-Financial Reporting Directive (NFRD) was one of the main ways the EU historically required certain companies to report on ESG issues. The regulation applied to EU “large public-interest companies” with more than 500 employees – around 12,000 companies in all. It was designed to encourage investors and financial executives to consider non-financial performance metrics when evaluating companies.

Specifically, the NFRD required covered companies to report on five categories of non-financial disclosures:

1. Environmental matters

2. Social matters and treatment of employees

3. Respect for human rights

4. Anti-corruption and bribery

5. Board diversity (including age, gender, and background)

For each of these topics, the NFRD required companies to provide information regarding the company’s business model, policies, risks, and non-financial key performance indicators.

However, as is discussed below, the NFRD has since been replaced with the CSRD which is far wider and more expansive in scope.

The EU Taxonomy Regulation was established in 2019 as part of the European Commission’s Action Plan on Sustainable Finance. The Taxonomy serves as a classification device, to establish a common understanding of how “sustainable” is defined. It focuses on a company’s activities – and classifies when those activities can be characterized as “environmentally sustainable” or “green.” It is meant to encourage investments towards sustainable economic activities pursued by companies, promoting environmentally friendly practices and standards.

The Taxonomy classifies activities as “sustainable” if they meet four criteria:

1. The economic activity contributes to one of the six enumerated environmental objectives (discussed below);

2. The economic activity does ‘no significant harm’ (“DNSH”) to any of the six environmental objectives;

3. The economic activity meets ‘minimum safeguards’ such as the UN Guiding Principles on Business and Human Rights to not have a negative social impact; and

4. The economic activity complies with the technical screening criteria (“TSCs”) (as defined by legislation called delegated acts — the first of which was applicable since January 2022 and the second as of 2023).

As discussed, to be sustainable, the first criterion economic activity must contribute to at least one of the six environmental objectives listed by the Taxonomy. These are:

1. Climate change mitigation;

2. Climate change adaptation;

3. The sustainable use and protection of water and marine resources;

4. The transition to a circular economy;

5. Pollution prevention and control; and

6. The protection and restoration of biodiversity and ecosystems.

The Taxonomy initially elaborated TSCs for 70 climate change mitigation activities 68 climate change adaptation activities. TSCs for the remaining four objectives were published in March 2022.

The Taxonomy is meant to work together with other EU ESG legislation. Companies covered by the new Corporate Sustainability Reporting Directive (“CSRD”) (discussed below) will be required to disclose: “(i) how and to what extent its activities are associated with environmentally sustainable economic activities; and (ii) information on the proportion of its turnover, capital expenditure and operating expenditure (together, its KPIs) derived from products or services associated with environmentally sustainable economic activities.” And, financial market participants covered by the Sustainable Finance Disclosure Regulation (“SFDR”) (also discussed below) may need to disclose how the activities the financial products they fund meet the Taxonomy criteria.

The Taxonomy also has a number of voluntary uses. For example: firms can use the Taxonomy criteria as an input to their environmental and sustainability transition strategies and plans; companies can elect to meet the criteria of the EU Taxonomy in order to help attract green investors; and investors can choose to use the Taxonomy as part of their due diligence when looking for sustainable investments.

The Sustainable Finance Disclosure Regulation (“SFDR”) was adopted as part of EU’s 2018 Sustainable Finance Action Plan “to improve transparency in the market for sustainable investment products, to prevent greenwashing and to increase transparency around sustainability claims made by financial market participants.” Effective starting March 10, 2021 (with certain disclosures required starting January 2022), the regulation generally applies to Financial Advisors (“FA”) and Financial Market Participants (“FMP”) based in or who market their products to the EU. Practically speaking, the SFDR covers banks, investment fund managers, financial consultancy firms, insurers, and pension fund administrators (though different requirements may apply depending on the size of an organization).

The SFDR focuses on disclosures regarding information on how ESG considerations are incorporated at both a company level and a product level. Some requirements apply to covered firms regardless of whether they have an ESG or sustainability focus. These include specific firm-level disclosures (which may vary depending on the size of the firm) regarding how covered entities address sustainability risks and principal adverse impacts. Sustainability risks are ESG issues (such as climate change) that could have a material negative impact on an investment. Principle Adverse Impacts (“PAIs”) are the negative effects that investment advice or decisions could have on sustainability factors. In addition to sustainability risks and PAIs, asset managers are also required to disclose information regarding the relationship between renumeration policies and sustainability risks.

The SFDR also requires different product-level disclosures, depending on the nature of the product. The SFDR classifies the products and services into three types of sustainable categorizations:

1. Article 6 (grey): Have no ESG focus and make no sustainability claims.

2. Article 8 (light green): Promote ESG factors and may invest in sustainable investments, but do not exclusively target ESG investments.

3. Article 9 (dark green): Specifically focus on sustainable investments.

The more a product focuses on ESG, the greater the requirements imposed by the SFDR are. Article 6 products are required to disclose “a Sustainability Risk Report that shows how ESG risk factors affect current investments and how these risk factors are integrated into future and current investments, as well as a Remuneration Policy which must be consistent with the SR Report.” If an Article 6 product does not integrate sustainability risk into its investment decisions it has to explain why. Products covered by Articles 8 and 9 require further disclosures, including information regarding the “EU taxonomy alignment of the products’ contents . . . .” Additionally, FMPs “must also disclose information on the products’ environmental and social characteristics for Article 8 products, and information on obtaining the products’ objectives for Article 9 products, as well as the methods of measuring and monitoring these points of information for both.”

The EU approved the Corporate Sustainability Reporting Directive (“CSRD”) in November 2022 as part of the European Green Deal. The CSRD is the successor to the Non-Financial Reporting Directive (“NFRD”) – providing more detailed reporting requirements and covering more companies (approximately 49,000 companies compared to around 12,000 under the NFRD).

The CSRD is generally aligned with both the Sustainable Finance Disclosure Regulation (“SFDR”) and utilizes the EU Taxonomy. Like the NFRD, under the CSRD companies will need to report on: (1) environmental matters; (2) social matters and treatment of employees; (3) human rights; (4) anti-corruption and bribery; and (5) board diversity. The new CSRD further requires covered companies to:

• Report using double materiality (discussing both the impact of their business on ESG issues and the risks that ESG challenges may pose to the company)

• Formulate long-term ESG targets and policy

• Conduct due diligence for both their own operations and supply chain

• Cleary identify who is responsible for ESG targets and progress

• Engage in integrated reporting and mandatory external assurance by an independent auditor.

The CSRD itself provides broad outlines for the required reporting. The detailed disclosure requirements will be filled in by the European Financial Reporting Advisory Group (“EFRAG”) and adopted by the European Commission through delegated acts. EFRAG submitted its first set of standards (the European Sustainability Reporting Standards or “ESRS”), which are expected to be adopted in June 2023. EFRAG is expected to release a second set of ESRS in the comping months that will apply to ten high-impact and/or energy intensive sectors.

The initial proposed ESRS include “two ‘cross-cutting’ general standards for how companies should prepare their disclosures, including explanations of how to define materiality, requirements for how sustainability information should be included in a company’s management report, and guidelines for how companies will be required to include information on other entities in their upstream and downstream value chains.” It also included ten topical standards providing detailed disclosure requirements for:

• Environmental factors: including climate change; water and marine resources; biodiversity and ecosystems; pollution; and resource use and circular economy.

• Social factors: including the company’s own workforce; workers across the value chain; impacted communities; and consumers/end-users.

• Governance factors: including corporate culture, business conduct policies, anti-corruption and bribery efforts, and lobbying activities).

The ESRS’s proposed climate change standard is extremely thorough and covers, inter alia, company’s Scope 1, 2, and 3 greenhouse gas emissions. In fact, commentators have observed that the CSRD goes even beyond the Task Force on Climate-Related Financial Disclosures (“TFCD”) – requiring (for example) double materiality, stakeholder consideration, and a focus on a 1.5°C (rather than a 2.0°C) warming scenario.

The CSRD will be rolled out in four phases. Currently, reporting will be required in:

• 2025 for companies already subject to the NFRD;

• 2026 for large companies not subject to the NFRD (defined as companies meeting two of the three criteria: more than 250 employees, €40 million in turnover, and €20 million in total assets);

• 2027 for listed small and midsize enterprises (“SMEs”) (except for micro undertakings), small and non-complex credit institutions and captive insurance undertakings; and

• 2029 for third-country undertakings with more than €150 million net revenue in the EU if they have an EU branch or subsidiary that meets certain thresholds.

The European Union (EU) adopted a new regulation establishing a Carbon Border Adjustment Mechanism (CBAM) in May of 2023. This new regulation aims to protect the EU market from the risk of ‘carbon leakage,’ which occurs when EU-based companies import carbon-intensive products from countries with less stringent climate policies or relocate their production to these countries. Carbon-intensive goods from countries without a carbon price gain a competitive pricing edge over goods produced within the EU’s Emissions Trading System (EU-ETS). This misalignment in environmental incentives between trading nations can diminish the overall impact of the EU’s ambitious climate policies and could even increase overall emissions. The regulation aims to support the EU in achieving its ambitious climate policies and to motivate global industries to adopt greener technologies.

How CBAM Works

The Carbon Border Adjustment Mechanism aligns the carbon price of imported goods with those produced domestically.

1. Embodied Emission Assessment: Initially, the process begins by evaluating the carbon emissions embedded in imported goods.

2. Carbon Price Assignment: The goods are then assigned a carbon price for the embedded emissions, aligned with the average weekly price of the EU Emissions Trading System (EU ETS).

3. CBAM Certificates: Importers are required to purchase CBAM certificates equivalent to the emissions of their imported goods. Companies must annually report the volume and associated GHG emissions of their imports, surrendering sufficient CBAM certificates priced based on the weekly average price of EU ETS. Financial obligations kick in starting January 1, 2026.

Implementation Regulation

On August 17, 2023, the EU Commission adopted the implementation regulation laying down the implementation and reporting obligations for the transition period of CBAM, effective from October 1, 2023 to December 31, 2025. The transition period will focus on reporting, rather than requiring payments or adjustments. This regulation specifies:

1. Quarterly Reporting Obligations

During the transitional period, entities engaged in trading must submit quarterly reports, although financial payments or adjustments are not required until after December 31, 2025. The transition period serves as a pilot to collect and analyze data and thereby to optimize the methodology for emission calculation and reporting for later stages.

Entities are required to submit their CBAM report to the CBAM Transitional Registry by the month following the end of each quarter. These reports must detail:

1) The volume of CBAM goods imported

2) Country of origin

3) The embedded direct GHG emissions

4) Production methods and qualifying parameters

5) The Carbon price already paid abroad

2. Scope of Goods

The initial application will cover imports of certain goods and selected precursors identified as carbon-intensive with the most significant risk of carbon leakage, including:

1) Cement

2) Iron and Steel

3) Aluminum

4) Fertilizers

5) Electricity

6) Hydrogen

3. Methodology for calculating embedded emissions of imports

The methodology for calculating the embedded emissions of imports under the CBAM allows for flexibility during the transitional phase. Companies can choose from the following reporting methods until July, 2024:

1) The EU Methodology:

a) Calculation-based approach: Emissions are calculated using activity data from laboratory analysis or standard values using measurements systems

b) Measurement-based approach: Emissions are measured by monitoring the concentration of greenhouse gases in flue gas and the flue gas flow rate

2) Alternative GHG Monitoring Schemes:

Until December 31, 2024, other GHG measurement methods are allowed, which include:

a) A carbon pricing scheme where the production installation is located

b) A mandatory emission monitoring scheme where the installation is located

c) An emission monitoring scheme at the installation which can include verification by an accredited verifier

3) Default Values

Until July 31, 2024, if the reporting entity lacks the necessary information for the above methods, they may utilize default values for reporting based on established reference values.

Development of CBAM after the Transition Period

Starting from January 1, 2025, the EU will mandate the exclusive use of the “EU Methodology” for calculating the embedded emissions of imported goods. The use of estimations and default values will be limited to complex goods.

As the EU ETS gradually eliminates free allowances from 2026 to 2034, the CBAM will be simultaneously phased in. Before the definitive system launches, CBAM's transitional phase will be evaluated. Furthermore, the scope of products under CBAM will be reassessed, potentially expanding to include more sectors covered by the EU ETS and other relevant goods by 2030.