Bloomberg Brief: Platform on Sustainable Finance Report on Usability and Data

This article was written by Cinzia Chiriac, Head of International Sustainability Policy & Regulatory Affairs, and Nadia Humphreys, Global Head of Sustainable Finance Data Solutions at Bloomberg.

The EU Platform on Sustainable Finance (PSF) recently launched its second usability report “Simplifying the EU Taxonomy to Foster Sustainable Finance” looking at how to unlock the EU Taxonomy’s potential and reduce some of the overhead with compliance. The report is aimed at supporting ongoing policy dialogue around how to streamline the EU Taxonomy as the EU looks to simplify its broader sustainable finance framework over the coming months and years.

For context, the Platform is an advisory body to the European Commission. The latest report outlines several recommendations based on input from Platform Members, industry practitioners, academics and technical experts in this field, following two years of extensive engagement. Nothing in the document binds the Commission to any specific policy outcome.

According to the report, the Platform’s recommendations are sized to reduce the corporate reporting burden by 33%, above the 25% proposed in the Draghi report published last year.

The report focuses on five key usability constraints, discussed in more detail below:

1. Do No Significant Harm (DNSH) assessment
2. Simplification of corporate reporting
3. A simplified Green Asset Ratio (GAR), to encourage green and transition-based lending
4. Broader use of Taxonomy estimates
5. The application of the Taxonomy to small and medium sized enterprises (SMEs)

Do No Significant Harm assessment

For DNSH, the Platform identifies 4 areas of concern:

• Asymmetry between the different users and uses of DNSH
• Consistency and usability in testing criteria
• Control over the verified outcome (assurance)
• International applicability

The Platform proposed a number of recommendations to improve the overall DNSH approach, including:

• Conducting a comprehensive usability test against all DNSH criteria.
• The testing criteria needs to be reviewed overall, highlighting that they can be difficult when assessing turnover (revenue) reporting. This is particularly relevant to the backward-looking nature of the evaluation process, where not all legal obligations may have been met for operations constructed before the testing criteria were introduced.
• Similarly, determining DNSH for capital expenditure (Capex) or debt, and understanding whether an activity will meet the DNSH criteria in the future, can be problematic when the criteria rely on observed outcomes; for example the carbon emissions profile of a new factory which can only be measured when the factory is operational. To address this, the Platform recommends adjusting the current DNSH approach to allow for certain criteria regarding contractual conditions and/or incentives to be defined at the time of approval and monitored during implementation to verify compliance with these conditions over time.
• Testing criteria should be objectively met; the company assessing itself or any independent party evaluating the company should be able to come to the same conclusion on whether a test passes or fails.
• Testing criteria should be accompanied by proof – clarity on what artefacts are needed to evidence compliance like permits, documentation, plans, verification.
• Testing criteria should not depend on third parties, for example, awaiting member states or governing bodies to rule on a matter of law. For example, a construction company that is instructed to perform road maintenance work is asked to have in place measures to mitigate traffic congestion, when that role may be the responsibility of the local authority.
• Wherever possible to do so, international proxies or standards should be referenced or the Commission should allow for estimates and proxies for operations or companies outside of the scope of the Corporate Sustainability Reporting Directive (CSRD).
• Specifically for use of proceeds (e.g. green debt, like loans or bonds) the financial entity should not have any additional due diligence required of them when holding one of these instruments. They should be able to rely on the information given to them at the time of purchasing the security or issuing the debt.
• For credit institutions, further guidance is required for DNSH to be applicable to car loans and mortgages.
• Most significantly, the Platform introduces the concept of “comply or explain” to support a due diligence based approach to evaluating a company’s compliance with DNSH on backward looking tests.

Simplification of corporate reporting

The report identifies several key shortcomings regarding the materiality assessments undertaken for the EU Taxonomy relative to the financial statement, namely around:

• The lack of minimum threshold for Taxonomy turnover and Capex disclosures, unlike the Accounting Directive, which sets minimum thresholds (e.g. IFRS at 10%). This results in a disconnect between the Taxonomy disclosure and the financial statement of the firm. The Platform therefore asks for a materiality threshold to be set, moving disclosure to voluntary for activities that sit underneath the threshold. The exact threshold value is not proposed by the Platform, but they ask for appropriate engagement with all stakeholders and clear guidance before executing this plan.
• The definition of operational expenditure (OpEx) under the Taxonomy is disconnected from financial reporting standards, making it difficult to compute and overall reducing its relevance and usefulness to the end-investment community. As a result of this finding, the Platform recommends only making Research & Development expenses part of the mandatory OpEx KPI, any additional OpEx disclosed would be voluntary.
• The Platform asks for further clarity on the treatment of Capex category C, which exists to allow companies without eligible activities to claim taxonomy-aligned capex for investment in things like energy efficiency of their buildings or the use of low carbon transportation.

A simplified Green Asset Ratio

The Platform undertook a comprehensive analysis on the challenges associated with reporting under the GAR, based on observations from the first reporting year of Taxonomy alignment for credit institutions. Common challenges identified were around the lack of data, complexity of Taxonomy criteria and legal uncertainty in light of the upcoming review of Article 8 disclosure requirements under the Taxonomy Regulation.

A number of recommendations were put forward in the report, aimed at simplifying the existing reporting process while ensuring the information disclosed remains decision-useful, including:

• The report asks for consistency between numerator and denominator for the GAR. The report includes guidance on how to better determine the content of each, including – for example – a recommendation around the treatment of derivatives, inclusion of sovereign, supranationals and government agencies (SSA) use of proceeds exposures, the application to retail lending and the inclusion of listed and unlisted SME financing.
• Given that many financial companies’ activities extend beyond EU-only investment, the Platform recommends the Commission consider allowing international proxies or estimates to complement reporting efforts.
• For retail banking, the report highlights particular usability issues, specifically for mortgages, car loans or lending for home improvements (like the installation of solar panels) where Taxonomy testing criteria (particularly DNSH and Minimum Safeguards) are not wholly applicable. The Platform calls for simplification of those criteria for those financing activities.
• The Platform also noted inconsistencies between the Taxonomy GAR calculation and the EBA Pillar III obligations, advising this to be resolved.
• The Platform also recommends reviewing and simplifying the reporting templates, for which a considerable amount of data is disclosed but only a fraction of which is useful to the reader.
• A review is also requested, in the next Platform mandate, around the proposal to expand the GAR to integrate the trading book, as well as fees and commissions.

Within this section, the Platform also notes that further guidance is needed on GUR. Specifically, the Platform recommends that premiums should be accounted for consistently for both eligibility and alignment purposes. There is also a need to clarify reinsurance requirements, and establish a materiality threshold for the ratio on underwriting activities exposed to the Taxonomy.

Treatment of derivatives

The Platform also reviewed how derivatives should be accounted for across the EU’s sustainable finance framework, namely the Taxonomy Regulation and Sustainable Finance Disclosure Regulation’s (SFDR) principal adverse impacts (PAI) regime and definition of sustainable investment (SI). Currently, there is asymmetry across regimes, and the report notes that derivatives are a challenging issue to address, due to the risk that, if calculated incorrectly, inflated Taxonomy figures may surface with no meaningful exchange of capital to support real economy change. However, derivatives are also considered important instruments used to access markets where a buyer is not a member of the exchange or to mitigate against local tax treatment. Therefore, the Platform highlights it is important to ensure the calculation of key performance indicators (KPIs) for derivatives is fair.

Broader use of Taxonomy estimates

The report notes that while CSRD will improve the availability of the data needed for financial companies to comply with their reporting obligations under the Taxonomy Regulation, there may still be instances where such data is unavailable from underlying investee companies and/or counterparties. In light of this, the Platform considers Taxonomy estimates and proxies should be allowed in certain instances.

Specifically, the Platform recommends:

• At the moment, Taxonomy estimates are permitted for financial product reporting (under articles 5 and 6 of the Taxonomy Regulation). The report asks that the use of estimates is also permitted for article 8 (entity level) disclosures.
• Estimates or proxies should only be used in the absence of company reported data, meaning for companies who do not themselves have an obligation to report under CSRD.
• The Commission should provide guidance on suitable estimates or proxies for financial product and entity level reporting.
• The Platform notes the important role of the International Platform on Sustainable Finance (IPSF) in providing guidance on whether a company reporting under its own domestic taxonomy could be considered a suitable proxy to the EU Taxonomy. This step is considered critical to enhancing global interoperability to ultimately reduce reporting burdens for global market participants.

SME application of the Taxonomy

The report notes that SMEs play a critical role to Europe’s sustainability ambitions, given that 99% of European businesses are SMEs, and estimated to contribute over 50% of the EU’s GDP while being responsible for more than 63% of enterprise CO₂- and broader GHG emissions.

The Platform recommends banks and other financiers to adopt two tailored approaches to classify the loans or other type of financing they provide to SMEs as sustainable (green or transition) finance:

1. A Simplified Approach for listed SMEs (green finance)
2. A Streamlined Approach for unlisted SMEs (transition finance)

An example of what a simplified approach would mean for DNSH, is that:

• The listed SME needs to remain compliant with applicable EU Environmental laws (for which it is in scope)
• The listed SME has due diligence processes in place and reports on them under the upcoming LSME standards indicator GOV-2, and human rights incidents and policies indicator S1-9 and section 3.

With regards to streamlining, most of the Platform advice is relevant to a broad range of stakeholders, not just SMEs, particularly with regards to recommendations around:

• The need for clarity on eligible activities and NACE mapping;
• Making test criteria objective and clear on what a pass looks like (including any evidence e.g. documentation required) under DNSH;
• Clarifying references to EU legislation such as highlighting in the proposed online tool the national transposed legislation when applicable to SMEs;
• Simplifying the life-cycle assessment requirements;

Conclusion

Overall, the report underscores the need for simplification of the EU’s Taxonomy framework, while emphasizing the importance of interoperability between the EU approach and other taxonomies under development across the globe. The publication of the report is timely, as the EU prepares to release an ‘omnibus’ regulation which will look to simplify the reporting obligations across the sustainable finance policy framework, including the Taxonomy, CSRD, and Corporate Sustainability Due Diligence Directive (CS3D).