Traversing the EU Climate Regulation Jungle

EU Climate Regulation in the Financial Sector

The first step of the European Green Deal was the introduction of the EU Taxonomy in 2020. The EU Taxonomy is a classification system that defines economic activities by sector and subsector, which are aligned with a net zero trajectory by 2050 and the broader sustainability goals covering water, pollution, and biodiversity. The definitions are set by performance thresholds, referred to as technical screening criteria. Financial institutions operating within the EU must disclose how and to what extent their financial products and portfolios align with the EU Taxonomy, with a focus on climate mitigation and adaptation. Alignment with the EU Taxonomy can help financial institutions to identify whether they are on the right track for the net zero economy.

The EU has also put in place the transparency framework SFDR (Sustainable Finance Disclosure Regulation) under which financial market participants, including asset managers and financial advisers, are obligated to categorise their products based on sustainability characteristics (e.g. Article 6, 8, or 9 products; with Article 6 representing those that do not explicitly promote sustainability, Articles 8 those that promote sustainability, and Article 9 those with sustainability as the core objective). Entities must disclose ESG information at both the entity and product level, including how sustainability risks are integrated into decision-making and the consequent impacts on returns. The SFDR requires entities to disclose the proportion of their investments aligned with the EU Taxonomy, creating a direct link between the two regulations.

Summary

These two regulations will likely encourage organisations to restructure their governance frameworks to prioritise ESG factors in their decision-making and strategy. Boards of directors may need specialised committees or external advisory groups to ensure ongoing compliance with EU Taxonomy criteria and the SFDR obligations. Companies will also need to appoint sustainability officers or integrate these responsibilities within existing leadership roles to ensure that financial strategies and ESG targets are aligned. Further, governance structures may increasingly tie executive compensation and board oversight to the achievement of sustainability goals. In the financial sector, bonuses or other incentives may be linked to the degree to which financial products meet sustainability thresholds, while for corporates, alignment with sustainability targets will be critical for accessing capital or attracting ESG-conscious investors. 

Requirements

Financial institutions must provide detailed reports on how and to what extent their investments align with the EU Taxonomy’s sustainability criteria. They must also connect their disclosures to the broader SFDR obligations. Finally, they are required to explain their alignment with net-zero goals, making ESG factors a central part of financial disclosures. 

Timeline

Financial institutions are obligated to fully integrate the EU Taxonomy and the SFDR into their reporting and operational frameworks by 2025, aligning investments with net-zero targets and demonstrating compliance. It is worth mentioning that large financial institutions (with more than 500 employees) were already required to disclose some SFDR-related information from 2021, and further requirements from 2023. 

Potential challenges

• Aligning with both the EU Taxonomy and the SFDR can be resource-intensive and difficult to implement. There is a regulatory overlap between the two regulations and potentially to other national and international requirements which adds complexity and costs, which could be a challenge for smaller institutions with limited resources. 

• The availability of standardised and comprehensive ESG data is limited and remains a challenge, particularly for smaller entities and for those who are dealing with large, diverse, and complex portfolios. 

• The lack of expertise on how to effectively implement these regulatory requirements into the day to day activities is also a challenge, and it could be helpful to get support from third parties (for example this small consultancy firm specialised in the area). 

EU Climate Regulation in the Corporate Sector

Reporting and Disclosure

The CSRD (Corporate Sustainability Reporting Directive), which replaced the NFRD (Non-Financial Reporting Directive) in January 2023, requires companies to disclose alignment of their activities and investments to the broader EU Green Deal agenda. Companies subject to the CSRD are obligated to report according to ESRS (European Sustainability Reporting Standards) which aims to cover the full range of ESG related issues, while staying interoperable and aligned with global reporting standards such as ISSB (International Sustainability Standards Board) and GRI (Global Reporting Initiative) (more about ESRS, ISSB, and GRI in an upcoming article). Note that the CSRD extends beyond banks, but financial institutions will also need to report accordingly.

Due Diligence

The still evolving CSDDD (Corporate Sustainability Due Diligence Directive) is tightly connected with the CSRD but with the difference that the CSRD requires companies to report material impacts and disclose according to the ESRS, while the CSDDD requires them to conduct due diligence on the related sustainability issues (have a look at RiskSphere’s previous coverage on the CSDDD here). Together the two regulations will drive more comprehensive and standardised sustainability reporting and due diligence practices in the corporate sector.

Summary

Like the financial regulations in the previous section, these two regulations will make corporates obligated to take more accountability in sustainability matters. This could include the introduction of new oversight mechanisms within the board to ensure adherence to the reporting requirements of the CSRD and the due diligence obligations of the CSDDD. Governance changes may also involve revising risk management practices to include a broader focus on ESG issues. This could also push organisations to tie executive and board incentives directly to sustainability goals, for example bonuses tied to specific ESG targets or compliance thresholds, with possible penalties for failure to comply.

Requirements

Under the CSRD, companies are obligated to report the sustainability impacts of their activities, investments, and governance. This reporting needs to be comprehensive, covering a wide range of ESG factors. Starting in 2025, the CSRD will also mandate companies to have a Paris Agreement-aligned emissions reduction plan to reach net zero by 2050. It may also be mentioned that auditors are tasked to provide assurance on reporting under the CSRD.

Under the CSDDD, companies are responsible for conducting due diligence to ensure that their operations and supply chains are aligned with sustainability standards. It may be noted that the requirements under the CSDDD will become more stringent as companies must ensure sustainable operations and supply chains. The governing body for the CSDDD is the European Commission, which will oversee the enforcement by national authorities. Non-compliance could lead to penalties and severe reputational risks.

Timeline

Corporations with over 500 employees and listed entities in the EU are already required to report under the CSRD since 2024. Smaller companies will be phased into the reporting obligations in the following steps:

• From 2025: Companies with >250 employees, >€40 million turnover, and >€20 million total assets.

• From 2026: Listed SMEs on EU-regulated markets, small and non-complex credit institutions, and captive insurance undertakings (though SMEs may opt to defer until 2028).

• From 2028: Non-EU companies with >€150 million turnover in the EU or with at least one subsidiary or branch within the EU exceeding certain size thresholds.

The CSDDD will apply to companies, parent companies, and franchises within the EU and from outside the EU (with the same turnover threshold in the EU). The new rules will come into force gradually in the following steps (note that these dates could still shift, depending on final legislative approval and amendments):

• From 2027: Companies with >5 000 employees and >€1.5 billion turnover.

• From 2028: Companies with >3 000 employees and >€900 million turnover.

• From 2029: Companies with >1 000 employees and >€450 million turnover.

Potential challenges

• Ensuring comprehensive reporting and compliance with the CSRD requirements across all the areas of ESG will be a big task for many corporates due to the complexity and overlap between these areas. Similarly, full compliance to the CSDDD will require companies to monitor their supply chains, which can be a tedious exercise for large companies with a complex global supply chain.

• Meeting the dual requirements of the CSRD and the CSDDD will likely involve considerable costs for companies, especially those with outdated reporting frameworks. A challenge here will be to extract the additional value compliance to these regulations could bring the organisation, i.e. making it an opportunity for higher efficiency and transparency within the organisation and not only a regulatory burden.

• As already stated, failing to comply with the CSRD and the CSDDD could lead to significant penalties such as fines and legal charges, not to mention the consequent reputational damages associated with these measures.

Traversing the regulatory jungle with RiskSphere

While these regulations impose a significant compliance challenge for organisations in the financial and corporate sector, they will also offer an opportunity for businesses to enhance their resilience, access to new markets, and transparency. An active ESG strategy represents an evolved approach to value management, expanding beyond traditional shareholder value by incorporating the contributions of all stakeholders to long-term organisational success. Success is measured not just by financial KPIs but through an integrated focus on financial and ESG performance.

As climate regulations evolve, organisations need to adopt initiative-taking governance structures and long-term planning to navigate this new landscape. At RiskSphere we stay at the forefront of these challenges and are always looking for new ways of helping your organisation to navigate the complexities of the current and future regulations.