EXECUTIVESUMMARY:OURMAINMESSAGES
This policy brief highlights our main messages regarding the review of the Disclosure Delegated Regulation of the Sustainable Finance Disclosure Regulation (SFDR), currently being drafted by the European Supervisory Authorities (ESAs). This review focuses on the part “Amendments regarding greenhouse gas (GHG) emissions reductiontargets”
Message 1:Thenewemphasison GHG targetsis laudable.Butmoretransparency isneeded on how the reductionisplannedtobeachieved.
WewelcomethatthenewemphasisondisclosingGHGemissionstargetsincludesthreedistinctmechanismsof investorimpact:divestingfromcarbon-intensivecompanies(A),investingincompaniesexpectedtodeliverGHG reductionsovertheinvestment’sduration(B),andengagingwithinvesteecompanies(C)
However, we propose a more nuanced disclosure regarding the pursuit of these strategies. For mechanism A, an explicit linkage between divestment and engagement efforts would illuminate the essential role that engagement plays. For mechanism B, we advocate for the introduction of three investee-level metrics that describe the “transition willingness” of carbon-intensive companies (i.e., target-setting, carbon management practices, and capital expenditures (capex)). For mechanism C, we suggest including another metric that describestheshareofportfoliocompaniesthataretargeted. Tostreamlinethedisclosureprocessfor financial marketparticipants(FMPs),werecommendmandatingthesemetricsforthemostcarbon-intensivesectors.
Message2:Additionaldetaileddisclosuresforcarboncredits(CCs)shouldincludespecificinformationto ensure transparency and allow investors to assess carbon credits and removals (CCs&Rs) and maintain theirenvironmentalintegrity
Controversy surrounding the reporting of CCs&Rs has revealed the need for transparency and mandatory disclosures to protect investors and promote high-quality CCs&Rs that contribute to emission reductions and sustainable development. Considering the evolving international carbon market and the emergence of voluntary and cooperative mechanisms, specific information should be provided to ensure transparency and allow investors to assess CCs&Rs and maintain their environmental integrity. This includes (A) disclosing the name, registry serial number, and verification standards of CCs&Rs. Also clarifying (B) their purpose (mandatory or voluntary), and (C) avoiding double counting by indicating whether corresponding adjustments have been made. Providing this information enables investors to make informed decisions and supportstheeffectivenessofthecarbonmarket.
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LISTOFACRONYMS:
BMBF:GermanFederalMinistryofEducationandResearch
CDM:CleanDevelopmentMechanism
ESAs:EuropeanSupervisoryAuthorities
ESRS:EuropeanSustainabilityReportingStandards
Capex:Capitalexpenditures
CCs:carboncredits
CCs&Rs:carboncreditsandremovals
CSDDD:CorporateSustainabilityDueDiligenceDirective
EFRAG:EuropeanFinancialReportingAdvisoryGroup
ESAs: EuropeanSupervisoryAuthorities
ETS:EmissionsTradingSystem
EU:EuropeanUnion
IFRS:InternationalFinancialReportingStandards
IPP:IndependentPowerProducer
FMP:financialmarketparticipant
GHG:greenhousegas
ISSB:InternationalSustainabilityStandardBoard
NDC:NationallyDeterminedContribution
RTS:RegulatoryTechnicalStandards
SFDR:SustainableFinanceDisclosureRegulation
TPI:TransitionPathwayInitiative
TPT:TransitionPlanTaskforce
TRBC:TheRefinitivBusinessClassification
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POLICYCONTEXT
ESAspublicconsultationonthereviewoftheSustainableFinanceDisclosure Regulation(SFDR)’sDisclosureDelegatedRegulation.
The Sustainable Finance Disclosure Regulation (EU) 2019/2088 (SFDR) aims to increase the transparency of sustainability-related impacts in the financial services sector. The Regulation requires entity-level (organisational)disclosuresandfinancialproduct-leveldisclosuresforFMPsandfinancialadvisors
The EU Commission has mandated the Joint Committee of the ESAs to review and revise the Regulatory Technical Standards (RTS) of the Delegated Regulation (EU) 2022/1288 (hereinafter the Disclosure Delegated Regulation) supplementing the SFDR. The Disclosure Delegated Regulation specifies the content and presentationofthedisclosuresrequiredfromFMPs.TheESAshaveproposednumerousamendments1 tothe DisclosureDelegatedRegulationandhavealsolaunchedapublicconsultationontheiramendmentsonthe12th of April 2023. This review is a key opportunity to increase its usability and meaningfulness, as well as ensure policycoherencewith otherpieces of legislationwithintheEUSustainableFinanceFramework. Thedeadline forcontributiontotheconsultationwasthe4thofJuly2023
This policy brief aims to capture the main issues of concern and main messages that our teams at Climate & Company and Uni Kassel have compiled as part of our analysis of the amendments regarding GHG emission reductiontargetsproposedbytheESAs.
OURKEYISSUESOFCONCERN/MAINMESSAGES
WewelcomethenewemphasisondisclosureofGHGemissionstargetsandtherequirednarrativeexplanation of how these targets will be achieved: A) by divesting from carbon-intensive companies; B) by investing in companiesthatareexpectedtoachieveGHGreductionsoverthelifeoftheinvestment;andC)byengagingwith investeecompanies.Thisdistinctionrecognisestheverydifferentmechanismsofinvestorimpact.Whilethefirst (A) focuses on achieving a reduction in financed emissions, for example by reallocating investments to less carbon-intensivecompanies,thesecond(BandC)emphasisesinvestingincompanieswithcredibletransition plans and employing an active engagement process, with a particular focus on carbon-intensive companies. These two strategies could lead to different results in terms of actual GHG emission reductions in the real economy. For example, looking only at financed emissions would neglect the need to invest in GHG-intensive companieswithviabletransitionplans.
While streamlined reporting on GHG emissions targets allows comparison between financial products, we suggest including further metrics that describe the divestment strategy (channel A), the “transition willingness”ofGHGintensivefirms(channelB)aswellastheengagementeffortsoftheFMP(channelC). This provides retail investors with decision-relevant information about the likelihood that investee companies will deliver GHG reductions over time, as well as the efforts that FMPs undertake via engagement or capital reallocation
ChannelA(Divestingfromcarbon-intensivecompanies):
While engagement should be the first step to incentivise and require investee companies to change their behaviour and business practices (the carrot), divestment serves as a threat in case engagement is not successfulandactionsarenottaken(thestick).ThisdistinctionalignswiththeCorporateSustainabilityDue 1
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Message1:ThenewemphasisonGHGtargetsislaudable.Butmoretransparency isneededhowthisisachieved.
ESAs’Jointconsultationpaper(12th April2023),link
DiligenceDirective(CSDDD) TheEUCommission’sproposalforaCSDDDacknowledgesthatengagementand divestmentmakeupatwo-stepapproach.TheEuropeanCommissionalsorecognisestheimportanceoftrying toexerciseinfluenceonunsustainablepracticesbeforedisengagingordivesting.Wethereforesuggest:
• Disclose link between divestment and engagement (qualitatively). Explain how the two channels are interlinked (e.g., whether divestments from carbon-intensive companies are part of a two-step approach)
[Example:
FMP X has set a GHG reduction target for an equity portfolio FMP X engages with carbon-intensive Company A by agreeing to set a reduction target for the next 2 years Company A is lacking progress. FMP X discloses the following as part of Channel A: For (all/most/some) companies we employ an engagement approach and divest if progress is not achieved ]
ChannelB(descriptionoftransitionwillingness):
Channel B refers to the strategy of investing in companies “that are expected to deliver GHG emissions reductionsoverthedurationof theinvestment” But howcaninvestors havemoretransparency regardingthe “transition willingness” of carbon-intensive investee companies? To increase transparency on this topic, we suggest including additional metrics. To keep the disclosure targeted and feasible for FMPs, we suggest mandatory disclosure for carbon-intensive companies and optional disclosure for non-carbon intensive companies.Thisdistinctionismotivatedbythespecificrelevanceofcurrentlycarbon-intensivesectors,asthey are responsible for most emissions. Considering additional metrics for carbon-intensive companies is also alignedwithbestpracticesfromfinancialecolabels(seetwodetailedexamplesinthefootnote2).
This raises the question of how to definecarbon-intensive companies. We propose an approach at sector and activitylevel(i.e.,definingalistofeconomicactivitiesforwhichadditionalmetricsneedtobedisclosed).Various initiativeshavealreadyattemptedtodefinecarbon-intensivecompanies(or“companiesintransition”).AnonexhaustiveoverviewisprovidedinAnnexI. For companies defined as “carbon-intensive” or as “companies in transition”, we suggest disclosure on the followingmetrics:
• Metric I: Share of “companies in transition” with a science-based target or transition plan: Science-based targets could be defined as the number of firms with targets validated by the ScienceBased Targets initiative. This would be in line with the (optional) criterion “Investments in companies without carbon emissions reduction initiatives aimed at aligning with the Paris Agreement” of Table 2 of Annex I of the Commission Delegated Regulation (EU) 2022/1288. Transition plans could be aligned with European Sustainability Reporting Standards (ESRS) E1-43 or internationally used frameworks, such as the UK Transition Plan Taskforce (TPT) Disclosure Framework 4 and the International SustainabilityStandardBoard’s(ISSB)ExposureDraftsparagraph135
• Metric II: Percentage of “companies in transition” with effective carbon management practices: Transition plan frameworks often include certain governance practices, e.g., TPT encompasses incentives and remuneration as well as board oversight as criteria. Financial incentives linked to sustainabilityperformancemotivatemanagersto aligntheirdecisionswith acompany’ssustainability strategy
6 . Sustainability board committees with sufficient influence in decision-making and expertise
2 NordicSwanEcolabel:Companiesfromcarbon-intensivesectorsareonlyeligibleiftheymeetadditionalcriteria(e.g.,>75%“green”Capex).TheNordic Swanlabelcriteriadefinethefollowingsectors:aluminium,aviation,automobiles,cement,mining,pulpandpaper,shipping,andsteel.(seelabel criteria,link) EUEcolabel:TheEUEcolabeldefinesanextensiveexclusionlistofenvironmentallyharmfulactivities.However, the“supplyanduseof solid,liquidandgaseousfossilfuelsforfuel,energygenerationintheformofelectricityand/orheat,heatingandcoolingusing thesefuels”are exemptedifarangeof“transitioncriteria”aremet(seedraftcriteriav4,link)
3 EuropeanFinancialReportingAdvisoryGroup(EFRAG)(2022),ESRSE1ClimatechangeExposureDraft,link
4 TransitionPlanTaskforce(2022),TheTransitionPlanTaskforceDisclosureFramework,link
5 InternationalFinancialReportingStandards(IFRS)(2022),DraftIFRSS2Climate-relatedDisclosures,link
6 Cohenetal.(2022),ExecutiveCompensationTiedtoESGPerformance:InternationalEvidence,link
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can also boost environmental performance 7 . Hence, disclosing the share of companies with “management-level sustainability-linked financial incentives” or “sustainability board committee” wouldprovidefurtherevidenceforanambitioustransitionplan.
• Metric III: Percentage of capex that “companies in transition” invest in “green” activities: Capex canbeareliableindicatorforcredibletransitionefforts(e.g.,afossilfuelcompanythatinvests100%of itscapexintorenewableenergies).IncorporatingcapexisalsoalignedwiththedraftEUEcolabelcriteria wherecapexis anintegralpart oftheportfolioselection8 “Green”capex, i.e., madeinenvironmentally sustainableeconomicactivities,canbemeasuredviatheEUTaxonomy
Despitethesereducedrequirementsfornon-carbonintensivecompanies,werecommendthatFMPsalsocheck whether these companies have transition plans. As the heading of this newly introduced category (“Does this product have a greenhouse gas (GHG) emission reduction target?)” states, the aim also for the non-carbon intensive companies is to continue to credibly reduce their emissions. Overall, it allows FMPs to credibly demonstratetheirreductiontargetsandavoidgreenwashingrisks.
ChannelC(engagingwithinvestees):
An active engagement approach requires guidance and disclosure on the engagement strategy. For example, engagementtends to bemore effective if financial market participants collaborate through investor initiatives toenhancetheirimpact9.Moreover,labelproviders,suchastheNordicSwanLabelortheEUEcolabelprovide guidance for a successful engagement process. Given these findings, the Delegated Act 2022/128810 could incorporatecollaborationconsiderationsandtheuseofexternalengagementguidelines.
• Metric IV: Percentage of “companies in transition” that were targeted by engagement efforts (IV.A) or where voting rights were exercised in alignment with environmental objectives (IV.B): Investing in carbon-intensive companies can drive change if the investment is accompanied by a structuredengagementprocess.Disclosingthesemetricswillprovidemoretransparency.ThedraftEU Ecolabel’scriterion4(engagement)containsfurtherinsightsonambitiousengagementefforts11
Importantconsideration:Toascertainthatthemostvaluableportfoliopositionssettargetsortransitionplans, thesemetrics are ideally provided in terms of investment sum covered bythe respective metric divided bythe totalinvestmentsum.
ForourresponsestotheremainingquestionsonGHGemissionstargets,pleaseconsultourpublicconsultation document Amongstotheraspects,weargueArt.9(3)productsshouldalsodiscloseinamoreelaboratemanner whatconstitutestheirtargetandwhetheritisalignedwiththe1.5°Cgoal.
Message2:Additionaldetaileddisclosuresforcarboncredits(CCs)shouldinclude specificinformationtoensuretransparencyandallowinvestorstoassessCCs&Rs andmaintaintheirenvironmentalintegrity.
We agree with the ESAs greenwashing concerns surrounding carbon credits (CCs) and believe that it is critical that investors are fully informed regarding their use and quality. As a result, we support additional detailed disclosurestoprovidethisinformation.TherecentcontroversialreportingoncarboncreditsandGHGremovals
7 Baraibar-DiezandOdriozola(2019),CSRCommitteesandTheirEffectonESGPerformanceinUK,France,Germany,andSpain,link
8 EuropeanCommission(2021),DevelopingtoEUEcolabelcriteriaforRetailFinancialProducts,link
9 Kölbeletal.(2020),CanSustainableInvestingSavetheWorld?ReviewingtheMechanismsofInvestorImpact,link
10 Art.29a(1)(iii)andArt.42a(1)(iii)
11 Criterion4ofthedraftEUEcolabelcriteriarequiresapplicantstohaveadocumentedengagementpolicy(describingtheobjective,strategy,methods andmonitoringefforts) Italsoprovidesguidanceonhowtoexercisevotingrights,specifyingwhichcompaniesshouldbeprioritised.Finally,theEU Ecolabelcriterionalsoprovidesacleardialoguepolicy(e.g.,whichcompaniestoengagewithinthefirstplace,anddisclosureoftheengagement process).
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(CCs&Rs),whicharesaidnottohaveledtothepropagatedemissionreductionsasassumed,hasdemonstrated that current reporting primarily serve to protect the reputation of investors as well as the disclosing companies.12We recommend making the detailed disclosure mandatory, as this protects investors and can positively highlight CCs&Rs with high quality standards that lead to emission reductions and sustainable development and set market incentives. Against the backdrop of the re-alignment of the international carbon market, in particular through the current Article 6 market of the Paris Agreement (Art. 6.2 Market and Art. 6.4 Market), alongside the established voluntary carbon market, we recommend that if CCs&Rs are disclosed, the following information is provided to ensure the necessary transparency for investors to assess them and maintaintheirenvironmentalintegrity:
1. The nameof the CCs&Rs, the serialnumber indicating the registry where they are held, and the standards used for verification and transparency in the carbon market (e.g., Clean Development Mechanism(CDM)Standard,GoldStandard,Verra,etc.).Asthereareconsiderabledifferencesinquality betweenthestandards,andasstandardswith lowerqualityrequirementscanalsobeusedunderthe newly emerging Art. 6.2 cooperation mechanism, we propose to provide this transparency-enabling information.
2. WhatpurposetheCCs&Rswereusedfor.Inparticular,adistinctionbetweenuseformandatoryand voluntary purposes is necessary. We are aware that currently there is no provision for the use of internationalemissionallowancesformandatorypurposeswithintheEuropeanUnion,suchastheEU Emissions Trading System (ETS) or the EU Nationally Determined Contributions (NDCs) targets. Nevertheless, there are some EU countries, such as Sweden, that are examining the extent to which they can use international emission certificates for their climate targets that go beyond the EU NDCs. Looking ahead, it is important that there is clarity on this issue, as the carbon market is currently undergoing very dynamic changes. Furthermore, specifying the use of CCs&Rs, whether for corporate carbon targets, CCs&Rs set-aside, national NDCs or to contribute to the mitigation of a developing country's NDCs, etc., favours the incentive to use them, as organisations can then clearly allocate the respective CCs&Rs to their own purposes and positively highlight certain investments as more environmentallyfriendly,butwithseparate disclosureandalwaysspecifyingtheirremainingemissions reductioncommitments.
3. Informationtoavoiddoublecounting.UndertheParisAgreement,AnnexIIcountriesarealsoobliged toformulatetheirownNDCtargetsforthefirsttime.Therefore,inthecarbonmarket,AnnexIIcountries nowhaveaninterestincountingemissionreductionstowardstheirowntargets.Asaresult,thereis a risk of double counting of CCs&Rs emerging. Therefore, it is important that the disclosure of CCs&Rs always indicates whether corresponding adjustments have been made. If no corresponding adjustmentshavebeenmade,itisrecommendedtoprovidepreciseinformationontheuseofCCs&Rs, as explained under point 2, to provide investors enough transparency to rule out the risk of double countingoftheCCs&Rs. 12
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SourceMaterial,2023,derivedfromWest et al.,2020,2023,Guizar-Coutiño et al.,2022
PUBLICATIONDETAILS
ACKNOWLEDGEMENTS
This work was partially financed by the German Federal Ministry of Education and Research (BMBF, “Fördermaßnahme „Klimaschutz und Finanzwirtschaft – KlimFi“) and is part of the joint research project “ClimLabels”.Moreinformationontheprojectpage
CREATEDBY
Climate&Company-TheBerlinInstituteforClimateTrainingandResearchgGmbH
MalteHessenius,NiklasGehrke,MaxTetteroo&LouiseSimon,SimonPfluger
Ahornallee2|12623Berlin
www.climateandcompany.com|hello@climcom.org
UniversitätKassel-FachbereichWirtschaftswissenschaften-FachgebietNachhaltigeFinanzwirtschaft
LisaKnob
Mönchebergstraße19|34125Kassel
www.uni-kassel.de|poststelle@uni-kassel.de
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AnnexI(Definitionoftransitionsectors)
Disclaimer: This is a non-exhaustive overview and is intended to provide a first point of orientation.
Approach1:Basedonenergy-intensity
Benzetal.(2020)13 suggestthefollowingindustry-baseddefinitionoftransitionsectors,whichisbasedonThe RefinitivBusinessClassification(TRBC)(6-digitRefinitivcodeinbrackets) Itstartsbytheenergyindustry, followedbyenergy-intensiveindustriesandproducersandusersofenergy-consumingproducts.Furthermore, duetoitshighdeforestationrisk,paperandforestproductsareadded.
Energyindustry Energy-intensive industry
Coal(501010) Chemicals(511010)
Electricutilities& IndependentPower Producers(IPPs) (591010)
Naturalgasutilities (591020)
Multilineutilities (591040)
Metals & Mining (512010)
Energy-consuming products
Aerospace & defense (transport)(521010)
Automobile & Auto Parts(531010)
Deforestation-prone industry
Paper & forest products(513010)
Oil&Gas(501020)
Constructionmaterials (512020)
Freight & Logistics Services (transport) (524050)
Passenger Transportation Services (transport) (524060)
Transport infrastructure (transport)(524070)
Oil&GasRelated Equipmentand Services(501030)
Approach2:BasedonTransitionPathwayInitiative(TPI)
TheTransitionPathwayInitiativehasthusfaridentified16businesssectorsonthetransitiontoalowcarbon economyacrossfourclusters(Dietzetal.,2021)14
Energy Transport
Coalmining Automobiles
Industrials and materials
Aluminum
Consumer goods and services
Consumergoods
13 Benzetal.(2020),Investors'carbonriskexposureandtheirpotentialforshareholderengagement, link
14 Dietzetal.(2021),TPIStateofTransitionReport2021,link
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Approach3:SectorlistaspartoftheNordicSwanLabel
TheNordicSwanLabelcriteria15 containonesection(O13)on “ReductionsofGHGemissionsincriticalsectors”
Portfoliocompaniesoperatinginhigh-emittingsectors(i.e., aluminium, aviation, automobiles, cement, mining, pulp and paper, shipping, and steel)mustfulfiloneofthefollowingrequirements:
- Atleast>0.3accordingtotheformulaabove;
- Atleast75%ofcapexisalignedwithEUTaxonomy;
- Companyhasavalidatedscience-basedtarget(orsimilaracceptedframeworkfortransition)
- Companyisamongthebest15%inGHGintensity(inaglobalcomparisonofitssector)
(Alternatively,oneofthefollowingcriteriaaremetatfundlevel:50%alignmentofrevenuesforthepartthatis eligibletotheEU’sclimatetaxonomy;fundhasalegallybindingcommitmenttofollowtheEUParis-Aligned Benchmark)
Approach4:EUEcolabelforfinancialretailproducts
Ecolabel v4: supply and use of solid, liquid and gaseous fossil fuels for fuel, energy generation in the form of electricityand/orheat,heatingandcooling
Companiesderivingmorethan5%oftheirturnoverfromthe“supplyanduseofsolid,liquidandgaseousfossil fuelsforfuel,energygenerationintheformofelectricityand/orheat,heatingandcooling”areexcludedunless theyfulfilthefollowingcriteria,demonstratingtheirwillingnesstowalkthetalk:
- Aturnoverofexcludedactivitiesof<30%
- A strategic plan toreduceGHGemissionstoa1.5Calignedlevelincludingcarbonneutralityby2050. Theplanshallalsoincludethephase-outofexcludedactivitiesoverthenext10years.
- ZeroCapex(andzerooperatingexpendituresinmaintenancecosts)forexcludedactivities.
- Scope1GHGemissionsdecreaseannuallybyatleast7%.
Ecolabelv3
TheEUEcolabelcriteriav316 containaspecificdefinitionof“companiesinvestingintransition”(seep.36ofdraft criteriav3)
Copy&Pastefromp.36
A company is considered as investing in transition if:
15 https://www.nordic-swan-ecolabel.org/4ad8eb/contentassets/1831da8fd64f4a04a2b27f6d0f3677a4/criteriadocument_101_investment-funds-and-investment-products-101_english.pdf
16 https://susproc.jrc.ec.europa.eu/product-bureau/sites/default/files/202011/Draft%20Technical%20Report%203%20-%20Retail%20financial%20products.pdf
10 Electricityutilities Airlines Cement Services Oilandgas Shipping Paper Oil and gas distribution Steel Diversifiedmining Chemicals
industrials
Other
• It obtains >95% of its revenue from economic activities in the energy, mobility, manufacturing and/or waste management sectors, and
• It currently generates between 5 and 50% of its total revenue from environmentally sustainable economic activities, and
• A formal commitment has been made to close down capital assets that would otherwise be excluded under criterion 3.1.
In addition, the following shall be demonstrated by the company’s strategic investment plan:
• How the company is investing to increase its’s green revenue base on a projected path to achieve >20% within a minimum of 5 year forward looking period, and
• A commitment to an average green capex over a minimum of 5 years of greater than 20%, based on a two year look back period and a minimum of 3 years forward looking period, and
• The means of raising capital shall be identified, to include own balance sheet resources, loans and bonds
Approach5:TransitionalactivitiesaccordingtotheEUTaxonomy
Another idea to identify transition sectors is to look at the economic activities a company engages in. The EU Taxonomy has thus far identified transitional activities for climate change mitigation in the following five sectors:
- Constructionandrealestate;
- Energy;
- Informationandcommunication(i.e.,dataprocessing,hostingandrelatedactivities);
- Manufacturing;
- Transport.
ThewholelistcanbefoundundertheEUTaxonomyCompass17
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17 link
