The EU Sustainability Regulatory Framework – Finding your Way Through the Maze

By GAIL Europe Regional Board

The EU Sustainability Regulatory Framework – Finding your Way Through the Maze

It is now well known that to promote the sustainable transformation of the economy, the European Union is taking a global lead in establishing the first trans-national sustainability regulatory framework. Eschewing a market-based approach, the EU has taken significant steps in forming meaningful frameworks of interconnecting principles on a grand scale, commonly referred to as “EU Sustainable Finance Framework”.

What remains less clear to many (or perhaps most) is how this framework will impact their business, directly and indirectly – particularly for those whose business extends beyond the geographic scope of the EU. Due to the trickle-down effect, there is no longer any company in Europe – and few outside of it – that is not at least indirectly affected by these regulations. This is not only because large companies and banks are passing on their direct reporting obligations on value chains and financing risks to smaller companies without a direct reporting obligation; or that they have to be prepared for the fact that customers, banks and investors are increasingly demanding sustainability by sending out questionnaires or even requesting sustainability reports based on the CSRD directive. Anyone who refuses or does not answer truthfully must expect, in the worst case, to lose access to EU markets and finance.

The European Board of the Global Alliance of Impact Lawyers (GAIL) is looking closely at the EU Sustainable Finance Framework. GAIL lawyers, in private practice, in-house and in other legal roles are actively engaged with the Sustainable Finance Framework, considering how it aligns with the current best practices in sustainable investing and thinking critically about how it will impact the future of sustainable investment in Europe and around the globe. In order to share this expertise more broadly, we at GAIL have prepared this short, practical introduction to the key aspects of the EU Sustainable Finance Framework.

We will follow with more detailed discussions around specific regulatory requirements and, in coordination with the global GAIL network, draw in the perspectives of the those in the global south, who have both most the benefit and the most to lose, in this rapidly changing regulatory space.

EU Sustainable Finance Framework

The three main EU pieces of legislation that are anchored in the EU Sustainable Finance Framework and are closely interlinked are the EU Taxonomy Regulation, the Corporate Sustainability Reporting Directive (CSRD), and the Sustainable Finance Disclosure Regulation (SFDR).

By creating a lexicon of what we talk about when we talk about sustainability, the EU Taxonomy Regulation effectively allows the rest of the EU Sustainable Finance Framework to work in a coherent and effective way. It provides a classification system that creates a uniform understanding of “green” or “sustainable” and already applies within the framework of the CSRD and SFRD.

• The Taxonomy Regulation directly impacts large companies (i.e. those that have more than 500 employees, and either a balance sheet of more than EUR 25 million or a net turnover of more than EUR 50 million) who are also public interest entities (i.e. EU-listed companies). These companies are required to include (consolidated) non-financial statements information, including how and to what extent their activities are associated with environmentally sustainable economic activities as regards related turnover, capital expenditure (capex) and operational expenditure (opex).
• In addition, by creating a standardized language for sustainability metrics, the Taxonomy Regulation also impacts anyone seeking to recognize sustainability in their own investments – whether in complying with other sustainability linked regulations, commercially through “green” / “sustainable” bonds or similar products, or through advertising their sustainability credentials.

An important aspect of the EU Sustainable Finance Framework is mandatory reporting for an increasing number of companies, both as regards the impact of ESG issues on the company’s value as well as the company’s impact on the environment and society at large (so-called “double materiality”). This also includes, directly and indirectly, non-EU companies, as will be shown in this piece. Reporting requirements require the use of and fluency with the Taxonomy Regulation noted above.

• The first major reporting requirements arise under the CSRD another major piece in the EU sustainability reporting jigsaw. It was adopted in January 2023 and was intended to be implemented into national law by the EU Member States by July 2024, but two thirds of the member states failed to do so. Implementation has been delayed until 2026 for sector specific reporting requirements and non-EU companies only. The CSRD follows a phased-in approach and applies, as of 2024, to all large public interest companies as per the above (reporting in 2025 on 2024 data), followed in 2025 by large companies with more than 250 employees and the same balance sheet total or net turnover as per the above. Implementation has been delayed until 2026 for sector specific reporting requirements and non-EU companies only. As of 2026, reporting obligations will also apply to all EU-listed SMEs (with the exception of micro companies), an obligation which can however be deferred to 2028.
• The CSRD not only applies indirectly to non-EU companies (it requires from in-scope companies to report about their value chain’s ESG impact, to the extent that it is material, applying the above double-materiality test), it also applies directly to certain non-EU companies. This affects in particular those that are listed on a EU regulated market with securities like stocks or bonds (depending on nature and size with reporting obligations starting in 2024, 2025 or 2026); generate annual EU revenues surpassing €150 million, with an EU branch annual net turnover of €40 million (reporting obligations starting in 2028), or generate annual EU revenues exceeding €150 million and own an EU subsidiary considered a large company (reporting obligations starting in 2028).
• According to the first European Sustainability Reporting Standards (ESRS), the focus to date has clearly been on environmental and consumption data, but the importance of social indicators is also increasing. Environmental data is primarily concerned with electricity and energy consumption, the CO2 footprint, wastewater and the emission of pollutants. Social data also reflects the employee structure, safety and health in the company. The governance data includes, for example, information on the implementation of the sustainability issues identified as material in the company’s organizational structure and the implementation of the sustainability strategy in the company’s policies. The provision of the data by the companies and the verification of the data by the financing party involves a great deal of effort.

Effective reporting is not possible without a deep understanding of the supply chain, which itself requires effective due diligence. Apart from wanting to increase the “doing” instead of just the “reporting”, EU policymakers are therefore increasingly also imposing sustainability due diligence obligations on both, certain EU and non-EU companies, forcing these companies (and through them suppliers as well as, in many cases, buyers of these companies) to identify, prevent and terminate certain harmful activities. The latest achievement in this regard is the adoption of the Corporate Sustainability Due Diligence Directive (CSDDD).

The SFDR affects all financial market participants and financial advisors in the EU and all providers of financial products offered within the EU. The SFDR aims to bring a level playing field on transparency in relation to sustainability risks in these markets, the consideration of adverse sustainability impacts in related investment processes and the provision of sustainability-related information with respect to financial products. The SFDR requires asset managers such as AIFMs and UCITS managers to provide prescript and standardised disclosures on how ESG factors are integrated at both an entity and product level. A significant portion of the SFDR applies to all asset managers, whether or not they have an express ESG or sustainability focus.

Developments in this field are ongoing, with the EU trying to clarify and optimize the overall EU sustainability reporting and due diligence framework.

Conclusion

Effective reporting is not possible without a deep understanding of the supply chain, which itself requires effective due diligence. Apart from wanting to increase the “doing” instead of just the “reporting”, EU policymakers are therefore increasingly also imposing sustainability due diligence obligations on both, certain EU and non-EU companies, forcing these companies (and through them suppliers as well as, in many cases, buyers of these companies) to identify, prevent and terminate certain harmful activities. The latest achievement in this regard is the adoption of the Corporate Sustainability Due Diligence Directive (CSDDD), on which we a reporting in a separate piece.