The effects of the current European ESG regulatory framework and respective challenges for Compliance

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ESG – a catchphrase that everybody is currently talking about. With the focus on incorporating Environmental (E), Social (S) and Governance (G) aspects further into the daily business life, it is a topic that affects more and more companies across all industries and services.

At first, this was primarily driven by challenges such as the ongoing climate change or the political and societal changes towards environmentally friendlier behavior especially backed-up by activist groups such as Fridays for Future [1]. Now, the international responses to the recent global pandemic are more oriented towards sustainability as well as the pressure which is now also increasing from stakeholders and regulators across the globe [2].

Especially regulations determining and disclosing ESG aspects within the financial industry are growing on a global scale. The European Union, with its landmark agreement, is the first supranational regulator that established a common standard for defining when an economic activity can be classified as environmentally sustainable [3]. With further requirements on the ESG disclosure, the European Union is accelerating its European Action Plan to support a more sustainable community [4].

On the one hand, ESG can be used as a material advantage against competitors and is seen as a promising business opportunity to consider the changing customer  preferences more adequately.

On the other hand, new regulatory changes for enhanced disclosure of ESG aspects not only create further transparency for investors, but also inherit compliance risks associated with non-disclosure, inaccurate, incomplete and/or false disclosure as well as greenwashing. In addition, it can also lead to major compliance and reputational risks when enterprises knowingly mislead investors by claiming to pursue ESG strategies whilst at the same time investing in companies that do not comply with them, as recent news showed [5].

Overview on the European regulatory ESG framework

One element of the European Action Plan calls for immediate action by updating the existing regulatory landscape and by complementing it with new regulations to tackle the consequences of climate change, resource depletion and other sustainability-related issues, also with the involvement of the financial industry. The aim is to reduce information asymmetries for end investors and to create overarching harmonized standards [6; recital 8, 10].

Several newly created regulations are based on or include soft law requirements such as the well-known United Nations Charter with its Sustainable Development Goals (SDGs) [6; recital 2]. These soft law requirements often reflect changing societal norms and are per se not binding, but by including them into hard law regulations their importance is being emphasized.

Furthermore, the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin), published several guidelines considering the European ESG regulatory framework, which are also non-binding for the financial services sector, but are considered unwritten law to be obeyed. The ‘Guidance Notice on Dealing with Sustainability Risks’ should provide additional guidance when implementing the various legal and regulatory ESG risk requirements [7]. With the planned draft guidelines on sustainable investment (Nachhaltiges Investmentvermögen) the risk of greenwashing should be reduced by ensuring that investment funds described as sustainable also comply with the respective binding regulatory requirements in their terms of investment [8].

The hard law regulations, the Taxonomy ((EU) 2020/852) and the Sustainable Finance Disclosure Regulation (SFDR, (EU) 2019/2088), with its regulatory technical standards and planned delegated acts form the center of the European ESG regulatory framework. These newly created regulations are binding for all European Member States and have been enacted to widen the scope and importance of the Non-Financial Reporting Directive (also known as the Corporate Social Responsibility Directive, 2014/95/EU) to undermine the European Union’s commitment for reaching the Paris Agreement and the 2030 Agenda for Sustainable Development [6; recital 2].

The Taxonomy defines the requirements for when an economic activity can be classified as sustainable and, in the future, also for the social and governance classification. It lays out the overall standards and sets the fundamentals. With the SFDR, the lawmakers intend to make the integration of sustainability risks, their impact on the return, the consideration of adverse sustainability impacts, the sustainable investment objectives, and the promotion of environmental or social characteristic more transparent within the investment decision-making and the advisory processes [6]. To complement the requirements from the SFDR, the MiFID II regulations (EU) 2017/565 and (EU) 2017/593 are amended to include the sustainability preferences of the customer into the advisory process [9; 10].

Furthermore, the Directives on Alternative Investment Fund Managers (AIFMD) and the Directive on Undertakings for the Collective Investments in Transferable Securities (UCITS) are two of a few more regulations that will also be updated to include ESG aspects.

On top, in Germany, the Federal Constitutional Court with its recently published revolution of the concept of freedom (enshrined in the Basic Law) set another milestone for ESG and its further (national, regulatory) developments. The concept of freedom is expanded to include climate protection, meaning that too little climate protection is seen as restricting freedom, and “a consequentially blind use of freedoms today reduces the freedom of tomorrow” so that “a proportional distribution of opportunities for freedom over all the generations is necessary” [11].

Effects o the current European ESG regulatory framework on Compliance

The wide range of mentioned regulations, though, no matter whether soft or hard law, brings several difficulties for financial services companies.

At first, (new) regulations need to be analyzed, set in context, and have to be harmonized with existing regulations in order to be able to be compliant with them. With new regulations and respective technical standards and guidance being published nearly monthly, it is currently hard to keep track of what exactly is required, what is replaced or changed, when it needs to be implemented and by whom. It also seems that some of the regulations are not aligned or even contradict each other. Misaligned timelines, differing parameters and conflicting terminology are just a few risks the influential advisory group Securities and Markets Stakeholder Group has warned the three European supervisory authorities (ESAs) about [12]. This can lead to ‘diverging measures being adopted at national level and different approaches in different financial services sectors might persist’ [6; recital 9], also causing problems of availability and quality of required data in the near future. In addition, so far only a green taxonomy has been produced, products focused on social objectives would end up being labelled non-compliant with the Taxonomy by default. This fragmented ESG regulatory framework not only undermines the sustainability agenda of European lawmakers’, but also brings enormous risks to the financial services companies that have to implement it. Even small differences in scope and wording can have serious consequences, including costs in compliance, and consequently may lead to reputational damage. Furthermore, misaligned regulations place an unnecessary administrative burden on institutions and risk repetitive workflows with the constant need for adjustment to existing processes and created outcomes.

Eventually, not only the alignment of European regulations will be required, but it will be necessary to effectively tackle the arising worldwide environmental, social and governance challenges, and it will be essential to reach a global common understanding.

Nevertheless, to be able to tackle the mentioned inconsistencies of and keep track with the prevailing regulatory ESG landscape, an effective, comprehensive, and operative compliance program and regular alignment with the business sector is essential. If not yet existing or not running efficiently, the following aspects with Compliance involvement can help to reduce the administrative burden:

  • Ensure that there is a new regulation monitoring process in place to warrant timely information concerning all incoming regulations, regulatory standards, guidance or other supporting materials;
  • Check ESG-related pre-contractual information, marketing materials and other client reports for accuracy, consistency and (regulatory) completeness;
  • Review and assess existing policies and procedures to verify whether additional policies and/or procedures might be necessary;
  • Constantly exchange and take part in discussions with banking associations;
  • Benchmark with competitors;
  • Ensure that the data delivered from data providers or cooperation partners is reliable, accurate and consistent with regulatory reporting requirements and own given standards;
  • Promptly set up (first and second level) internal controls which include the new ESG aspects;
  • Ensure effective (in-house) training of staff on regulatory aspects and the respective importance of ESG requirements, the institution’s classification system as well as ESG-related product criteria matching to client preferences.

These examples show that Compliance ‘can play a valuable role by working with the business to ensure ESG disclosures are accurate, truthful, and complete’ [13], hence increase investor confidence and trust and reduce regulatory consequences at a later stage.


The above assessment shows that the pressure from all sorts of stakeholders, involving lawmakers, regulators or even society at large on the financial industry to adhere to, disclose and report against ESG metrics is rising and increasingly urgent and compelling.

To be able to fulfill the ambitious European Action Plan with its various numbers of frequently arising regulations and comprising materials, enormous efforts have to be made, especially by financial services companies. Involving Compliance as early as possible into adjustments of existing processes, policies, client documents and others could reduce or minimize unnecessary compliance costs, regulatory consequences, and increase investor trust. Additionally, to ensure a timely, accurate and complete implementation of the requested (regulatory) requirements, a transitional application of the new taxonomy-related regulatory technical standards as well as further alignments and harmonization of the European ESG-related regulations would limit the negative effects on the business and compliance processes of financial services companies.

[1] Fridays for Future; here.
[2] European Parliament: Covid-19: the EU plan for the economic recovery, here; 17th December 2020.
[3] European Commission: Regulation (EU) 2020/852 of the European Parliament and the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088; here; 18th June 2020.
[4] European Commission: An Action Plan for nature, people and the economy; here; 27th April 2017.
[5] All Africa online: Central Africa: Deutsche Bank Must End Its Sustainability Farce in Central Africa; here; 15th April 2021.
[6] European Commission: Regulation (EU) 2019/2088 of the European Parliament and the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector; here; 27th December 2019.
[7] BaFin: Guidance notice on Dealing with Sustainability Risks; here;
15th January 2021.
[8] FONDS professionell ONLINE: BaFin will strengere Regeln für Nachhaltigkeitsfonds; here; 17th May 2021.
[9] European Commission: Commission Delegated Directive amending Delegated Directive (EU) 2017/593 as regards the integration of sustainability factors into the product governance obligations; here; 21st April 2021.
[10] European Commission: Commission Delegated Regulation amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms; here; 21st April 2021.
[11] Bernd Ulrich (SZ): Die Befreiung der Freiheit; here; 30th April 2021.
[12] Securities and Markets Stakeholder Group (SMSG): Advice to the ESAs, here;
13th May 2021.
[13] Compliance Week: Compliance playing an increasingly important role in ESG disclosure; here; 23rd December 2019.

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