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The European Union has introduced new regulations to promote sustainable economic growth, including the EU Taxonomy Regulation and the Sustainable Finance Disclosure Regulation (SFDR).
These regulations both refer to the principle of "do no significant harm" (DNSH), which aims to ensure that investments promoting sustainability in one area do not cause negative impacts elsewhere in the environment or society. However, the definition and application of DNSH varies between the two regulations, causing confusion among financial market participants (FMPs). In this article, we shed light on the key differences between applying DNSH principles across the EU Taxonomy and SFDR, and how fund managers and companies can comply with both regulations effectively.
The European Green Deal relies on a variety of regulations and policies to promote sustainable economic growth. Two specific regulations that are relevant for FMPs are the EU Taxonomy Regulation and the Sustainable Finance Disclosure Regulation (SFDR). These two regulations are deeply intertwined as they cross-reference each other and share similar principles, while assessing sustainability credentials through slightly different lenses.
One concept that has been developed as a result of these regulations is the "do no significant harm" (DNSH) principle. The DNSH is a central component of both the EU Taxonomy and the SFDR. However, the definition and application of DNSH varies across the regulations, leading to some confusion and concern among FMPs who are impacted by these rules. In light of this, it is important for FMPs to understand the key differences between DNSH principles in the EU Taxonomy and the SFDR in order to comply with both regulations effectively.
DNSH is a principle that aims to prevent otherwise sustainable investments from having a negative impact on the environment or the society. It was first adopted by the EU regulators to prevent short-sighted investment strategies and ensure that investment processes take into account a variety of environmental and social objectives, rather than focusing solely on a single one. The DNSH principle seeks to ensure that actions that support one environmental objective do not negatively impact other objectives. As such, it is a central component for classifying economic activities and financial products as sustainable.
If you want to learn more about the six environmental objectives and the EU Taxonomy, you can read our guides on EU Taxonomy eligibility and alignment.
The EU Taxonomy is a framework that classifies economic activities as environmentally sustainable based on specific Technical Screening Criteria (TSC). Accordingly, the economic activities only qualify as environmentally sustainable if they:
The DNSH principle is outlined in the EU Taxonomy regulation as a requirement to avoid significant harm to any of the environmental objectives set out in the regulation. This is to ensure that economic activities do not qualify as environmentally sustainable if they cause harm to the environment to an extent that outweighs their contribution to an environmental objective.
The EU Taxonomy sets out scientific and target-based DNSH criteria for each activity. For example, an activity that contributes to the “climate change adaptation” objective could have a corresponding DNSH requirement to meet GHG emissions thresholds so as to not harm the “climate change mitigation” objective. Therefore, an economic activity failing to meet the criteria would also not qualify as “Taxonomy-aligned”, despite substantially contributing to a core environmental objective.
The third requirement in the EU Taxonomy is to meet the minimum safeguards. Similar to the DNSH, the minimum safeguards ensure that economic activities that cause social harm are not classified as environmentally sustainable. Therefore, to align with the Taxonomy, companies need to comply with a number of social frameworks including the OECD Guidelines for Multinational Enterprises, UN Guiding Principles on Business and Human Rights, including the declaration on Fundamental Principles and Rights at Work of the International Labour Organisation (ILO), the eight fundamental conventions of the ILO, and the International Bill of Human Rights. Read our article on minimum safeguards to find out more on this topic.
The SFDR aims to provide greater transparency in the financial sector by requiring firms to disclose information about the sustainability of their products and services. The DNSH concept plays an important role in the assessment of sustainable investments as defined by the SFDR
Based on the definition provided in the SFDR, a sustainable investment is defined as an investment in an economic activity that contributes to an environmental or social objective, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices. The DNSH principle is outlined in Article 2 (17) of the SFDR and requires that financial products making sustainable investments ensure that neither the environmental nor the social objectives are significantly harmed. The specific requirements for DNSH compliance are laid out in the regulatory technical standards (RTS) pertaining to the SFDR. Specifically, it states that FMPs can use the principal adverse impact (PAI) indicators to ensure their compliance with DNSH requirements. These indicators include environmental, social and governance (ESG) factors that could have a negative impact on the investment.
In addition, sustainable investments must be aligned with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights. The objective is to bring the principle in line with the Minimum Safeguards in Article 18 of the Taxonomy Regulation and for FMPs to disclose information on how they consider the principal adverse impacts of their investment decisions on sustainability factors.
While there are many similarities in the definition of DNSH in the EU Taxonomy and the SFDR, there are important differences that should be considered. One such distinction is the level at which the DNSH requirements are applied. The EU Taxonomy criteria need to be met at the activity level, meaning it focuses on ensuring that the specific economic activities being classified as environmentally sustainable do not cause harm. On the other hand, the SFDR DNSH principle is more broad and applies at the portfolio company level.
Another distinction is that the EU Taxonomy DNSH has set scientific targets for six environmental objectives. In contrast, the SFDR uses a broader approach and applies the DNSH criteria for both environmental and social objectives. Therefore, FMPs should consider the DNSH requirements for each regulation carefully to ensure compliance with both the EU Taxonomy and the SFDR.
That being said, it is important to stress that the relationship between the EU Taxonomy and the SFDR is a complex and evolving topic in and of itself: if you wish to learn more, we strongly advise that you read our guide on this topic.
By ensuring that investments that contribute substantially to one environmental objective do not also significantly damage another objective at the same time, the DNSH principle plays a central role in the EU’s plan to steer capital towards business activities that have a positive net impact on the planet.
The DNSH principle is featured both in the EU Taxonomy and in the SFDR, but there are some subtle differences about the definition and application of the DNSH in each of these regulations that users need to understand.
Given the complexity of this new regulatory framework, getting it right can be challenging for funds and companies. Our technology can help you at every step of your EU Taxonomy and SFDR reporting journey and streamline the data collection and analysis process. If you want to learn more, grab a virtual coffee with us!
Disclaimer: The information provided in this content is for educational and informational purposes only and should not be construed as legal or investment advice. The content is not intended to be a substitute for professional advice. Always seek the advice of a qualified professional before making any investment or legal decisions. The author and publisher of this content are not responsible for any actions taken based on the information provided. Any reliance on the information in this content is solely at the reader's own risk.
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