ESG is the acronym for environmental, social and governance, which are three criteria in measuring sustainability and ethical impact of an investment in a business or a company. Even though financial products have for years been marketed as "sustainable" or "green" there are no global guidelines as to which factors are to be taken into consideration when evaluating whether an investment is fulfilling these criteria or what these criteria exactly are. In general:
- environmental criteria is deemed to examine how a business is affecting the natural environment through climate change, waste and pollution, resource depletion, greenhouse gas emission and deforestation;
- social criteria is deemed to examine how a business affects society and treats people and is contributing to, employee relations (such as fair pay, benefits, retirement plans) and diversity, working conditions, local communities and health and safety; and
- governance criteria is deemed to examine how a corporation policies itself and how it is managed and focuses on internal strategies such as executive remuneration, management structure, compliance with laws and corruption and bribery and tax strategies.
In order to set some uniform standards to the ESG sector on the EU level, during the summer 2020 the European Council and Parliament adopted Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088 (the "Taxonomy Regulation"). The Taxonomy Regulation sets out a classification system according to which businesses and investors can evaluate whether certain activities are environmentally sustainable, and thus aims to increase transparency and limit the risk of greenwashing (meaning marketing products as environmentally sustainable without sufficient factual basis for such claims) and market fragmentation in the classification of green activities and investment projects. Having uniform criteria would also enable businesses and investors to compare various products with each other. The Taxonomy Regulation addresses mostly environmental considerations, but it can be expected that at least some EU-wide framework will be set out for social and governance factors later on. Based on the Taxonomy Regulation the European Commission shall by the end of 2021 assess whether and how the scope of the Taxonomy Regulation could be extended to cover other sustainability objectives, such as social objectives.
The Taxonomy Regulation does not mandate any investments into economic activities meeting this set of sustainability criteria. It merely provides tools for assessing which businesses or products can be deemed as environmentally sustainable. Member States and the European Union shall apply the criteria to determine whether an economic activity qualifies as environmentally sustainable for the purposes of any measure setting out requirements for financial market participants or issuers in respect of financial products or corporate bonds that are made available as environmentally sustainable. Further, the Taxonomy Regulation applies to financial market participants that make available financial products and sets out certain requirements for financial market participants and large public interest entities on disclosure of information on whether their businesses and products meet the criteria set out in the Taxonomy Regulation.
In determining whether an economic activity is "environmentally sustainable", the Taxonomy Regulation set outs four criteria. An economic activity qualifies as environmentally sustainable if that activity:
- contributes substantially to one or more of the environmental objectives (see below);
- does not significantly harm any of the environmental objectives;
- is carried out in compliance with the minimum social and governance safeguards (such as compliance with the UN Guiding Principles on Business and Human Rights); and
- comply with technical screening criteria to be adopted under the Taxonomy Regulation.
The "environmental objectives" set out by the Taxonomy Regulation are:
- climate change mitigation;
- climate change adaptation;
- 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 Taxonomy Regulation empowers the European Commission to set out technical screening criteria defining "substantial contribution" and "do not significantly harm" for each environmental objective by certain dates set out in the Taxonomy Regulation by adopting delegated acts. These technical screening criteria will be regularly updated based on scientific evidence and input from experts and relevant stakeholders.
On 21 April the first delegated act on sustainable activities for the first two environmental objectives (climate change adaptation and mitigation) (the "Delegated Act") was published. The Delegated Act sets out the technical screening criteria under which specific economic activities qualify as contributing substantially to climate change mitigation and climate change adaptation and for determining whether those economic activities satisfy minimum requirements that need to be met to avoid significant harm to any of the relevant environmental objectives. The Delegated Act sets out sector specific performance criteria for "substantial contribution" and "do no significant harm" in respect of different types of sectors, businesses and products, from growing of different types of crops and generation of electricity to education and arts and entertainment activities. The Delegated Act will be formally adopted at the end of May 2021 and will enter into force at the end of the scrutiny period. The Delegated Act will apply from 1 January 2022 onwards. The technical screening criteria for the last four environmental objectives are to be adopted by 31 December 2021 and applied from 1 January 2023 onwards.
The earlier drafts of the Delegated Act have caused concern prior to its official adaptation. Stakeholders have expressed varying view as to which sectors can constitute environmentally sustainable activity and what those sector specific requirements should be. Further, the earlier drafts of the Delegated Act have been accused of being politics driven rather than based on scientific evidence. It will be interesting to see how the stakeholders react to this now published Delegated Act. The initial view seems to be that the European Commission has listened to some of the concerns from for example the Swedish real estate sector.