CSRD, SFDR, Taxonomy and CSDD: What does that all mean?

I wrote my doctoral thesis on the financing of social enterprises. One of the first projects where I applied this knowledge was an ex-ante evaluation titled “Imperfections in the social investment market and options on how to address them”. It was written in 2013 for the European Commission and analyzed the options to mobilize more funding for social enterprises.

Since then I have been involved in other topics on a European level such as a market analysis for the InvestEU Fund, the evaluation of the Social Business Initiative (SBI) which involved some 400 interviews and a study on impact investing and human rights for the European Parliament. 

During this time, I have probably spent more than 12 months reading every piece of legislation, accompanying documents, work plans and evaluation studies and learned something: You can summarize all initiatives and action plans in a single paragraph, but it is impossible to oversee the resulting complexity.

The example of the Social Business Initiative

Let me give you an example. The Social Business Initiative was meant to achieve four objectives:

Personally, I think that is more than enough to understand the Social Business Initiative. It was also largely successful in achieving its objectives.

All concrete actions are then measures to contribute to these objectives. For example, social entrepreneurship became a part of a program for small and medium-sized enterprises (COSME) and there was one action line dedicated to the promotion of the social economy and social enterprises. This was part of a push to help social enterprises becoming eligible as target group in public programs.

The complete map is shown in the following figure.

The same happens when it comes to access to finance with four different expect outcomes:

For example, guarantee schemes managed by the EIF are an efficient method to attract private capital to the sector. However, the concrete names of these programs are of secondary importance.

My main point is that it is important to start with the objectives or expected outcomes of an action plan. All concrete actions are then “just” a measure to achieve the objectives.

CSRD, SFDR, Taxonomy and CSDD

Let us now move to everything around CSRD, SFDR, Taxonomy and CSDD. What does that even mean?

Personally, I prefer to think about the flow of information and capital. There are different ways how companies can be incentivized to change their operations. For example, we have been involved in project around the Carbon Border Adjustment Mechanism (CBAM) which incentivizes non-EU companies which export to EU markets to cut their carbon emissions. It is quite clear that these mechanisms work efficiently.

There are also all forms of regulation around standards and information regulation. Of course, there are support schemes which should help companies to employ persons with disabilities, change their car fleet or support start-ups. Obviously, this is a very important part of the overall regulatory landscape.

The second part is the flow of information from the investments to the capital owners influencing investment decisions. Obviously, (retail) investors decide where they want to allocate their funding.

SFDR, Taxonomy and CSRD focus on the investment decisions of the capital owners. First, the capital owners need better information from the capital managers which is covered in the SFRD. Second, the capital managers need this information first. This is covered in the CSRD and the Taxonomy.  

CSRD

The Corporate Sustainability Reporting Directive (CSRD) is a reporting requirement which was published in 2021 and entered into force in early 2023. We can expect the first reports in 2025 based on FY2024 number.

It was part of the European Green Deal and aims to contribute to the completion of the Capital Markets Union. Investors will have better and more comparable non-financial information.

The following figure shows the relevant objectives which drove the development of the CSRD. At a general level, it was important to reduce systemic risks, direct capital flows to companies that address and social and environmental problems and strengthen the social contract between companies and citizens.

This leads to a set of specific objectives. For example, the information should be comparable across all reporting companies. This sounds like a small thing but led to the development of the European Sustainability Reporting Standards (ESRS).

CSDD Directive

The Corporate Sustainability Due Diligence Directive (CSDD Directive) changes the governance practices of companies as it entails a duty (!) to identify and mitigate negative social and environmental impacts. It also includes a duty for the directors.

The intervention logic of the CSDD is best outlined in the Commission Staff Working Document. In general, the CSDD’s objectives will be achieved through the

  1. increasing directors’ accountability for sustainable value creation and incorporating (long-term) sustainability factors in decision-making of companies; and
  2. increasing corporate responsibility for preventing and mitigating adverse human rights and environmental impacts, including in companies’ value chains, in line with the EU’s international commitments regarding human rights and the environment. 

This means that there is a need for clarification, the integration of sustainability risks and the improvement of corporate governance practices.

Taxonomy

The EU Taxonomy is a classification system of sustainable activities which entered into force in the summer of 2020. There is a close relationship of the Taxonomy to the CSRD and the SFDR as is shown in a figure below.

In general terms, the Taxonomy Regulation sets out 4 overarching conditions that an economic activity must meet in order to qualify as environmentally sustainable:

  1. Making a substantial contribution to at least one environmental objective;
  2. Doing no significant harm to any of the other five environmental objectives;
  3. Complying with minimum safeguards; and,
  4. Complying with the technical screening criteria set out in the Taxonomy delegated acts.

Obviously, this needs to be done in a very sector-specific way. As of 2024, these criteria have been developed for economic activities than can contribute to climate change mitigation and climate change adaptation. For example, the Commission Delegated Regulation (EU) 2021/2139 of 4 June 2021 supplementing Regulation (EU) 2020/852 of the European Parliament and of the Council outlines the technical screening criteria for areas such as inland freight water transport, production of heat/cool from bioenergy or storage of hydrogen.

The developments are quite promising. The numbers from a staff working document published in 2023 show that 139 companies (22.9%) report that their capital expenditure (CapEx) is already aligned with the Taxonomy.

SFDR

The Sustainable Finance Disclosure Regulation (SFDR) is a transparency framework to help capital owners to make better informed investment decisions.

There is an accurate observation in a document saying that “while the SFDR was meant as a disclosure regime, the market has been using it in a different way, namely as a labelling scheme.” This is also the reason why most are familiar with Article 8 or Article 9 funds. For example, fund managers need to disclose information such as the one below if they want to offer “financial products referred to in Article 9”.

However, let us take a look at the Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector. It is meant to “lay down harmonised rules for financial market participants and financial advisers on transparency with regard to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability‐related information with respect to financial products.”

The regulation also includes how remunerations should be linked to sustainability risks but three articles are important.

Article 4 introduces the “Transparency of adverse sustainability impacts at entity level”. This article mandates that financial market participants publish on their website how they consider principal adverse impacts of investment decision son sustainability factors.

Article 8 specifies transparency requirements for financial products promoting environmental or social characteristics. It requires financial market participants to disclose how these characteristics are met and the consistency of any associated benchmarks.

Article 9 mandates specific pre-contractual disclosures for financial products with sustainable investment objectives, ensuring transparency in how these products align with sustainability goals. It requires disclosure of the alignment of any designated index with the sustainable investment objective and, if applicable, how it differs from broad market indices.

The Joint Committee of the European Supervisory Authorities has published a consolidated Q&A version on the SFDR and it shows the relationship between Article 8 and 9 products and the links to the Taxonomy.

Conclusion

It is clear that misalignments and confusion in the market still exist in the market. However, structures will be developing continuously and converge on common practices.

Going forward, I expect that all companies across the European Union will start reporting on their sustainability activities as it is a part of the funding process. For this reason, I would keep an eye on the VSME:

EFRAG launched a second workstream on sustainability reporting standards for small, medium enterprises (‘SMEs’) in November 2022 namely VSME. The workstream is outside the CSRD mandate and it is triggered by market needs for a voluntary sustainability reporting standard for non-listed SMEs and micro-entities to support them in facing the ESG requests of banks or partners in their value chain.

We can also expect that more capital owners want to have a portfolio aligned with sustainability preferences. At the moment, it is more about the equity and investment side, but we can also expect more activities for credit institutions.