Commission Publishes FAQs on ESG Article 8 Taxonomy Regulation

On 21 December 2023, the European Commission published a draft notice containing Frequently Asked Questions (the 2023 FAQs) to help interpret and implement certain legal provisions under the EU Taxonomy Regulation.

The 2023 FAQs will be formally published in due course, once they have been translated into the official languages of the EU.

Background

The Taxonomy Regulation is a transparency tool that sets out harmonised criteria for determining whether an eligible economic activity qualifies as environmentally sustainable.  Article 8 of the Regulation includes a disclosure obligation (the Article 8 disclosure obligation), which applies to entities which are already required to include a non-financial statement in their management report under the Non-Financial Reporting Directive (In-scope Entities).

The Article 8 disclosure obligation requires In-scope Entities to include information on how and to what extent their activities are associated with taxonomy-aligned economic activities in their non-financial statements or consolidated non-financial statements.

Article 8 applies to both financial undertakings (i.e., asset managers, credit institutions, investment firms, insurance undertakings or reinsurance undertakings) and non-financial undertakings that qualify as In-scope Entities.

The details of the key performance indicators or KPIs to be used by In-scope Entities are set out in a delegated act (the Article 8 Delegated Act, which we summarised here).

The technical screening criteria (TSCs) which In-scope Entities must use to determine whether or not an eligible economic activity qualifies as being environmentally sustainable are set out in a series of delegated acts:

• the Climate Delegated Act - this sets out TSCs for the first two environmental objectives, namely climate change mitigation and climate change adaptation;

• the Complementary Delegated Act- this amends the Climate Delegated Act to take account of activities related to natural gas and nuclear power; and

• the Environmental Delegated Act - this sets out TSCs for the remaining environmental objectives, namely the sustainable use and protection of water and marine resources, the transition to a circular economy, pollution prevention and control, and the protection and restoration of biodiversity and ecosystems.

The Commission has also previously published four sets of FAQs to provide guidance on various aspects of the Article 8 disclosure obligation.

For more information about the Level 2 measures and FAQs under the Taxonomy Regulation, see our online resource here.

Application of the Article 8 disclosure obligation

In-scope Entities that are non-financial undertakings have been reporting their alignment with the Taxonomy Regulation since 1 January 2023, with financial undertakings due to start reporting during 2024. 

The phased approach is because financial undertakings are largely dependent on receiving data from their non-financial counterparts in order to be able to report. Similarly, while the previous FAQs focussed on the reporting obligations of non-financial undertakings, the 2023 FAQs concentrate on the obligations of financial undertakings. 

What do the 2023 FAQs contain?

The 2023 FAQs contain 71 questions and answers, organised as follows:

General Questions

A. Scope of covered entities (FAQ 1)         

B. Scope of the consolidation of disclosures (FAQ 2)

C. Taxonomy-assessment of exposures to individual undertakings (FAQs 3 - 6)

D. Taxonomy assessment of groups (FAQs 7 - 12)

E. Taxonomy assessment of specific exposures (FAQs 13 - 31)

F. Verification/assurance/evidence of compliance with the TSC (FAQs 32 - 36)

G. Compliance with minimum safeguards (FAQs 37 - 38)

Questions related to specific financial undertakings

A.  Credit institutions (FAQs 39 - 66)

B. Insurance and reinsurance undertakings (FAQs 67 - 70)

C. Asset managers (FAQ 71)

What do Simmons think are the ten most relevant 2023 FAQs?

Our summary of what we consider to be the ten most relevant FAQs is as follows:

1. Scope of covered entities

The Article 8 Delegated Act defines a Financial Undertaking as an asset manager, a credit institution, an investment firm or an insurance or reinsurance undertaking. 

FAQ1 looks at the treatment of entities that would generally be thought of as "financial undertakings" - CCPs, CSDs, leasing companies and payment institutions - and states that, on the basis that such entities are not included within the list of financial undertakings, they should report using the KPIs for non-financial undertakings.

However, these entities are encouraged to publish voluntary disclosures using the KPIs for financial undertakings, and in particular:

• if an entity performs the same activities as a financial undertaking, it may voluntarily report using the KPIs for that financial undertaking; and

• if the entity's home Member State requires it to hold a financial undertaking's licence, then again it may voluntarily report using the KPIs for that financial undertaking.

2. Reporting where counterparty KPIs are unavailable or inaccurate

The availability of counterparty data will be an issue for reporting financial undertakings during 2024, especially where the counterparty is itself a financial undertaking and therefore will also be reporting for the first time.  FAQ5 advises that, where information is not publicly available:

• as a first step, financial undertakings should contact their counterparties in order to obtain the relevant information

• if the relevant information is not available, then the advice is to use KPIs disclosed in previous years (which will not be the case for a financial undertaking counterparty);

• where information from previous years is not available, then the exposure should be reported as not-aligned (i.e., a zero value).

However, this zero value can be contextualised in the reporting entity's qualitative disclosures, and the entity may also choose to voluntarily report an estimated alignment for the counterparty (bearing in mind that voluntary reporting must be kept separate from the mandatory disclosures).

3. Reporting by financial conglomerates

Large groups (i.e., those preparing a consolidated sustainability reporting in accordance with Article 29a of the Accounting Directive) will frequently have several different types of financial undertaking within the group, for example investment firms, insurance undertakings and credit institutions. 

FAQ7 states that the parent entities of such financial conglomerates should follow the prudential scope of consolidation for their activities that fall under prudential regulation and report at group level the consolidated KPIs of their respective business segments. Therefore, the parent undertaking of an investment firm, insurance undertaking and a credit institution would report using the KPIs specified in the following Annexes of the Article 8 Delegated Act:

• Annexes V and VI for the banking activities carried out by the credit institution;

• Annexes VII and VIII for the investment activities carried out by the investment firm; and

• Annexes IX and X for the insurance activities carried out by the insurance undertaking.

In addition to this, and to fulfil the requirement to report at group consolidated level, the parent undertaking would also compute and publish in the contextual disclosures referred to in Annex XI, a consolidated group-level KPI in the form of a weighted average of the corresponding KPIs for the banking, investment and insurance activities, weighted in proportion to the turnover derived from each activity.

4. Exposures to regional governments

The Article 8 Delegated Act provides that exposures to central governments, central banks and supranational issuers are to be excluded from both the numerator and denominator of the KPIs of financial undertakings. FAQ15 clarifies that "central governments" includes all administrative departments of a state and all of central agencies whose competence extends over the whole territory of that state.  Therefore, exposures to regional governments, municipalities or to undertakings whose owners or shareholders are central governments, central banks and supranational issuers are not covered by the exclusion.

5. Exposures to entities not subject to the Accounting Directive

As noted previously by the Commission, while the Article 8 Delegated Act provides that exposures to (EU and non-EU) undertakings which do not fall under Articles 19a and 29a of the Accounting Directive are excluded from the numerator of the KPIs of financial undertakings, it goes on to provide that financial undertakings should include in the numerator the proceeds of environmentally sustainable bonds and debt securities whose purpose is to finance specific identified activities and assets regardless of whether or not the issuer is itself in scope of the Accounting Directive.

FAQ16 states that in addition to this, financial undertakings are free to report voluntary information or estimates of the Taxonomy-alignment of such excluded exposures (again bearing in mind that voluntary reporting must be kept separate from the mandatory disclosures).

6. Exposures to securitisations, structured notes and covered bonds

FAQ27 sets out the following treatment for each of these asset classes:

• Securitisations: financial undertakings should adopt a "look through" approach:

• Originators/banks should not include the underlying assets sold to the SPV on the basis that the will have no remaining legal or economic ownership of the assets.

• Investors should look through their exposure to the SPV and assess the Taxonomy-alignment of the underlying assets.

• Structured notes: reporting will depend on the structure of the note:

• Where the use of proceeds is known, it can be reported as Taxonomy-aligned to the extent that the proceeds are financing Taxonomy-aligned economic activities or assets and

• Where the use of proceeds is unknown, its Taxonomy-alignment will depend on the KPI of the issuer of the structured note.

• Covered bonds: on the basis that (unlike securitisations) they are kept on the balance sheet of the issuer

• Issuers/originating banks should disclose the Taxonomy-alignment of the collateral assets in the same way as it does for all of its other on-balance sheet assets.

• Investors: where the use of proceeds in unknown, the investor should use the KPI of the covered bond issuer to compute the numerator of its own KPI and, for covered bonds where the use of proceeds is known, the investor should assess to what extent the proceeds are financing Taxonomy-aligned economic activities or assets.

7. Requirement to review documents attesting compliance with the TSC

When assessing the Taxonomy alignment of financing where the use of proceeds is known, financial undertakings are entitled to base the assessment on information provided by the counterparty.  However, FAQ33 points out that financial undertakings are required under sectoral regulations to conduct adequate due diligence to ensure their own compliance with the applicable law. On this basis, financial undertakings should check whether the information concerning Taxonomy alignment provided by their counterparties includes adequate documentary evidence that respective individual TSC are met. Q33 provides several illustrations of this principle, for example where a TSC requires verification by an independent third party, a financial undertaking should receive a copy of this verification, and a declaration by the client that the verification was performed would not suffice to infer Taxonomy-alignment of the economic activity.

8. Do financial undertakings have to comply with minimum safeguards or is this only relevant at the level of the investee company?

Under the Taxonomy Regulation, the requirement to comply with the minimum safeguards under applies to the entity that performs an economic activity and which claims that its activity is Taxonomy-aligned. 

FAQ37 clarifies that when computing the KPIs relating to the Taxonomy-alignment of their exposures to other undertakings, financial undertakings themselves do not therefore need to comply with the minimum safeguards given that financing activities are not as such Taxonomy-eligible. The FAQ goes on to state that financial undertakings should obtain adequate documentary evidence that their counterparties meet the minimum safeguards, before deeming exposures to those undertakings to be Taxonomy-aligned.

9. Treatment of repo contracts

FAQ44 clarifies that repos that are recorded in a credit institution's banking book should be considered as "loans and advances" for Taxonomy reporting purposes, on the basis that a repo transaction is a form of collateralised lending where a securities seller (equivalent to a borrower) agrees to sell those securities to a securities buyer (equivalent to a lender) temporarily and both parties simultaneously agree to reverse this transaction at a specified later date.

On this basis:

• The borrower in the repo should account for the exposure to the securities in its own Taxonomy KPI during the term of the repurchase transaction; and

• The lender in the repo should account for the repurchase transaction exposure as 'loans and advances' and use the KPI of the borrower to compute the numerator of its own Taxonomy KPI for the repo exposures in the banking book.

10. Assigning NACE codes to exposures for the purpose of template 2 of the GAR disclosures

A credit institution filling in the GAR template is required to provide the NACE code of the counterparty's main activity.  FAQ61 states that:

• if the exposure refers to more than one entity, it should refer to the NACE code of the principal activity of the counterparty that was the most relevant for the institution to grant the exposure;

• if the counterparty is a holding company, the credit institution should consider the NACE sector of the principal activity of the specific counterparty controlled by the holding company which received the funding.

Conclusion

The 2023 FAQs provide clarity to financial undertakings on a number of important points as they prepare for the first year of reporting Taxonomy-alignment.  It is interesting that several of the FAQs refer to the difficulties that financial undertakings will face in respect of the availability and accuracy of counterparty data. 

We have been closely monitoring the evolution of the EU sustainable finance regulations and their interaction with regulations in other jurisdictions and are assisting a large number of financial and nonfinancial undertakings with their ESG reporting obligations.

Please contact us to discuss how we may help you.